Class Business
Debate Proforma Assignment
Business Cycle– Peak– Trough
Industry relationship to business cycles– Cyclical – Defensive
Business Cycles
Leading Indicators - tend to rise and fall in advance of the economy
– Avg. weekly hours of production workers– Stock Prices – Yield Curve
Coincident Indicators - indicators that tend to change directly with the economy
– Industrial production– Manufacturing and trade sales
Lagging Indicators - indicators that tend to follow the lag economic performance
– Ratio of trade inventories to sales– Ratio of consumer installment credit outstanding to personal
income
NBER Cyclical Indicators:
Sensitivity to business cycles Factors affecting sensitivity of earnings to business
cycles– Sensitivity of sales of the firm’s product to the
business cycles– Operating leverage– Financial leverage
Industry life cycles
Industry Analysis
Financial Statements
Income Statement– Profitability over a given time period
Balance Sheet– “Stock” measure of firm’s financial position
Statement of Cash Flows– Actual Flow of Funds
Old Image of 10-k Links
Example First and SecondLink
New Image of 10-k Links
Example First and SecondLink
Overview of Proforma Analysis
Forecasting Income Statement Accounts
Income Statement Forecast Method
Sales Forecasted by choice
Cost of Sales (GOGS) Calculated: Sales – Gross Profit
Gross Profit Percent of Sales (“Gross Margin”)
Selling, General, and Admin. Expense (SG&A) Percent of Sales
Income before Depreciation and Amortization (EBITDA) Calculated: Gross Profit – SG&A
Depreciation and Amortization Expense (Dep. and Amort.) Percent of Net PP&E
Income after Dep. and Amort. (EBIT) Calculated: EBITDA – Dep. and Amort.
Non-Operating Income (Expense) Forecast driven by expected company policy
Initial Interest ExpensePercent of Prior Year Net Debt (ST Borrowing + LT Debt – Excess
Cash)
Pretax Income Calculated: EBIT + Non-Operating Income – Interest Expense
Income Taxes Percent of Pretax Income (“Tax Rate”)
Net Income Calculated: Pretax Income – Income Taxes
Dividends Percent of Net Income (“Payout Ratio”)
Addition to Retained Earnings Calculated: Net Income – Dividends
Forecasting Balance Sheet Accounts
Balance Sheet Forecast Method
Assets
Excess Cash (Plug item)Zero if operating assets are greater than sources of funds; otherwise,
the amount required to make the sheet balance
Current Assets Percent of Sales
Net Property, Plant, & Equipment Percent of Sales (“Fixed Asset Turnover”)
Intangibles Forecast driven by expected company policy
Other Long Term Assets Percent of Sales
Total Assets Calculated: sum of all asset accounts
Liabilities & Owners’ Equity
Current Liabilities Percent of Sales
Short Term Borrowing (Plug item)Zero if sources of funds are greater than operating assets; otherwise,
the amount required to make the sheet balance
Long Term Debt Forecast driven by expected company policy
Other Liabilities & Preferred Percent of Sales
Shareholders’ Equity Constant based on most recent year’s data
New Retained Earnings Sum of forecasted Additions to Retained Earnings
Total Liabilities & Shareholders’ Equity Calculated: sum of all liability and equity accounts
More on Forecasting
Forecasting– Economic Plausibility
• use ratios
– Accounting Consistency• Plug Figures
– Base much of forecasts on sales forecasts
Ratio Analysis
Purpose of Ratio Analysis Uses
– Trend analysis– Comparative analysis– Forecasting
Use by External Analysts– Important information for investment community
and ratings agencies
Dividend Discount Models:General Model
VD
ko
t
tt
( )11
V0 = Value of Stock Dt = Dividend k = required return
Constant Growth Model
VoD g
k g
o
( )1
g = constant perpetual growth rate
Estimating Dividend Growth Rates
g ROE b
g = growth rate in dividends ROE = Return on Equity for the firm b = plowback or retention percentage rate
= (1- dividend payout percentage rate)
Return on Equity
Equity
DebtRateInterest -ROA ROA rate)Tax -(1 ROE
Financial Leverage and ROE
– ROA = EBIT/Total Assets– ROE = Net Profit/Equity
ROE Example Company A and B have same ROA or same assets in total
of $500 million, but B has financed 30% of their assets while A has no debt. Assume they both pay 40% corporate tax rates, interest on company B’s debt is 7%.
What is A and B’s ROE if their ROA is 12%?– ROEA = .6*[.12 + (.12 - .07)*0] = .072 or 7.2%
– ROEB = .6*[.12 + (.12 - .07)*(150/350)] = .084 or 8.4%
What is A and B’s ROE if their ROA is 6%?– ROEA = .6*[.06 + (.06 - .07)*0] = .036 or 3.6%
– ROEB = .6*[.06 + (.06 - .07)*(150/350)] = .033 or 3.3%
Du Pont Decomposition of ROE
ROE = Net Profit
Pretax Profit
x
Pretax Profit
EBIT
xEBIT
Sales
Sales
Assetsx x
Assets
Equity
(1) x (2) x (3) x (4) x (5)
x Turnover x LeverageInterestBurden
Profit Margin
x
x ROA Compound Leverage Factorx
Walmart versus Neiman-Marcus?
=
=
Tax Burden
Tax Burden
x
Quality of Earnings:Areas of Accounting Choices
Allowance for bad debts Non-securing items Reserves management Stock options Revenue recognition Off-balance sheet assets and liabilities