1. Company Analysis Timothy R. Mayes, Ph.D. FIN 3600: Chapter 12

2. Overview of Company Analysis Once we’ve completed the economic forecast and industry analysis, we can focus on choosing the best positioned company in our chosen industry Selecting a company will involve an analysis of:  The company’s management  The company’s financial statements  Key drivers for future growth Obviously, we are looking for companies with the best management, strong financials, great prospects, and that are undervalued by the market Always remember that the past is irrelevant, what you are buying is future results

3. Evaluating Management Strong management is vital for companies to perform in accord with the highest expectations of investors Unfortunately, evaluating the quality of a company’s management team is very difficult, especially for individual investors Professionals have the advantage in that they have many contacts within the industry who are familiar with the management team, and they can visit the company and talk with the team personally

4. Evaluating Management (cont.) As an individual, there are several things you can do:  Read the 10k – it has information on the background of executives and board members. Information includes age, pay, stock ownership, etc  Read the business press – There are often stories which provide insights into the character and abilities of senior management  Call investor relations – They can answer any reasonable questions that you may have  Study the financial statements – Good management leads to solid financials

5. Evaluating Management (cont.) Despite your best efforts at judging management’s ability, things can go wrong History is replete with examples of formerly great managers running their new companies into the ground Here are a few examples that come to mind:  AT&T – C. Michael Armstrong  Sunbeam – “Chainsaw” Al Dunlap  Apple Computer – John Scully  Long-term Capital Management – John Meriwether, Robert Merton, and Myron Scholes (the latter two were Nobel Prize winners in economics)

6. Financial Statement Analysis There are three statements to watch:  Income statement  Balance sheet  Statement of cash flows Two major tools:  Ratios  Growth rates

7. The Income Statement The income statement provides us with information about the firms revenues and expenses over some previous time period (usually quarterly, semiannually, and annually) The key variables to watch are revenues, gross profit margins, operating profit margins, net profit margins We especially want to evaluate the quality of the firm’s earnings

8. Quality of Earnings Under GAAP, companies are allowed fairly wide latitude on how they recognize revenues and handle “extraordinary” income and expenses Many companies freely admit to “managing” or “smoothing” earnings, believing that it adds to the stability of the stock price over time Analysts need to watch for such shenanigans, as it may signal problems Here are a couple of recent examples of questionable quality of earnings:  Qwest – Raised revenue recognition questions when analysts discovered that they had counted all of the future revenues from a 20-year contract as current earnings.  Waste Management – Had trouble recently when it tried to claim as “extraordinary” its expense for painting its huge fleet of trucks. This added 3 cents per share (about 10%) and let them beat expectations by 2 cents (see “Waste Management Excludes Some Expenses in Accounting”, WSJ Online, 23 Aug 2001)  Priceline.com – Was claiming as revenue the entire price of an airline ticket when, in fact, they only received a commission on its sale and never actually took ownership of the ticket

9. Quality of Earnings (cont.) Another thing to watch for are “pro-forma” or “as if” earnings. Some analysts have described these as “all the good stuff and none of the bad.” Many companies, especially those in the “new economy”, began reporting pro-forma numbers a few years ago. The funny part is that the Wall Street analysts went along with the game, even long after it became clear that there would never be any real earnings. (See notes on Reg G below.) Also, look for where earnings are coming from. Increased sales, or decreased expenses? Sales can increase forever, but costs can only be cut so far. Generally, when costs are cut to increase profits, this must be looked at as a temporary boost. These types of issues lead to serious questions about management’s truthfulness and bring into question the quality of the firm’s earnings. Typically, when these things are revealed, stock prices drop as investor uncertainty rises

10. Earnings Manipulation

11. The Balance Sheet The balance sheet describes the assets, liabilities, and equity of the firm at a point in time Key variables to watch on the balance sheet are cash, accounts receivable, inventories, and long- term debt Always remember what Benjamin Graham said in Security Analysis, “liabilities are real but the assets are of questionable value.”

12. The Statement of Cash Flows Ultimately, cash is king and the statement of cash flows tells us exactly why a firm’s cash balance changed The statement of cash flows is far more difficult to manipulate than the income statement, and can help to gauge the quality of earnings The Cash Flows from Operations section is the most important as it measures the cash provided by the day to day operation of the business A company could, for example, show steadily rising revenues and net income, but negative cash flows from operations. How? If accounts receivable is rising. This can only go on for so long before the company has grown its revenues right into bankruptcy because it isn’t collecting on those sales. Positive earnings must always be confirmed by positive cash flows. This statement is as important, if not more so, than the income statement. Always examine it to find out what management is doing with the shareholder’s money

13. Analyzing Financial Ratios Financial ratios are the microscope that allows us to see behind the raw numbers and find out what’s really going on Financial ratios fall into five categories:  Liquidity  Efficiency  Leverage  Coverage  Profitability When analyzing ratios always remember that no one ratio provides the whole story, and that the standards for each ratio are different for every industry

14. Liquidity Ratios The current ratio, quick ratio and cash ratio all fall into this category They help us to see if the company is able to meet its short-term obligations

15. Efficiency Ratios The efficiency ratios tell us how effectively management is using the firm’s assets to generate sales Inventory turnover, accounts receivable turnover, days sales outstanding, fixed asset turnover, and total asset turnover all fall into this category

16. Leverage Ratios How much debt does the firm have? That’s the question answered by the leverage ratios Examples are the debt ratio and debt to equity ratio Remember that lots of debt is great as long as sales are increasing, but terrible if sales decline Some debt is, without a doubt, good, but too much can be disastrous Especially be on the lookout for companies with a high proportion of fixed costs (high operating leverage) and with lots of debt. Airlines are a good example

17. Coverage Ratios Coverage ratios are most important to creditors, but whatever is important to creditors is important to shareholder’s too Examples of coverage ratios include the times interest earned ratio and the fixed charge coverage ratio

18. Profitability Ratios Investors tend to focus the most on profitability ratios, but the others are important as well Examples include the gross profit margin, operating profit margin, net profit margin, return on assets and return on equity

19. Using Financial Ratios There are two key uses of financial ratios:  Trend Analysis – Looking for trends over time in ratios. For example, we’d like to see that the inventory turnover ratio is rising. Normally, at least five years of data should be used.  Comparison to Industry Averages – If we assume that, on average, the firm’s competitors are doing things right, then it makes sense to make these comparisons. This can also help to identify areas of relative strength and weakness

20. Growth Rates Growth rates of various variables are important as well Key variables to calculate growth rates of are revenues, operating profits, and free cash flow

21. Manipulation of Financial Statements Financial statements may be manipulated in a number of ways to help identify key trends:  Common-size  Common base year  Inflation adjusted Each of these techniques can provide insights that are not easily seen on the unadjusted financial statements