1. برنامج توعية وتدريب المحللين الماليين
الدكتور منذر بركات
إدارة البحوث والتوعية
هيئة الأوراق المالية والسلع

2. Financial Analysts Awareness & Training Program
Dr. Mounther Barakat
Securities and Commodities Authority

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

4. Balance Sheet: Assets Cash A/R Inventories Total CA Gross FA
Less: Dep.
Net FA
Total Assets
2007
7,282
632,160
1,287,360
1,926,802
1,202,950
263,160
939,790
2,866,592
2006
57,600
351,200
715,200
1,124,000
491,000
146,200
344,800
1,468,800

5. Balance sheet: Liabilities and Equity
Accts payable
Notes payable
Accruals
Total CL
Long-term debt
Common stock
Retained earnings
Total Equity
Total L & E
2007
524,160
636,808
489,600
1,650,568
723,432
460,000
32,592
492,592
2,866,592
2006
145,600
200,000
136,000
481,600
323,432
203,768
663,768
1,468,800

6. Income statement Sales COGS Other expenses EBITDA Depr. & Amort. EBIT
Interest Exp.
EBT
Taxes
Net income
2007
6,034,000
5,528,000
519,988
(13,988)
116,960
(130,948)
136,012
(266,960)
(106,784)
(160,176)
2006
3,432,000
2,864,000
358,672
209,328
18,900
190,428
43,828
146,600
58,640
87,960

7. Other data No. of shares EPS DPS Stock price 2007 100,000 -DHS1.602
2006
DHS0.88
DHS0.22
DHS8.50

8. Statement of Retained Earnings (2007)
DHS203,768
(160,176)
(11,000)
$32,592
Balance of retained
earnings, 12/31/06
Add: Net income, 2007
Less: Dividends paid
earnings, 12/31/07

9. Statement of Cash Flows (2007)
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)

10. Statement of Cash Flows (2007)
(711,950)
436,808
400,000
(11,000)
825,808
(50,318)
57,600
7,282
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

11. 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.

12. Did the expansion create additional net operating after taxes (NOPAT)?
NOPAT = EBIT (1 – Tax rate)
NOPAT07 = -$130,948(1 – 0.4)
= -$130,948(0.6)
= -$78,569
NOPAT06 = $114,257

13. What effect did the expansion have on net operating working capital?
NOWC = Current Non-interest
assets bearing CL
NOWC07= ($7,282 + $632,160 + $1,287,360) – ( $524,160 + $489,600)
= $913,042
NOWC06 = $842,400

14. What effect did the expansion have on operating capital?
Operating capital = NOWC + Net Fixed Assets
Operating Capital07= $913,042 + $939,790
= $1,852,832
Operating Capital06 = $1,187,200

15. What is your assessment of the expansion’s effect on operations?
Sales
NOPAT
NOWC
Operating capital
Net Income
2007
$6,034,000
-$78,569
$913,042
$1,852,832
-$160,176
2006
$3,432,000
$114,257
$842,400
$1,187,200
$87,960

16. What was the free cash flow (FCF) for 2007?
FCF07 = NOPAT – Net capital investment
= -$78,569 – ($1,852,832 - $1,187,200)
= -$744,201
Is negative free cash flow always a bad sign?

17. Return on Invested Capital (ROIC)
ROIC can be used to evaluate Simple Co.’s performance:
ROIC = NOPAT / Total operating capital in place at the beginning of the year
ROIC07 = -$78,569 / $1,187,200 = -6.6%

18. 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

19. 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.

20. EVA07 = NOPAT – (A-T cost of capital) (Capital)
What is the firm’s EVA? Assume the firm’s after-tax percentage cost of capital was 10% in 2006 and 13% in 2007.
EVA07 = NOPAT – (A-T cost of capital) (Capital)
= -$78,569 – (0.13)($1,852,832)
= -$78,569 - $240,868
= -$319,437
EVA06 = $114,257 – (0.10)($1,187,200)
= $114,257 - $118,720
= -$4,463

21. 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.

22. Pure Expectations Hypothesis
Maturity Yield
1 year 6.0%
2 years 6.2%
3 years 6.4%
4 years 6.5%
5 years 6.5%
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?

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

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

25. Returns (Amount received – Amount invested)
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%.

26. 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.

27. 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 (%)
100 15
-70
Firm X
Firm Y

28. The average and the standard deviation
Average Standard
Return Deviation
Small-company stocks 17.3% 33.2%
Large-company stocks
L-T corporate bonds
L-T government bonds
Treasury bills .

29. Return comparisons Recession Below avg Average Above avg Boom Economy
Prob.
T-Bill A B C M
Recession
0.1
8.0%
-22.0%
28.0%
10.0%
-13.0%
Below avg
0.2
-2.0%
14.7%
-10.0%
1.0%
Average
0.4
20.0%
0.0%
7.0%
15.0%
Above avg
35.0%
45.0%
29.0%
Boom
50.0%
-20.0%
30.0%
43.0%

30. 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.

31. 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.

32. Calculating expected returns.

33. Summary Calculating expected returns.
Exp return
A %
M %
C %
T-bill %
B %
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?

34. Risk: Calculating the standard deviation

35. Risk: Calculating the standard deviation

36. Risk: Calculating the standard deviation
Prob.
T - bill A
Rate of Return (%)

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

38. Comparing Risk and Return
Security
Expected return
Risk, σ
T-bills
8.0%
0.0% A
17.4%
20.0% B
1.7%
13.4% C
13.8%
18.8% M
15.0%
15.3%

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

40. Risk rankings, by coefficient of variationCV
T-bill A B C M
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.

41. 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.

42. Illustrating diversification effects of a stock portfolio
# Stocks in Portfolio
,000+
Company-Specific Risk
Market Risk 20
Stand-Alone Risk, sp
sp (%) 35

43. 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.

44. 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.

45. 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.

46. 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.

47. Illustrating the calculation of beta
See Excel file

48. 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.

49. Can the beta of a security be negative?
Yes, if the correlation between Stock i and the market is negative (i.e., ρi,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.

50. Beta coefficients _ ki kM -20 0 20 40 40 20 T-bills: β = 0 -20 40 20
-20
A: β = 1.30
T-bills: β = 0
B: β = -0.87

51. Comparing expected return and beta coefficients
Security Exp. Ret. Beta
A % M C
T-Bills B
Riskier securities have higher returns, so the rank order is OK.

52. The Security Market Line (SML):
SML: ki = kRF + (kM – kRF) βi
Assume kRF = 8% and kM = 15%.
The market (or equity) risk premium is RPM = kM – kRF = 15% – 8% = 7%.

53. 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.

54. Calculating required rates of return
kA = 8.0% + (15.0% - 8.0%)(1.30)
= 8.0% + (7.0%)(1.30)
= 8.0% + 9.1% = 17.10%
kM = 8.0% + (7.0%)(1.00) = 15.00%
kC = 8.0% + (7.0%)(0.89) = 14.23%
kT-bill = 8.0% + (7.0%)(0.00) = %
kB = 8.0% + (7.0%)(-0.87)= %

55. Expected vs. Required returns

56. Illustrating the Security Market Line. B A
T-bills C
SML
kM = 15
kRF = 8
SML: ki = 8% + (15% – 8%) βi
ki (%)
Risk, βi

57. The three basic concepts of valuation
Investors can only spend cash so "Cash is good and more cash is better."
Cash today is worth more than cash tomorrow.
Risky cash flows are worth less than safe cash flows.
These three imply the value of a company depends on the size, timing, and riskiness of its cash flows.

58. Valuation of a Simple Company
Investors are:
Debtholders
Stockholders 9

59. More investors…
Simple Co.’s shares of stock also compete in the market for investors.
Stockholders are the owners of the firm, and the value of ownership is the value of the asset, less any debt that is owed.
For example: Suppose Simple Co. is worth $501 million. It owes $150 million to debtholders. So Simple Co.’s equity is worth $501 – 150 = $351 million.

60. The Corporate Valuation Model
PV of cash flows available to all investors—called free cash flows (FCFs).
Discount free cash flows at the average rate of return required by all investors—called the weighted average cost of capital (WACC)

61. Steps in the corporate value model
Determine weighted average cost of capital
Estimate expected future free cash flows
Find value of company

62. Estimating the Weighted Average Cost of Capital (WACC)
Company has two types of investors
Debtholders
Stockholders
Each type of investor expects to receive a return for their investment
The return an investor receives is a “cost of capital” from company’s viewpoint.

63. Cost of Debt Simple Co.’s cost of debt: rD = 9%.
But Simple Co. can deduct interest, so cost to Simple Co. is after-tax rate on debt.
If tax rate is 40%, then after-tax cost of debt is:
After-tax rD = 9%(1-0.4) = 5.4%.

64. Cost of Equity
Cost of equity, rs, is higher than cost of debt because stock is riskier.
Simple Co.: rs = 12%

65. Weighted Average Cost of Capital
WACC is average of costs to all investors, weighted by the target percent of firm that is financed by each type.
For Simple Co., target percent financed by equity:
wS = 70%
For Simple Co., target percent financed by debt:
wD = 30%
(More….)

66. WACC (Continued) WACC = wD rD (1-T) + wS rS
= 0.3(9%)( ) + 0.7(12%)
= 10.02%

67. Free Cash Flow (FCF)
FCF is the amount of cash available from operations for distribution to all investors (including stockholders and debtholders) after making the necessary investments to support operations.
A company’s value depends upon the amount of FCF it can generate.

68. Calculating FCF
FCF = net operating profit after taxes minus investment in operating capital

69. Operating Current Assets
Operating current assets are the CA needed to support operations.
Op CA include: cash, inventory, receivables.
Op CA exclude: short-term investments, because these are not a part of operations.

70. Operating Current Liabilities
Operating current liabilities are the CL resulting as a normal part of operations.
Op CL include: accounts payable and accruals.
Op CA exclude: notes payable, because this is a source of financing, not a part of operations.

71. Balance Sheet: Assets
Op. CA 162, , ,400.0
Total CA 162, , ,400.0
Net PPE 199, , ,500.0
Tot. Assets 361, , ,900.0

72. Balance Sheet: Claims 2005 2006 2007 Op. CL 57,911.5 62,999.7 66,150.0
Op. CL 57, , ,150.0
Total CL 57, , ,150.0
L-T Debt 136, , ,223.0
Total Liab. 194, , ,373.0
Equity 166, , ,527.0
TL & Eq. 361, , ,900.0

73. Income Statement 2005 2006 2007 Sales 400,000.0 420,000.0 441,000.0
Sales 400, , ,000.0
Costs 344, , ,881.6
Op. prof. 56, , ,118.4
Interest 11, , ,875.5
EBT 44, , ,242.9
Taxes (40%) 17, , ,297.2
NI 26, , ,945.7
Dividends 21, , ,400.0
Add. RE 5, , ,545.7

74. NOPAT (Net Operating Profit After Taxes)
NOPAT is the amount of after-tax profit generated by operations.
NOPAT is the amount of net income, or earnings, that a company with no debt or interest-income would have.
NOPAT = (Operating profit) (1-T)
= EBIT (1-T)

75. Calculating NOPAT NOPAT = (Operating profit) (1-T) = EBIT (1-T)
NOPAT07 = (1-0.4) = million.

76. Calculating Operating Capital
Operating capital (also called total operating capital, or just capital) is the amount of assets required to support the company’s operations, less the liabilities that arise from those operations.
The short-term component is net operating working capital (NOWC).
The long-term component is factories, land, equipment.

77. Net Operating Working Capital
NOWC = Operating current assets
– Operating current liabilities
This is the net amount tied up in the “things” needed to run the company on a day-to-day basis.

78. Net Operating Working Capital
NOWC = Operating CA – Operating CL
NOWC07 = $176.4 – $66.15
= $ million

79. Operating Capital Operating capital =
Net operating working capital (NOWC) plus
Long-term capital, such as factories, land, equipment.

80. Operating Capital Capital07 = $110.25 + $220.50 = $330.75 million
Operating Capital = NOWC + LT Op. Capital
Capital07 = $ $220.50
= $ million
This means in 2007 Simple Co. had $ million tied up in capital needed to support its operations. Investors supplied this money. It isn’t available for distribution.

81. Investment in Operating Capital
Operating capital in 2006 was $ million
Operating capital in 2007 was $ million
Simple Co. had to make a net investment of $ – $ = $ million in operating capital in 2007.

82. Calculating FCF FCF = NOPAT – Investment in operating capital
= $ – $
= $ million

83. Uses of FCF There are five ways for a company to use FCF
1. Pay interest on debt.
2. Pay back principal on debt.
3. Pay dividends.
4. Buy back stock.
5. Buy nonoperating assets (e.g., marketable securities, investments in other companies, etc.)

84. Non-operating income NOPAT Working Capital Fixed Assets Dividends
Buy back stock
Pay interest
Fixed Assets
Pay principal
Buy non-op assets
Free Cash Flow
Reinvestmen

85. How Did Simple Co. use its FCF?
Paid dividends: $23.4 million
Paid after-tax interest of: $12,875.5 (1-0.4) = $ million
For a total of $ million! This is $7.162 million more than the $23.9 million FCF available! Where did it come from?
Simple Co. increased its borrowing by $ – $ ) = $7.162 million to make up the difference.

86. Corporate Valuation
Forecast financial statements and use them to project FCF.
Discount the FCFs at the WACC
This gives the value of operations

87. Value of Operations
Of course, this requires projecting free cash flows out forever.

88. Constant growth
If free cash flows are expected to grow at a constant rate of 5%, then this is easy:
FCF
There is an easy formula for the present value of free cash flows that grow forever at a constant rate…

89. Constant Growth Formula
The summation can be replaced by a single formula:

90. The value of operations

91. Value of Equity Sources of Corporate Value Claims on Corporate Value
Value of operations = $ million
Value of non-operating assets = $0 (in this case)
Claims on Corporate Value
Value of Debt = $ million
Value of Equity = ?
Value of Equity = $ $ = $ million, or just $351 million.

92. Value of Equity Price per share = Equity / # of shares
= $351 million / 10 million shares
= $35.10 per share

93. A picture of the breakdown of Simple Co.’s value

94. Return on Invested Capital (ROIC)
ROIC can be used to evaluate Simple Co.’s performance:
ROIC = NOPAT / Total operating capital in place at the beginning of the year

95. Return on Invested Capital (ROIC)
ROIC07 = NOPAT07 / Capital06
ROIC07 = / = 12.6%.
This is a good ROIC because it is greater than the return that investors require, the WACC, which is 10.02%. So Simple Co. added value during 2007.

96. Economic Value Added (EVATM) (also called Economic Profit)
EVA is another key measure of operating performance.
EVA is trademarked by Stern Stewart, Inc.
It measures the amount of profit the company earned, over and above the amount of profit that investors required.
EVA = NOPATt – WACC(Capitalt-1)

97. Calculating EVA EVA = NOPAT- (WACC)(Begng. Capital)
EVA07 = NOPAT07 – (0.1002)(Capital06)
EVA07 = $ – (0.1002)( )
= $ – $
= $ million
(More…)

98. Economic profit…
This shows that in 2007 Simple Co. earned about $8 million more than its investors required.
Another way to calculate EP is
EVAt = (ROIC – WACC)Capitalt-1
= ( – )$
= $ million

99. Intuition behind EVA
If the ROIC – WACC spread is positive, then the firm is generating more than enough “profit,” and is increasing value. But, if the ROIC – WACC spread is negative, then the firm is destroying value, in the sense that investors would be better off taking their money and investing it elsewhere.