Fundamental Analysis

Overview of Company Analysis Once we’ve completed the economic forecast and industry analysis, we can focus on choosing the best positioned company in our chosen industry Selecting a company will involve an analysis of: –The company’s management –The company’s financial statements –Key drivers for future growth Obviously, we are looking for companies with the best management, strong financials, great prospects, and that are undervalued by the market Always remember that the past is irrelevant, what you are buying is future results

Evaluating Management Strong management is vital for companies to perform in accord with the highest expectations of investors Unfortunately, evaluating the quality of a company’s management team is very difficult, especially for individual investors Professionals have the advantage in that they have many contacts within the industry who are familiar with the management team, and they can visit the company and talk with the team personally Information on Management: –Read the 10k – it has information on the background of executives and board members. Information includes age, pay, stock ownership, etc –Read the business press – There are often stories which provide insights into the character and abilities of senior management –Call investor relations – They can answer any reasonable questions that you may have –Study the financial statements – Good management leads to solid financials

Financial Statement Analysis There are three statements to watch: –Income statement –Balance sheet –Statement of cash flows Two major tools: –Ratios –Growth rates

The Income Statement Information about the firms revenues and expenses over some previous time period) The key variables to watch are revenues, gross profit margins, operating profit margins, net profit margins We especially want to evaluate the quality of the firm’s earnings

Quality of Earnings Under GAAP, companies are allowed fairly wide latitude on how they recognize revenues and handle “extraordinary” income and expenses Many companies freely admit to “managing” or “smoothing” earnings, believing that it adds to the stability of the stock price over time Here are a couple of recent examples of questionable quality of earnings: –Qwest – Raised revenue recognition questions when analysts discovered that they had counted all of the future revenues from a 20-year contract as current earnings. –Waste Management – Had trouble recently when it tried to claim as “extraordinary” its expense for painting its huge fleet of trucks. This added 3 cents per share (about 10%) and let them beat expectations by 2 cents (see “Waste Management Excludes Some Expenses in Accounting”, WSJ Online, 23 Aug 2001) –Priceline.com – Was claiming as revenue the entire price of an airline ticket when, in fact, they only received a commission on its sale and never actually took ownership of the ticket

Quality of Earnings Another thing to watch for are “pro-forma” or “as if” earnings. Some analysts have described these as “all the good stuff and none of the bad.” Many companies, especially those in the “new economy”, began reporting pro-forma numbers a few years ago. The funny part is that the Wall Street analysts went along with the game, even long after it became clear that there would never be any real earnings. Also, look for where earnings are coming from. Increased sales, or decreased expenses? Sales can increase forever, but costs can only be cut so far. Generally, when costs are cut to increase profits, this must be looked at as a temporary boost. These types of issues lead to serious questions about management’s truthfulness and bring into question the quality of the firm’s earnings. Typically, when these things are revealed, stock prices drop as investor uncertainty rises

Earnings Manipulation

The Balance Sheet The balance sheet describes the assets, liabilities, and equity of the firm at a point in time Key variables to watch on the balance sheet are cash, accounts receivable, inventories, and long-term debt Always remember what Benjamin Graham said in Security Analysis, “liabilities are real but the assets are of questionable value.”

The Statement of Cash Flows It tells us exactly why a firm’s cash balance changed Far more difficult to manipulate than the income statement, and can help to gauge the quality of earnings The Cash Flows from Operations section is the most important as it measures the cash provided by the day to day operation of the business A company could, for example, show steadily rising revenues and net income, but negative cash flows from operations. How? If accounts receivable is rising. This can only go on for so long before the company has grown its revenues right into bankruptcy because it isn’t collecting on those sales. Positive earnings must always be confirmed by positive cash flows.

Using Financial Ratios There are two key uses of financial ratios: –Trend Analysis – Looking for trends over time in ratios. For example, we’d like to see that the inventory turnover ratio is rising. Normally, at least five years of data should be used. –Comparison to Industry Averages – If we assume that, on average, the firm’s competitors are doing things right, then it makes sense to make these comparisons. This can also help to identify areas of relative strength and weakness

Analyzing Financial Ratios Financial ratios are the microscope that allows us to see behind the raw numbers and find out what’s really going on Financial ratios fall into five categories: –Liquidity –Efficiency –Leverage –Coverage –Profitability Financial statements may be manipulated in a number of ways to help identify key trends: –Common-size –Common base year –Inflation adjusted

Key Profitability Financial Ratios Gross profit margin, operating profit margin, net profit margin, return on assets and return on equity. ROE: measures the profitability for contributors of equity capital ROA: measures the profitability for all contributors of capital Leverage has a significant effect on profitability measures

ROE = Net Profit Pretax Profit x EBIT x Sales Assets xx Equity (1) x (2) x (3) x (4) x (5) x Margin x Turnover x Leverage Tax Burden Interest Burden Decomposition of ROE x ROA

ROE and Dupont analysis First definition Second definition

Ratio Decomposition Analysis for Nodett and Somdett

Coverage and Leverage Ratios Coverage ratios are most important to creditors, but whatever is important to creditors is important to shareholder’s too. Examples of coverage ratios include the times interest earned ratio and the fixed charge coverage ratio. How much debt does the firm have? That’s the question answered by the leverage ratios Examples are the debt ratio and debt to equity ratio. Remember that lots of debt is great as long as sales are increasing, but terrible if sales decline. Some debt is, without a doubt, good, but too much can be disastrous. Especially be on the lookout for companies with a high proportion of fixed costs (high operating leverage) and with lots of debt. Airlines are a good example

Key Efficiency Ratios The efficiency ratios tell us how effectively management is using the firm’s assets to generate sales. Inventory turnover, accounts receivable turnover, days sales outstanding, fixed asset turnover, and total asset turnover all fall into this category

Key Liquidity Ratios The current ratio, quick ratio and cash ratio all fall into this category. They help us to see if the company is able to meet its short-term obligations

Key Market Ratios

Financial Statements, 2004 – 2007 ($ thousands)

Financial Ratios for Major Industry Groups

Economic Value Added Difference between return on assets (ROA) and the opportunity cost of capital (k) EVA = above difference time the invested capital EVA can be positive or negative for firms that have positive earnings

Comparability Problems Accounting Differences –Inventory Valuation –Depreciation Inflation International Accounting Conventions –Reserves – many other countries allow more flexibility in use of reserves. –Depreciation – US allows separate tax and reporting presentations. –Intangibles – treatment varies widely.