Value Investing

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value investing, financial fraud, undervalued assets, financial ratios, warren buffett, Benjamin Graham

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  • great material can you sent me a copy to drjimphilip@yahoomail.ac.in
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  • Great material! Thanks! Could you please share a copy with me too alexandrecrestana@gmail.com
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  • Dear Jens: This PPT is really sums. Please arrange to the same to my email ID : aryankb.investment@gmail.com,
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  • Thank you for the great presentation upload! Very useful to teach my children and family. Please send a copy to ajitha_2020@rediffmail.com if you please. Regards. Gnana Raju
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  • Very good indeed, you have made difficult issue easy.
    I extend Biswajeet's kind request for a copy.
    If possible, please e-mail to andre.reginato@uol.com.br.
    Thank you very much
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Value Investing

  1. 1. Value Investing: Find real value Understanding financial statements, ratios and detecting creative accounting
  2. 2. Agenda Balance Sheet Cash Flow Important Ratios/Terms Timing: Buy Rules JensWeschta2 Timing: Buy Rules Accounting Fraud Free Financial Sites
  3. 3. Balance Sheet Assets Liabilities Current Assets Current Liabilities Cash Accounts payable (owed to suppliers) Receivables (collected from goods and services) Taxes payable (tax that has to be paid) Inventory (goods held for sale) Accrued liabilities (interest on debt due within one year) Prepaid expenses (operatioing cost that have been paid in advance) Other current liabilities (due within one year) Other current assets Non-current Liabilities Non-current Assets Long-term debt (debt mature beyond one year, including bank borrowings) JensWeschta3 Non-current Assets Long-term debt bank borrowings) Gross property, plant and equipment (gross refers to initial cost) Deferred taxes liabilities (tax that has to be paid in future) Accumulated Depreciation (total amount by which all assets have been depreciated) Minority interest Net property, plant and equipment (gross – depreciation) Other long-term liabilities (due after one year) Goodwill (excess over book value) Stockholders' equity Intangible assets (usually at historic costs) Common stock Other long-term assets Additional paid-in capital (capital in excess of par) Retained earnings (not paid dividends (cummulative)) Treasury stock (negative number) Accumulated other comprehensive income (unrealized gain/loss assets, not realized in Innome Statement)
  4. 4. Cash Flow JensWeschta4
  5. 5. Cash Flow: Survival Needs 1/2 Cash Flow Statement Cash Flows From Operating Activities Net income + Depreciation & amortization + Deferred Tax Cash Flows From Investing Activities - Investments in property plant and equipment - Acquisitions net - Other investing activities Cash Flows From Financing Activities - Debt repayment • If the company is not able to meet these needs with its CFO the company has to issue new debt or stocks Sources of funds (CFO) Uses of funds (Needs) JensWeschta5 - Debt repayment - Dividend paid (preferred) new debt or stocks • Is the company able to generate enough cash flow to meet its debt obligation? • When is the debt due? • What happend the last time when debt was due (lower Earnings, no dividend payments)? • If interest rates rise and the company has to roll over its debt, it means the company has to pay more interest = lower earnings in the future
  6. 6. Cash Flow: Survival Needs 1/2 2007 2008 2009 2010 2011 Cash Flows From Operating Activities 13.723 16.455 17.114 15.880 14.763 Cash Flows From Investing Activities - 2.483 - 2.549 - 2.353 - 597 - 3.482 Debt Repayment - - - 5.007 - 10.344 - 55 Dividends Paid - 4.209 - 4.655 - 5.044 - 5.458 - 5.767 Sum 7.031 9.251 4.710 - 519 5.459 JensWeschta6 Sum 7.031 9.251 4.710 - 519 5.459 • This is the CF from a public traded company • In 2010 the CF was negative (-519) • In order to show strong CF the company issued new debt (3.830) • So the overall figure was not -519 but 3.311
  7. 7. Cash Flow: Cash Flow Statement 1/3 Cash Flow Statement Cash Flows From Operating Activities Net income Depreciation & amortization Receivables (3.500) Inventory 2.000 Accounts payable Accrued liabilities Income taxes payable Other working capital Other non-cash items Cash Flow Statement Cash Flows From Operating Activities Net income Depreciation & amortization Receivables Inventory Accounts payable 1.000 Accrued liabilities (500) Income taxes payable 2.000 Other working capital Other non-cash items JensWeschta7 • Increase in an asset account (-) • Decrease in asset account (+) Other non-cash items • Increase in an liability account (+) • Decrease in liability account (-) • Direct impact on working capital (balance sheet) • A growing company has a need for more capital spending • If the company is growing it is reasonable to assume that the company needs more working capital
  8. 8. Cash Flow: Cash Flow Statement 2/3 Cash Flow Statement Cash Flows From Operating Activities Net income Depreciation & amortization Inventory Accounts payable Accrued liabilities Income taxes payable Other working capital Other non-cash items Cash Flows From Investing Activities JensWeschta8 Cash Flows From Investing Activities Investments in property plant and equipment Acquisitions net Other investing activities Cash Flows From Financing Activities Debt issued Debt repayment Common stock repurchased Dividend paid Other financing activities • Depreciation and amortization will be rising along with investing activities • Increased investing activities means more depreciation and amortization in the future
  9. 9. Cash Flow: Cash Flow Statement 3/3 Cash Flow Statement Cash Flows From Operating Activities Net income Depreciation & amortization Deferred income taxes Inventory Accounts payable Accrued liabilities Income taxes payable Other working capital Other non-cash items • New item on CF-Statement: • Deferred income taxes: company paying less income tax than the income statement shows = higher earnings today but less earnings in the future • Company using different deprication methods (income tax report vs. public report) • Straight line depriciation in public report means higher earnings now JensWeschta9 Cash Flows From Investing Activities Investments in property plant and equipment Acquisitions net Other investing activities Cash Flows From Financing Activities Debt issued Debt repayment Common stock repurchased Dividend paid Other financing activities • Is the company able to generate enough cash flow to meet its debt obligation? • When is the debt due? • What happend the last time when debt was due (lower Earnings, no dividend payments)? • If interest rates rise and the company has to roll over its debt, it means the company has to pay more interest = lower earnings in the future
  10. 10. Cash Flow: Increasing Shareholder Value Cash Flow Statement Cash Flows From Operating Activities Net income Depreciation & amortization Inventory Accounts payable Accrued liabilities Income taxes payable Other working capital Other non-cash items Cash Flows From Investing Activities • Increase in capital spending (CFI) • Increase the dividend to common stockholders (CFF) • Repurchase company bonds or prepay other debt (CFF) • Repurchase the company’s outstanding preferred or common stocks • Hoard cash (attractive for takeover) • Buybacks of common stocks (Treasury Stock on the balance sheet) JensWeschta10 Cash Flows From Investing Activities Investments in property plant and equipment Acquisitions net Other investing activities Cash Flows From Financing Activities Debt issued Debt repayment Common stock repurchased Dividend paid Other financing activities
  11. 11. Important Ratios/Terms JensWeschta11
  12. 12. LT Debt to Equity Ratio LT Debt to Equity Ratio LTDebt/ Equity • A high financial leverage ratio indicates possible difficulty in paying interest and principal while obtaining more funding. Assets Liabilities Current Assets Current Liabilities Cash Short-term debt Receivables Accounts payable Inventory Taxes payable Other current assets Accrued liabilities Other current liabilities Non-current Assets Non-current Liabilities Gross property plant and equipment Long-term debt Accumulated Depreciation Deferred taxes liabilities LT debt/equity (Recent yr) (%) Total Long Term Debt for the most recent fiscal year divided by Total Shareholder Equity for the same period. JensWeschta12 interest and principal while obtaining more funding. • Range 20%-50% depending on the nature of the business an the earning power • If a company’s earnings fluctuate than 30% is the maximum Deferred taxes liabilities Net property plant and equipment Minority interest Goodwill Other long-term liabilities Intangible assets Stockholders' equity Other long-term assets Common stock Additional paid-in capital Retained earnings Treasury stock Accumulated other comprehensive income Debt an Interest
  13. 13. Interest Coverage Ratio Interest Coverage Ratio EBIT/ Total Interest Income Statement Revenue (Sales) Cost of revenue Gross profit Operating expenses Sales General and administrative Other operating expenses Operating income Interest Expense Other income (expense) Interest coverage Also known as Times Interest Earned, this is the ratio of Earnings Before Interest and Taxes for the most recent year divided by the Interest Expense for the same period. JensWeschta13 • The lower the ratio, the more the company is burdened by debt expense. • When a company's interest coverage ratio is 1.5 or lower, its ability to meet interest expenses may be questionable. • If current ratio is deteriorating as well the company may be in trouble Other income (expense) Income before taxes Provision for income taxes Other income Net income from continuing operations Net income from discontinuing operations Net income available to common shareholders Debt an Interest
  14. 14. Current Ratio Current Ratio Current Assets/ Current Liabilities • Measures the company’s ability to pay off its short term liabilities • When the current ratio is very low it could indicate that the Current ratio The ratio of current assets divided by current liabilities. Current ratio is a measure of liquidity. Assets Liabilities Current Assets Current Liabilities Cash Short-term debt Receivables Accounts payable Inventory Taxes payable Other current assets Accrued liabilities Other current liabilities Non-current Assets Non-current Liabilities Gross property plant and equipment Long-term debt Accumulated Depreciation Deferred taxes liabilities Net property plant and JensWeschta14 • When the current ratio is very low it could indicate that the company will need to borrow in the future • Old rule is 2:1 current ratio • Best watched over period of time • If ratio is deteriorating something might be wrong = check efficiency ratio to confirm 2008 2009 2010 2011 2,4 2,5 1,2 0,7 4% -52% -42% Financial Condition Net property plant and equipment Minority interest Goodwill Other long-term liabilities Intangible assets Stockholders' equity Other long-term assets Common stock Additional paid-in capital Retained earnings Treasury stock Accumulated other comprehensive income
  15. 15. Inventory Turnover Inventory Turnover Sales/ Inventory • Build up in inventory can be a warning signal that something is Assets Liabilities Current Assets Current Liabilities Cash Short-term debt Receivables Accounts payable Inventory Taxes payable Other current assets Accrued liabilities Other current liabilities Non-current Assets Non-current Liabilities Gross property plant and equipment Long-term debt Accumulated Depreciation Deferred taxes liabilities Net property plant and The ratio is showing how many times a company's inventory is sold and replaced over a period. the Income Statement Revenue (Sales) Cost of revenue Gross profit Operating expenses Sales General and administrative Other operating expenses Operating income Interest Expense JensWeschta15 warning signal that something is wrong • Only useful when compared to previous years • Sharp decline of this ratio is a warning signal • Some investors use COGS since price changes by the company can distort the ratio 2008 2009 2010 2011 2,3 2,5 2,4 1,5 8% -4% -37,5% Net property plant and equipment Minority interest Goodwill Other long-term liabilities Intangible assets Stockholders' equity Other long-term assets Common stock Additional paid-in capital Retained earnings Treasury stock Accumulated other comprehensive income Financial Condition Other income (expense) Income before taxes Provision for income taxes Other income Net income from continuing operations Net income from discontinuing operations Net income available to common shareholders
  16. 16. Receivables Turnover Receivables Turnover Sales/ Receivables • Like inventory turnover ratio this Assets Liabilities Current Assets Current Liabilities Cash Short-term debt Receivables Accounts payable Inventory Taxes payable Other current assets Accrued liabilities Other current liabilities Non-current Assets Non-current Liabilities Gross property plant and equipment Long-term debt Accumulated Depreciation Deferred taxes liabilities The ratio quantifies the firm's effectiveness in extending credit as well as collecting debts. Income Statement Revenue (Sales) Cost of revenue Gross profit Operating expenses Sales General and administrative Other operating expenses Operating income Interest Expense JensWeschta16 • Like inventory turnover ratio this ratio can be warning signal that something is wrong • Best watched over period time • If ratio suddenly declines, it may indicate that customers were not paying their bills Net property plant and equipment Minority interest Goodwill Other long-term liabilities Intangible assets Stockholders' equity Other long-term assets Common stock Additional paid-in capital Retained earnings Treasury stock Accumulated other comprehensive income Financial Condition Other income (expense) Income before taxes Provision for income taxes Other income Net income from continuing operations Net income from discontinuing operations Net income available to common shareholders
  17. 17. Return on Equity Return on Equity Net Profit after Tax/ Equity Assets Liabilities Current Assets Current Liabilities Cash Short-term debt Receivables Accounts payable Inventory Taxes payable Other current assets Accrued liabilities Other current liabilities Non-current Assets Non-current Liabilities Gross property plant and equipment Long-term debt Accumulated Depreciation Deferred taxes liabilities Net property plant and Return on equity (5 yr avg) (%) Most recent 5y Avg. Income divided by the Average Common Equity, expressed as a percentage. Income Statement Revenue (Sales) Cost of revenue Gross profit Operating expenses Sales General and administrative Other operating expenses Operating income Interest Expense JensWeschta17 • Measure of the efficiency of a company to borrow money (long term) to help the company grow • A company cannot borrow money unless it has a good equity base • Min 15% Net property plant and equipment Minority interest Goodwill Other long-term liabilities Intangible assets Stockholders' equity Other long-term assets Common stock Additional paid-in capital Retained earnings Treasury stock Accumulated other comprehensive income Financial Condition Other income (expense) Income before taxes Provision for income taxes Other income Net income from continuing operations Net income from discontinuing operations Net income available to common shareholders
  18. 18. Return on Investment Return on Equity Net Profit after Tax/ Assets Liabilities Current Assets Current Liabilities Cash Short-term debt Receivables Accounts payable Inventory Taxes payable Other current assets Accrued liabilities Other current liabilities Non-current Assets Non-current Liabilities Gross property plant and equipment Long-term debt Accumulated Depreciation Deferred taxes liabilities Net property plant and Return on investment (5 yr avg) (%) Most recent 5y Avg. Income After Taxes divided by the average (Total Long term Debt + Long term Liabilities + Shareholders Equity), expressed as a percentage. Income Statement Revenue (Sales) Cost of revenue Gross profit Operating expenses Sales General and administrative Other operating expenses Operating income Interest Expense JensWeschta18 Net Profit after Tax/ Capitilazition • Measure of the efficiency of how efficiently the company is able to use its assets to generate profit • Important ratio for many analysts Net property plant and equipment Minority interest Goodwill Other long-term liabilities Intangible assets Stockholders' equity Other long-term assets Common stock Additional paid-in capital Retained earnings Treasury stock Accumulated other comprehensive income Financial Condition Other income (expense) Income before taxes Provision for income taxes Other income Net income from continuing operations Net income from discontinuing operations Net income available to common shareholders
  19. 19. DSO • Days’ sales outstanding (DSO) DSO Receivables/ Revenue * Days in period Assets Liabilities Current Assets Current Liabilities Cash Short-term debt Receivables Accounts payable Inventory Taxes payable Other current assets Accrued liabilities Other current liabilities Non-current Assets Non-current Liabilities Gross property plant and equipment Long-term debt Accumulated Depreciation Deferred taxes liabilities Net property plant and The ratio measures the average number of days that a company takes to collect revenue after a sale has been made Income Statement Revenue (Sales) Cost of revenue Gross profit Operating expenses Sales General and administrative Other operating expenses Operating income Interest Expense JensWeschta19 • Days’ sales outstanding (DSO) evaluates whether customers are paying their bills on time. A higher DSO could indicate aggressive revenue recognition • Higher DSO means inflating net income Net property plant and equipment Minority interest Goodwill Other long-term liabilities Intangible assets Stockholders' equity Other long-term assets Common stock Additional paid-in capital Retained earnings Treasury stock Accumulated other comprehensive income Financial Condition Other income (expense) Income before taxes Provision for income taxes Other income Net income from continuing operations Net income from discontinuing operations Net income available to common shareholders
  20. 20. Net Profit Margin Net Profit Margin Net Profit after Tax/ Sales • The greater the margin the more efficiently the company is managed Net profit margin (%) The ratio of net income to revenue. Income Statement Revenue (Sales) Cost of revenue Gross profit Operating expenses Sales General and administrative Other operating expenses Operating income Interest Expense JensWeschta20 • The greater the margin the more efficiently the company is managed • Within an industry the company with the higher profit margin is a better investment if profits decline Profitability Other income (expense) Income before taxes Provision for income taxes Other income Net income from continuing operations Net income from discontinuing operations Net income available to common shareholders
  21. 21. Free Cash Flow to Sales Free Cash Flow to Sales Free CF/ Sales • Measures the company ability to turn sales into cash The ratio illustrates the percentage of free cash flow to the amount of sales. Cash Flow Statement Cash Flows From Operating Activities Net income Depreciation & amortization Inventory Accounts payable Accrued liabilities Income taxes payable Other working capital Other non-cash items Cash Flows From Investing Activities Income Statement Revenue (Sales) Cost of revenue Gross profit Operating expenses Sales General and administrative Other operating expenses Operating income Interest Expense JensWeschta21 into cash • It is much more difficult to distort free cash flow with accounting gimmicks than to manipulate earnings Profitability Cash Flows From Investing Activities Investments in property plant and equipment Acquisitions net Other investing activities Cash Flows From Financing Activities Debt issued Debt repayment Common stock repurchased Dividend paid Other financing activities Interest Expense Other income (expense) Income before taxes Provision for income taxes Other income Net income from continuing operations Net income from discontinuing operations Net income available to common shareholders
  22. 22. P/E Ratio P/E-Ratio Stock Price/ Earnings per Share • Most important ratio when determine the fair price of the stock P/E ratio The ratio of the stock price to the sum of its reported earnings, which may or may not account for dilution, over the last 4 quarters. Income Statement Revenue (Sales) Cost of revenue Gross profit Operating expenses Sales General and administrative Other operating expenses Operating income Interest Expense Other income (expense) JensWeschta22 • Most important ratio when determine the fair price of the stock • A company with a higher growth rate should sell at a higher P/E • Look at P/E Range over period of time for a stock, i.e. 15 – 37 for an given year • To say a stock with a P/E of 15 (as most books do) is fairly valued is too simple Stock Evaluation Other income (expense) Income before taxes Provision for income taxes Other income Net income from continuing operations Net income from discontinuing operations Net income available to common shareholders
  23. 23. Working Capital Working Capital Current Assets - Current Liabilities = Working Capital • Also known as “Net Current Assets” Assets Liabilities Current Assets Current Liabilities Cash Short-term debt Receivables Accounts payable Inventory Taxes payable Other current assets Accrued liabilities Other current liabilities Non-current Assets Non-current Liabilities Gross property plant and equipment Long-term debt Accumulated Depreciation Deferred taxes liabilities Net property plant and JensWeschta23 • Also known as “Net Current Assets” • According to Ben Graham (mentor of Warren Buffett) a company trading at 66% (or lower) of Net Current Assets is a “bargain” Net property plant and equipment Minority interest Goodwill Other long-term liabilities Intangible assets Stockholders' equity Other long-term assets Common stock Additional paid-in capital Retained earnings Treasury stock Accumulated other comprehensive income
  24. 24. Capitalization Capitalization LT Debt + Stockholder’s Equity = Capitalization • The term is hard to define • On the balance sheet it refers to LT debt plus equity Assets Liabilities Current Assets Current Liabilities Cash Short-term debt Receivables Accounts payable Inventory Taxes payable Other current assets Accrued liabilities Other current liabilities Non-current Assets Non-current Liabilities Gross property plant and equipment Long-term debt Accumulated Depreciation Deferred taxes liabilities JensWeschta24 Net property plant and equipment Minority interest Goodwill Other long-term liabilities Intangible assets Stockholders' equity Other long-term assets Common stock Additional paid-in capital Retained earnings Treasury stock Accumulated other comprehensive income
  25. 25. Debt • Short term debt/liabilities is thought of financing inventories or receivables • Long term debt is thought of financing capital equipment • However some companies do it the other way around Assets Liabilities Current Assets Current Liabilities Cash Short-term debt Receivables Accounts payable Inventory Taxes payable Other current assets Accrued liabilities Other current liabilities Non-current Assets Non-current Liabilities Gross property plant and equipment Long-term debt Accumulated Depreciation Deferred taxes liabilities JensWeschta25 Net property plant and equipment Minority interest Goodwill Other long-term liabilities Intangible assets Stockholders' equity Other long-term assets Common stock Additional paid-in capital Retained earnings Treasury stock Accumulated other comprehensive income
  26. 26. Book Value • A more conservative approach is to exclude Book Value Total Assets - Total Liabilities = Book Value Assets Liabilities Current Assets Current Liabilities Cash Short-term debt Receivables Accounts payable Inventory Taxes payable Other current assets Accrued liabilities Other current liabilities Non-current Assets Non-current Liabilities Gross property plant and equipment Long-term debt Accumulated Depreciation Deferred taxes liabilities JensWeschta26 • A more conservative approach is to exclude “Intangible Assets” and “Goodwill” form “Total Assets” • The value of both items is hard to determine and gives the company a lot of room on how to price them • Book value is often thought as a price which a stock will not fall for long. • A stock selling below book value of about 25%-50% does not stay there for a long time because the price attracts buyers if the business is still sound Deferred taxes liabilities Net property plant and equipment Minority interest Goodwill Other long-term liabilities Intangible assets Stockholders' equity Other long-term assets Common stock Additional paid-in capital Retained earnings Treasury stock Accumulated other comprehensive income
  27. 27. Earnings per Share Growth Rate 1/3 • The EPS growth rate gives a good picture of the rate at which a company has grown its profitability per share • All things being equal, stocks with higher Year 1 2 3 4 5 6 7 8 9 10 EPS 1,87 1,69 3,8 -3,97 6,84 4,73 -4,75 6,7 6,2 3,35 5/1 1 5         y y EPS EPS = 73,15% JensWeschta27 • All things being equal, stocks with higher earnings-per-share growth rates are generally more desirable than those with slower earnings-per-share growth rate 10/1 1 10         y y EPS EPS = 17,91%
  28. 28. Earnings per Share Growth Rate 2/3 • EPS is easy to manipulate • Only two of the following options create real value for stockholders Net Income Price increase Accounting tricks JensWeschta28 EPS Net Income/ # of Shares Shares Buy back shares Issuing new shares Increase sales
  29. 29. Earnings per Share Growth Rate 3/3 • Companies will buy back shares when they are optimistic • Companies will issue new shares when need money Negative Net Income growth rate 45% EPS 30% Positive Net Income growth rate 30% EPS 50% JensWeschta29 EPS growth rate 30% EPS growth rate 50% New shares issued Share buy back
  30. 30. Rate of Return (Current Yield) Yield Earnings per Share/ Price • What is your expected yield when you purchase the stock at certain price JensWeschta30 • A more conservative approach is to exclude “Intangible Assets” and “Goodwill” form “Total Assets” • The value of both items is hard to determine and gives the company a lot of room on how to price them • Book value is often thought as a price which a stock will not fall for long. • A stock selling below book value of about 25%-50% does not stay there for a long time because the price attracts buyers if the business is still sound
  31. 31. What is a Conservative Investment? Ben Graham on conservative investments: Debt Situation Current Ratio > 2 Debt Situation Working Capital > Long Term Debt Profitability Some Earning in the last 10 years (no deficits) • According to the mentor of Warren Buffett (Ben Graham) a conservative investment has the following characteristics: JensWeschta31 Profitability Some Earning in the last 10 years (no deficits) Profitability Earnings Growth past 10 years min. 3% p.a. Note: • Ben Graham lived through the Great Depression and World War II. He saw first hand what too much debt/leverage on the balance sheet can cause • Warren Buffett improved Ben Grahams work • The characteristics presented on this slide are not the complete list but in my opinion are still valid and timeless
  32. 32. What is a Bargain? Bargain: Net Current Assets 66% below Net Current Assets Ben Graham: Bargain: BookValue 25%-50% below Book Value William H. Pike: JensWeschta32 Net Current Assets Current Assets - Current Liabilities = Net Current Assets BookValue Total Assets -Total Liabilities = BookValue
  33. 33. Timing: Buy Rules JensWeschta33
  34. 34. • Tax are due on April, 17th in the US. • US citizens sell stocks to pay their taxes. • If stocks are up in the first three month of the year a sell off usually starts at the beginning of April. • In this case stock starts rising after April 17th. • Historically April is either the second best or best month for US Tax collection JensWeschta34 • Historically April is either the second best or best month for US stocks • That is one of the reason for the saying:“sell in may and go away”
  35. 35. • Company’s with huge cash amount can either • Invest in new products an services, • Pay dividends to their shareholders, • Buy other companies, • Retain earnings, • Buy back their shares (“Treasury stock” on the balance sheet). Company buy backs JensWeschta35 • Buy back their shares (“Treasury stock” on the balance sheet). • When a company buys back shares it means less shares are available in the market.This usually causes stock prices to rise since the same amount of money is chasing less shares (ceteris paribus) • When a company sells shares either to an IPO, or stock options the opposite is true
  36. 36. • Insider have information which are not available to the public • When a company buys back its own shares but insider selling their shares this should be warning signal • If you are the CEO of a public company and you expect turbulences ahead you want to sell your shares at the highest price Company buy backs vs. Insider selling JensWeschta36 price • So the company uses its free cash flow and buy back its own shares therefore insider can sell their shares at a higher price • With insider I mean CEO, CFO etc.
  37. 37. • High quality stocks trade in a certain P/E range on a year to year basis. • Look at period of 5-10 years and calculate the P/E range. • Buy at the lower price of the range. • Usually you will find a certain pattern which gives you a good indication when to buy a stock and when to sell the stock or hedge P/E Ratio Range 1/2 JensWeschta37 indication when to buy a stock and when to sell the stock or hedge your position with a long put. • A good start is to use past earnings growth to predict future earnings
  38. 38. P/E Ratio Range 2/2 Date High Low EPS P/E-High P/E-Low 12/30/2011 76,16 56,18 3,72 20,5 15,1 12/31/2010 67,76 46,5 3,12 21,7 14,9 12/31/2009 56,29 31,45 2,8 20,1 11,2 12/31/2008 63,04 34,33 2,65 23,8 13,0 12/31/2007 56,59 37,4 2,34 24,2 16,0 JensWeschta38 12/31/2007 56,59 37,4 2,34 24,2 16,0 12/29/2006 39,68 31,26 2,05 19,4 15,2 12/30/2005 33,55 27,67 1,88 17,8 14,7 12/31/2004 30,81 26,61 1,67 18,4 15,9 12/31/2003 28,96 20,47 1,36 21,3 15,1 12/31/2002 26,4 19,08 0,89 29,7 21,4 P/E-High P/E-Low Average 21,7 15,3 Buy at the lower range: P/E = 15
  39. 39. Accounting Fraud JensWeschta39
  40. 40. Net Income growth faster than CFO 2009 2011 Net Income 11 25 127% Cash from Operations 14 21 50% Red Flag: High net income along with low CFO often signals the presence of earnings manipulation Cash Flow Statement Cash Flows From Operating Activities Net income Depreciation & amortization Inventory Accounts payable Accrued liabilities Income taxes payable Other working capital Other non-cash items Cash Flows From Investing Activities Income Statement Revenue (Sales) Cost of revenue Gross profit Operating expenses Sales General and administrative Other operating expenses Operating income Interest Expense JensWeschta40 manipulationCash Flows From Investing Activities Investments in property plant and equipment Acquisitions net Other investing activities Cash Flows From Financing Activities Debt issued Debt repayment Common stock repurchased Dividend paid Other financing activities Interest Expense Other income (expense) Income before taxes Provision for income taxes Other income Net income from continuing operations Net income from discontinuing operations Net income available to common shareholders
  41. 41. Receivables growing much faster than Revenue RED FLAG: Receivables grow faster than revenue = less futures earnings, 1996 1997 1998 1999 Revenue $10,630 $10,884 $14,350 $14,900 %-change 2,4% 31,8% 3,8% Receivables $1,542 $2,732 $3,981 $4,156 %-change 77,2% 45,7% 4,4% Assets Liabilities Current Assets Current Liabilities Cash Accounts payable Receivables Taxes payable Inventory Accrued liabilities Other current assets Other current liabilities Non-current Liabilities Non-current Assets Long-term debt Gross property plant and equipment Deferred taxes liabilities Accumulated Depreciation Minority interest Income Statement Revenue (Sales) Cost of revenue Gross profit Operating expenses Sales General and administrative Other operating expenses Operating income Interest Expense JensWeschta41 than revenue = less futures earnings, thus overstating net income Receivables Revenue/365 As a result A/R days increase: Net property plant and equipment Other long-term liabilities Goodwill Stockholders' equity Intangible assets Common stock Other long-term assets Additional paid-in capital Retained earnings Treasury stock Accumulated other comprehensive income Other income (expense) Income before taxes Provision for income taxes Other income Net income from continuing operations Net income from discontinuing operations Net income available to common shareholders
  42. 42. RED FLAG: Inventory grow faster than revenue = overstating net income 1996 1997 1998 1999 Revenue $10,630 $10,884 $14,350 $14,900 %-change 2,4% 31,8% 3,8% Inventory $1,542 $2,732 $3,981 $4,156 %-change 77,2% 45,7% 4,4% Assets Liabilities Current Assets Current Liabilities Cash Accounts payable Receivables Taxes payable Inventory Accrued liabilities Other current assets Other current liabilities Non-current Liabilities Non-current Assets Long-term debt Gross property plant and equipment Deferred taxes liabilities Accumulated Depreciation Minority interest Inventory growing much faster than accounts receivable Income Statement Revenue (Sales) Cost of revenue Gross profit Operating expenses Sales General and administrative Other operating expenses Operating income Interest Expense JensWeschta42 than revenue = overstating net income Inventory COGS/365 As a result inventory days increase Net property plant and equipment Other long-term liabilities Goodwill Stockholders' equity Intangible assets Common stock Other long-term assets Additional paid-in capital Retained earnings Treasury stock Accumulated other comprehensive income Other income (expense) Income before taxes Provision for income taxes Other income Net income from continuing operations Net income from discontinuing operations Net income available to common shareholders
  43. 43. Understatement of Inventory vs. Accounts payable RED FLAG: Most accounts payable transactions are for the purchase of inventory.Therefore changes in 1996 1997 1998 1999 Inventory $144,736 $148,251 $144,052 $141,898 %-change 2,4% -2,8% -1,5% Accounts payable $110,942 $100,354 $107,279 $115,424 %-change -9,5% 6,9% 7,6% Assets Liabilities Current Assets Current Liabilities Cash Accounts payable Receivables Taxes payable Inventory Accrued liabilities Other current assets Other current liabilities Non-current Liabilities Non-current Assets Long-term debt Gross property plant and equipment Deferred taxes liabilities Accumulated Depreciation Minority interest JensWeschta43 for the purchase of inventory.Therefore changes in accounts payable should closely track changes in inventory. An understatement of accounts payable can be linked to an understatement of cost of goods sold and an overstatement of net income Accumulated Depreciation Minority interest Net property plant and equipment Other long-term liabilities Goodwill Stockholders' equity Intangible assets Common stock Other long-term assets Additional paid-in capital Retained earnings Treasury stock Accumulated other comprehensive income
  44. 44. Sudden appearance of Deferred Asset Accounts RED FLAG: The sudden appearance of a deferred asset account or a sharp increase in such an account Assets Liabilities Current Assets Current Liabilities Cash Accounts payable Receivables Taxes payable Inventory Accrued liabilities Other current assets Other current liabilities Non-current Liabilities Non-current Assets Long-term debt Gross property plant and equipment Deferred taxes liabilities Accumulated Depreciation Minority interest JensWeschta44 asset account or a sharp increase in such an account (deferred costs, deferred expenses, deferred charges, deferred R&D) Accumulated Depreciation Minority interest Net property plant and equipment Other long-term liabilities Goodwill Stockholders' equity Intangible assets: Deferred Assets Common stock Other long-term assets Additional paid-in capital Retained earnings Treasury stock Accumulated other comprehensive income
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