1. 1-1 Financial Analysts Awareness Program Dr. Mounther Barakat Securities and Commodities Authority

2. 1-2 برنامج المحللين الماليين د. منذر بركات العمري هيئة الاوراق المالية والسلع

3. 1-3 Forecasting Example Cash & sec.$ 20Accts. pay. & accruals$ 100 Accounts rec. 240Notes payable 100 Inventories 240Total CL$ 200 Total CA$ 500L-T debt100 Common stock500 Net fixedRetained assets 500 earnings 200 Total assets$1,000Total claims$1,000 Balance sheet, in millions of dollars

4. 1-4 Sales$2,000.00 Less:Var. costs (60%)1,200.00 Fixed costs 700.00 EBIT$ 100.00 Interest 16.00 EBT$ 84.00 Taxes (40%) 33.60 Net income$ 50.40 Dividends (30%)$15.12 Add’n to RE$35.28 Income statement, in millions of dollars Forecasting Example

5. 1-5 Key assumptions Operating at full capacity in 2006. Each type of asset grows proportionally with sales. Payables and accruals grow proportionally with sales. 2006 profit margin (2.52%) and payout (30%) will be maintained. Sales are expected to increase by $500 million. (%GS = 25%)

6. 1-6 Determining additional funds needed AFN AFN= (A*/S 0 )ΔS – (L*/S 0 ) ΔS – M(S 1 )(RR) = ($1,000/$2,000)($500) – ($100/$2,000)($500) – 0.0252($2,500)(0.7) = $180.9 million.

7. 1-7 How shall AFN be raised? The payout ratio will remain at 30 percent (d = 30%; RR = 70%). No new common stock will be issued. Any external funds needed will be raised as debt, 50% notes payable and 50% L-T debt.

8. 1-8 Forecasted Income Statement Sales$2,0001.25$2,500 Less:VC1,2000.601,500 FC 7000.35 875 EBIT$ 100$ 125 Interest 16 16 EBT$ 84$ 109 Taxes (40%) 34 44 Net income$ 50$ 65 Div. (30%)$15$19 Add’n to RE$35$46 Forecast Basis 2007 Forecast 2006

9. 1-9 2007 1 st Pass Forecasted Balance Sheet (2007) - Assets 2006 Forecast Basis Cash$ 200.01$ 25 Accts. rec.2400.12300 Inventories 2400.12 300 Total CA$ 500$ 625 Net FA 5000.25 625 Total assets$1,000$1,250

10. 1-10 2007 1 st Pass 2006 Forecast Basis Forecasted Balance Sheet (2007) - Liabilities and Equity AP/accruals$ 1000.05$ 125 Notes payable 100 100 Total CL$ 200$ 225 L-T debt 100100 Common stk.500500 Ret.earnings 200+46* 246 Total claims$1,000$1,071 * From income statement.

11. 1-11 What is the additional financing needed (AFN)? Required increase in assets= $ 250 Spontaneous increase in liab.= $ 25 Increase in retained earnings= $ 46 Total AFN= $ 179 The company must have the assets to generate forecasted sales. The balance sheet must balance, so we must raise $179 million externally.

12. 1-12 How will the AFN be financed? Additional N/P 0.5 ($179) = $89.50 Additional L-T debt 0.5 ($179) = $89.50 But this financing will add to interest expense, which will lower NI and retained earnings. This will lower equity financing and increase debt financing, and so on. We will generally ignore financing feedbacks.

13. 1-13 2007 2 nd Pass 2007 1 st Pass AFN Forecasted Balance Sheet (2007) - Assets Cash$ 25-$ 25 Accts. rec.300-300 Inventories 300- 300 Total CA$ 625$ 625 Net FA 625- 625 Total assets$1,250$1,250

14. 1-14 2007 2 nd Pass 2007 1 st Pass AFN Forecasted Balance Sheet (2007) - Liabilities and Equity AP/accruals$ 125-$ 125 Notes payable 100+89.5 190 Total CL$ 225$ 315 L-T debt 100+89.5189 Common stk.500-500 Ret.earnings 246- 246 Total claims$1,071$1,250

15. 1-15 Advanced Forecasting Use of regressions for each item Use of iterations in finding interest income and expense Forecasting with stock dividends, stock repurchase, stock issuance, stock splits, ….

16. 1-16 Analyzing PE and PB and its Usages Case I

17. 1-17 Analyzing PE and PB and its Usages Case I

18. 1-18 Analyzing PE and PB and its Usages Case II

19. 1-19 Analyzing PE and PB and its Usages Case II

20. 1-20 Analyzing PE and PB and its Usages Case III

21. 1-21 Analyzing PE and PB and its Usages Case III

22. 1-22 Analyzing PE and PB and its Usages Case IV

23. 1-23 Analyzing PE and PB and its Usages Case IV

24. 1-24 Analyzing PE and PB and its Usages Conclusions Reinvestment of free cash flow at rates of return in excess of capital costs creates growth in abnormal earnings, resulting in valuation multiple expansion. The PE is a function of the prospective growth in future abnormal earnings. Usages of PE in any other cases will result in mispricing and arbitrage opportunities. This huge limitation should be considered among many other ones.

25. 1-25 Analyzing PE and PB and its Usages Conclusions Which PE to use the historical average of the same firm’s PE’s, OR The PE of similar firms, OR The PE of the industry How are PE’s used for companies that have more than one division (weighted average?!)

26. 1-26 Analyzing PE and PB and its Usages Conclusions PE does take risk into account indirectly (i.e. through the used pricing model’s discount rate). PE gives the dollar amount (Price) the investor is willing to pay for one dollar of continued earnings. PE is the reciprocal of the required rate of return. Empirical studies show that the required rate of return (calculated using other return models like the market model or CAPM) is usually different from the one calculated by PE ratios. Only sustainable earnings are used, transitory or non recurring earnings must be excluded.

27. 1-27 Analyzing PE and PB and its Usages Recommendations Use PE ratios with maximum caution Know when it is used and what it means PB is also problematic some times, it is used when there are abnormal returns regardless whether they grow or not.

28. 1-28 Balance Sheet: Assets Cash A/R Inventories Total CA Gross FA Less: Dep. Net FA Total Assets 2006 7,282 632,160 1,287,360 1,926,802 1,202,950 263,160 939,790 2,866,592 2005 57,600 351,200 715,200 1,124,000 491,000 146,200 344,800 1,468,800

29. 1-29 Balance sheet: Liabilities and Equity Accts payable Notes payable Accruals Total CL Long-term debt Common stock Retained earnings Total Equity Total L & E 2006 524,160 636,808 489,600 1,650,568 723,432 460,000 32,592 492,592 2,866,592 2005 145,600 200,000 136,000 481,600 323,432 460,000 203,768 663,768 1,468,800

30. 1-30 Income statement Sales COGS Other expenses EBITDA Depr. & Amort. EBIT Interest Exp. EBT Taxes Net income 2006 6,034,000 5,528,000 519,988 (13,988) 116,960 (130,948) 136,012 (266,960) (106,784) (160,176) 2005 3,432,000 2,864,000 358,672 209,328 18,900 190,428 43,828 146,600 58,640 87,960

31. 1-31 Other data No. of shares EPS DPS Stock price 2006 100,000 - DHS 1.602 DHS 0.11 DHS 2.25 2005 100,000 DHS 0.88 DHS 0.22 DHS 8.50

32. 1-32 Statement of Retained Earnings (2006) Balance of retained earnings, 12/31/05 Add: Net income, 2006 Less: Dividends paid Balance of retained earnings, 12/31/06 DHS 203,7 68 (160,176) (11,000) $32,592

33. 1-33 Statement of Cash Flows (2006) OPERATING ACTIVITIES Net income Add (Sources of cash): Depreciation Increase in A/P Increase in accruals Subtract (Uses of cash): Increase in A/R Increase in inventories Net cash provided by ops. (160,176) 116,960 378,560 353,600 (280,960) (572,160) (164,176)

34. 1-34 Statement of Cash Flows (2006) L-T INVESTING ACTIVITIES Investment in fixed assets FINANCING ACTIVITIES Increase in notes payable Increase in long-term debt Payment of cash dividend Net cash from financing NET CHANGE IN CASH Plus: Cash at beginning of year Cash at end of year (711,950) 436,808 400,000 (11,000) 825,808 (50,318) 57,600 7,282

35. 1-35 Notes from the statement of CFs? Net cash from operations = -$164,176, mainly because of negative NI. The firm borrowed $825,808 to meet its cash requirements. Even after borrowing, the cash account fell by $50,318.

36. 1-36 Did the expansion create additional net operating after taxes (NOPAT)? NOPAT = EBIT (1 – Tax rate) NOPAT 06 = -$130,948(1 – 0.4) = -$130,948(0.6) = -$78,569 NOPAT 05 = $114,257

37. 1-37 What effect did the expansion have on net operating working capital? NOWC = Current - Non-interest assets bearing CL NOWC 06 = ($7,282 + $632,160 + $1,287,360) – ( $524,160 + $489,600) = $913,042 NOWC 05 = $842,400

38. 1-38 What effect did the expansion have on operating capital? Operating capital = NOWC + Net Fixed Assets Operating Capital 06 = $913,042 + $939,790 = $1,852,832 Operating Capital 05 = $1,187,200

39. 1-39 What is your assessment of the expansion’s effect on operations? Sales NOPAT NOWC Operating capital Net Income 2006 $6,034,000 -$78,569 $913,042 $1,852,832 -$160,176 2005 $3,432,000 $114,257 $842,400 $1,187,200 $87,960

40. 1-40 What effect did the expansion have on net cash flow and operating cash flow? NCF 06 = NI + Dep = ($160,176) + $116,960 = -$43,216 NCF 05 = $87,960 + $18,900 = $106,860 OCF 06 = NOPAT + Dep = ($78,569) + $116,960 = $38,391 OCF 05 = $114,257 + $18,900 = $133,157

41. 1-41 What was the free cash flow (FCF) for 2006? FCF = OCF – Gross capital investment - OR - FCF 06 = NOPAT – Net capital investment = -$78,569 – ($1,852,832 - $1,187,200) = -$744,201 Is negative free cash flow always a bad sign?

42. 1-42 Economic Value Added (EVA) EVA = After-tax __ After-tax Operating Income Capital costs = Funds Available __Cost of to Investors Capital Used = NOPAT – After-tax Cost of Capital

43. 1-43 EVA Concepts In order to generate positive EVA, a firm has to more than just cover operating costs. It must also provide a return to those who have provided the firm with capital. EVA takes into account the total cost of capital, which includes the cost of equity.

44. 1-44 What is the firm’s EVA? Assume the firm’s after-tax percentage cost of capital was 10% in 2005 and 13% in 2006. EVA 06 = NOPAT – (A-T cost of capital) (Capital) = -$78,569 – (0.13)($1,852,832) = -$78,569 - $240,868 = -$319,437 EVA 05 = $114,257 – (0.10)($1,187,200) = $114,257 - $118,720 = -$4,463

45. 1-45 Did the expansion increase or decrease MVA? MVA = Market value __Equity capital of equity supplied During the last year, the stock price has decreased 73%. As a consequence, the market value of equity has declined, and therefore MVA has declined, as well.

46. 1-46 Pure Expectations Hypothesis MaturityYield 1 year6.0% 2 years6.2% 3 years6.4% 4 years6.5% 5 years6.5% If PEH holds, what does the market expect will be the interest rate on one-year securities, one year from now? Three-year securities, two years from now?

47. 1-47 Spot and forward rates 6.2% = (6.0% + x%) / 2 12.4%= 6.0% + x% 6.4%= x% PEH says that one-year securities will yield 6.4%, one year from now.

48. 1-48 Spot and forward rates 6.5% = [2(6.2%) + 3(x%) / 5 32.5% = 12.4% + 3(x%) 6.7%= x% PEH says that one-year securities will yield 6.7%, one year from now.

49. 1-49 Returns The rate of return on an investment can be calculated as follows: (Amount received – Amount invested) Return = ________________________ Amount invested For example, if $1,000 is invested and $1,100 is returned after one year, the rate of return for this investment is: ($1,100 - $1,000) / $1,000 = 10%.

50. 1-50 What is Risk? Two types of investment risk Stand-alone risk Portfolio risk Investment risk is related to the probability of earning a low or negative actual return. The greater the chance of lower than expected or negative returns, the riskier the investment.

51. 1-51 Probability distributions A listing of all possible outcomes, and the probability of each occurrence. Can be shown graphically. Expected Rate of Return Rate of Return (%) 100150-70 Firm X Firm Y

52. 1-52 The average and the standard deviation Average Standard Return Deviation Small-company stocks17.3%33.2% Large-company stocks12.720.2 L-T corporate bonds 6.1 8.6 L-T government bonds 5.7 9.4 U.S. Treasury bills 3.9 3.2.

53. 1-53 Return comparisons EconomyProb.T-BillABCM Recession 0.18.0%-22.0%28.0%10.0%-13.0% Below avg 0.28.0%-2.0%14.7%-10.0%1.0% Average 0.48.0%20.0%0.0%7.0%15.0% Above avg 0.28.0%35.0%-10.0%45.0%29.0% Boom 0.18.0%50.0%-20.0%30.0%43.0%

54. 1-54 T-Bills and their risk and return. T-bills will return the promised 8%, regardless of the economy. No, T-bills do not provide a risk-free return, as they are still exposed to inflation. Although, very little unexpected inflation is likely to occur over such a short period of time. T-bills are also risky in terms of reinvestment rate risk. T-bills are risk-free in the default sense of the word.

55. 1-55 Asset and market returns. A – Moves with the economy, and has a positive correlation. This is typical. B – Is countercyclical with the economy, and has a negative correlation. This is unusual.

56. 1-56 Calculating expected returns.

57. 1-57 Summary Calculating expected returns. Exp return A 17.4% M 15.0% C 13.8% T-bill 8.0% B 1.7% A has the highest expected return, and appears to be the best investment alternative, but is it really? Have we failed to account for risk?

58. 1-58 Risk: Calculating the standard deviation

59. 1-59 Risk: Calculating the standard deviation

60. 1-60 Risk: Calculating the standard deviation C Prob. T - bill A 0 8 13.8 17.4 Rate of Return (%)

61. 1-61 Standard Deviation as a Measure of Risk Standard deviation (σ i ) measures total, or stand-alone, risk. The larger σ i is, the lower the probability that actual returns will be closer to expected returns. Larger σ i is associated with a wider probability distribution of returns.

62. 1-62 Comparing Risk and Return SecurityExpected return Risk, σ T-bills8.0%0.0% A17.4%20.0% B1.7%13.4% C13.8%18.8% M15.0%15.3%

63. 1-63 Coefficient of Variation (CV) A standardized measure of dispersion about the expected value, that shows the risk per unit of return.

64. 1-64 Risk rankings, by coefficient of variation CV T-bill0.000 A1.149 B7.882 C1.362 M1.020 B has the highest degree of risk per unit of return. A, despite having the highest standard deviation of returns, has a relatively average CV.

65. 1-65 Investor attitude towards risk Risk aversion – assumes investors dislike risk and require higher rates of return to encourage them to hold riskier securities. Risk premium – the difference between the return on a risky asset and less risky asset, which serves as compensation for investors to hold riskier securities.

66. 1-66 Illustrating diversification effects of a stock portfolio # Stocks in Portfolio 10 20 30 40 2,000+ Company-Specific Risk Market Risk 20 0 Stand-Alone Risk,  p  p (%) 35

67. 1-67 Breaking down sources of risk Stand-alone risk = Market risk + Firm-specific risk Market risk – portion of a security’s stand-alone risk that cannot be eliminated through diversification. Measured by beta. Firm-specific risk – portion of a security’s stand- alone risk that can be eliminated through proper diversification.

68. 1-68 Capital Asset Pricing Model Model based upon concept that a stock’s required rate of return is equal to the risk-free rate of return plus a risk premium that reflects the riskiness of the stock after diversification. Primary conclusion: The relevant riskiness of a stock is its contribution to the riskiness of a well- diversified portfolio.

69. 1-69 Beta Measures a stock’s market risk, and shows a stock’s volatility relative to the market. Indicates how risky a stock is if the stock is held in a well-diversified portfolio.

70. 1-70 Calculating betas Run a regression of past returns of a security against past returns on the market. The slope of the regression line (sometimes called the security’s characteristic line) is defined as the beta coefficient for the security.

71. 1-71 Illustrating the calculation of beta See Excel file

72. 1-72 Comments on beta If beta = 1.0, the security is just as risky as the average stock. If beta > 1.0, the security is riskier than average. If beta < 1.0, the security is less risky than average. Most stocks have betas in the range of 0.5 to 1.5.

73. 1-73 Can the beta of a security be negative? Yes, if the correlation between Stock i and the market is negative (i.e., ρ i,m < 0). If the correlation is negative, the regression line would slope downward, and the beta would be negative. However, a negative beta is highly unlikely.

74. 1-74 Beta coefficients kiki _ kMkM _ - 20 0 20 40 40 20 -20 A: β = 1.30 T-bills: β = 0 B: β = -0.87

75. 1-75 Comparing expected return and beta coefficients SecurityExp. Ret. Beta A 17.4% 1.30 M 15.0 1.00 C 13.8 0.89 T-Bills 8.0 0.00 B 1.7-0.87 Riskier securities have higher returns, so the rank order is OK.

76. 1-76 The Security Market Line (SML): SML: k i = k RF + (k M – k RF ) β i Assume k RF = 8% and k M = 15%. The market (or equity) risk premium is RP M = k M – k RF = 15% – 8% = 7%.

77. 1-77 What is the market risk premium? Additional return over the risk-free rate needed to compensate investors for assuming an average amount of risk. Its size depends on the perceived risk of the stock market and investors’ degree of risk aversion. Varies from year to year, but most estimates suggest that it ranges between 4% and 8% per year.

78. 1-78 Calculating required rates of return k A = 8.0% + (15.0% - 8.0%)(1.30) = 8.0% + (7.0%)(1.30) = 8.0% + 9.1%= 17.10% k M = 8.0% + (7.0%)(1.00)= 15.00% k C = 8.0% + (7.0%)(0.89)= 14.23% k T-bill = 8.0% + (7.0%)(0.00)= 8.00% k B = 8.0% + (7.0%)(-0.87)= 1.91%

79. 1-79 Expected vs. Required returns

80. 1-80 Illustrating the Security Market Line.. B. A T-bills. C SML k M = 15 k RF = 8 -1 0 1 2 SML: k i = 8% + (15% – 8%) β i k i (%) Risk, β i