1 Security Analysis The Role of Income Statements

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Security Analysis

The Role of Income Statements

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General Notes On Accounting

Role of accountant versus role of financial analyst

Regulated by FASB – a self-regulatory organization

Principles versus rulesAssumptionsMonetary Unit

Economic Entity

Going Concern

Periodicity

PrinciplesMatching

Cost

Full Disclosure

ConstraintsMateriality

Conservatism

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The Relationships between the Financial StatementsThe Relationships between the Financial Statements

Balance Sheet–12/31/03

Assets Cash Other current assets Long-term investments Long-lived assets Intangible assets

Liabilities and Stockholders’ Equity Current liabilities Long-term liabilities Contributed capital Retained earnings

Balance Sheet–12/31/04

Assets Cash Other current assets Long-term investments Long-lived assets Intangible assets

Liabilities and Stockholders’ Equity Current liabilities Long-term liabilities Contributed capital Retained earnings

Statement of Cash Flows–1/1/04–12/31/04

Net cash flow from operating activitiesNet cash used by investing activitiesNet cash provided by financing activitiesChange in cash balanceBeginning cash balance (12/31/03)Ending cash balance (12/31/04)

Income Statement–1/1/04–12/31/04

Revenues− Expenses= Net income

Statement of Retained Earnings 1/1/04–12/31/04

Beginning retained earnings balance+ Net income− DividendsEnding retained earnings balance

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Analyst Role Collect Important Facts About

Business

Identify and Analyze Key Investment Controversies

Identify Gaps Between Intrinsic Value and Market Price

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Obstacles to Success Inadequate or Incorrect Data

Uncertainty of Future

Wacky Market Conditions

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The Research Process

Why Write a Report?

What is the First Step of the Written Research Process?

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Written Research Process Build a Financial Model Income Statement Balance Sheet Cash Flow Statement Begin with Public Documents (10k,

10Q) Does what I see make sense???

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Financial Models

Good Models Lead to Good Management Discussions

Good Models Should Inform Rather Than Impress

Good Modeling Requires Critical Thinking

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Begin with the Income Statement

Most Widely Used Statement Most Widely Manipulated

Statement Examination of Balance Sheet and

Cash Flow Statement Validate Truth of the Income Statement

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Income

Start With Stated Income Statement Numbers and Adjust

Why Adjust?

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S&P 500 Reported, Operating and Adjusted EPS

Amoritization of Stock Adjusted As a Share ofReported Operating Nonrecurring Pension Option "Core" Reported "Operating"Earnings Earnings Items* Expense Grants Earnings Earnings Earnings

1988 $23.75 $24.65 $1.16 $0.70 $0.15 $22.64 95% 92%1989 22.87 24.02 1.43 0.66 0.21 21.72 95 901990 21.73 23.03 1.67 0.75 0.3 20.31 93 881991 16.29 19.6 2.26 1.07 0.36 15.91 98 811992 18.86 21.71 2.3 1.24 0.41 17.76 94 821993 21.85 25.92 2.59 1.41 0.48 21.45 98 831994 29.92 31.02 2.67 1.61 0.66 26.08 87 841995 33.6 36.51 2.95 1.39 0.75 31.42 94 861996 38.73 40.49 3.54 1.4 1.17 34.38 89 851997 39.72 44.71 3.29 1.23 1.67 38.51 97 861998 37.71 44.1 4.09 1.23 2.18 36.6 97 831999 48.17 50.78 5.34 0.69 3.52 41.23 86 81200 50 55.86 6.32 0.75 4.75 44.04 88 79

2001 24.7 45.82 6.29 0.4 4.55 34.58 140 752002 28.54 46.04 6.06 -0.05 2.75 37.28 130 81

2003e 47.74 54.74 5.62 -1.5 3.5 47.12 99 862004e 56.5 63 4.65 -1.5 3.73 56.12 99 89

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Earnings Management Tools

Timing of Investment Spending Revenue Recognition Capitalize Operating Expenses Write - Offs Bad Debt Reserves Income from Investments Pension Expense

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Other Earnings Adjustments

Employee Stock Options

Repeated One-time Charges

Accretive/Dilutive Acquisitions

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1998 1999 2000

Sales $8,489 $12,173 $18,928

Net Income 1,880 2,520 3,910

Net Margin

22% 20% 20%

Shares Outstanding

6,658 7,062 7,438

Earnings Per Share

$0.28 $0.36 $0.53

(dollars in millions)

Summary Income Statement

Source: Mark Kleiman

Cisco Systems

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1998 1999 2000

Options Issued (millions) 282 245 295

Average Exercise Price $10.00 $22.22

$52.10

Black-Scholes Value / Option $3.75 $8.40 $19.44

Total Value of Options Issued ($millions)

$1,007 $2,058

$5,735


Cisco Systems (dollars in millions)

1998 1999 2000

Sales $8,489 $12,173

$19,928

“Operating” Net Income $1,880 $2,520

$3,910

Less: Employee Option Expense ($1,007)

($2,058)

($5,735)

Plus: Tax Benefit at 40% $403 $823 $2,294

Net Income $1,276 $1,285

$469

Shares Outstanding 6,658 7,062 7,438

Earnings Per Share $0.19 $0.18 $0.06

Cisco Systems

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Employee Option Impact

Company 2000 2001 2000 2001 2000 2001

Microsoft 14,275 15,425 11,148 6,565 3,127 8,860

Cisco Systems 5,589 4,148 5,734 4,259 (145) (111)

America Online 5,167 6,245 1,588 4,810 3,579 1,435

Apple Computer

1,092 (52) 1,184 354 (92) (406)

Yahoo! 310 44 1,088 603 (778) (559)

Ebay 83 218 360 545 (277) (327)

Dell Computer 3,299 2,213 3,231 1,643 68 570

Oracle 3,186 3,988 2,015 245 1,171 3,743

Amazon.com (417) (156) 458 276 (875) (432)

Pre-tax Income (1)Value of

Options GrantedAdjusted

Pre-tax Income

($ in millions)


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Financial Reports Restatements in U.S. in 1990-2002(Sources: Financial Executives International and General Accounting Office)

0

50

100

150

200

250

Year

Frequency

FEI Data FEI Data/SEC Enforced GAO Data

From: “Minding Our Manners” Shyam Sunder, Yale University

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1997

1998

1999

2000

2001

Sales $9,357

$9,210

$9,300

$9,408

$9,430

Net Income

724 801 882 906 896

E.P.S. $1.93

$2.15

$2.40

$2.52

$2.55

H.J. Heinz Company ($in millions)


Results as adjusted

1997

1998

1999

2000

2001

Sales $9,357

$9,210

$9,300

$9,408

$9,430

Net Income

302 802 474 891 478

E.P.S. $0.81

$2.15

$1.29

$2.47

$1.41

Serial Restructuring

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1991

1996

2001

Sales $6,060

$8,749

$9,428

Media Advertising

429 566 509

Advertising / Sales

7.1% 7.0% 5.4%

Colgate Palmolive

Discretionary Expenses


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Procter & Gamble Company (dollars in millions)RESTRUCTURING CHARGES Adjustme

nt

1998 1999 2000 2001 2002

Core Net Earnings $2.68 $2.98 $3.10 $3.27 $3.59

After-tax Restructure $0.26 $0.48 $1.05 $0.50 $0.46

OPTIONS

Granted 20.3 7 14.4 28.4 25

Value / Option $24.60

$32.20

$37.20

$22.50

$21.10

After-tax Value $300 $135 $321 $383 $317

Per Share 0.21 0.09 0.23 0.27 0.23 $0.21

POSTRETIREMENT BENEFITS

Pension Assets $1,523

$1,555

$1,691

$1,432

$1,332

Assumed Return 9.0% 7.9% 8.1% 8.3% 8.6%

0.03

Other Plans $2,611

$2,516

$1,274

$1,449

$2347

Assumed Return 9.0% 10.0% 10.0% 10.0% 9.5%

DISCRETINARY EXPENSES

Sales $37,154

$38,125

$40,238

$39,244

$40,238

Advertising Costs $3,704

$3,538

$3,793

$3,612

$3,773

Percentage 10.0% 9.3% 9.4% 9.2% 9.4% $0.10

Total $0.80

Shares Outstanding 1427 1447 1427 1406 1405

The adjustment for restructuring charges and options is the average five year earnings impact.

The adjustment for postretirement benefits is the lower earnings impact of using a 7% investment return for 2002.

The discretionary expenses adjustment incorporates the earnings impact of a 10% advertising / sales expense ratio for 2002.


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Top 11 Measures

1. Cash from Operations2. Cash from Operations / Earnings3. Days Sales Outstanding (DSO’s)4. Operating Asset Turnover5. Operating Margins6. Loan Loss Reserves7. Days of Inventory Turnover8. Employee Stock Options9. Capital Expenditure to Depreciation Ratio10. R&D / Marketing Spending to Sales11. Restructuring / One Time Charges

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Illusory Earnings Growth Through Accretive Acquisition

Acquirer TargetEarnings $10 $10Shares 10 10EPS $1 $1Shares O/S, Price 10, $40 10, $20P/E 40 20Market Cap $400 $200

Theoretically, combination value = $400 + $200:Earnings = $20, so P/E = $600/$20 = 30. EPS = $1.33 33%

growth!

Alternatively, if the combination P/E migrates to the Acquirer P/E of 40:

Stock price goes from $40 to $53.33 (+33%) and EPS remains $1

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Growth Investor Income Statement

Rate of Growth of Revenue and Earnings

Consistency of Growth

Acceleration and Deceleration

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Value Investor Income Statement

Bottom Line (GAAP) Oriented Focus Quality of EPS and

Conservative Accounting Evaluate History of EPS Cycle Valuation Driven by Whole Cycle

Earnings

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Conclusion

Analyst must employ both Qualitative and Quantitative methods.

Focus on creating Rational Basis for Purchase

Assess what Accounting Issues impact sustainability of Revenue and Income Performance.

Start with Income Statement and Adjust with a Cynical eye.

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Valuing Future Growth

Zero Value Growth∆ Capital * Cost Equity (r)

Franchise Value Growth(∆ Capital * (ROE-R))

Operating Leverage∆ ROE * Capital

0

+ or -

+ or -

Value Impact

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Outputs of Fundamental Analysis

Source: Trevor Harris, Morgan Stanley Equity Research

RNOA

Operating ProfitMargin

[PM]

Operating AssetTurnover[opATO]

Net Operating Assets (NOA)

Revenues

OperatingIncome

Revenues

Revenues

Marketing

R&D

Other

Capacity

New ProductsExisting ProductsChannelsRegions

FixedVariable

FixedVariable

Fixed - RequiredVariable - Growth

FixedVariable

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Profitability MapOperating Margin

Low HighL

owH

igh

OperatingAssetTurnover

CannedFoodArea

Source: Trevor Harris, Morgan Stanley Equity Research

HighMultiple

Area

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Profile of High P/E Stock

Healthy margins likely to persist

Stable base of business

Significant sources of upside revenues