1. Financial Statements Economics 98 / 198 Fall 2007 Copyright 2007 Jason Lee

2. Announcements Oct 31 versus Nov 31 lecture? Simulation Exercise - Money

3. CURRENT EVENT / NEWS

4. LECTURE CONTENT

5. Today’s Lecture Trading Psychology Financial Statements introduction – Income Statement – Balance Sheet – Cash Flow Statement – Earning Season Ratio Analysis

6. TRADING PSYCHOLOGY

7. Trading Psychology Emotions severely impair your judgment in deciding whether to buy or sells tocks HOPE FEAR GREED PRIDE

9. Psychology & The Stock Market Emotions can wreak havoc on your results and decisions Need to take emotion out of investing Do this by developing a system with rules to follow with discipline

10. Trading Psychology “Your biggest enemy, when trading, is within yourself. Success will only come when you learn to control your emotions” - Edwin Lefevre

11. Accounting 101: Financial Statements

12. Reporting Financial Statements Public co. required to publish 10K and 10Q – 10K = Annual financial reports – 10Q = Quarterly financial reports Income Statement Balance Sheet Statement of Cash Flows Why do we care about these reports?

13. The Income Statement Shows how much a company earned or lost during that specific period Considered the most analyzed statement for investors Divulges into a company’s profitability IS THE COMPANY MAKING PROFIT?

14. Income Statements Generally, 3 Major Parts – Revenues – Expenses – Net Income Earnings Per Share (EPS) = Profits / Shares Outstanding Investors pay very close attention to profits (earnings) and revenue (sales) Income = Revenues - Expenses

15. Balance Sheet Summarizes company’s assets, liabilities, and shareholders’ equities at specific time Assets = Liabilities + Shareholder’s Equity How do we analyze this statement? We use ratios and changes in trends to analyze the information

16. Balance Sheet Assets – Current Assets: life span of 1 year or less – Non-Current assets Liabilities – Current Liabilities – Non-current liabilities Shareholder’s Equity – Common / Preferred Stock – Retained Earnings

17. Statement of Cash Flows Shows how much money coming in (inflows) and going out (outflows) – Cash flow from operations – Cash flow from investing – Cash flow from financing Shows if company having trouble with cash – Profitable companies can struggle cash flows. Why? Cash is king! Pays for bills and funds operations!

18. Earnings Season Companies release quarterly reports and annual reports – “Financial Report Cards” Stock analysts issue earnings estimate – Consensus earnings estimates Earnings surprise is a good thing – Meeting / beating / missing expectations – If below estimates, then stock usually head downwards fast!

20. Understanding Earnings Actual earnings value is important, but so is the growth of these earnings Compare EPS / Revenue? – Do we compare them to last quarter? – Do we compare them to the same quarter last year?

21. EPS % Growth: Google Q2 2007 Source: MSN Money Stock Quotes EPS growth calculated comparing Q2 2007 to Q2 2006 Q2 2007EPS Growth 2007 Q2 EPS 2006 Q2 EPS $2.98 / sh $2.39 / sh =25%

22. Why do Investors Care About Earnings? Strong earnings or expectations of strong earnings drive stock prices. Why? – Potential for greater reinvestment, and greater earnings – Passing the money to shareholders in various forms (dividends, buybacks, etc.) Ultimately, earnings provide a return on the investment for shareholders

23. Ratio Analysis

24. Used to gain idea of valuation and financial performance Compared to competitors and historical values to gain understanding about company’s value – Is it undervalued? Overvalued? – How is it performing?

25. Profit Margins = net income / net sales (revenue) – Measures how much out of every dollar of sales a company actually keeps in earnings High profit margins indicates that management efficient at controlling costs – Increased earnings are good, but if costs are increasing faster than sales, leads to lower profit per sale Good sign if company has growing profit margins

26. Profit Margins: Example Company has a net income of $10 million from sales of $100 million, giving it a profit margin of 10% ($10 million/$100 million) If in the next year net income rose to $15 million on sales of $200 million. Would its profit margins be growing or diminishing? What does this mean?

27. Price to Earnings Ratio (P/E) P/E Ratio = Price per share / Earnings per share – Look at company’s earnings relative to its price Most basic valuation method of company – How do you we use it? Ex. If BIG OIL co. has P/E ratio of 15 and has solid fundamentals, and the industry average is 40, then the BIG OIL would be considered undervalued

28. Price to Earnings Ratio (P/E) Use as a guide, not a guarantee in your analysis Sometimes, there is a reason for high or low P/E ratios (understanding business and industry is important) – High P/E ratios: investors may be willing to pay more for less earnings because its expect higher growth rates in the future – Low P/E ratios: may seem like a bargain, but low ratio may signal questionable future prospects

29. Return on Equity (ROE) = Net Income / Shareholder’s Equity – how much profit a company can generate with the money shareholders have invested – Is it a profit-making machine or an inefficient clunker? Useful for comparing profitability and efficiency of a company to other firms in same industry – can indicate whether a company is growing without pouring new capital into business Growing ROE also shows management making better use of money invested by shareholders

30. Return on Equity (ROE) PC Industry Example (Dell vs. Gateway vs. HP) Dell HP Gateway

31. Debt-to-Equity Ratios Debt / Equity Ratio = Total Liabilities / Shareholder’s Equity – Proportion of equity and debt to finance assets High ratio: aggressive debt, potential for higher earnings per share but at more risk – More volatile earnings and larger interest expenses Compare this similar companies Warren Buffet preferred to see lower ratio so that earnings growth is generated by investors rather than borrowed money

32. Google Example

33. Other Relevant Ratios Current Ratio Return on Assets Inventory Turnover Interest Coverage More on Ratio Analysis / Financial Statement Analysis: http://www.investopedia.com/university/ratios/ratios1.asp http://www.investopedia.com/university/financialstatements/ UGBA 102A: Introduction to Financial Accounting

34. Reading Motley Fool. “Analyzing Stocks” Recommended: Investopedia. “Valuation”