Financial Statements Economics 98 / 198 Spring 2008 Copyright 2008 Lawrence Wu

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LECTURE CONTENT

Today’s Lecture Trading Psychology Financial Statements introduction – Income Statement – Balance Sheet – Cash Flow Statement – Earning Season Ratio Analysis

TRADING PSYCHOLOGY

Trading Psychology Emotions severely impair your judgment in deciding whether to buy or sell stocks HOPE FEAR GREED PRIDE

Psychology & The Stock Market Emotions can wreak havoc on your results and decisions Need to take emotion out of investing Do this by developing a system with rules to follow with discipline

Trading Psychology “Your biggest enemy, when trading, is within yourself. Success will only come when you learn to control your emotions” - Edwin Lefevre

Accounting 101: Financial Statements

Reporting Financial Statements Public companies required to publish 10K and 10Q and file with the SEC – 10K = Annual financial reports (audited) – 10Q = Quarterly financial reports (unaudited) Income Statement Balance Sheet Statement of Cash Flows Why do we care about these reports?

The Income Statement Shows how much a company earned or lost during that specific period Considered the most analyzed statement for investors Divulges into a company’s profitability IS THE COMPANY MAKING PROFITS?

Income Statements Generally, 3 Major Parts – Revenues – Expenses – Net Income Earnings Per Share (EPS) = Profits / Shares Outstanding Investors pay very close attention to profits (earnings) and revenue (sales) Income = Revenues - Expenses

Income Statement  Expenses  Cost of Goods Sold (COGS) – other than raising the prices of its products, there is little management can do to keep a large increase in COGS from cutting into profits  Selling, General, and Administrative Expenses (SG&A) – includes Depreciation/Amortization – good measure of management’s efficiency at controlling costs  Research and Development (R&D)  Taxes, interest payments

Income Statement  Net Income (“bottom line”) = Revenue – Expenses  Gross Income = Revenue – COGS  Operating Income = Revenue – (COGS + SG&A)  Profit Margin = Net Income / Revenue  Gross Income Margin = Gross Income / Revenue  Operating Margin = Operating Income / Revenue  Earnings can be increasing, while profit margins are shrinking  Earnings Per Share (EPS) = Profits / Shares Outstanding

Balance Sheet Summarizes company’s assets, liabilities, and shareholders’ equities at specific time Assets = Liabilities + Shareholder’s Equity How do we analyze this statement? We use ratios and changes in trends to analyze the information

Balance Sheet Assets – Current Assets: life span of 1 year or less – Non-Current assets Liabilities – Current Liabilities – Non-current liabilities Shareholder’s Equity – Common / Preferred Stock – Retained Earnings

Balance Sheet  Assets  Current Assets: items that are converted to cash within a year – Cash and cash equivalents – Inventory ﮦInventory Turnover = Sales / Inventory ﮦlow turnover indicates poor sales and excess inventory – Accounts Receivable ﮦthe less money tied up as receivables, the better  Non-Current Assets: items that are more permanent – Property, Plant, and Equipment (PP&E) – Intangibles: intellectual property, deferred charges, goodwill

Balance Sheet  Liabilities  Current Liabilities: obligations due within a year – Accounts Payable ﮦthe longer a company can stretch out the collection period for its payables, the better – Quick Ratio = (Current Assets – Inventory) / Current Liabilities ﮦquick ratio of 1 or higher indicates company is able to meet its short-term obligations  Non-Current Liabilities: obligations due beyond a year  typically bank and bondholder debt

Balance Sheet  Shareholders’ Equity  Retained Earnings – investors should be aware of how a company puts retained capital to use and what return is produced  Preferred Stock, Common Stock, Paid-in Capital  Debt/Equity Ratio = Total Liabilities / Shareholders’ Equity – low debt/equity ratio indicates less risk and less volatile earnings, generated primarily from shareholders’ investment, as opposed to borrowed money  Return on Equity (ROE) = Net Income / Shareholders’ Equity – high ROE shows management makes good use of money invested by shareholders

Statement of Cash Flows Shows how much money coming in (inflows) and going out (outflows) – Cash flow from operations – Cash flow from investing – Cash flow from financing Shows if company having trouble with cash – Profitable companies can have low cash flows. Why? Cash is king! Pays for bills and funds operations!

Statement of Cash Flows  reconciles Income Statement and Balance Sheet by recording company’s cash transactions (inflows and outflows)  shows how much actual cash company made over a specific period of time (gets rid of “accounting noise”)  Profitable ≠ Positive Cash Flow, and vice versa

Statement of Cash Flows  Cash from Operations (CFO)  cash transactions regarding core business operations – outflows: buy inventory, pay operating costs, pay interest on debt, pay taxes – inflows: make sales  changes in CFO are usually a preview of future changes in net income

Statement of Cash Flows  Cash from Investing (CFI)  cash transactions regarding purchase/sale of income- producing assets – outflows: buy assets (PP&E) – inflows: divest of assets  large investments can lead to negative net cash flow, but may pay off in the long run  Cash from Financing (CFF)  cash transactions between company and its owners and creditors – outflows: pay dividend – inflows: sell equity, issue debt  negative CFF usually means company is taking on debt, but could also mean it is making dividend payments and stock repurchases, which could be good for shareholders

Other Important Sections in Financial Filings  Management Discussion and Analysis (MD&A)  Auditor’s Report, a.k.a. Report of Independent Accountants  Notes to Financial Statements

Earnings Season Companies release quarterly reports and annual reports – “Financial Report Cards” Stock analysts issue earnings estimate – Consensus earnings estimates Earnings surprise is a good thing – Meeting / beating / missing expectations – If below estimates, then stock usually plummets!

Understanding Earnings Actual earnings value is important, but so is the growth of these earnings Compare EPS / Revenue? – Do we compare them to last quarter? – Do we compare them to the same quarter last year?

EPS % Growth: Google Q Source: MSN Money Stock Quotes EPS growth calculated comparing Q to Q Q2 2007EPS Growth 2007 Q2 EPS 2006 Q2 EPS $2.98 / sh $2.39 / sh =25%

Why do Investors Care About Earnings? Strong earnings or expectations of strong earnings drive stock prices. Why? – Potential for greater reinvestment, and greater earnings – Passing the money to shareholders in various forms (dividends, buybacks, etc.) Ultimately, earnings provide a return on the investment for shareholders

Ratio Analysis

Used to gain idea of valuation and financial performance Compared to competitors and historical values to gain understanding about company’s value – Is it undervalued? Overvalued? – How is it performing?

Profit Margins = net income / net sales (revenue) – Measures how much out of every dollar of sales a company actually keeps in earnings High profit margins indicates that management efficient at controlling costs – Increased earnings are good, but if costs are increasing faster than sales, leads to lower profit per sale Good sign if company has growing profit margins

Profit Margins: Example Company has a net income of $10 million from sales of $100 million, giving it a profit margin of 10% ($10 million/$100 million) If in the next year net income rose to $15 million on sales of $200 million. Would its profit margins be growing or diminishing? What does this mean?

Price to Earnings Ratio (P/E) P/E Ratio = Price per share / Earnings per share – Look at company’s earnings relative to its price Most basic valuation method of company – How do you we use it? Ex. If BIG OIL co. has P/E ratio of 15 and has solid fundamentals, and the industry average is 40, then the BIG OIL would be considered undervalued

Price to Earnings Ratio (P/E) Use as a guide, not a guarantee in your analysis Sometimes, there is a reason for high or low P/E ratios (understanding business and industry is important) – High P/E ratios: investors may be willing to pay more for less earnings because its expect higher growth rates in the future – Low P/E ratios: may seem like a bargain, but low ratio may signal questionable future prospects

Return on Equity (ROE) = Net Income / Shareholder’s Equity – how much profit a company can generate with the money shareholders have invested – Is it a profit-making machine or an inefficient clunker? Useful for comparing profitability and efficiency of a company to other firms in same industry – can indicate whether a company is growing without pouring new capital into business Growing ROE also shows management making better use of money invested by shareholders

Debt-to-Equity Ratios Debt / Equity Ratio = Total Liabilities / Shareholder’s Equity – Proportion of equity and debt to finance assets High ratio: aggressive debt, potential for higher earnings per share but at more risk – More volatile earnings and larger interest expenses Compare this similar companies Warren Buffet preferred to see lower ratio so that earnings growth is generated by investors rather than borrowed money

Google Example Profit Margin13%24%29%25% ROE14%15.6%18.1%18.5% Debt/Equity EPS Growth261%198%134%

Other Relevant Ratios Current Ratio Return on Assets Inventory Turnover Interest Coverage More on Ratio Analysis / Financial Statement Analysis: UGBA 102A: Introduction to Financial Accounting

Reading Motley Fool. “Analyzing Stocks” Recommended: Investopedia. “Valuation”