Spring 2012 Practice Questions

Security Analysis (Spring 2012)Asif Ali Qureshi, CFA Question # 1 (Solution) 2

Security Analysis (Spring 2012)Asif Ali Qureshi, CFA Question # 2 (Solution) 3

Security Analysis (Spring 2012)Asif Ali Qureshi, CFA Question # 3 (Solution) 4

Security Analysis (Spring 2012)Asif Ali Qureshi, CFA Question # 3 (Solution) 5

Security Analysis (Spring 2012)Asif Ali Qureshi, CFA Question # 3 (Solution) 6

Security Analysis (Spring 2012)Asif Ali Qureshi, CFA Question # 4 (Solution) 7

Security Analysis (Spring 2012)Asif Ali Qureshi, CFA Question # 5 (Solution) 8

Security Analysis (Spring 2012)Asif Ali Qureshi, CFA Question # 6 (Solution) 9

Security Analysis (Spring 2012)Asif Ali Qureshi, CFA Question # 7 (Solution) 10

Security Analysis (Spring 2012)Asif Ali Qureshi, CFA Question # 8 (Solution) 11

Security Analysis (Spring 2012)Asif Ali Qureshi, CFA Question # 8 (Solution) 12

Spring 2012 Estimating Earning per Share (EPS)

Security Analysis (Spring 2012)Asif Ali Qureshi, CFA 14 Earnings per Share (EPS)  EPS measures the portion of a company's profit allocated to each outstanding share of common stock.  IAS-33 (Earnings Per Share) prescribes the principles for the determination and presentation of earnings per share (EPS).  Complex capital structures need to be appropriately accounted for.  When a company has any securities that are potentially convertible into common stock (ordinary shares), it is said to have a complex capital structure.  Such securities can potentially “dilute” the ordinary shareholders’ portion in the company’s earnings.  Examples of these kind of securities are convertible bonds, convertible preferred stock, employee stock options and warrants.

Security Analysis (Spring 2012)Asif Ali Qureshi, CFA 15 Basic EPS  Basic EPS is calculated by dividing the profit or loss attributable to ordinary equity holders of a company by the weighted average number of ordinary shares outstanding during the period.  The denominator is calculated by adjusting the shares in issue at the beginning of the period by the number of shares bought back or issued during the period, multiplied by a time-weighting factor.  If no. of shares increase as a result of stock dividend, stock bonus, or stock split, the EPS calculation reflects the change retroactively.

Security Analysis (Spring 2012)Asif Ali Qureshi, CFA 16 Example 1: Basic EPS  For the year ended 31-dec-2006, ABC Co. had net income of $2,500,000. The company declared $200,000 of dividends on preferred stock and also had following common stock share info:  Shares outstanding on 01-jan-20061,000,000  Shares issued on 01-apr ,000  Shares repurchased on 01-oct-2006(100,000)  Shares outstanding on 31-dec-20061,100,000 Weighted avg. shares = 1,000,000 x (3/12) + 1, 200,000 x (6/12) + 1,100,000 x (3/12) = 1,125,000 Basic EPS= ($2,500,000 – $200,000) / 1,125,000 = $2.04

Security Analysis (Spring 2012)Asif Ali Qureshi, CFA Bonus issue  In a capitalization or bonus issue or a share split, ordinary shares are issued to existing equity holders for no additional consideration.  The number of ordinary shares outstanding is increased without an increase in resources.  The number of ordinary shares outstanding before the event is adjusted for the proportionate change in the number of ordinary shares outstanding as if the event had occurred at the beginning of the earliest period presented. 17

Security Analysis (Spring 2012)Asif Ali Qureshi, CFA Example 2: Basic EPS – adjusting for bonus issue 18

Security Analysis (Spring 2012)Asif Ali Qureshi, CFA Rights Issue  Rights issue result in a change in the resources available to the entity.  In a rights issue the exercise price is often less than the fair value (or market price) of the shares. Such a rights issue includes a bonus element.  If a rights issue is offered to all existing equity holders, the number of ordinary shares to be used in calculating basic and diluted EPS for all periods before the rights issue is the number of ordinary shares outstanding before the issue, multiplied by the following factor: 19

Security Analysis (Spring 2012)Asif Ali Qureshi, CFA Example 3: Basic EPS – adjusting for rights issue 20

Security Analysis (Spring 2012)Asif Ali Qureshi, CFA Example 3: Basic EPS – adjusting for rights issue 21

Security Analysis (Spring 2012)Asif Ali Qureshi, CFA Example 3: Basic EPS – adjusting for rights issue x 1.1

Security Analysis (Spring 2012)Asif Ali Qureshi, CFA Example 3: Basic EPS – adjusting for rights issue 23

Security Analysis (Spring 2012)Asif Ali Qureshi, CFA Example 3: Basic EPS – adjusting for rights issue 24

Security Analysis (Spring 2012)Asif Ali Qureshi, CFA 25 Diluted EPS: Convertible Preference Stock  Diluted EPS is calculated by adjusting the earnings and number of shares for the effects of dilutive options & other dilutive securities.  Diluted EPS when company has convertible preference stock  Diluted EPS is calculated using the if-converted method (i.e., what EPS would have been if the convertible preferred stock had been converted at the beginning of the period)  If such conversion had taken place, there would not have been any preferred dividends paid out during the period and no preferred stock outstanding at the period end.

Security Analysis (Spring 2012)Asif Ali Qureshi, CFA 26 Example 4: Diluted EPS – Convertible Preference Stock  XYZ company had net income of $1,750,000 for the year ending 31-dec The company had an average of 500,000 shares of common stock outstanding and 20,000 shares of convertible preferred shares. Each preferred share pays a dividend of $10 and convertible into 5 shares of the company’s common stock. Calculate the company’s basic and diluted EPS.

Security Analysis (Spring 2012)Asif Ali Qureshi, CFA 27 Example 4: Diluted EPS – Convertible Preference Stock  XYZ company had net income of $1,750,000 for the year ending 31-dec The company had an average of 500,000 shares of common stock outstanding and 20,000 shares of convertible preferred shares. Each preferred share pays a dividend of $10 and convertible into 5 shares of the company’s common stock. Calculate the company’s basic and diluted EPS.

Security Analysis (Spring 2012)Asif Ali Qureshi, CFA 28 Diluted EPS: Convertible Debt  Diluted EPS when company has convertible debt outstanding  Diluted EPS calculated using if-converted method.  If convertible bond had been converted into common stock, the company would not have paid interest on the convertible debt and would have had more shares of common stock.

Security Analysis (Spring 2012)Asif Ali Qureshi, CFA 29 Example 5: Diluted EPS – Convertible Debt  NewCo reported net income of $750,000 for the year ended 31-dec The company had an average of 690,000 shares of common stock outstanding. In addition, the company has only one potentially dilutive security: $50,000 of 6% convertible bonds, convertible into a total of 10,000 shares. Assuming a tax rate of 30% calculate NewCo’s basic and diluted EPS.

Security Analysis (Spring 2012)Asif Ali Qureshi, CFA 30 Example 5: Diluted EPS – Convertible Debt  NewCo reported net income of $750,000 for the year ended 31-dec The company had an average of 690,000 shares of common stock outstanding. In addition, the company has only one potentially dilutive security: $50,000 of 6% convertible bonds, convertible into a total of 10,000 shares. Assuming a tax rate of 30% calculate NewCo’s basic and diluted EPS. $50,000 x 6% x (1 – 30%)

Security Analysis (Spring 2012)Asif Ali Qureshi, CFA 31 Diluted EPS: Warrants and Options  Diluted EPS when a company has stock options, warrants, or their equivalents outstanding  Diluted EPS is calculated using the treasury stock method (US GAAP)  i.e., what EPS would have been if a) the options had been exercised and b) the company had used the proceeds to repurchase common stock.

Security Analysis (Spring 2012)Asif Ali Qureshi, CFA 32 Example 6: Diluted EPS – Warrants & Options  OldCo reported net income of $2,300,000 for the year ended 30-jun-2005 and had an average of 800,000 common shares outstanding. The company has outstanding 30,000 options with an exercise price of $35 and no other potentially dilutive securities. Over the year, the company’s market price has averaged $55/share. Calculate OldCo’s basic and diluted EPS.

Security Analysis (Spring 2012)Asif Ali Qureshi, CFA 33 Example 6: Diluted EPS – Warrants & Options  OldCo reported net income of $2,300,000 for the year ended 30-jun-2005 and had an average of 800,000 common shares outstanding. The company has outstanding 30,000 options with an exercise price of $35 and no other potentially dilutive securities. Over the year, the company’s market price has averaged $55/share. Calculate OldCo’s basic and diluted EPS. If options exercised, OIdCo would have issued 30,000 new shares and received $1,050,000 (30,000 x 35) as proceeds. Total shares would have increased to 830,000 (800, ,000) OldCo could have used the proceeds to buy back its own 19,091 shares ($1,050,000 / $55) from the market. Total shares would resultantly reduce to 810,909 (830,000 – 19,091).

Security Analysis (Spring 2012)Asif Ali Qureshi, CFA 34 Example 6: Diluted EPS – Warrants & Options  OldCo reported net income of $2,300,000 for the year ended 30-jun-2005 and had an average of 800,000 common shares outstanding. The company has outstanding 30,000 options with an exercise price of $35 and no other potentially dilutive securities. Over the year, the company’s market price has averaged $55/share. Calculate OldCo’s basic and diluted EPS.

Security Analysis (Spring 2012)Asif Ali Qureshi, CFA 35 Anti-dilutive Securities  It is possible that some potentially convertible securities could be antidilutive i.e., their inclusion in the computation would result in an EPS higher than the company’s basic EPS.  Under accounting standards, antidilutive securities are not included in the calculation of diluted EPS.

Security Analysis (Spring 2012)Asif Ali Qureshi, CFA 36 Example 7: Anti-dilutive Securities  MaxCo had net income of $1,750,000 for the year ended 31-dec The company had an average of 500,000 shares of common stock outstanding, 20,000 of convertible preferred, and no other potentially dilutive securities. Each preferred share pays a dividend of $10 and is convertible into 3 shares of the company’s common stock. What is the company’s basic and diluted EPS?

Security Analysis (Spring 2012)Asif Ali Qureshi, CFA 37 Example 7: Anti-dilutive Securities  MaxCo had net income of $1,750,000 for the year ended 31-dec The company had an average of 500,000 shares of common stock outstanding, 20,000 of convertible preferred, and no other potentially dilutive securities. Each preferred share pays a dividend of $10 and is convertible into 3 shares of the company’s common stock. What is the company’s basic and diluted EPS? 20,000 x 3 20,000 x $10

Security Analysis (Spring 2012)Asif Ali Qureshi, CFA 38 Common Size Income Statement  Common-size analysis of the income statement can be performed by stating each line item on the income statement as %age of revenues (vertical common size analysis).  Common size analysis helps in:  Time series analysis i.e., analyzing a company’s performance over time by explaining relative movements in costs and margins.  Cross-sectional analysis i.e., comparative analysis of two or more companies, which helps understand the differences in operating and financial efficiencies, strategies, etc.

Spring 2012 Financial Analysis Techniques

Security Analysis (Spring 2012)Asif Ali Qureshi, CFA 40 Financial Statement Analysis Framework Financial statements/other data Discussions with industry players Company site visits Data from previous phase Input and processed data Analytical results and previous reports Institutional guidelines for published reports Periodically repeating the above process Organized financial statements Financial data tables (excel sheets) Adjusted financial statements Common-size statements Ratios and Graphs Models/Forecasts Analytical Results Analyst Report Updated reports and communication Collect Input Data Process Data Analyze and Interpret Processed Data Develop & Commu- nicate conclusions & recommendations Follow-up Articulate the purpose & context of Analysis Phase Analyst’s function: Debt or Equity Client communication Institutional guidelines Sources of Information Statement of purpose Questionnaire Nature/content of report Timetable and budgets Output

Security Analysis (Spring 2012)Asif Ali Qureshi, CFA 41 Analysis Tools and Techniques  Financial Ratios  Common Size Analysis  Graphical Analysis  Regression Analysis

Security Analysis (Spring 2012)Asif Ali Qureshi, CFA 42 Categories of Financial Ratios Activity Ratios Activity ratios measure how efficiently a company performs day-to-day tasks, such as inventory management, receivables collection, etc. Liquidity Ratios Liquidity ratios measure the company’s ability to meet its short-term obligations. Solvency Ratios Solvency ratios measure a company’s ability to meet long- term obligations. Leverage and long-term debt ratios are subset of these ratios. Profitability Ratios Profitability ratios measure the company’s ability to generate profitable sales from its resources (assets). Valuation Ratios Valuation ratios measure the quantity of an asset or flow (e.g., earnings) associated with ownership of a specified claim (e.g., debt or equity)

Security Analysis (Spring 2012)Asif Ali Qureshi, CFA 43 Activity Ratios  Activity ratios measure how efficiently a company performs day-to-day tasks, such as inventory management, receivables collection, etc.  Activity ratios combine information from P&L and balance sheet.  P&L covers a time period while balance sheet is as of a specific date. Therefore, average balance sheet data should be used in estimating the activity ratios.  For meaningful analysis, activity ratios (likely all other sets of financial ratios) should be evaluated both on time-series and cross-sectional basis.

Security Analysis (Spring 2012)Asif Ali Qureshi, CFA 44 Key Activity Ratios

Security Analysis (Spring 2012)Asif Ali Qureshi, CFA 45 Inventory Turnover (days)  Measures how quickly the inventory is being converted into cash.  A low inventory turnover (days), relative to the industry, generally implies efficient inventory management.  However, low inventory turnover (days) may also indicate inventory shortages, which in turn hurts potential revenues.

Security Analysis (Spring 2012)Asif Ali Qureshi, CFA 46 Attock Cement: Inventory Turnover

Security Analysis (Spring 2012)Asif Ali Qureshi, CFA 47 Receivables Turnover (days)  Measures how quickly the company is converting its receivables into cash.  A low receivable turnover (days), relative to the industry, generally indicates efficient receivables collection and low (client) credit risks.  However, the same may also indicate that the company is potentially loosing sales due to over-stringent credit policies.

Security Analysis (Spring 2012)Asif Ali Qureshi, CFA 48 Attock Cement: Receivables Turnover

Security Analysis (Spring 2012)Asif Ali Qureshi, CFA 49 Payables Turnover (days)  Measures average suppliers payment cycle of a company.  A high payable turnovers (days), relative to the industry, indicates that the company has more favorable credit terms from its suppliers.  However, for a given period, the same may also indicate that the company is facing problems in meeting its payments towards its suppliers.

Security Analysis (Spring 2012)Asif Ali Qureshi, CFA 50 Attock Cement: Payables Turnover

Security Analysis (Spring 2012)Asif Ali Qureshi, CFA 51 Working Capital Turnover  Measures how efficiently the company generates revenue with its working capital.  A high working capital, relative to industry, would indicate higher efficiency.  For some companies, working capital can be near zero or negative, which renders this ratio incapable of being interpreted. Asset turnover ratios are more useful in such situations.

Security Analysis (Spring 2012)Asif Ali Qureshi, CFA 52 Attock Cement: Working Capital Turnover

Security Analysis (Spring 2012)Asif Ali Qureshi, CFA 53 Assets turnover  Measures the company’s overall ability to generate revenues with a given level of assets.  A higher ratio, relative to the industry, generally shows greater efficiency.

Security Analysis (Spring 2012)Asif Ali Qureshi, CFA 54 Attock Cement: Total Assets Turnover

Security Analysis (Spring 2012)Asif Ali Qureshi, CFA 55 Liquidity Ratios  Liquidity ratios measure the company’s ability to meet its short-term obligations.  In day-to-day operations, liquidity management is typically achieved through efficient use of assets. In the medium term, liquidity is also addressed by managing the structure of liabilities.  Contingent liabilities, such as letters of credit or financial guarantees, can also be relevant when assessing liquidity.  The level of liquidity needed varies markedly from one industry to another. Liquidity ratios of sectors such as Utilities and Telecoms, are generally lower than those for manufacturing industries.

Security Analysis (Spring 2012)Asif Ali Qureshi, CFA 56 Key Liquidity Ratios Cash Conversion Cycle = Inventory Turnover (days) + Receivables Turnover (days) – Payables Turnover (days)

Security Analysis (Spring 2012)Asif Ali Qureshi, CFA 57 Attock Cement: Cash Conversion Cycle Inventory Turnover (days) + Receivables Turnover (days) – Payables Turnover (days) = Cash Conversion Cycle

Security Analysis (Spring 2012)Asif Ali Qureshi, CFA 58 Solvency Ratios  Solvency ratios measure a company’s ability to meet long-term obligations.  They provide information about the relative amount of debt in the company’s capital structure and the adequacy of earnings and cash flows to cover interest expense and other fixed charges (such as lease payments) as they come due.  A company’s relative solvency is fundamental to valuation of its debt securities and its creditworthiness.

Security Analysis (Spring 2012)Asif Ali Qureshi, CFA 59 Key Solvency Ratios

Security Analysis (Spring 2012)Asif Ali Qureshi, CFA 60 Prudential Regulations (R-5)  Linkage between financial indicators of the borrower and total exposure from financial institution:  While taking any exposure, banks / DFIs shall ensure that the total exposure (fund-based and / or non-fund based) availed by any borrower from financial institutions does not exceed 10 times of borrower’s equity as disclosed in its financial statements (obtained in accordance with para 2 of Regulation R-3), subject to the condition that the fund based exposure does not exceed 4 times of its equity as disclosed in its financial statements. However, where the equity of a borrower is negative and the borrower has injected fresh equity during its current accounting year, it is eligible to obtain finance not exceeding 4 times of the fresh injected equity provided the borrower shall plough back at least 80% of the net profit each year until such time that it is able to borrow without this relaxation. (After 30th June 2008, the borrower will be eligible only upto 3 times of his fresh injected equity).

Security Analysis (Spring 2012)Asif Ali Qureshi, CFA 61 Prudential Regulations (Equity of Borrower)  Equity of the Borrower includes paid-up capital, general reserves, balance in share premium account, reserve for issue of bonus shares and retained earnings / accumulated losses, revaluation reserves on account of fixed assets and subordinated loans.  Preference shares qualifying the criteria listed in PR shall also be included in the equity of the borrower.

Security Analysis (Spring 2012)Asif Ali Qureshi, CFA 62 Profitability Ratios

Security Analysis (Spring 2012)Asif Ali Qureshi, CFA 63 Attock Cement – Profitability Ratios (I)

Security Analysis (Spring 2012)Asif Ali Qureshi, CFA 64 Attock Cement – Profitability Ratios (II)

Security Analysis (Spring 2012)Asif Ali Qureshi, CFA 65 DuPont Analysis  Du-Pont model explains ROE or ROA in terms of its contributing elements. NI/EBT  One minus the tax rate EBT/EBIT  One minus interest burden EBIT/Sales  Operating margin Sales/Assets  Asset turnover Assets/Equity  Leverage

Security Analysis (Spring 2012)Asif Ali Qureshi, CFA 66 Example: DuPont Analysis

Security Analysis (Spring 2012)Asif Ali Qureshi, CFA 67 Valuation Ratios

Security Analysis (Spring 2012)Asif Ali Qureshi, CFA 68 Enterprise Value  The value of the underlying business operations.  The price of acquiring the right to 100% of enterprise profit and cash flow.  Component of Enterprise Value  Market capitalization  Value of other equity related claims  Value of minority interests  Value of interest bearing debt  Value of debt deemed provisions (eg pensions)  EV may also be measured as net of cash and investments.

Security Analysis (Spring 2012)Asif Ali Qureshi, CFA 69 Attock Cement – Valuation Ratios