Chapter 19

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Chapter 19

  1. 1. Fin2802: Investments Spring, 2010 Dragon Tang <ul><li>Lecture 15 </li></ul><ul><li>Financial Statement Analysis </li></ul><ul><li>March 18, 2010 </li></ul><ul><li>Readings: Chapter 19 </li></ul><ul><li>Practice CFA Problem Sets: 6-9,13,14,16 </li></ul>FIN 2802, Spring 10 - Tang Chapter 19: Financial Statement Analysis
  2. 2. Everyone gets sick sometime! <ul><li>Take your stocks to a doctor! </li></ul><ul><li>Regular checkups will prevent big problems </li></ul>FIN 2802, Spring 10 - Tang Chapter 19: Financial Statement Analysis
  3. 3. Financial Statement Analysis FIN 2802, Spring 10 - Tang Chapter 19: Financial Statement Analysis <ul><li>Objectives: </li></ul><ul><li>Use a firm’s income statement , balance sheet , and statement of cash flows to calculate standard financial ratios . </li></ul><ul><li>Calculate the impact of taxes and leverage on a firm’s return on equity using ratio decomposition analysis. </li></ul><ul><li>Measure a firm’s operating efficiency </li></ul><ul><li>Identify likely sources of biases in accounting data. </li></ul>
  4. 4. Fundamental Analysis <ul><li>Economics </li></ul><ul><li>Finance </li></ul><ul><li>Accounting </li></ul><ul><ul><li>How to interpret reported data? </li></ul></ul>FIN 2802, Spring 10 - Tang Chapter 19: Financial Statement Analysis
  5. 5. Financial Statements <ul><li>The Balance Sheet: Snapshot of Financial Condition </li></ul><ul><ul><li>Assets – Liabilities = Shareholders’ Equity </li></ul></ul><ul><ul><li>Current vs long-term </li></ul></ul><ul><li>Income Statement: Summary of Profitability </li></ul><ul><ul><li>Revenue – Expenses = Net Income </li></ul></ul><ul><ul><li>Expenses: raw material; salary; interest; tax </li></ul></ul><ul><ul><li>EBIT=Earnings – Raw Material – Salary </li></ul></ul><ul><li>The Statement of Cash Flows: “Actual” Cash </li></ul><ul><ul><li>More reliable </li></ul></ul><ul><ul><li>Activities: Operating; Investing; Financing </li></ul></ul><ul><ul><li>Depreciation is not smoothed </li></ul></ul>FIN 2802, Spring 10 - Tang Chapter 19: Financial Statement Analysis
  6. 6. Accounting vs Economic Earnings <ul><li>Economic earnings: Sustainable cash flow that can be paid out without impairing the productive capacity </li></ul><ul><li>Accounting earnings: “Models” are used </li></ul><ul><li>Accounting earnings are still useful </li></ul>FIN 2802, Spring 10 - Tang Chapter 19: Financial Statement Analysis
  7. 7. Return on Equity (ROE) <ul><li>ROE=Net profit/Equity </li></ul><ul><li>Trend in ROE </li></ul><ul><li>Watch out financial leverage: </li></ul><ul><li>ROA: Return on Assets=EBIT/Assets </li></ul>FIN 2802, Spring 10 - Tang Chapter 19: Financial Statement Analysis
  8. 8. Du Pont System: Decomposition of ROE FIN 2802, Spring 10 - Tang Chapter 19: Financial Statement Analysis x ROA = Margin X Turnover ROE = Net Profit Pretax Profit x Pretax Profit EBIT x EBIT Sales Sales Assets x x Assets Equity (1) x (2) x (3) x (4) x (5) x Margin x Turnover x Leverage Tax Burden Interest Burden
  9. 9. Practice <ul><li>An analyst applies the DuPont system of financial analysis to the following data for a company: </li></ul><ul><ul><li>Leverage ration 2.2 </li></ul></ul><ul><ul><li>Total asset turnover 2.0 </li></ul></ul><ul><ul><li>Net profit margin 5.5% </li></ul></ul><ul><ul><li>Dividend payout ratio 31.8% </li></ul></ul><ul><li>What is the company’s return on equity? </li></ul>FIN 2802, Spring 10 - Tang Chapter 19: Financial Statement Analysis
  10. 10. Ratio Analysis <ul><li>Asset utilization ratios: Efficiency </li></ul><ul><ul><li>Fixed-asset turnover=Sales/Fixed Assets </li></ul></ul><ul><ul><li>Inventor turnover=cost of goods sold/average inventory </li></ul></ul><ul><ul><li>Average collection period=(Account receivables/Sales)*365 </li></ul></ul><ul><li>Liquidity and coverage ratios: Financial health </li></ul><ul><ul><li>Current ratio=current assets/current liabilities </li></ul></ul><ul><ul><li>Quick ratio=(cash+receivables)/current liabilities </li></ul></ul><ul><ul><li>Interest coverage ratio=EBIT/interest expense </li></ul></ul><ul><li>Market price ratios: Relative Value </li></ul><ul><ul><li>Market/Book ratio(P/B): “Safeness” </li></ul></ul><ul><ul><li>Price-earnings ratio (P/E): No easy bargain </li></ul></ul><ul><ul><li>E/P=ROE/(P/B) </li></ul></ul><ul><li>Choose a benchmark! </li></ul>FIN 2802, Spring 10 - Tang Chapter 19: Financial Statement Analysis
  11. 11. Intel ’ s Financial Ratios Over Time FIN 2802, Spring 10 - Tang Chapter 19: Financial Statement Analysis
  12. 12. Economic Value Added (EVA) <ul><li>EVA=(ROA-Capitalization Rate)  Capital Invested </li></ul><ul><li>Growth is not the whole picture! </li></ul><ul><li>EVA can be positive or negative for firms that have positive earnings </li></ul>FIN 2802, Spring 10 - Tang Chapter 19: Financial Statement Analysis
  13. 13. Key Financial Ratios of Growth Industries Inc. FIN 2802, Spring 10 - Tang Chapter 19: Financial Statement Analysis
  14. 14. Growth Industries Statements of Cash Flow FIN 2802, Spring 10 - Tang Chapter 19: Financial Statement Analysis
  15. 15. Comparability Problems <ul><li>GAAP (Generally Accepted Accounting Principles) is not unique </li></ul><ul><ul><li>Inventory valuation: LIFO vs FIFO </li></ul></ul><ul><ul><li>Depreciation: Straight line vs Accelerated </li></ul></ul><ul><ul><li>Real interest payments </li></ul></ul><ul><li>Quality of earnings affected by: </li></ul><ul><ul><li>Allowance of bad debt; nonrecurring items; stock option; revenue recognition; off-balance-sheet assets and liabilities </li></ul></ul><ul><li>GAAP vs IAS (International Accounting Standards) </li></ul>FIN 2802, Spring 10 - Tang Chapter 19: Financial Statement Analysis
  16. 16. Quality of Earnings: Areas of Accounting Choices <ul><li>Allowance for bad debts </li></ul><ul><li>Non-recurring items </li></ul><ul><li>Reserves management </li></ul><ul><li>Stock options </li></ul><ul><li>Revenue recognition </li></ul><ul><li>Off-balance sheet assets and liabilities </li></ul>FIN 2802, Spring 10 - Tang Chapter 19: Financial Statement Analysis
  17. 17. Figure 19.2 Comparative Accounting Rules FIN 2802, Spring 10 - Tang Chapter 19: Financial Statement Analysis
  18. 18. Adjusted Versus Reported Price-Earnings Ratios FIN 2802, Spring 10 - Tang Chapter 19: Financial Statement Analysis
  19. 19. Value Investing <ul><li>Benjamin Graham </li></ul><ul><li>Pick value stocks (low P/B) </li></ul><ul><li>Rule: stock price < net current-asset value </li></ul><ul><li>Information sources: S&P’s Outlook and Value Line Investment Survey </li></ul>FIN 2802, Spring 10 - Tang Chapter 19: Financial Statement Analysis
  20. 20. Browne: Value Investing Checklist <ul><li>What is the outlook for pricing for products? </li></ul><ul><li>Can the company sell more? </li></ul><ul><li>Can the company increase profits on existing sales? </li></ul><ul><li>Can the company control expenses? </li></ul><ul><li>How much of the additional sales are net profits? </li></ul><ul><li>How competitive is the company? </li></ul><ul><li>Any one-time expenses? </li></ul><ul><li>Any unprofitable operations? </li></ul><ul><li>How well does the company meet expectations? </li></ul><ul><li>Growth over the next five year </li></ul><ul><li>Excess cash, competition strategies, acquisition value, stock repurchases, insider trading activities </li></ul>FIN 2802, Spring 10 - Tang Chapter 19: Financial Statement Analysis
  21. 21. Summary <ul><li>Fundamental Analysis </li></ul><ul><li>Economic earnings vs accounting earnings </li></ul><ul><li>Financial Statements </li></ul><ul><li>Du Pont System; ratio analysis </li></ul><ul><li>Economic Value Added </li></ul><ul><li>Comparability </li></ul><ul><li>Next: Macroeconomy and Stock Market </li></ul>FIN 2802, Spring 10 - Tang Chapter 19: Financial Statement Analysis

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