Chapter 17 Company Analysis

Define fundamental analysis at the company level. Explain the accounting aspects of a company’s earnings. Describe the importance of EPS forecasts. Estimate the P/E ratio of a company. Use the beta coefficient to estimate the risk of a stock. Learning Objectives

Last step in top-down approach is individual company analysis Goal: estimate share’s intrinsic value  Constant growth version of dividend discount model  Value justified by fundamentals Fundamental Analysis

Multiple Growth Rate Y1-2=8% Y3-4=6% Y 5 → 3.5% forever D5 =3.50; RR=12% P0=?

Earnings multiple could also be used P 0 = estimated EPS  justified P/E ratio Stock is under- (over-) valued if intrinsic value is larger (smaller) than current market price Focus on earnings and P/E ratio  Dividends paid from earnings  Close correlation between earnings and stock price changes Fundamental Analysis

How is EPS derived and what does EPS represent? Financial statements provide majority of financial information about firms Analysis implies comparison over time or with other firms in the same industry Focus on how statements used, not made Accounting Aspects of Earnings

Balance Sheet  Items listed in order of liquidity (assets) or in order of payment (liabilities)  Assets Cash vs. non-cash assets  Non-cash assets may be worth more or less than the amount carried on the books Depreciation methods for fixed assets Inventory evaluation choices Basic Financial Statements

Balance Sheet  Liabilities Fixed claims against the firm  Equity Residual claims Adjusts when the value of assets change Linked to Income Statement  “Snapshot” at one point in time Basic Financial Statements

Income Statement Sales or revenues - Product costs Gross profit - Period Costs EBIT - Interest EBT - Taxes Net Income available to owners - Dividends Addition to Retained Earnings EPS and DPS Basic Financial Statements

Earnings per share EPS = Net Income/average number of shares outstanding  Net Income before adjustments in accounting treatment or one-time events Certifying statements  Auditors do not guarantee the accuracy of earnings, but only that statements are a fair financial representation Basic Financial Statements

EPS for a company is not a precise figure that is readily comparable over time or between companies  Alternative accounting treatments used to prepare statements  Difficult to gauge the ‘true’ performance of a company with any one method  Investors must be aware of these problems Problems with Reported Earnings

Important to determine whether a company’s profitability is increasing or decreasing and why Return on equity (ROE) emphasized because it is a key component in finding earnings and dividend growth EPS = ROE  Book value per share Analyzing a Company’s Profitability

Share prices depend partly on ROE Management can influence ROE Decomposing ROE into its components allows analysts to identify adverse impacts on ROE and to predict future trends Highlights expense control, asset utilization, and debt utilization DuPont Analysis

ROE depends on the product of:  Profit margin on sales: EBIT/Sales  Total asset turnover: Sales/Total Assets  Interest burden: Pre-tax Income/EBIT  Tax burden: Net Income/Pre-tax Income  Financial leverage: Total Assets/Equity ROE = EBIT efficiency  Asset turnover  Interest burden  Tax burden  Leverage DuPont Analysis

Expected EPS is of the most value Stock price is a function of future earnings and the P/E ratio  Investors estimate expected growth in dividends or earnings by using quarterly and annual EPS forecasts Estimating internal growth rate  EPS 1 = EPS 0 (1+g) Obtaining Estimates of Earnings

Future expected growth rate matters in estimating earnings, dividends g = ROE  (1 – Payout ratio)  Only reliable if company’s current ROE remains stable  Estimate is dependent on the data period What matters is the future growth rate, not the historical growth rate Estimating an Internal Growth Rate

Security analysts’ forecasts of earnings  Consensus forecast superior to individual Time series forecast  Use historical data to make earnings forecasts Evidence favours analysts over statistical models in predicting what actual reported earnings will be  Analysts are still frequently wrong Forecasts of EPS

What is the role of expectations in selecting stocks?  Old information will be incorporated into stock prices if market is efficient  Unexpected information implies revision Stock prices affected by  Level and growth in earnings  Market’s expectation of earnings Earnings Surprises

Analysts attempt to guess earnings Company provides “guidance” as to what it thinks earnings will be “Guidance number” plays a major role in the consensus estimate Variance of the actual reported earnings has constituted the earnings surprise Earning surprises are guided by companies in the form of earnings preannouncements Earnings Game

The surprise element in earnings reports is what really matters There is a lag in adjustment of stock prices to earnings surprises One earnings surprise leads to another  Watch revisions in analyst estimates Stocks with revisions of 5% or more – up or down – often show above or below-average performance Using Earnings Estimates

Measures how much investors currently are willing to pay per dollar of earnings  Summary evaluation of firm’s prospects  A relative price measure of a stock A function of expected dividend payout ratio, required rate of return, expected growth rate in dividends The P/E Ratio

Dividend levels usually maintained  Decreased only if no other alternative  Not increased unless it can be supported  Adjust with a lag to earnings In theory, the higher the expected payout ratio, the higher the P/E ratio  However, growth rate will probably decline, adversely affecting the P/E ratio Dividend Payout Ratio

A function of the riskless rate of return and a risk premium k = RF + RP Constant growth version of dividend discount model can be rearranged so that k = (D 1 /P 0 ) + g  Growth forecasts are readily available Required Rate of Return

Risk premium for a stock regarded as a composite of business, financial, and other risks If the risk premium rises (falls), then k will rise (fall) and P 0 will fall (rise) If RF rises (falls), then k will rise (fall) and P 0 will fall (rise) Discount rates and P/E ratios move inversely to each other Required Rate of Return

Function of return on equity and the retention rate g = ROE  (1 – Payout ratio)  The higher the g, the higher the P/E ratio P/E ratio depends on  Confidence that investors have in expected growth  Reasons for earnings growth Expected Growth Rate

Regardless of detail and complexity, analysts and investors seek an estimate of earnings and a justified P/E ratio to determine intrinsic value Security analysis always involves predicting an uncertain future; mistakes will be made and outlooks will differ Fundamental Security Analysis in Practice

Appendix 17-A Financial Ratio Analysis Used to examine a firm’s financial performance A ratio on its own has limited value – to be useful, one must examine:  Trends  Ratios of comparable firms or industry benchmarks

Five types of ratios used to analyze a firm: 1. Liquidity: ability to generate cash and meet short-term debt 2. Asset Management: ability to effectively manage its assets to generate sales and profits 3. Debt Management: ability to effectively handle its debt 4. Profitability: ability to generate profits 5. Value: market value versus accounting values Appendix 17-A Financial Ratio Analysis

STATEMENT OF INCOME: Total Revenue Cost of Sales Depreciation/Amortization Interest Expense Research / Exploration Other Expense Unusual Items Pre-Tax Income Income Tax Earnings BEFORE Extra. Items Extraordinary Items Income AFTER Extra. Items Dividends - Preferred Shares Income Available to Common Shares Earnings /Share Common Shares - Year End (1000s) Common Shares - Average (1000s) Dividends - Common Shares Market Price per Share (Close) Example

ASSETS: Cash & Equivalent Accounts Receivable Inventory Marketable Securities Other Current Assets Fixed Assets - Gross less: Accumulated Depreciation Fixed Assets - Net Assets LIABILITIES AND EQUITY: Bank Loans & Equivalent Accounts Payable Current Portion of L-T Debt Current Liabilities Long-Term Debt & Debentures Deferred Taxes & Credits Equity: Preferred Stock Common Stock Retained Earnings Total Equity Liabilities + Equity

XYZ COMPANY FINANCIAL RATIOS: Current Ratio Acid Test (Quick) Ratio ACP (days) Inventory Turnover Total Asset Turnover Debt Ratio Debt-to-Equity Ratio Equity Multiplier TIE (or Interest Coverage) Net Income Margin6.23%4.27%3.46%3.52%2.99% Return on Assets (ROA)7.73%4.72%3.90%3.51%3.11% Return on Equity (ROE)16.93%14.69%14.42%11.98%13.49% P/E Ratio M/B Ratio Dividend Yield1.75%2.24%2.68%1.11%1.81% Dividend Payout Ratio

INDUSTRY AVERAGES FINANCIAL RATIOS: Current Ratio Acid Test (Quick) Ratio ACP (days) Inventory Turnover Total Asset Turnover Debt Ratio Debt-to-Equity Ratio Equity Multiplier TIE (or Interest Coverage) Net Income Margin8.47%6.03%4.34%4.19%5.68% Return on Assets (ROA)15.08%8.64%5.95%5.27%7.01% Return on Equity (ROE)23.68%15.72%10.59%8.96%12.20% P/E Ratio M/B Ratio Dividend Yield1.71%1.73%2.86%2.67%2.08% Dividend Payout Ratio

A. Liquidity 1. Current Ratio = Current assets / Current liabilities For XYZ (2004): = 2,418,600 / 2,265,800 = Quick Ratio = [CA – Inventory] / Current liabilities For XYZ (2004) = (2,418,600 – 1,803,100) / 2,265,800 = 0.27

B. Asset Management 3. Average Collection Period (ACP) = Account Receivable / (Sales/365days) For XYZ (2004): = 380,400 / (4,448,000/365) = days Note: A/R Turnover = Sales / Acct Receivable = 365 / ACP For XYZ (2004) = 365/31.22 days = times

B. Asset Management (Cont’d) 4. Inventory Turnover = Cost of goods / Inventory or= Net Sales / Inventory For XYZ (2004) (using COGS): = (4,005,800) /1,803,100 = 2.22 times Days Inventory = Inventory / Daily COGS (or Sales) = 365 / Inventory Turnover For XYZ (2004) = 365/2.22 = days 5. Total Asset Turnover = Sales / TA = 4,488,000 / 4,270,000 = 1.042

C. Debt Ratios 6. Debt Ratio = Total Debt / TA = (2,265, ,700) / 4,270,000 = Debt-to-Equity = Total Debt / Total Equity = (2,265, ,700) / 984,100 = TA = Debt + Equity

C. Debt Ratios (Cont’d) 8. Leverage Ratio (or Equity Multiplier) = TA / Equity = 4,270,000 / (984,100) = Higher values More debt 9. TIE (or Interest Coverage) = EBIT / Interest = (150, ,000) / 79,000 = 2.91 times

D. Profitability 10. ROE = NI / Equity = 132,800 / 984,100 = 13.49% 11. ROA = NI / TA = 132,800 / 4,270,000 = 3.11% 12. Net Income Margin = NI / Sales = 132,800 / 4,448,000 = 2.99%

E. Value Ratios 13. Dividends Payout = DPS / EPS or = Common Dividends / Earnings Available to Common Shareholders = 32,200 / 130,200 =.2473 = 24.73% 14. P/E = Market Price per Share / EPS = / 0.85 = 13.68

E. Value Ratios (Cont’d) 15. Market-to-book (M/B) = Market price per share / Book value per share = / [(984,100 – 34,100) / 154,280] = / 6.16 = Dividend Yield = DPS / Market price per share = (32,200 / 153,237) / =.21 / = 1.81%

DuPont Analysis Tax Burden Interest Burden EBIT Efficiency TA Turnover NI / Sales = Net Income Margin NI / TA = ROA Leverage Ratio = TA / Equity Leverage Ratio

Net Profit Margin Asset Turnover Leverage Ratio

XYZ (2004) NI / EBT = 132,800 / 150,900 =.880 EBT / EBIT = 150,900 / (150, ,000) = 150,900 / 229,900 =.656 EBIT / Sales = 229,900 / 4,448,000 =.0517 Sales / TA = (previously calculated) TA / Equity = (previously calculated) ROE = (.8800)(.6564)(.0517)(1.042)(4.339) =.1350 = 13.50% This differs from the 13.49% we calculated previously due to rounding errors

XYZ (2004) NI / Sales = (previously calculated) Sales /TA = (previously calculated) Calculate ROA = (.0299)(1.042) =.0311 = 3.11% (equals the 3.11% previously calculated) TA / Equity = (previously calculated) So, ROE = (.0299)(1.042)(4.339) = 13.52% (differs from 13.49% previously calculated due to rounding errors)

Liquidity Below average  Current and quick ratios of 1.07 and 0.27 are both well below industry averages of 1.69 and 1.09 Bad trend  Current ratio has been steady, but quick ratio has deteriorated significantly Low and deteriorating quick ratio is due to high levels of inventory

Asset Management Collections as measured by ACP is above average (31 days versus 47 days) and is improving Inventory turnover is very low (2.3 versus industry average of 8.2), and has been continually deteriorating, and they maintain high inventory levels TA turnover is below average, has been over the period, and continues to deteriorate

Debt Management Debt levels have increased steadily and coverage has deteriorated  Debt ratio is 0.76 (from 0.51 in 2000)  Debt-to-equity is 3.28 (from 1.11 in 2000)  Coverage is 2.91 (from in 2000) Debt capacity and coverage are both below average  Debt ratio is 0.76 versus 0.32 industry average  Debt-to-equity is 3.28 versus 0.55 industry average  Coverage is 2.91 versus 8.61 industry average

Profitability Steady decline in net income margin, ROA, and ROE over period Below industry averages, except for ROE  ROE is above average due to use of greater leverage (as noted above)

DuPont Analysis XYZ (2004)  ROE = (NI/Sales) (Sales/TA) ((TA/Equity) = (.0299)(1.042)(4.339) = 13.51% Industry averages (2004)  ROE = (NI/Sales) (Sales/TA) ((TA/Equity) = (.0568)(1.23)(1.74) = 12.16% This analysis suggests that XYZ displays an above average ROE due to its higher leverage factor, and despite the fact it has below average profitability and asset turnover

Value Ratios P/E and M/B ratios are close to average, which is also the case for their dividend yields (Note: a lower dividend yield implies a higher price) They have been close to, or slightly above average over the entire period This suggests the market views XYZ as an “average” company despite some of the problems we have observed

Summary Below average and deteriorating in terms of liquidity, inventory turnover, and debt management However, they are profitable, even if they are not up to industry standards, and their profitability is dwindling The market views XYZ as an “average” company despite its problems XYZ will probably have to deal with its debt, inventory and liquidity problems in order to maintain an average valuation in the market

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