1. Contents - I External Environment Internal Environment The Future
Financial System
Financial sector
The mechanics of moving resources
Economic forces
Industry factors
Internal Environment
Inputs, Operations, Outputs and supporting activities
The various departments
Corporate governance and agency problems
Company risk and return
The Future
Forecasted cash flows
Forecasted growth rates

2. Contents II Types of Financial Analysis Fundamental Analysis
Profit Maximization.
ROE (Du Pont) Analysis
Factors That Affect Stock Value
Fundamental Valuation Models
Technical Analysis
Use of Exotics in Financial Analysis and valuation
Use of Mathematics in Financial Analysis
Forecasting in financial Analysis
PE and PB Rations in Depth Analysis

3. Review -What is Financial Analysis
To evaluate and valuate.
Evaluate determinants of financial performance
Determine and put a value to performance parameters
Make a decision

4. Review of the First Session
Introduction to the financial system including an explanation of the financial sector, participants in the financial system and interest and money as the driver and lubricants of the economy.
Reviewed the external and internal environment and their effects as determinants of forecasting and drivers of value.
Reviewed the basics of financial analysis like its scope and content and some new trends in financial analysis that are becoming the new tools that are increasingly used especially in valuation of financial derivatives and other structured financial instruments.

5. Manager – Shareholder
Agents--managers with a fiduciary duty to act in the best interests of owners
Agency problem--managers maximize their own self-interests at the expense of owners
High salaries of CEOs
Emphasis on short-term performance at expense of long-term performance
Empire building for status
perquisites
The burden is to align the interests of the manager with those of the shareholders
This puts a DRAIN on the performance and value of the firm.
Tactics used to align interest:
Manager part owner
Stock options
Bonuses
Cash dividends
Debt
Monitoring
Corporate control markets

6. Shareholder – Debt holder
The conflict of interest arises here when the firm is over indebted.
Shareholders will get into high risk – high return investments, if such investments materialize, shareholders will reap most of the benefit (debt holders are paid a fixed percentage and the residual goes to the shareholders), if not most of the loss will be on the side of the debt holders.
The solution is covenants
The financial analyst needs to assess such situation in the process of determining a risk premium among other things.

7. Shareholder - Shareholder
A rises in companies with subsidiaries and affiliates
The interests of the subsidiary shareholders are not in line with those of the shareholders of the parent companies
Appears in capital budgeting decisions especially when the parent and the subsidiary are in two different tax and regulatory regimes

8. Auditors
Auditors are prone to be lenient in auditing financial statements and in valuing business because they are paid by the very same party they are auditing or do not want to lose future business opportunities.
Such considerations need to be taken into account when financially analyzing a firm.

9. Regulators
The regulators interests may be different from those of the company being analyzed
The regulator may enact regulations that hurt the company for the public good; levying taxes is an example.

10. The Market for Corporate Control
Participants in the financial markets are monitoring each other to capitalize on opportunities of buying an undervalued firm.
Firms that have corporate governance problems are prone to incur higher rate of return due to the risk premium added from such problems.
The financial analyst needs to incorporate such factors in estimating and forecasting required rates of return and future cash flows.

11. Company Risk and Return
The analyst needs to incorporate specific analysis of the riskness of the company to reflect that on the required rate of return on investing sums of money in such company.
Many measures of risk, the most important ones are the most simple ones, because they are the ones used most in industry practice.
Beta
Sigma
VaR
Many more like: down side risk, coefficient of variation, regressions, time series, FF two factor model, FF multi factor models, Merton intertemporal model, stochastic models, stress tests under various distributions …..

12. Types of Financial Analysis
Fundamental: use of all relevant information and to predict value – assumes markets efficiency.
Technical: use of past price, trading volume and people behavior to predict value – assumes market inefficiency.
Naïve: Financial ratios and some calculated indicators – limited usefulness.

13. Fundamental Analysis
The value of an asset is equal to the present value of all of its future net cash flow.
Need to take previous factors into account when forecasting cash flows, growth rates and required rates of return.
Depends on all relevant information
Believes in Semi strong form market efficiency.

14. Is stock price maximization the same as profit maximization?
No, despite a generally high correlation amongst stock price, EPS, and cash flow.
Current stock price relies upon current earnings, as well as future earnings and cash flow.
Some actions may cause an increase in earnings, yet cause the stock price to decrease (and vice versa).

15. Profit Maximization Example:
Equity = 10 million DHS1 a share book value, no RE, no PIC and no reserves.
Profits = DHS10 million
CEO and CFO claim that they can maximize profits by increasing them to DHS10.5 million if they company would issue 1 million new shares.
In this case profits are maximized however profitability is lowered

16. Profit Maximization
Well, what happened to profitability?

17. Profit and Profitability Maximization
Example:
Equity = 1 million DHS1 a share book value, no RE, no PIC and no reserves.
Profits = DHS1 million
CEO and CFO claim that they can maximize profits by increasing them to DHS1.5 million if they company would retain all of last year’s earnings, i.e. DHS1 million .
In this case profits and profitability are maximized

18. Profit and Profitability Maximization
How would this affect return on equity?

19. Maximizing Profits, Profitability and Return on Equity!
Use leverage to increase the return on equity
However this will increase the riskness of the firm
Increasing risk lowers the price.
Furthermore, the return on total assets will decline

20. Maximizing Profits, Profitability and Return on Equity!
Example
same as last example, but instead of retaining earnings, finance growth operations and profits by borrowing from the bank at 10%.

21. What would happen to the Return on total assets?
Maximizing Profits, Profitability and Return on Equity!
What would happen to the Return on total assets?

22. ROE Analysis

23. ROE Analysis

24. ROE Analysis

25. ROE Analysis

26. Factors that affect stock price
Projected cash flows to shareholders
Timing of the cash flow stream
Riskiness of the cash flows

27. Basic Valuation Model
To estimate an asset’s value, one estimates the cash flow for each period t (CFt), the life of the asset (n), and the appropriate discount rate (k)

28. Dividend Discount Models
Constant growth
Two growth
Multi growth
Stochastic
Additive w and w/o bankruptcy
Geometric w and w/o bankruptcy

29. Residual Income Valuation

30. Multipliers PE PB
V/EBIT
P/S
P/CF

31. Technical analysis
Depends on past prices and trading volumes to predict price and performance
Markets are inefficient
Prices are trendy
Can be very mathematical

32. Technical Charts Point and figure Candlesticks OHLC Price lines
Moving averages ……

33. Technical Indicators
Candlesticks: hammer, bullish engulfing, morning star, bearish engulfing, hanging man, harami, Marubozu, three white soldiers, …. Many more.
Technical indicators: moving averages, exponential moving averages, Bollinger bands, slow stochastic, fast stochastic, Trin, Trix, Money flow index, RSI, Average directional index, Williams %R, Price rate of change, Oscillators, …. Many more.

34. Exotic Financial Analysis
Stochastic models in forecasting items and future interest rates and discount rates, and the previously mentioned stochastic dividend discount models.
Real Options
Abandonment Options

35. Use of Mathematics
Towards the end of this program and as an introduction to future programs we will look into the mathematics of financial analysis and their numerical solutions especially for derivatives and their use in equity and other securities financial analyses.

36. 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

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

38. 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%)

39. Determining additional funds needed AFN
AFN = (A*/S0)ΔS – (L*/S0) ΔS – M(S1)(RR)
= ($1,000/$2,000)($500)
– ($100/$2,000)($500)
– ($2,500)(0.7)
= $180.9 million.

40. 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.

41. Forecasted Income Statement
2006
Forecast
Basis
2007
Forecast
Sales $2, $2,500
Less: VC 1, ,500 FC
EBIT $ $ 125
Interest
EBT $ $ 109
Taxes (40%)
Net income $ $
Div. (30%) $15 $19
Add’n to RE $35 $46

42. Forecasted Balance Sheet (2007) - Assets
Basis
2007
1st Pass
2006
Cash $ $
Accts. rec
Inventories
Total CA $ $ 625
Net FA
Total assets $1,000 $1,250

43. Forecasted Balance Sheet (2007) - Liabilities and Equity
Basis
2007
1st Pass
2006
AP/accruals $ $ 125
Notes payable
Total CL $ $ 225
L-T debt
Common stk
Ret.earnings *
Total claims $1,000 $1,071
* From income statement.

44. What is the additional financing needed (AFN)?
Required increase in assets = $ 250
Spontaneous increase in liab. = $
Increase in retained earnings = $
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.

45. How will the AFN be financed?
Additional N/P
0.5 ($179) = $89.50
Additional L-T debt
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.

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

47. Forecasted Balance Sheet (2007) - Liabilities and Equity
1st Pass
2007
2nd Pass
AFN
AP/accruals $ $ 125
Notes payable
Total CL $ $ 315
L-T debt
Common stk
Ret.earnings
Total claims $1,071 $1,250

48. 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, ….

49. Analyzing PE and PB and its Usages Case I

50. Analyzing PE and PB and its Usages Case I

51. Analyzing PE and PB and its Usages Case II

52. Analyzing PE and PB and its Usages Case II

53. Analyzing PE and PB and its Usages Case III

54. Analyzing PE and PB and its Usages Case III

55. Analyzing PE and PB and its Usages Case IV

56. Analyzing PE and PB and its Usages Case IV

57. 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 case will result in mispricing and arbitrage opportunities.
This huge limitation should be considered among many other ones.

58. 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

59. 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 if 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.

60. 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.

61. Tools of Financial Analysis
See you all in December