1. Chapter 17 Company Analysis

2. Define fundamental analysis at the company level. Explain the accounting aspects of a company’s earnings. Describe the importance of EPS forecasts. Estimate the P/E ratio of a company. Use the beta coefficient to estimate the risk of a stock. Learning Objectives

3. Last step in top-down approach is individual company analysis Goal: estimate share’s intrinsic value  Constant growth version of dividend discount model  Value justified by fundamentals Fundamental Analysis

4. Multiple Growth Rate Y1-2=8% Y3-4=6% Y 5 → 3.5% forever D5 =3.50; RR=12% P0=?

5. Earnings multiple could also be used P 0 = estimated EPS  justified P/E ratio Stock is under- (over-) valued if intrinsic value is larger (smaller) than current market price Focus on earnings and P/E ratio  Dividends paid from earnings  Close correlation between earnings and stock price changes Fundamental Analysis

6. How is EPS derived and what does EPS represent? Financial statements provide majority of financial information about firms Analysis implies comparison over time or with other firms in the same industry Focus on how statements used, not made Accounting Aspects of Earnings

7. Balance Sheet  Items listed in order of liquidity (assets) or in order of payment (liabilities)  Assets Cash vs. non-cash assets  Non-cash assets may be worth more or less than the amount carried on the books Depreciation methods for fixed assets Inventory evaluation choices Basic Financial Statements

8. Balance Sheet  Liabilities Fixed claims against the firm  Equity Residual claims Adjusts when the value of assets change Linked to Income Statement  “Snapshot” at one point in time Basic Financial Statements

9. Income Statement Sales or revenues - Product costs Gross profit - Period Costs EBIT - Interest EBT - Taxes Net Income available to owners - Dividends Addition to Retained Earnings EPS and DPS Basic Financial Statements

10. Earnings per share EPS = Net Income/average number of shares outstanding  Net Income before adjustments in accounting treatment or one-time events Certifying statements  Auditors do not guarantee the accuracy of earnings, but only that statements are a fair financial representation Basic Financial Statements

11. EPS for a company is not a precise figure that is readily comparable over time or between companies  Alternative accounting treatments used to prepare statements  Difficult to gauge the ‘true’ performance of a company with any one method  Investors must be aware of these problems Problems with Reported Earnings

12. Important to determine whether a company’s profitability is increasing or decreasing and why Return on equity (ROE) emphasized because it is a key component in finding earnings and dividend growth EPS = ROE  Book value per share Analyzing a Company’s Profitability

13. Share prices depend partly on ROE Management can influence ROE Decomposing ROE into its components allows analysts to identify adverse impacts on ROE and to predict future trends Highlights expense control, asset utilization, and debt utilization DuPont Analysis

14. ROE depends on the product of:  Profit margin on sales: EBIT/Sales  Total asset turnover: Sales/Total Assets  Interest burden: Pre-tax Income/EBIT  Tax burden: Net Income/Pre-tax Income  Financial leverage: Total Assets/Equity ROE = EBIT efficiency  Asset turnover  Interest burden  Tax burden  Leverage DuPont Analysis

15. Expected EPS is of the most value Stock price is a function of future earnings and the P/E ratio  Investors estimate expected growth in dividends or earnings by using quarterly and annual EPS forecasts Estimating internal growth rate  EPS 1 = EPS 0 (1+g) Obtaining Estimates of Earnings

16. Future expected growth rate matters in estimating earnings, dividends g = ROE  (1 – Payout ratio)  Only reliable if company’s current ROE remains stable  Estimate is dependent on the data period What matters is the future growth rate, not the historical growth rate Estimating an Internal Growth Rate

17. Security analysts’ forecasts of earnings  Consensus forecast superior to individual Time series forecast  Use historical data to make earnings forecasts Evidence favours analysts over statistical models in predicting what actual reported earnings will be  Analysts are still frequently wrong Forecasts of EPS

18. What is the role of expectations in selecting stocks?  Old information will be incorporated into stock prices if market is efficient  Unexpected information implies revision Stock prices affected by  Level and growth in earnings  Market’s expectation of earnings Earnings Surprises

19. Analysts attempt to guess earnings Company provides “guidance” as to what it thinks earnings will be “Guidance number” plays a major role in the consensus estimate Variance of the actual reported earnings has constituted the earnings surprise Earning surprises are guided by companies in the form of earnings preannouncements Earnings Game

20. The surprise element in earnings reports is what really matters There is a lag in adjustment of stock prices to earnings surprises One earnings surprise leads to another  Watch revisions in analyst estimates Stocks with revisions of 5% or more – up or down – often show above or below-average performance Using Earnings Estimates

21. Measures how much investors currently are willing to pay per dollar of earnings  Summary evaluation of firm’s prospects  A relative price measure of a stock A function of expected dividend payout ratio, required rate of return, expected growth rate in dividends The P/E Ratio

22. Dividend levels usually maintained  Decreased only if no other alternative  Not increased unless it can be supported  Adjust with a lag to earnings In theory, the higher the expected payout ratio, the higher the P/E ratio  However, growth rate will probably decline, adversely affecting the P/E ratio Dividend Payout Ratio

23. A function of the riskless rate of return and a risk premium k = RF + RP Constant growth version of dividend discount model can be rearranged so that k = (D 1 /P 0 ) + g  Growth forecasts are readily available Required Rate of Return

24. Risk premium for a stock regarded as a composite of business, financial, and other risks If the risk premium rises (falls), then k will rise (fall) and P 0 will fall (rise) If RF rises (falls), then k will rise (fall) and P 0 will fall (rise) Discount rates and P/E ratios move inversely to each other Required Rate of Return

25. Function of return on equity and the retention rate g = ROE  (1 – Payout ratio)  The higher the g, the higher the P/E ratio P/E ratio depends on  Confidence that investors have in expected growth  Reasons for earnings growth Expected Growth Rate

26. Regardless of detail and complexity, analysts and investors seek an estimate of earnings and a justified P/E ratio to determine intrinsic value Security analysis always involves predicting an uncertain future; mistakes will be made and outlooks will differ Fundamental Security Analysis in Practice

27. Appendix 17-A Financial Ratio Analysis Used to examine a firm’s financial performance A ratio on its own has limited value – to be useful, one must examine:  Trends  Ratios of comparable firms or industry benchmarks

28. Five types of ratios used to analyze a firm: 1. Liquidity: ability to generate cash and meet short-term debt 2. Asset Management: ability to effectively manage its assets to generate sales and profits 3. Debt Management: ability to effectively handle its debt 4. Profitability: ability to generate profits 5. Value: market value versus accounting values Appendix 17-A Financial Ratio Analysis

29. STATEMENT OF INCOME:20002001200220032004 Total Revenue...............14260002143300289230030586004448000 Cost of Sales...............12387001931400255940026992004005800 Depreciation/Amortization...40100436007680075300101300 Interest Expense............53007500532005260079000 Research / Exploration......00363005370073100 Other Expense...............3310043600461005640037900 Unusual Items...............00000 Pre-Tax Income..............108800117200120500121400150900 Income Tax..................-19900-25700-20400-13700-18100 Earnings BEFORE Extra. Items8890091500100100107700132800 Extraordinary Items.........00000 Income AFTER Extra. Items8890091500100100107700132800 Dividends - Preferred Shares35003800400029002600 Income Available to Common Shares854008770096100104800130200 Earnings /Share.............0.68 0.7060.7270.85 Common Shares - Year End (1000s)125658131398141443152337154280 Common Shares - Average (1000s)125536128932136073144121153237 Dividends - Common Shares...1470022000287002740032200 Market Price per Share (Close)6.697.637.8817.1311.63 Example

30. ASSETS:20002001200220032004 Cash & Equivalent...........1500008400087500179200235100 Accounts Receivable.........174000428800413700360100380400 Inventory...................22020058350099270012157001803100 Marketable Securities.......00000 Other.......................00000 Current Assets......5442001096300149390017550002418600 Fixed Assets - Gross13727001650500195620022776002914600 less: Accumulated Depreciation-766200-809800-886600-961900-1063200 Fixed Assets - Net..........606500840700106960013157001851400 Assets..............11507001937000256350030707004270000 LIABILITIES AND EQUITY:19971998199920002001 Bank Loans & Equivalent.....147800346800537400620800828500 Accounts Payable............3472006844008318009014001380900 Current Portion of L-T Debt.540030000208001930056400 Current Liabilities........5004001061200139000015415002265800 Long-Term Debt & Debentures.83500211000425500586600963700 Deferred Taxes & Credits....4160042000538004330056400 Equity: Preferred Stock.....158300157700374003570034100 Common Stock........190600223100347400476800465200 Retained Earnings...176300242000309400386800484800 Total Equity........525200622800694200899300984100 Liabilities + Equity11507001937000256350030707004270000

31. XYZ COMPANY FINANCIAL RATIOS:20002001200220032004 Current Ratio1.091.031.071.141.07 Acid Test (Quick) Ratio0.650.480.360.350.27 ACP (days)44.5473.0252.2142.9731.22 Inventory Turnover5.623.312.582.22 Total Asset Turnover1.241.111.131.001.04 Debt Ratio0.510.660.710.690.76 Debt-to-Equity Ratio1.112.042.622.373.28 Equity Multiplier2.193.113.693.414.34 TIE (or Interest Coverage)21.5316.633.273.312.91 Net Income Margin6.23%4.27%3.46%3.52%2.99% Return on Assets (ROA)7.73%4.72%3.90%3.51%3.11% Return on Equity (ROE)16.93%14.69%14.42%11.98%13.49% P/E Ratio9.8411.2111.1523.5613.68 M/B Ratio2.292.151.703.021.89 Dividend Yield1.75%2.24%2.68%1.11%1.81% Dividend Payout Ratio0.170.250.300.260.25

32. INDUSTRY AVERAGES FINANCIAL RATIOS:20002001200220032004 Current Ratio2.122.852.252.011.69 Acid Test (Quick) Ratio1.211.971.361.241.09 ACP (days)35.2034.0944.5045.9046.90 Inventory Turnover7.788.207.688.528.16 Total Asset Turnover1.781.431.371.261.23 Debt Ratio0.230.330.320.290.32 Debt-to-Equity Ratio0.360.610.560.490.55 Equity Multiplier1.571.821.781.701.74 TIE (or Interest Coverage)34.4142.195.955.538.61 Net Income Margin8.47%6.03%4.34%4.19%5.68% Return on Assets (ROA)15.08%8.64%5.95%5.27%7.01% Return on Equity (ROE)23.68%15.72%10.59%8.96%12.20% P/E Ratio6.429.0812.1322.3815.53 M/B Ratio1.511.421.282.001.88 Dividend Yield1.71%1.73%2.86%2.67%2.08% Dividend Payout Ratio0.130.240.350.390.26

33. A. Liquidity 1. Current Ratio = Current assets / Current liabilities For XYZ (2004): = 2,418,600 / 2,265,800 = 1.07 2. Quick Ratio = [CA – Inventory] / Current liabilities For XYZ (2004) = (2,418,600 – 1,803,100) / 2,265,800 = 0.27

34. B. Asset Management 3. Average Collection Period (ACP) = Account Receivable / (Sales/365days) For XYZ (2004): = 380,400 / (4,448,000/365) = 31.22 days Note: A/R Turnover = Sales / Acct Receivable = 365 / ACP For XYZ (2004) = 365/31.22 days = 11.69 times

35. B. Asset Management (Cont’d) 4. Inventory Turnover = Cost of goods / Inventory or= Net Sales / Inventory For XYZ (2004) (using COGS): = (4,005,800) /1,803,100 = 2.22 times Days Inventory = Inventory / Daily COGS (or Sales) = 365 / Inventory Turnover For XYZ (2004) = 365/2.22 = 164.4 days 5. Total Asset Turnover = Sales / TA = 4,488,000 / 4,270,000 = 1.042

36. C. Debt Ratios 6. Debt Ratio = Total Debt / TA = (2,265,800 + 963,700) / 4,270,000 = 0.756 7. Debt-to-Equity = Total Debt / Total Equity = (2,265,800 + 963,700) / 984,100 = 3.282 TA = Debt + Equity

37. C. Debt Ratios (Cont’d) 8. Leverage Ratio (or Equity Multiplier) = TA / Equity = 4,270,000 / (984,100) = 4.339 Higher values More debt 9. TIE (or Interest Coverage) = EBIT / Interest = (150,900 + 79,000) / 79,000 = 2.91 times

38. D. Profitability 10. ROE = NI / Equity = 132,800 / 984,100 = 13.49% 11. ROA = NI / TA = 132,800 / 4,270,000 = 3.11% 12. Net Income Margin = NI / Sales = 132,800 / 4,448,000 = 2.99%

39. E. Value Ratios 13. Dividends Payout = DPS / EPS or = Common Dividends / Earnings Available to Common Shareholders = 32,200 / 130,200 =.2473 = 24.73% 14. P/E = Market Price per Share / EPS = 11.63 / 0.85 = 13.68

40. E. Value Ratios (Cont’d) 15. Market-to-book (M/B) = Market price per share / Book value per share = 11.63 / [(984,100 – 34,100) / 154,280] = 11.63 / 6.16 = 1.89 16. Dividend Yield = DPS / Market price per share = (32,200 / 153,237) / 11.63 =.21 / 11.63 = 1.81%

41. DuPont Analysis Tax Burden Interest Burden EBIT Efficiency TA Turnover NI / Sales = Net Income Margin NI / TA = ROA Leverage Ratio = TA / Equity Leverage Ratio

42. Net Profit Margin Asset Turnover Leverage Ratio

43. XYZ (2004) NI / EBT = 132,800 / 150,900 =.880 EBT / EBIT = 150,900 / (150,900 + 79,000) = 150,900 / 229,900 =.656 EBIT / Sales = 229,900 / 4,448,000 =.0517 Sales / TA = 1.042 (previously calculated) TA / Equity = 4.339 (previously calculated) ROE = (.8800)(.6564)(.0517)(1.042)(4.339) =.1350 = 13.50% This differs from the 13.49% we calculated previously due to rounding errors

44. XYZ (2004) NI / Sales = 0.0299 (previously calculated) Sales /TA = 1.042 (previously calculated) Calculate ROA = (.0299)(1.042) =.0311 = 3.11% (equals the 3.11% previously calculated) TA / Equity = 4.339 (previously calculated) So, ROE = (.0299)(1.042)(4.339) = 13.52% (differs from 13.49% previously calculated due to rounding errors)

45. Liquidity Below average  Current and quick ratios of 1.07 and 0.27 are both well below industry averages of 1.69 and 1.09 Bad trend  Current ratio has been steady, but quick ratio has deteriorated significantly Low and deteriorating quick ratio is due to high levels of inventory

46. Asset Management Collections as measured by ACP is above average (31 days versus 47 days) and is improving Inventory turnover is very low (2.3 versus industry average of 8.2), and has been continually deteriorating, and they maintain high inventory levels TA turnover is below average, has been over the period, and continues to deteriorate

47. Debt Management Debt levels have increased steadily and coverage has deteriorated  Debt ratio is 0.76 (from 0.51 in 2000)  Debt-to-equity is 3.28 (from 1.11 in 2000)  Coverage is 2.91 (from 21.53 in 2000) Debt capacity and coverage are both below average  Debt ratio is 0.76 versus 0.32 industry average  Debt-to-equity is 3.28 versus 0.55 industry average  Coverage is 2.91 versus 8.61 industry average

48. Profitability Steady decline in net income margin, ROA, and ROE over period Below industry averages, except for ROE  ROE is above average due to use of greater leverage (as noted above)

49. DuPont Analysis XYZ (2004)  ROE = (NI/Sales) (Sales/TA) ((TA/Equity) = (.0299)(1.042)(4.339) = 13.51% Industry averages (2004)  ROE = (NI/Sales) (Sales/TA) ((TA/Equity) = (.0568)(1.23)(1.74) = 12.16% This analysis suggests that XYZ displays an above average ROE due to its higher leverage factor, and despite the fact it has below average profitability and asset turnover

50. Value Ratios P/E and M/B ratios are close to average, which is also the case for their dividend yields (Note: a lower dividend yield implies a higher price) They have been close to, or slightly above average over the entire period This suggests the market views XYZ as an “average” company despite some of the problems we have observed

51. Summary Below average and deteriorating in terms of liquidity, inventory turnover, and debt management However, they are profitable, even if they are not up to industry standards, and their profitability is dwindling The market views XYZ as an “average” company despite its problems XYZ will probably have to deal with its debt, inventory and liquidity problems in order to maintain an average valuation in the market

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