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Security Analysis

Security Analysis. The Role of Income Statements. General Notes On Accounting. Role of accountant versus role of financial analyst Regulated by FASB – a self-regulatory organization Principles versus rules. Assumptions Monetary Unit Economic Entity Going Concern Periodicity.

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Security Analysis

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  1. Security Analysis The Role of Income Statements

  2. General Notes On Accounting • Role of accountant versus role of financial analyst • Regulated by FASB – a self-regulatory organization • Principles versus rules Assumptions Monetary Unit Economic Entity Going Concern Periodicity Principles Matching Cost Full Disclosure Constraints Materiality Conservatism

  3. The Relationships between the Financial Statements Statement of Cash Flows–1/1/04–12/31/04 Net cash flow from operating activities Net cash used by investing activities Net cash provided by financing activities Change in cash balance Beginning cash balance (12/31/03) Ending cash balance (12/31/04) Balance Sheet–12/31/04 Balance Sheet–12/31/03 Assets Cash Other current assets Long-term investments Long-lived assets Intangible assets Liabilities and Stockholders’ Equity Current liabilities Long-term liabilities Contributed capital Retained earnings Assets Cash Other current assets Long-term investments Long-lived assets Intangible assets Liabilities and Stockholders’ Equity Current liabilities Long-term liabilities Contributed capital Retained earnings IncomeStatement–1/1/04–12/31/04 Revenues − Expenses = Net income Statement of Retained Earnings 1/1/04–12/31/04 Beginning retained earnings balance + Net income − Dividends Ending retained earnings balance

  4. Analyst Role • Collect Important Facts About Business • Identify and Analyze Key Investment Controversies • Identify Gaps Between Intrinsic Value and Market Price

  5. Obstacles to Success • Inadequate or Incorrect Data • Uncertainty of Future • Wacky Market Conditions

  6. The Research Process • Why Write a Report? • What is the First Step of the Written Research Process?

  7. Written Research Process • Build a Financial Model Income Statement Balance Sheet Cash Flow Statement • Begin with Public Documents (10k, 10Q) • Does what I see make sense???

  8. Financial Models • Good Models Lead to Good Management Discussions • Good Models Should Inform Rather Than Impress • Good Modeling Requires Critical Thinking

  9. Begin with the Income Statement • Most Widely Used Statement • Most Widely Manipulated Statement • Examination of Balance Sheet and Cash Flow Statement Validate Truth of the Income Statement

  10. Income Start With Stated Income Statement Numbers and Adjust Why Adjust?

  11. S&P 500 Reported, Operating and Adjusted EPS

  12. Earnings Management Tools • Timing of Investment Spending • Revenue Recognition • Capitalize Operating Expenses • Write - Offs • Bad Debt Reserves • Income from Investments • Pension Expense

  13. Other Earnings Adjustments • Employee Stock Options • Repeated One-time Charges • Accretive/Dilutive Acquisitions

  14. Cisco Systems (dollars in millions) Summary Income Statement Source: Mark Kleiman

  15. Cisco Systems Cisco Systems (dollars in millions) Source: Mark Kleiman

  16. Employee Option Impact ($ in millions) Value of Options Granted Adjusted Pre-tax Income Pre-tax Income (1) Source: Mark Kleiman

  17. Financial Reports Restatements in U.S. in 1990-2002(Sources: Financial Executives International and General Accounting Office) From: “Minding Our Manners” Shyam Sunder, Yale University

  18. Serial Restructuring H.J. Heinz Company ($in millions) Results as adjusted Source: Mark Kleiman

  19. Discretionary Expenses Colgate Palmolive Source: Mark Kleiman

  20. Procter & Gamble Company(dollars in millions) The adjustment for restructuring charges and options is the average five year earnings impact. The adjustment for postretirement benefits is the lower earnings impact of using a 7% investment return for 2002. The discretionary expenses adjustment incorporates the earnings impact of a 10% advertising / sales expense ratio for 2002. Source: Mark Kleiman

  21. Top 11 Measures • Cash from Operations • Cash from Operations / Earnings • Days Sales Outstanding (DSO’s) • Operating Asset Turnover • Operating Margins • Loan Loss Reserves • Days of Inventory Turnover • Employee Stock Options • Capital Expenditure to Depreciation Ratio • R&D / Marketing Spending to Sales • Restructuring / One Time Charges

  22. Illusory Earnings Growth Through Accretive Acquisition Acquirer Target Earnings $10 $10 Shares 10 10 EPS $1 $1 Shares O/S, Price 10, $40 10, $20 P/E 40 20 Market Cap $400 $200 Theoretically, combination value = $400 + $200: Earnings = $20, so P/E = $600/$20 = 30. EPS = $1.33 33% growth! Alternatively, if the combination P/E migrates to the Acquirer P/E of 40: Stock price goes from $40 to $53.33 (+33%) and EPS remains $1

  23. Growth Investor Income Statement • Rate of Growth of Revenue and Earnings • Consistency of Growth • Acceleration and Deceleration

  24. Value Investor Income Statement • Bottom Line (GAAP) Oriented • Focus Quality of EPS and Conservative Accounting • Evaluate History of EPS Cycle • Valuation Driven by Whole Cycle Earnings

  25. Conclusion • Analyst must employ both Qualitative and Quantitative methods. • Focus on creating Rational Basis for Purchase • Assess what Accounting Issues impact sustainability of Revenue and Income Performance. • Start with Income Statement and Adjust with a Cynical eye.

  26. Zero Value Growth ∆ Capital * Cost Equity (r) Franchise Value Growth (∆ Capital * (ROE-R)) Operating Leverage ∆ ROE * Capital 0 Valuing Future Growth Value Impact + or - + or -

  27. Outputs of Fundamental Analysis New Products Existing Products Revenues Channels Regions Fixed Operating Income Capacity Variable Fixed Operating Profit Margin [PM] Marketing Variable Fixed - Required Revenues R&D Variable - Growth RNOA Fixed Other Variable Revenues Operating Asset Turnover [opATO] Net Operating Assets (NOA) Source: Trevor Harris, Morgan Stanley Equity Research

  28. Profitability Map Operating Margin High Multiple Area Low High High Operating Asset Turnover Canned Food Area Low Source: Trevor Harris, Morgan Stanley Equity Research

  29. Healthy margins likely to persist Stable base of business Significant sources of upside revenues Profile of High P/E Stock

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