1. INVESTMENTS | BODIE, KANE, MARCUS Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Chapter Nineteen 1 Financial Statement Analysis

2. 19-2 INVESTMENTS | BODIE, KANE, MARCUS Financial Statement Analysis Financial statement analysis can be used to discover mispriced securities. Financial accounting data are widely available; however, accounting earnings and economic earnings are not always the same thing.

3. 19-3 INVESTMENTS | BODIE, KANE, MARCUS Financial Statements Income Statement: –Profitability over time Balance Sheet: –Financial condition at a point in time Statement of Cash Flows: –Tracks the cash implications of transactions.

4. 19-4 INVESTMENTS | BODIE, KANE, MARCUS Accounting Versus Economic Earnings Economic earnings –Sustainable cash flow that can be paid to stockholders without impairing productive capacity of the firm Accounting earnings –Affected by conventions regarding the valuation of assets

5. 19-5 INVESTMENTS | BODIE, KANE, MARCUS Table 19.1 Consolidated Statement of Income for Home Depot, 2012

6. 19-6 INVESTMENTS | BODIE, KANE, MARCUS Table 19.2 Consolidated Balance Sheet for Home Depot, 2012

7. 19-7 INVESTMENTS | BODIE, KANE, MARCUS Table 19.3 Statement of Cash Flows for Home Depot, 2012

8. 19-8 INVESTMENTS | BODIE, KANE, MARCUS Measuring Firm Performance Manager responsibilities: –1. Investment decisions –2. Financing decisions Ratios used to show efficiency and profitability of these decisions: –ROA- income earned per dollar deployed –ROC- income earned per dollar invested (long term) –ROE net income realized by shareholders per dollar invested

9. 19-9 INVESTMENTS | BODIE, KANE, MARCUS Measuring Firm Performance ROE is a key determinant of earnings growth. Past profitability does not guarantee future profitability. Security values are based on future profits. Expectations of future dividends determine today’s stock value.

10. 19-10 INVESTMENTS | BODIE, KANE, MARCUS Financial Leverage and ROE ROE can differ from ROA because of leverage. Leverage makes ROE more volatile. Let t=tax rate and r=interest rate, then:

11. 19-11 INVESTMENTS | BODIE, KANE, MARCUS Financial Leverage and ROE If there is no debt or ROA = r, ROE will simply equal ROA(1 - t). If ROA > r, the firm earns more than it pays out to creditors and ROE increases. If ROA < r, ROE will decline as a function of the debt-to-equity ratio.

12. 19-12 INVESTMENTS | BODIE, KANE, MARCUS Table 19.5 Impact of Financial Leverage on ROE

13. 19-13 INVESTMENTS | BODIE, KANE, MARCUS Economic Value Added EVA is the difference between return on assets (ROA) and the opportunity cost of capital (k), multiplied by the capital invested in the firm. EVA is also called residual income If ROA > k, value is added to the firm.

14. 19-14 INVESTMENTS | BODIE, KANE, MARCUS Example 19.2 Intel In 2012, Intel’s cost of capital was 7.8%. Its ROA was 13.9% and its capital base was $56.34 billion. Intel’s EVA = (0.139-0.078) x $56.34 billion = $3.44 billion

15. 19-15 INVESTMENTS | BODIE, KANE, MARCUS Decomposition of ROE DuPont Method 1.Tax Burden 2.Interest Burden 3.Margin 4.Turnover 5.Leverage

16. 19-16 INVESTMENTS | BODIE, KANE, MARCUS Decomposition of ROE ROA=EBIT/Sales x Sales/Assets = margin x turnover Margin and turnover are unaffected by leverage. ROA reflects soundness of firm’s operations, regardless of how they are financed.

17. 19-17 INVESTMENTS | BODIE, KANE, MARCUS Decomposition of ROE ROE=Tax burden x ROA x Compound leverage factor Tax burden is not affected by leverage. Compound leverage factor= Interest burden x Leverage

18. 19-18 INVESTMENTS | BODIE, KANE, MARCUS Table 19.7 Ratio Decomposition Analysis for Nodett and Somdett

19. 19-19 INVESTMENTS | BODIE, KANE, MARCUS Choosing a Benchmark Compare the company’s ratios across time. Compare ratios of firms in the same industry. Cross-industry comparisons can be misleading.

20. 19-20 INVESTMENTS | BODIE, KANE, MARCUS Table 19.8 Differences between Profit Margin and Asset Turnover across Industries

21. 19-21 INVESTMENTS | BODIE, KANE, MARCUS Table 19.9 Summary of Key Financial Ratios

22. 19-22 INVESTMENTS | BODIE, KANE, MARCUS Table 19.9 Summary of Key Financial Ratios

23. 19-23 INVESTMENTS | BODIE, KANE, MARCUS Table 19.9 Summary of Key Financial Ratios

24. 19-24 INVESTMENTS | BODIE, KANE, MARCUS Table 19.9 Summary of Key Financial Ratios

25. 19-25 INVESTMENTS | BODIE, KANE, MARCUS Table 19.10 Summary of Key Financial Ratios

26. 19-26 INVESTMENTS | BODIE, KANE, MARCUS Figure 19.3 DuPont Decomposition for Home Depot

27. 19-27 INVESTMENTS | BODIE, KANE, MARCUS Comparability Problems Accounting Differences –Inventory Valuation –Depreciation Inflation and Interest Expense Fair Value Accounting Quality of Earnings International Accounting Conventions

28. 19-28 INVESTMENTS | BODIE, KANE, MARCUS International Accounting Differences Reserves – many other countries allow more flexibility in use of reserves Depreciation – US allows separate tax and reporting presentations Intangibles – treatment varies widely

29. 19-29 INVESTMENTS | BODIE, KANE, MARCUS Figure 19.4 Adjusted Versus Reported Price-Earnings Ratios

30. 19-30 INVESTMENTS | BODIE, KANE, MARCUS The Graham Technique Rules for stock selection : –Purchase common stocks at less than their working-capital value. –Give no weight to plant or other fixed assets. –Deduct all liabilities in full from assets.