Fundamental Analysis and Stocks Economics 71a: Spring 2007 Mayo, Chapter 9 Lecture notes 3.3

Why Read or Care?  Investment strategies Growth  Use accounting numbers to estimate growth Value  Compare accounting numbers to price

Goals  Accounting statements  Financial ratios  Ratios and valuation

Accounting Statements  Income statement  Balance sheet  Statement of retained earnings  Statement of cash flows

Income Statement  Flow variables  Revenues – Cost of goods sold

Income Statement Example  Sales revenues $50  Cost of goods sold $-25  Advertising/Admininstrative expenses $-2  Depreciation $-5  Interest payments $-1  Taxes $-3  Earnings = $14  EBIT = Earnings before interest and taxes = = $18 (operating income)

Extraordinary Items: One Time Income and Expenses  “Below the line”  Should come after other items  Part of total earnings  Left out of EBIT “core earnings”, “operating earnings”  Definitions are blurry on this

Examples  Lawsuit settlements  One time asset sales (patents/real estate)  Pension fund adjustments  Changing accounting systems

Income Statement Example  Total revenues $50  Cost of goods sold $-25  Advertising + Admin. expenses $-2  Depreciation $-5  Interest payments $-1  Taxes $-3  **Earnings = $14 (“core earnings”)  EBIT = Earnings before interest and taxes = = $18 (operating income)  Lawsuit settlement = $-8  Earnings = $6

Balance Sheet Accounting Value of the Firm  Assets (things firm owns)  Liabilities (Loans)  Stockholders’ equity (Assets - Liabilities) Also called  Book value  Net worth

Assets  Cash  Accounts receivable  Inventories  Land  Plant and equipment Less: Depreciation

Liabilities  Accounts payable  Notes payable (short term debt)  Long term debt

Balance Sheet  Assets Cash $5 Plant and equipment $100  Liabilities Accounts payable $1 Long term debt $75  Shareholder equity = $29 Book value

Balance Sheet  Shareholders equity Common stock (at issue)  $10 Capital surplus  $5 Retained earnings  20 Purchased stock (negative)  Treasury stock = 29

Cash Flow  Pure measure of incoming - outgoing cash  Differences with income statement No depreciation No accounts payable/receivable Inventories (account for costs of producing and putting in inventory)

Cash Flow Parts  Operating Activities  Investment Activities  Financial Activities

Operating Cash Flow  Earnings = $5 Adjust to get to cash flow  Depreciation : +5 –Why? Remove depreciation adjustments  Increase in accounts payable: +5 –Why? Haven’t paid this yet.  Increase in accounts receivable: -2 –Why? Haven’t received this yet.  Increase in inventories: -10 –Production costs reflect only goods sold. Adjustment: = 3 = operating cash flow

Investment Cash Flow  Increase in gross fixed assets  Purchases of new plant and equipment  -30 million : New office building  Total investment cash flow = -30 million

Finance Cash Flow  Increase in long term debt:  +50 million of incoming funds  Dividends:  -20 million payout of divs  Total finance cash flow = +30 million

Depreciation  Assets “wear out”  Firms slowly write them off  Balance and income statements  Types of depreciation Straight line depreciation  Same amount each year  Example: 10 years, $100,000 = $10,000 per year Accelerated depreciation  More in the early years Production based depreciation

Tax Impact of Depreciation (Timing Effects, 10% tax rate, Asset size = 300) Year (Straight) Earnings Before D Deprec.Tax (Accel.)

Goals  Accounting statement  Financial Ratios  Ratios and valuation

Financial Ratios  Ratios of various financial variables  Uses Analyze financial well being of a firm Compare different stocks in terms of current values  “Find good investments”

Ratios  Liquidity ratios  Activity ratios  Profitability ratios  Leverage ratios  Coverage ratios  Market ratios  Dividend payout ratio

Liquidity Ratios  Current ratio Current assets / Current liabilities Short term, ability to pay bills  Quick ratio (Current assets - inventory) / Current liabilities Take short term inventory out of current assets

Activity Ratios  Inventory turnover Sales/(Average inventory)  Receivables turnover (Annual credit sales)/(accounts receivable) High number indicates rapid turnover in credit sales  Fixed asset turnover Sales/(fixed assets) (land, plant + equipment)

Profitability Ratios  Operating profit margin EBIT/Sales  Net profit margin Earnings/Sales  Gross profit margin (Revenues-Cost of goods sold)/sales

Profitability Ratios  Return on total assets (ROA) Earnings/(total assets)  Return on equity (ROE) Earnings/(shareholder equity)

Leverage Ratios  Debt to net worth Debt/(share holder equity)  Debt ratio Debt/(total assets)

Coverage Ratios  Times-interest earned EBIT/ (interest charges)

Market Ratios  Share price versus accounting value  Very important  Examples Price/Earnings ratio Market/Book (M/B) ratio Dividend yield (dividend/Price)

Price Earnings Ratio P/E Ratio

Price Earnings Ratio  Price per earnings  Example: Microsoft  About 20  $20 per $1 of earnings

High Flying P/E’s  AOL (1999) near 600  Dell Computer (1999) 100  For many dot com’s no P/E since earnings are zero

PEG Ratio

Market to Book Ratio (M/B)

Market to Book Ratio  Market value of the firm relative to its accounting value  Key tool for “value investors”  Extensive academic evidence that low market to book firms do better on average

Dividend Yield  Dividend/Price % payout in dividends relative to price A little like interest, but not really Dividends are not guaranteed

Dividend Payout  Net Income Dividends Retained Earnings  Dividend Payout ratio = Divs/Earnings

Goals  Accounting statement  Financial Ratios  Ratios and valuation

Fundamental Analysis  Use information about firm to evaluate stock price  Growth Estimate earnings growth and future prospects  Value Find “undervalued” stocks

Ratio Analysis  Many methods  Compare ratios to appropriate comparison set  Example: P/E ratio for a pharmaceutical firm Compare to industry If low -> buy

Problems With Accounting Information  Misses “intangibles” Knowledge base (patents) Customer base  Sometimes numbers are zero or negative

More Problems with Accounting Information  There are many ways to derive accounting numbers  Large “fudge factors”  Can clever accountants make things look better?

Accounting “Tricks”  Off balance sheet items Enron Stock options  Expenses to balance sheet Worldcom AOL maintenance -> new investment  Log revenue forecasts now Xerox  Taking over low p/e firms

Goals  Accounting statement  Financial Ratios  Ratios and valuation