1 FIN 2802, Spring 10 - Tang Chapter 19: Financial Statement Analysis Fin2802: Investments Spring, 2010 Dragon Tang Lecture 15 Financial Statement Analysis March 18, 2010 Readings: Chapter 19 Practice CFA Problem Sets: 6-9,13,14,16

2 FIN 2802, Spring 10 - Tang Chapter 19: Financial Statement Analysis Everyone gets sick sometime! Take your stocks to a doctor! Regular checkups will prevent big problems

3 FIN 2802, Spring 10 - Tang Chapter 19: Financial Statement Analysis Financial Statement Analysis Objectives: Use a firm’s income statement, balance sheet, and statement of cash flows to calculate standard financial ratios. Calculate the impact of taxes and leverage on a firm’s return on equity using ratio decomposition analysis. Measure a firm’s operating efficiency Identify likely sources of biases in accounting data.

4 FIN 2802, Spring 10 - Tang Chapter 19: Financial Statement Analysis Fundamental Analysis Economics Finance Accounting –How to interpret reported data?

5 FIN 2802, Spring 10 - Tang Chapter 19: Financial Statement Analysis Financial Statements The Balance Sheet: Snapshot of Financial Condition –Assets – Liabilities = Shareholders’ Equity –Current vs long-term Income Statement: Summary of Profitability –Revenue – Expenses = Net Income –Expenses: raw material; salary; interest; tax –EBIT=Earnings – Raw Material – Salary The Statement of Cash Flows: “Actual” Cash –More reliable –Activities: Operating; Investing; Financing –Depreciation is not smoothed

6 FIN 2802, Spring 10 - Tang Chapter 19: Financial Statement Analysis Accounting vs Economic Earnings Economic earnings: Sustainable cash flow that can be paid out without impairing the productive capacity Accounting earnings: “Models” are used Accounting earnings are still useful

7 FIN 2802, Spring 10 - Tang Chapter 19: Financial Statement Analysis Return on Equity (ROE) ROE=Net profit/Equity Trend in ROE Watch out financial leverage: ROA: Return on Assets=EBIT/Assets

8 FIN 2802, Spring 10 - Tang Chapter 19: Financial Statement Analysis 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 Du Pont System: Decomposition of ROE x ROA = Margin X Turnover

9 FIN 2802, Spring 10 - Tang Chapter 19: Financial Statement Analysis Practice An analyst applies the DuPont system of financial analysis to the following data for a company: Leverage ration 2.2 Total asset turnover2.0 Net profit margin5.5% Dividend payout ratio31.8% What is the company’s return on equity?

10 FIN 2802, Spring 10 - Tang Chapter 19: Financial Statement Analysis Ratio Analysis Asset utilization ratios: Efficiency –Fixed-asset turnover=Sales/Fixed Assets –Inventor turnover=cost of goods sold/average inventory –Average collection period=(Account receivables/Sales)*365 Liquidity and coverage ratios: Financial health –Current ratio=current assets/current liabilities –Quick ratio=(cash+receivables)/current liabilities –Interest coverage ratio=EBIT/interest expense Market price ratios: Relative Value –Market/Book ratio(P/B): “Safeness” –Price-earnings ratio (P/E): No easy bargain –E/P=ROE/(P/B) Choose a benchmark!

11 FIN 2802, Spring 10 - Tang Chapter 19: Financial Statement Analysis Intel ’ s Financial Ratios Over Time

12 FIN 2802, Spring 10 - Tang Chapter 19: Financial Statement Analysis Economic Value Added (EVA) EVA=(ROA-Capitalization Rate)  Capital Invested Growth is not the whole picture! EVA can be positive or negative for firms that have positive earnings

13 FIN 2802, Spring 10 - Tang Chapter 19: Financial Statement Analysis Key Financial Ratios of Growth Industries Inc.

14 FIN 2802, Spring 10 - Tang Chapter 19: Financial Statement Analysis Growth Industries Statements of Cash Flow

15 FIN 2802, Spring 10 - Tang Chapter 19: Financial Statement Analysis Comparability Problems GAAP (Generally Accepted Accounting Principles) is not unique –Inventory valuation: LIFO vs FIFO –Depreciation: Straight line vs Accelerated –Real interest payments Quality of earnings affected by: –Allowance of bad debt; nonrecurring items; stock option; revenue recognition; off-balance-sheet assets and liabilities GAAP vs IAS (International Accounting Standards)

16 FIN 2802, Spring 10 - Tang Chapter 19: Financial Statement Analysis Quality of Earnings: Areas of Accounting Choices Allowance for bad debts Non-recurring items Reserves management Stock options Revenue recognition Off-balance sheet assets and liabilities

17 Figure 19.2 Comparative Accounting Rules FIN 2802, Spring 10 - Tang Chapter 19: Financial Statement Analysis

18 FIN 2802, Spring 10 - Tang Chapter 19: Financial Statement Analysis Adjusted Versus Reported Price-Earnings Ratios

19 FIN 2802, Spring 10 - Tang Chapter 19: Financial Statement Analysis Value Investing Benjamin Graham Pick value stocks (low P/B) Rule: stock price < net current-asset value Information sources: S&P’s Outlook and Value Line Investment Survey

20 FIN 2802, Spring 10 - Tang Chapter 19: Financial Statement Analysis Browne: Value Investing Checklist 1.What is the outlook for pricing for products? 2.Can the company sell more? 3.Can the company increase profits on existing sales? 4.Can the company control expenses? 5.How much of the additional sales are net profits? 6.How competitive is the company? 7.Any one-time expenses? 8.Any unprofitable operations? 9.How well does the company meet expectations? 10.Growth over the next five year 11.Excess cash, competition strategies, acquisition value, stock repurchases, insider trading activities

21 FIN 2802, Spring 10 - Tang Chapter 19: Financial Statement Analysis Summary Fundamental Analysis Economic earnings vs accounting earnings Financial Statements Du Pont System; ratio analysis Economic Value Added Comparability Next: Macroeconomy and Stock Market