1. Fundamental Analysis and Stocks
Economics 71a: Spring 2007
Mayo, Chapter 9
Lecture notes 3.3

2. Why Read or Care? Investment strategies Growth Value
Use accounting numbers to estimate growth
Value
Compare accounting numbers to price

3. Goals
Accounting statements
Financial ratios
Ratios and valuation

4. Accounting Statements
Income statement
Balance sheet
Statement of retained earnings
Statement of cash flows

5. Income Statement
Flow variables
Revenues – Cost of goods sold

6. Income Statement Example
Sales revenues $50
Cost of goods sold $-25
Advertising/Admininstrative expenses $-2
Depreciation $-5
Interest payments $-1
Taxes $-3
Earnings = $14
EBIT = Earnings before interest and taxes
= = $18 (operating income)

7. Extraordinary Items: One Time Income and Expenses
“Below the line”
Should come after other items
Part of total earnings
Left out of
EBIT
“core earnings”, “operating earnings”
Definitions are blurry on this

8. Examples Lawsuit settlements
One time asset sales (patents/real estate)
Pension fund adjustments
Changing accounting systems

9. Income Statement Example
Total revenues $50
Cost of goods sold $-25
Advertising + Admin. expenses $-2
Depreciation $-5
Interest payments $-1
Taxes $-3
**Earnings = $14 (“core earnings”)
EBIT = Earnings before interest and taxes
= = $18 (operating income)
Lawsuit settlement = $-8
Earnings = $6

10. Balance Sheet Accounting Value of the Firm
Assets (things firm owns)
Liabilities (Loans)
Stockholders’ equity
(Assets - Liabilities)
Also called
Book value
Net worth

11. Assets Cash Accounts receivable Inventories Land Plant and equipment
Less: Depreciation

12. Liabilities Accounts payable Notes payable (short term debt)
Long term debt

13. Balance Sheet Assets Liabilities Shareholder equity 105-76 = $29
Cash $5
Plant and equipment $100
Liabilities
Accounts payable $1
Long term debt $75
Shareholder equity = $29
Book value

14. Balance Sheet Shareholders equity Common stock (at issue)
$10
Capital surplus $5
Retained earnings 20
Purchased stock (negative)
Treasury stock -6
= 29

15. Cash Flow Pure measure of incoming - outgoing cash
Differences with income statement
No depreciation
No accounts payable/receivable
Inventories (account for costs of producing and putting in inventory)

16. Cash Flow Parts Operating Activities Investment Activities
Financial Activities

17. Operating Cash Flow Earnings = $5 Adjust to get to cash flow
Depreciation : +5
Why? Remove depreciation adjustments
Increase in accounts payable: +5
Why? Haven’t paid this yet.
Increase in accounts receivable: -2
Why? Haven’t received this yet.
Increase in inventories: -10
Production costs reflect only goods sold.
Adjustment: = 3 = operating cash flow

18. Investment Cash Flow Increase in gross fixed assets
Purchases of new plant and equipment
-30 million : New office building
Total investment cash flow = -30 million

19. Finance Cash Flow Increase in long term debt: Dividends:
+50 million of incoming funds
Dividends:
-20 million payout of divs
Total finance cash flow = +30 million

20. Depreciation Assets “wear out” Firms slowly write them off
Balance and income statements
Types of depreciation
Straight line depreciation
Same amount each year
Example: 10 years, $100,000 = $10,000 per year
Accelerated depreciation
More in the early years
Production based depreciation

21. Tax Impact of Depreciation (Timing Effects, 10% tax rate, Asset size = 300)
Year
(Straight)
Earnings
Before D
Deprec.
Tax 1
300
100 20 2 3
(Accel.)
200 10 50 25

22. Goals
Accounting statement
Financial Ratios
Ratios and valuation

23. Financial Ratios Ratios of various financial variables Uses
Analyze financial well being of a firm
Compare different stocks in terms of current values
“Find good investments”

24. Ratios Liquidity ratios Activity ratios Profitability ratios
Leverage ratios
Coverage ratios
Market ratios
Dividend payout ratio

25. Liquidity Ratios Current ratio Quick ratio
Current assets / Current liabilities
Short term, ability to pay bills
Quick ratio
(Current assets - inventory) / Current liabilities
Take short term inventory out of current assets

26. Activity Ratios Inventory turnover Receivables turnover
Sales/(Average inventory)
Receivables turnover
(Annual credit sales)/(accounts receivable)
High number indicates rapid turnover in credit sales
Fixed asset turnover
Sales/(fixed assets) (land, plant + equipment)

27. Profitability Ratios Operating profit margin Net profit margin
EBIT/Sales
Net profit margin
Earnings/Sales
Gross profit margin
(Revenues-Cost of goods sold)/sales

28. Profitability Ratios Return on total assets (ROA)
Earnings/(total assets)
Return on equity (ROE)
Earnings/(shareholder equity)

29. Leverage Ratios Debt to net worth Debt ratio
Debt/(share holder equity)
Debt ratio
Debt/(total assets)

30. Coverage Ratios
Times-interest earned
EBIT/ (interest charges)

31. Market Ratios Share price versus accounting value Very important
Examples
Price/Earnings ratio
Market/Book (M/B) ratio
Dividend yield (dividend/Price)

32. Price Earnings Ratio P/E Ratio

33. Price Earnings Ratio Price per earnings Example: Microsoft About 20
$20 per $1 of earnings

34. High Flying P/E’s AOL (1999) near 600 Dell Computer (1999) 100
For many dot com’s no P/E since earnings are zero

35. PEG Ratio

36. Market to Book Ratio (M/B)

37. Market to Book Ratio
Market value of the firm relative to its accounting value
Key tool for “value investors”
Extensive academic evidence that low market to book firms do better on average

38. Dividend Yield Dividend/Price % payout in dividends relative to price
A little like interest, but not really
Dividends are not guaranteed

39. Dividend Payout Net Income Dividend Payout ratio = Divs/Earnings
Dividends
Retained Earnings
Dividend Payout ratio = Divs/Earnings

40. Goals
Accounting statement
Financial Ratios
Ratios and valuation

41. Fundamental Analysis
Use information about firm to evaluate stock price
Growth
Estimate earnings growth and future prospects
Value
Find “undervalued” stocks

42. Ratio Analysis Many methods
Compare ratios to appropriate comparison set
Example:
P/E ratio for a pharmaceutical firm
Compare to industry
If low -> buy

43. Problems With Accounting Information
Misses “intangibles”
Knowledge base (patents)
Customer base
Sometimes numbers are zero or negative

44. More Problems with Accounting Information
There are many ways to derive accounting numbers
Large “fudge factors”
Can clever accountants make things look better?

45. Accounting “Tricks” Off balance sheet items Expenses to balance sheet
Enron
Stock options
Expenses to balance sheet
Worldcom
AOL
maintenance -> new investment
Log revenue forecasts now
Xerox
Taking over low p/e firms

46. Goals
Accounting statement
Financial Ratios
Ratios and valuation