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- 1. TEACHING THE FUNDAMENTALS OF FUNDAMENTAL INVESTMENT ANALYSIS James L. Kuhle, California State University, Sacramento Ralph A. Pope, California State University, Sacramento Carl H. Walther, California State University, Sacramento Abstract Fundamental investment analysis of a public corporation’s prospects requires quantitative and qualitative analysis to determine the investment value of its shares. Integrative spreadsheets offer students significant help in a semester project in determining the intrinsic investment value of a corporation of their choice. I. INTRODUCTION AND PURPOSE This article illustrates a systematic approach for teaching fundamental investment analysis. Students analyze the investment potential of a publicly traded corporation. The semester project consists of three parts: a complete ratio and DuPont analysis to determine the current financial position of the company, a strategic analysis to determine the major strengths and weaknesses of the company, and a forecast of the future performance and discounted future cash flow analysis to determine the company’s intrinsic investment value. II. THE IMPORTANCE OF HISTORIC RATIO ANALYSIS At the core of fundamental investment analysis is the ability to calculate, analyze, and interpret the meaning of financial ratios to determine the financial position of the firm. Ratios are used to discern changing patterns and potential trouble spots that may arise in the future business life of a firm. They allow the analyst to standardize key financial variables from the balance sheet and income statement for comparison to industry averages or those of a major competitor. The semester project requires each student to obtain financial data on his or her target firm from the SEC website (www.sec.gov) and, using integrative Excel spreadsheets supplied by the professor, to calculate relevant ratios in the four financial management areas: liquidity, asset utilization, employed leverage, and profitability. III. ANALYSIS OF THE COCA COLA COMPANY The Excel spreadsheet (Exhibit 1) is set up with logic statements to make assessments regarding time-series trends and cross-sectional analysis. The cross-sectional analysis allows the student to compare his/her selected company to the industry average, while the time-series analysis allows for a trend comparison over the past three years.
- 2. Exhibit 1 Time-Series and Cross-Sectional Ratio Analysis for Coca Cola 1994-1996 Industry Cross- Time- Ratios Formula 1994 1995 1996 Average Sectional Series Quick (acid test) Current Assets - Inventory/Current 0.66 0.59 0.67 0.90 Bad Variable Liability Current Current Assets/Current Liability 0.83 0.74 0.80 1.20 Bad Variable Current Liability to Net Worth Current Liability/Net Worth 1.18 1.36 1.20 0.88 Bad Variable Current Liability to Inventory Current Liability/Inventory 5.89 6.58 7.78 7 Bad OK Total Liability to Net Worth Total Liability/Net Worth 0.67 0.75 0.73 1.3 Good Variable Fixed asset to Net Worth Fixed Assets/Net Worth 1.66 2.03 1.87 3 Good Variable Average Collection Period Accounts Receivable/(Sales x 365) 57.2 60.3 64.1 40 Bad OK Sales to Inventory Annual Net Sales/Inventory 15.45 16.13 19.48 10 Good OK Assets to Sales Total Assets/Net Sales 0.86 0.83 0.87 0.45 Bad Variable Sales to Net Working Capital Sales/Net Working Capital (16.65) (9.49) (9.22) 6.1 Bad OK Account Payable to Sales Accounts Payable/Annual Net 0.158 0.161 0.160 0.40 Good Variable Sales Inventory Turnover Sales/Inventory 5.89 6.21 7.08 5 Good OK Fixed Asset Turnover Sales/Fixed Assets 1.87 1.64 1.61 5.4 Bad Variable Total Asset Turnover Sales/Total Assets 1.17 1.20 1.15 1.4 Bad Variable Total Debt Ratio Total Debt/Total Assets 0.25 0.27 0.28 0.30 Good Variable Debt-Equity L-T Debt/Equity 0.27 0.21 0.18 0.10 Bad OK Time Interest Earned EBIT/Interest Payments 18.73 15.91 16.07 15 Good Variable Gross Profit Margin (GPM) Gross Profits/Sales 0.619 0.615 0.637 0.32 Good Variable Operating Profit Margin Operating Profits/Sales 0.230 0.240 0.248 0.20 Good OK Net Profit Margin (NPM) Net Profits/Sales 0.156 0.166 0.188 0.15 Good OK Return on Total Assets (%) Net Profits/Total Assets 18% 20% 22% 0.16 Good OK Return on Equity (ROE) (%) Net Profits/Total Equity 48% 55% 57% 0.30 Good OK Earnings Per Share (EPS) Net Profit/Number of Shares $0.99 $1.19 $1.40 Outstanding Price/Earnings (P/E) HIGH 25.51 19.07 38.26 LOW 16.32 14.13 25.51 Coca Cola’s liquidity is substandard when compared with the industry. The current ratio for 1996 is below industry average. In addition, its quick ratio also indicates less liquidity than the industry average with no discernable trend of improvement over the last three years. Therefore, Coca Cola’s liquidity position could be characterized as substandard. The activity ratios reveal a second dimension of the Coca Cola Company. These ratios indicate the relative efficiency with which the company uses investors’ assets. The inventory turnover ratio measures how rapidly the company “turns over” or uses dollars invested in inventory. In the case of Coca Cola, there are positive values reported based on industry average and cross-sectional comparisons. The inventory turnover for 1996 was 7.08 in comparison to an industry average of 5. Likewise, the three-year trend indicates a continual improvement in inventory turnover. Other activity ratios indicate similar positive results based on both cross- sectional and time-series analysis. The third group of ratios deals with the use of debt in the capital structure as well as the ability to meet interest payments from operating income. Both the total debt ratio and the debt- to-equity ratio indicate a favorable assessment based on cross-sectional and time-series analysis.
- 3. In addition, the times-interest-earned (TIE) ratio indicates that the company covers interest charges over 16 times. This again compares favorably to the industry average of 15 times. The fourth category ratios deal with profitability. Coca Cola’s gross profit margin is clearly superior in comparison with the industry average. It is also obvious that Coca Cola does a superior job of cost cutting, resulting in higher operating profits when compared to the industry. In addition, the net profit margin of 18.8 percent net return on sales compares well to only 15 percent for the industry. Next, return on total assets also indicates favorable performance. Coca Cola’s 1996 return on total assets is 22 percent compared to 16 percent for the industry. Further, the return on equity for 1996 was 57 percent, more than twice that of the industry average of 22 percent. The DuPont analysis for Coca Cola (Exhibit 2) allows the students to consider all the “parts” that affect the stockholders’ return on equity. The 1996 return on equity of 56.73 percent is a function of three triggers the financial manager has to control the performance of the firm: the net profit margin, total asset turnover, and the financial leverage multiplier. The strength of the DuPont system is its ability to dissect the balance sheet and income statement and isolate financial areas of low performance or concern. A comparison of the firm’s net profit margin, total asset turnover, and financial leverage multiplier to the industry averages can pinpoint area(s) of substandard performance that led to a low average return on equity. Exhibit 2 DuPont Analysis 1 Industry 1994 1995 1996 Average Return on Equity 48% 55% 57% 22% Net Profit Margin 16% 17% 19% 15% Total Asset Turnover 1.2X 1.2X 1.2X .9X Financial Leverage Multiplier 2.7X 2.8X 2.6X 1.6X 1 numbers are rounded In summary, the ratio analysis suggests superior performance over the last three years. Coca Cola is an excellent example of a fundamentally sound, long-term growth company that continues to return to its shareholders in excess of 40 percent return on investment per year. It meets the criteria of a “franchise product” company, one whose product is unique with few substitutes, has a high demand, and has little or no government regulation. In addition, Coca Cola continues to be an aggressive cost cutter as reflected by a continual increase in the operating profit margin. IV. STRATEGIC ANALYSIS The strategic analysis includes an assessment of the company’s strengths, weaknesses, opportunities, and threats. In addition, the student is required to do an environmental scan of the industry in order to determine who the competition is, what the relative market share is and could
- 4. be, and the degree to which the company has a competitive advantage in both domestic and international markets. The Coca Cola Company has many strengths and opportunities and only minor weaknesses and threats to face. First, the company’s product is clearly a franchise—that is its major strength. Second, its ability to get the product to the customer at the least cost, when they want it, is a strength that is surpassed only by its advertising prowess. Coca Cola recently entered both the Chinese and Indian markets with distribution networks that have been in place for a number of years. Its relative success in these markets will ultimately determine if sales will double every three years, according to the company’s CEO. The strategic analysis requires the student to consider the non-quantitative factors that contribute to the overall fundamental soundness of the company. The student is required to consider these non-quantitative factors in the final analysis of whether the company should be a prospective investment. V. FORECASTS OF FUTURE PERFORMANCE In the final phase of the semester project the student determines the intrinsic investment value of Coca Cola’s stock. The intrinsic value is based on the present value of the annual cash flows the stockholders receive over the next 10 years. Exhibit 3 uses historic data for the last six years to determine the stockholders’ cash flow, the annual growth rate of stockholders’ cash flow, and the six-year average past growth rate of stockholders’ cash flow. EXHIBIT 3 Return on Equity Calculations Calculations 1991 1992 1993 1994 1995 1996 Price Per Share 14.884 20.664 21.084 22.275 31.892 42 Owner’s Cash Flow (NI + Dep - Cap'l Exp) 1085.349 1132.147 1735.297 2069.735 2507.772 2940 Annual CF Growth Rate 0.043117 0.532748 0.192726 0.211639 0.172355 5-Year Average CF Growth 23.1% Annual Sales Growth 10% 0.130310 0.068260 0.158910 0.113049 0.023915 5-Yr Average Sales Growth Value Added 7.679334 0.321823 0.844302 7.729150 6.948563 Average Value Added $4.73 Owner's CF Per Share 0.408348 0.433158 0.668733 0.811056 1.001266 1.187878 Using the 1996 shareholder’s cash flow ($2.94 billion) the cash flow to the shareholders is projected to grow at the six-year average past growth rate (Exhibit 4) over the next 10 years.
- 5. EXHIBIT 4 Stock Intrinsic Valuation Model Two-Stage Earnings Growth Projections (10-Year/5-Year) 1 2 3 4 5 6 7 8 9 10 Prior Year Cashflow 2940 3619.14 4455.161 5484.30 6751.177 8310.699 10230.47 12593.7 15502.85 19084.0 (Millions) 10-Year Growth Rate As 0.231 0.231 0.231 0.231 0.231 0.231 0.231 0.231 0.231 0.231 Decimal (.00) Cash Flow 3619.14 4455.161 5484.303 6751.17 8310.699 10230.47 12593.71 15502.8 19084.01 23492.4 Discount Rate As Decimal 0.15 0.15 0.15 0.15 0.15 0.15 0.15 0.15 0.15 0.15 (.00) Discount Factor (Multiply) 0.869565 0.756143 0.657516 0.57175 0.497176 0.432327 0.375937 0.32690 0.284262 0.24718 Discounted Value Per Annum 3147.078 3368.742 3606.018 3860.00 4131.886 4422.915 4734.442 5067.91 5424.868 5806.96 Sum of Present Value of 43570.83 Input Discount And Growth Rates: Cashflows 1st 10 Year Growth Rate 0.231 Residual Value: 2nd Period Growth Rate 0.04 Cashflow in Year 10 23492.42 Discount Rate 0.15 Growth Rate as Decimal (.00) 0.04 Owner’s Cash Flow (millions) 2940 (g) Number of Shares 2475000000 Cashflow in Year 11 24432.12 Intrinsic Value (millions) 98473.08 Capitalization Rate (K-G) 0.11 Number of Shares 2475000000 Value at the End of Year 10 222110.2 Intrinsic Value Per Share 39.78 Discount Factor Year 10 0.247184 Intrinsic(Per Share)/Market 0.94 Present Value of Residual 54902.24 Next, using the dividend valuation model, the capital asset pricing model, and the bond yield-plus-risk-premium model, the investors’ required rate of return for investing in Coca Cola is estimated to be approximately 15 percent. This rate is used to discount the stockholders’ future cash flows to their present value. Finally the terminal value of Coca Cola’s stock 10 years from now is estimated using the dividend valuation model (P10 = D11 – ks – g) and also discounted to the present value at the investors’ required rate of return. The sum of the present value of each of the next 10 years’ cash flows to the stockholders and the present value of Coca Cola’s stock 10 years from now represents the intrinsic investment value of Coca Cola’s stock. Finally, the student compares Coca Cola’s intrinsic value to its actual stock price to make an investment decision. VI. CONCLUSIONS This paper presents a systematic approach, using Excel spreadsheets, to teach fundamental analysis. The student semester project consists of three major parts, a complete ratio analysis based on historic financial statements, a strategic analysis that identifies the company’s strengths, weaknesses, opportunities, and threats, and a present value analysis of stockholders’ future expected cash flows. The discounted future cash flows to the stockholders represent the intrinsic value of Coca Cola’s stock and is compared to the actual stock price. While the project appears to be extensive, the Excel spreadsheets tend to make short work of the analysis. Students have found the experience quite rewarding.
- 6. V. REFERENCES Copeland, Tom, Koller, Tim, and Jack Murrin, McKinsey & Company, Inc., 2000, Valuation, Measuring and Managing the Value of Companies, John Wiley & Sons, Inc. Fraser, Lyn M., and Aileen Ormiston, 2000, Understanding Financial Statements, Prentice Hall, Inc. Higgins, Robert C., 1995, Analysis for Financial Management, Richard D. Irwin, Inc.

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