CH 19 Financial Statement Analysis

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Framework of Analysis

Fundamental Analysis– Research to predict stock value that focuses on such

determinants as earnings and dividends prospects, expectations for future interest rates, and risk evaluation of the firm

Top-down approach (“Three-Step” Valuation Approach– Domestic and global economic analysis– Industry analysis– Company analysis

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Investment Process

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FINANCIAL STATEMENT ANALYSIS

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Financial Statement Analysis

Financial statement analysis can be used to discover mispriced securities.

Financial accounting data are widely available, but– Accounting earnings and economic earnings

are not always the same thing!

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Financial Statements

Income Statement: – Profitability over time

Balance Sheet: – Financial condition at a point in time

Statement of Cash Flows: – Tracks the cash implications of

transactions.

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Accounting Versus Economic Earnings

Economic earnings– Sustainable cash flow that can be paid

to stockholders without impairing productive capacity of the firm

Accounting earnings– Affected by conventions regarding the

valuation of assetsExample: LIFO vs. FIFO

Depreciation expense

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Consolidated Statement of Income for Home Depot, 2012

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Consolidated Balance Sheet for Home Depot, 2012

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Statement of Cash Flows for Home Depot, 2012

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Measuring Firm Performance

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Measuring Firm Performance

Manager responsibilities:– 1. Investment decisions– 2. Financing decisions

Ratios used to show efficiency and profitability of these decisions:– ROA- income earned per dollar deployed– ROC- income earned per dollar invested (long term)– ROE net income realized by shareholders per dollar

invested

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Profitability Measures

ROE measures profitability for contributors of equity capital.–After-tax profit/book value of equity

ROA measures profitability for all contributors of capital.–EBIT/total assets

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Past vs. Future ROE

ROE is a key determinant of earnings growth.– Firm’s growth rate = ROE x Retention Ratio

Past profitability does not guarantee future profitability.– Security values are based on future profits.– Expectations of future dividends determine today’s

stock value.

ROA and ROE are linked, but their relationship is affected by the firm’s financial policies.– One should pay attention the firm’s debt-equity mix and

to the interest rate on its debt.

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Financial Leverage and ROE

ROE can differ from ROA because of leverage.

Leverage makes ROE more volatile.

Let t = tax rate and r = interest rate, then:

Equity

DebtROAROA1ROE rt

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Financial Leverage and ROE, cont’d

If there is no debt or ROA = r, ROE will simply equal ROA(1 - t).

If ROA > r, the firm earns more than it pays out to creditors and ROE increases.

If ROA < r, ROE will decline as a function of the debt-to-equity ratio.

Equity

DebtROAROA1ROE rt

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Impact of Financial Leverage on ROE

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Economic Value Added

A firm should be viewed as successful only if– The return on its projects is better than the rate investors could

expect to earn for themselves (on a risk-adjusted basis) in the capital market.

EVA is the difference between return on assets (ROA) and the opportunity cost of capital (k), multiplied by the capital invested in the firm.

EVA is also called residual income

If ROA > k, value is added to the firm.

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Example: Intel

In 2012, Intel’s cost of capital was 7.8%. Its ROA was 13.9% and its capital base was $56.34 billion.

Intel’s EVA = (0.139-0.078) x $56.34 billion = $3.44

billion

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ROE = Net Profit

Pretax Profit

x

Pretax Profit

EBITx

EBIT

Sales

Sales

Assetsx x

Assets

Equity

(1) x (2) x (3) x (4) x (5)

x Margin x Turnover x Leverage Tax

Burden

Interest

Burden

Ratio Analysis:Decomposition of ROE

DuPont Method

x

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Decomposition of ROA

ROA = EBIT/Sales X Sales/Assets

= margin X turnover

Margin and turnover are unaffected by leverage.

ROA reflects soundness of firm’s operations, regardless of how they are financed.

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Decomposition of ROE

ROE

=Tax burden X ROA X Compound leverage factor

Tax burden is not affected by leverage.

Compound leverage factor= Interest burden X Leverage

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Ratio Decomposition Analysis for Nodett and Somdett

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Choosing a Benchmark

Compare the company’s ratios across time.– Time-series analysis

Compare ratios of firms in the same industry.– Peer group analysis

Cross-industry comparisons can be misleading.

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Time-Series Analysis

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Op Income / Sales for Enron

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1984 1986 1988 1990 1992 1994 1996 1998 2000

Time-Series Analysis

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Saxton IndustryCompany Average Conclusion

A. Profitability1. Profit Margin ……………… 5.0% 6.7% Below average2. Return on Assets ………….. 12.5% 10.0% Above

average due to high turnover

3. Return on Equity ………….. 20.0% 15.0% Good

B. Asset Utilization4. Receivables turnover ……. 11.4 10.0 Good5. Average collection period…. 32.0 36.0 Good6. Inventory turnover ………... 10.8 7.0 Good7. Fixed asset turnover ………. 5.0 5.4 Below

average8. Total asset turnover ………. 2.5 1.5 Good

C. Liquidity9. Current ratio ……………… 2.67 2.1 Good10. Quick Ratio ……………….. 1.43 1.0 Good

D. Debt Utilization11. Debt to total assets ……….. 37.5% 33.0% Slightly

more debt12. Times interest earned ……. 11.0 7.0 Good

Peer Group Analysis

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Peer Group Analysis

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Peer Group Analysis

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Differences between Profit Margin and Asset Turnover across Industries

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Industry Differences

Industry Turnover-profit margin tradeoff

Industries with high turnover such as groceries retail apparel tend to have low profit margins, while industries with high margins such as utilities tend to have low turnover.

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Industry Differences

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Summary of Key Financial Ratios

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Summary of Key Financial Ratios

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Summary of Key Financial Ratios

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Summary of Key Financial Ratios

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Summary of Key Financial Ratios

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Ratio Analysis

Which ratio measures the financial or credit risk?

Which ratio measures the company’s ability to service its fixed interest payment?

Which ratio measures the company’s ability to pay off short-term obligations like notes payables and accounts payables?

Which ratio measures how well the company generates revenues and controls costs and expenses (i.e., overall operating effectiveness)?

Which ratio measures the company’s ability to deliver the shareholder’s value?

Which ratio measures the company’s market price relative to $1 of capital that was invested by shareholders?

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Accounting Differences– Inventory Valuation– Depreciation

Inflation and Interest Expense

Fair Value Accounting

Quality of Earnings

International Accounting Conventions

Comparability Problems

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International Accounting Differences

Reserves – many other countries allow more flexibility in use of reserves

Depreciation – US allows separate tax and reporting presentations

Intangibles – treatment varies widely

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Adjusted Versus Reported Price-Earnings Ratios

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The Graham Technique

Rules for stock selection:– Purchase common stocks at less than

their working-capital value.– Give no weight to plant or other fixed

assets.– Deduct all liabilities in full from assets.