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Financial analysis
What is this? • Goal of this lecture: learn how to make a financial analysis – Focus on corporate accounts… – …To obtain a photograph of the firms’ economics – Not real valuaAon, but good first pass
• sources: – Financial statements – Market info (-‐ Info on comparable companies – Market studies, analyst research – Direct contact with the company)
Outline
1 Financial statements: the economic view
2 The 4 step method
3 ExtracAng info from the stockmarket
Textbook references
• Economic view of financial statements – Vernimmen: chapters 2-‐10
• 4 steps method – Vernimmen: chapters 11-‐16
• Financial analysis is NOT accounAng – I am no accountant ! – AccounAng from a finance perspecAve
• I don’t want to be as precise and exhausAve as an accountant • Want to focus on big items that are economically meaningful
Financial statements: a refresher
• Three main statements – Income statement
• « meaningful » cash movements
– Cash flow statement • True cash movements
– Balance sheet • Cumulated investments and their financing (through retained earnings or security issues)
Income Statement, « by Nature » + Net Sales + change in inventories of finished goods
= Produc=on -‐ purchase of raw materials + change in inventories of raw materials -‐ personnal expenses -‐ taxes other than corporate income tax -‐ write downs / offs of trade assets & inventories
= EBITDA -‐ amorAzaAon, depreciaAon of fixed assets
= EBIT -‐ Financial expenses + Financial income = Profit before tax and non recurrent items +/-‐ Non recurring items -‐ Corporate Income Tax ( T ) = Net income ( r E .E ) -‐ Dividends = Retained earnings ( Δ RE )
~ τ x (profit before tax) à deprecia=on is tax free à interest is tax free
« theore=cal » cash flow statement
+ operaAng receipts -‐ operaAng expenses = Opera=ng Cash flows -‐ capital expenditure + fixed assets disposals = Free cash flow before tax -‐ Financial expenses + Financial income -‐ Dividends + proceeds from share issues
-‐ Corporate Income Tax = net decrease in debt / net incr. in cash
-‐ Share Buybacks
… but in prac=ce different presenta=on à
PresentaAon #1 From EBITDA to operaAng cash flows
• OCF = EBITDA -‐ ΔWC
• OperaAng receipts = Net sales – change in trade receivables • OperaAng expenses = operaAng costs (excl. DepreciaAon) –
change in trade payables + change in inventories (material) è OCF = operaAng receipts – operaAng expenses = net sales – operaAng costs + ΔTrade Pay. -‐ ΔTrade rec. -‐ ΔInv(mat.)
= EBITDA – ΔInv(finished Goods) + ΔTrade Pay. – ΔTrade rec. -‐ ΔInv(mat.) = EBITDA -‐ (-‐ΔTrade pay. + ΔTrade rec. + ΔInv)
Δ Working Capital
EBITDA
-‐ ΔWC = Opera=ng Cash flows -‐ capital expenditure + fixed assets disposals = Free cash flow before tax -‐ Financial expenses + Financial income -‐ Dividends + proceeds from share issues
-‐ Corporate Income Tax = Net decrease in debt
-‐ Share Buybacks
cash flow statement presenta=on #1: « star=ng » from EBITDA
PresentaAon #2 From Net Inc to CF from op.
someAmes: we use Net Inc. to compute cash flows, & use a different CF concept CF from op. = operaAng receipts – operaAng expenses – interest expenses = EBITDA -‐ ΔWC – interest expenses = Net Inc + D&A -‐ cap. gains -‐ ΔWC
+ Amor=za=on and Provision -‐ ΔWC = Cash flows from opera=ons -‐ capital expenditure + fixed assets disposals = Free cash flow before tax -‐ Financial expenses + Financial income -‐ Dividends + proceeds from share issues
-‐ Corporate Income Tax = Net decrease in debt
-‐ Share Buybacks
Net income
cash flow statement presenta=on #2: « star=ng » from Net inc.
Examples
• on the web
– Look at Starbuck’s or General motors
• Gremlin case
Balance sheet: details
-‐ Prepaid products -‐ Trade payables -‐ Tax liabiliAes
-‐ Commercial paper -‐ short term bank debt
-‐ Long term bank debt -‐ Bonds -‐ ConverAble bonds
-‐ Preferred stock -‐ Common stock -‐ Retained earnings -‐ Net Income
-‐ trade receivables -‐ inventories of:
-‐ Finished product -‐ Semi finished -‐ Materials
-‐ Intangible fixed assets
-‐ Patents -‐ Brands
-‐ Tangible fixed assets -‐ Land&buildings -‐ Machines
The “economic” balance sheet
• Assets are a bad indicator of “employed capital” – assets increase when suppliers are paid later, and the firm stores addi4onal inputs
– assets increase when the firm retains earnings to hold more cash
è to remove these OPTICAL ILLUSIONS remove cash on both sides remove trade payables on both sides è idea: focus on “financial investors”
Equity
Bank debt
Fixed Assets
Trade recevables
Assets Liabilities
Convertible debt
Trade payables, prepaids
inventories
Cash&equivalents
Fixed Assets: (machines, land, patents)
Operating capital Capital invested
NET DEBT
Equity
Working Capital
WC = Inventories + trade receivables - trade payables - prepaids NET DEBT = DEBT – cash – cash equivalents
Removing ficiAous assets&liabiliAes
examples
• Deutsche telekom
• Microsok
• Walmart
Pilalls of simplificaAon
• aggregaAng balance sheet items requires assumpAons – compuAng equity is harder than you think – CompuAng debt is harder than you think – CompuAng assets is harder than you think è let’s discuss some of these assumpAons
It’s hard to compute equity
• From a financial viewpoint – converAble bonds are partly equity – preferred stock is equity
• Only do the adjustment when this is worth it – When this is BIG
It’s hard to compute debt
• Some liabiliAes are off balance sheet – Info in the footnotes of the financial statements
• Examples – Leased assets: commitment to rent an asset
• is big: 16% of assets (~ long term debt) • if operaAng lease: off balance sheet • If capital lease: on balance sheet but creditors cannot seize it
– Defined benefit pension obligaAons • Pension funds = 30% of large firms’ financial debt • Backed by assets, but firm has to inject capital if underfunded è = added leverage
example
10K filing, footnote 18
It’s hard to compute fixed assets: goodwill
Debt = 50
Equity = 100 Fixed assets = 120
W.cap. = 30
Acquiror
Equity = 80 Fixed assets = 80
Target Buys at price 200
Debt = ???
Equity = ??? Fixed assets = ??
W.cap. = ??
Merged en=ty
Assume acquiror issues 200 of new stock, or 200 of new debt what is the important convention??? How does it affect measured leverage?
The 4 step method 1. Value crea=on: à trends in sales&margins
2. Investment Analysis: à trends in CAPX& working capital
3. Financing Analysis: à trends in cash flows&balance sheet fragility
4. Profitability Analysis: à compute profitability raAos: ROE, ROCE
… while we walk through the steps: Gremlin case
Step #1: value creaAon • Goal: isolate trends in EBITDA
• Start with some broad economic analysis – On the environment:
• Is it a mature or growing industry? • Is it a cyclical or stable industry? • Any pressure to consolidate? • Any regulatory risk?
– On the firm • How does it deal with compeAAon? • Who owns the firm? A family, the public, a fund?
Value creaAon: the scissors effect
• Insight: look at the trends in sales & costs separately
• Nega=ve cissors effect – When costs grow faster than sales – EBITDA decreases – EBITDA/sales (« EBITDA margin ») decreases
• Posi=ve cissors effect – The opposite
Value creaAon: breakeven point
• Insight: – find the level of sales required to make profit = 0 – & see how far the firm is from that level
• To do this, need a model of how costs depend on sales: Costs = Fixed + c.Sales
Value creaAon: breakeven point
• breakeven point: Sales that lead to profit = 0 0 = SalesBE – Fixed Cost – c x SalesBE è SalesBE = Fixed cost / (1-‐c)
• Higher if Fixed cost is big, or if c is big
Value creaAon breakeven point
• In pracAce, how do I compute the cost funcAon?
• Use the income statement by funcAon – Cost of goods sold : mostly variable – R&D, SG&A: mostly fixed – MartkeAng&sales : both
• The horizon maters – In the long run, more costs are variable
Value creaAon: operaAng leverage
• Impact of a 1% change in sales on profits – If sales are close to BE point?
– If sales >> BE point?
Value creaAon: operaAng leverage
• If firm close to BE point, profits are volaAle – Conversely: volaAle profits è close to BE
• MathemaAcally:
€
EBITDA = Sales − c × Sales −Fixed cost= (1− c) × sales − 1− c( )salesBE
⇒ΔEBITDAEBITDA
=ΔSalesSales
×Sales
Sales − SalesBE
&
' (
)
* +
Big if sales ~ salesBE
Value creaAon: operaAng leverage
• Explain:
Company in 2003 Sales growth
Net income growth
Tesco + 18 % + 22 %
Roche + 11 % + 24 %
Heidelberg Cement + 9 % + 215 %
Value creaAon: operaAng leverage
• Which company has the biggest fixed costs?
Company in 2003 Sales growth
Net income growth
Volkswagen - 2 % - 4 %
BMW - 2 % - 48 %
Step #2: investment analysis
• Discusses trends in overall assets
• First, look at bumps and trends in fixed assets • cash flows from investment • CAPEX – depreciaAon • goodwill
• Second, look at working capital: WC = Inventories + Receivables – Payables -‐ prepaid
Fixed assets: an example
Explain what is happening to Danone
Working capital
• Working capital pros and cons: Cons
– Needs to be financed with costly debt or equity Pros
– avoids botlenecks in producAon – trade credit more expensive than bank debt
• Classical arrangement in US manufacturing: “2/10 net 30” • 2% discount if paid < 10 days, else full price paid in 30 days • Equivalent interest rate of the loan … 70% annual !!! why? • This cost is oken implicitly omited in WC analysis
working capital
• In general: low WC is considered as good – WC analysis classic tool to detect anomalies & management quality
• But keep in mind that: – WC depends on the industry – WC depends on the business cycle – WC may have strong seasonal paterns
Investment analysis: working capital raAos
• Typical raAos
€
WC Turnover = 365 × WCAnnual Sales
Receivables = 365 ×Accounts Receivables
Annual Sales
Payables = 365 × Accounts PayablesAnnual Purchases
Inventories =365 ×Inventories
Annual Sales
#
$
% % %
&
% % %
Step #3: financing analysis
• Two quesAons related to firm survival: Are cash flows large enough to pay interest on debt ? Is there a liquidity risk ?
Perspec0ve of bondholder, not shareholder
• Tools: – analysis of cash flow statement à Compare operaAng cash flows & financial expenses
– compare dura4ons of assets and liabili4es à Compare WC & short term debt net of cash
Financing analysis the cash flow statement
• First, look at all components of “decrease in net Debt” and their evoluAon:
Net Inc. + Deprec. – ΔWC (=CF from Op.)
-‐ (CAPEX – Asset sales) (=CF from inv.) – dividends + proceeds from equity issues (=CF from fin.) = Decrease in Net Debt
Financing analysis: raAos
• Leverage (not very informaAve) informaAve
• Credit analysts prefer “cash flow-‐based” measures
InterestsEBITDACoverageInterest
EBITDADebtNet Coverage ServiceDebt
=
=
Leverage = Financial DebtTotal Assets
Why leverage ra=o is not so reliable: The Tale of Two Companies
Company in 2003 Net Debt / Assets
Net Debt / EBITDA
Unilever 71 % 2.2
Rémy Cointreau < 50 % 3.8 !
Unilever’s operations are so profitable that it can afford more debt !
è Prefer Net Debt / EBITDA to leverage !!!
Financing analysis: raAos
è How much should Net Debt / EBITDA be worth ?
• Standards: <= 3 years : Healthy situaAon 4 years : CriAcal (but also LBOs) 5,6 years : Debt becomes « junk », distress likely
• Beware ! à stable industries may tolerate raAos of 4,5 or 6 à firms with « good collateral » (land) also ! à private equity typically takes 6 (more before crisis)
Financing analysis: balance sheet liquidity
• Risk of liquidity mismatch – Even if PV of assets > PV of liabiliAes – Assets mature in the long run (investment) – LiabiliAes mature in the short run (short term debt) (give examples of industries where this is common)
• In theory, not a problem if rollover is possible • But in pracAce: « Rollover risk »
– Creditors have doubts, they want to cash in & run – Cheap short run credit can dry up suddenly (Crisis)
Rollover risk in the banking system
tradiAonal banking system
large depositors,
retail investors
bank borrower
loans
US shadow banking system
large depositors,
retail investors
money market
mutual funds
ABCP conduit
CDO
ABS vehicle, fanny mae, freddy mac
shares CP
CDO originator
loans
broker -‐ dealers
hedge funds prop trading
securiAes lenders
borrower
repo
Rollover risk in shadow banks
• Three ra4os to measure maturity mismatch:
year) 1( sLiabilitieCurrent CashRatioCash
year) 1( sLiabilitieCurrent sInventorieyear) 1( AssetsCurrent RatioQuick
year) 1( sLiabilitieCurrent year) 1( AssetsCurrent RatioCurrent
<=
<
−<=
<
<=
Financing analysis: raAos
Liquidity risk
• How to deal with it? – Secure LT financing – Backstop liquidity: credit lines – Hold cash / short term assets
Which firms hold more cash ?
Step #4: profitability analysis
• QuesAon: is the firm profitable enough? – Is EBIT high enough? – Is Net Income high enough?
Profitability analysis: ROCE
• Is EBIT high enough? • Compute Return on Capital Employed:
ROCE = (1-‐τ) x EBIT / CE where τ = corporate income tax rate
• Idea: « operaAng return » • (1-‐τ) x EBIT = « Net OperaAng Profit Aker Tax » • ROCE overesAmates taxes
Profitability analysis: ROE
• Is Net Income high enough? • Compute Return on Equity:
ROE = Net Income / Equity
• IntuiAon: – Normalize Net Income by the investment of those who receive it (shareholders only)
Profitability analysis: leverage effect
• SubsAtute debt for equity: which effect on ROE ?
• 2 opposite forces 1. Reduces shareholders’ investment 2. Reduces Net Income (more interest)
• In pracAce, (1.) dominates à ROE goes up. – b/c interest income < ROCE (see later) – This is the « leverage effect » à
100 110
A project, of operating return (ROCE) = 10% costs 100 and pays 110:
There is no debt: ROE =(110 – 100)/100 = 10/100
=10%
Profitability analysis: leverage effect
50 50
59 51
Entrepreneur borrows 50, with interest rate 2% ROE =(110 – 50 – 50*(1+0.02))/50 = 9/50
= 18% !!!!
A money machine ?
Profitability analysis: leverage effect
Bad luck: the project is not profitable (ROCE=0%) costs 100 et generates 100 only :
100 100
When there is no debt: ROE =(100 – 100)/100 = 0
=0%
Profitability analysis: leverage effect
50 50
49 51
Entrepreneur has borrowed 50, with interest rate 2% ROE =(100 – 50 – 50*(1+0.02))/50 = -1/50
= -2% !!!!
Even though project is not loss making !!!
Profitability analysis: leverage effect
Very bad luck: the project only makes ROCE = - 10% costs 100 et generates 90 only :
100 90
When there is no debt: ROE =(90 – 100)/100 = -10/100
=-10%
Profitability analysis: leverage effect
50 50
39 51
Entrepreneur has borrowed 50, with interest rate 2% ROE =(90 – 50 – 50*(1+0.02))/50 = -11/50
= -22% !!!!
Leverage = more risk !!!
Profitability analysis: leverage effect
Profitability analysis: leverage effect
• Leverage makes ROE much more volaAle – Debtholders are always senior to shareholders – first dollars of EBIT are pledged to debtholders
• In exchange for their contribuAon to capital • In exchange for low interest rate
• If success, shareholders get big profit for small investment
• If failure, shareholders absorb all the loss
Profitability analysis: leverage effect
• Easy to show that:
ROE = ROCE + (NetDebt / Equity) x ( ROCE – (1-‐τ)xinterest )
– Net Debt / Equity : « gearing raAo » – ROE increases with gearing if interest is low – ROE more sensiAve to ROCE shocks if gearing is big
raAo analysis to evaluate solvency (back to step #3)
ROCE ROE
Firm A 7% 20% Firm B 10% 10% Firm C 10% 6% Firm D 12% 20%
• each of these firms issue bonds. which one will have the lowest spread?
Leverage effect: A numerical example
• MegaBank: – Lends @ 4% to its borrowers – Borrows @ 2% from money markets & depositors – Has a leverage raAo of 90% – A corporate tax rate of 50%
How large is the leverage effect at
MegaBank? (i.e. what is its contribution to ROE ?)
Hidden vs Official Leverage: Back to shadow banks
Sponsoring bank: guarantees that ABCP issued by conduit will pay off (gets a fee in exchange) what is the effect sponsoring bank ROE?
Total ABCP issuances
Total ABCP issuances
what is the effect on sponsoring bank ROE?
ABCP investors exert put option conduits go back to balance sheet
Using market informaAon: raAos
• Stock price = PV of expected future dividends
• Three raAos: – PER: stock price scaled by earnings – Price to Book: stock price scaled by book equity – Dividend Yield: dividends scaled by stock price
• All three ra4os serve to measure market expecta4ons of future growth
Using market informaAon: PER
• Price Earnings raAo (or « P/E raAo ») PER = Stock Price / Expected earnings Per Share
• Gordon-‐Shapiro formula PER = b / (re – g)
– re = cost of equity – g = expected (constant) growth rate – b = payout raAo = Dividends / Net Income
• High P/E means «low risk» or «high growth» – In 2003, Renault = 7, Google = 76 !!!
• Is the market forming good expectaAons ? NO à
average PER varies over Ame (source: bob shiller’s website)
0
5
10
15
20
25
30
35
40
45
50
1860 1880 1900 1920 1940 1960 1980 2000 2020
Pric
e-Ea
rnin
gs R
atio
(CA
PE)
Year
CAPE Price E10 Ratio
1901 1966
2000
Price-Earnings Ratio
1981
1921
1929
21.45
0
10
20
30
40
50
60
70
1952 1954 1956 1958 1960 1962 1964 1966 1968 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012
Cumula=ve Return of P/E strategy Long low P/E, Short high P/E
market neutral – Sharpe ra4o = 0.9
Real estate market: price-‐to-‐rent raAo in the US
2.00%
2.50%
3.00%
3.50%
4.00%
4.50%
5.00%
5.50%
6.00%
6.50%
1960.1 1966.1 1972.1 1978.1 1984.1 1990.1 1996.1 2002.1 2008.1
• Price to rent raAo in France
Using market informaAon Price to Book
• Price to Book PB = Stock Price / Equity per share
• Price to book is related to PER PB = PER x ROE
– What firms typically have a high PB ?
Using market informaAon Dividend Yield
• Dividend Yield DY = Dividend per Share / Stock Price
• Which firms typically have a high DY ?
how well have dividend paying stocks been doing recently?
• look @ a specialized mutual fund, to monitor performance – Acker: VHDYX
• htp://www.google.com/finance?q=VHDYX&ei=KlWlUODrJer1wAOlTg
-‐0.6
-‐0.4
-‐0.2
0
0.2
0.4
0.6
0.8
1
1928
1930
1932
1934
1936
1938
1940
1942
1944
1946
1948
1950
1952
1954
1956
1958
1960
1962
1964
1966
1968
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
2012
Cumula=ve Return of DY strategy market neutral -‐ sharpe ra4o = 0.1
Using market informaAon: example
Compute PER, DY, PB, ROE for both corporations Comment on the differences…
which stock is this?
Financial analysis: wrapping up
• Use financial statements to understand the dynamics of: – value creaAon – assets (in parAcular WC) – Net cash holdings – Profits
• Use market prices to understand market expectaAon of future profits