Accounting, Analysis and Valuation Fundamentals

© Barry M Frohlinger 1981 - 2017

Accounting, Analysis and Valuation Fundamentals

© Barry M Frohlinger, Inc. copyright 1981 – 2017 Use of these materials are protected by copyright law

Theseminar’sfirstsessions objectiveistoincreaseeachparticipant'sgeneralabilityto:[1]Understandthemechanicalframework forreportingbusinessactivitiesandbeabletoinfer,fromasetoffinancialstatements,thebusinessactivities(transactions)whichareincludedtherein.

[2]Beabletoexplaintheinterrelationshipsofthefinancialstatements bothinwholeandforanypart,andbeable,foranyfigureinthefinancialstatements,torelateittothecashfloweffects.

[3]UnderstandFinancialAnalysis,includingratiocalculations.

[4]UnderstandFIvsC&I

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© Barry M Frohlinger, Inc. copyright 1981 – 2017 Use of these materials are protected by copyright law 2

•You purchased an apartment on September 22, 2006 and paid $150,000.

•The apartment is identical to your neighbors who sold their apartment today for $200,000.

•What is the value of your apartment?

•______________Value

•______________Value


Similar/Identical Assets [relative valuation]

Similar Identical

3


•Book Value and Net Book Value

•Fair Market Value and Net Realizable Value

•Liquidation Value

•Enterprise Value

•Loanable Value

•Equity Value


Value

• Several types and definitions of value sought by analysts. Some of the most common are:• Book Value and Net Book

– Book Value is the historic cost and – Net Book Value is the Book Value net of all expenses since the asset was put into place

» P,P,E [net] is a common example • Fair Market value

– The estimated amount for which an asset or liability should exchange on the valuation date» between a willing buyer and a willing seller » in an arm's length transaction, » after proper marketing with a reasonable time for exposure in the open market, with

sufficient buyers and sellers » where the parties had each acted knowledgeably and prudently.

• Net realizable value – the FMV net of transaction costs

• Liquidation value – May be analyzed as either a forced liquidation or an orderly liquidation. – It assumes a seller is compelled to sell

• Enterprise Value– Economic [fair]value of the firm’s net operating assets [firm value]– The value of the firm’s core operations, without regard to capital structure

• Loanable Value– The amount a lender is willing to lend to a borrower

• Equity Value – The residual value, provided by the owner

• Investment Value– The value of a business to a specific buyer, based upon the nature and characteristics of the

buyer, including potential synergies or economies of scale.


The Continuum of Value

Liquidation Value

Fair Market Value

Investment Value

6


TEVA

• Look at the Teva Balance Sheet [page 11]

• Find the Property, Plant and Equipment and its net book value

• Property, Plant, and Equipment (PP&E) is tangible items that are expected to be used in more than one period and that are used in production or operating a firm. Examples of PP&E classes are buildings, furniture and fixtures, land, machinery, and vehicles.

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Book and Net Book

Book Net BookAccounts Receivables Allowance for

doubtful accounts receivables

Inventory Allowance for unsalable inventory

PPE AccumulatedDepreciation

Finite Life IdentifiableIntangible

Accumulated Amortization

Natural Resources Accumulated Depletion

Deferred Tax Assets Valuation Allowance

8


McDonald’s

• Look at the McDonald’s Balance Sheet [page 9]

• At FYE 2009, what is the

– Book Value

– Net Book Value

– Market Value

• Of Property, Plant and Equipment

9


TEVA

• Look at the Teva Balance Sheet [page 10 and 11]

• At FYE 2015, what is the

– Book Value

– Net Book Value

– Market Value

• Of Property, Plant and Equipment

10


TEVA

• Look at the Teva Balance Sheet.

• Find Accounts Receivable.

• Accounts receivable represents amounts due from buyers [customers] to a firm who have purchased goods or services from the firm on credit. Accounts receivable is listed as a current asset on the balance sheet.

• A common ratio is Accounts Receivable Turnover in days [how long it takes to get paid from customers].

– The ratio is Accounts Receivable/Revenue * 360.

– Calculate Accounts Receivable Turnover in days for 2015 for Teva

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TEVA

• Look at the Teva Balance Sheet.

• Find Inventory.

• Inventory is an asset that is intended to be sold in the ordinary course of business. Inventory is typically broken down into three categories if the firm is a manufacturer [only finished goods if the firm is a retailer or wholesaler]:

• Raw materials. Material to be used in the production of finished goods.• Work-in-process. Items that are in the midst of production, and which are not yet in a state ready for

sale to customers.• Finished goods. Goods [products] ready for sale to customers. May be termed merchandise in a retail

environment where items are bought from suppliers in a state ready for sale.• Inventory is listed as a current asset on the balance sheet.

• A common ratio is Inventory Turnover in days [how long it takes to sell inventory to customers]. – The ratio is Inventory/Cost of Good Sold * 360.

– Calculate Inventory Turnover in days for 2015 for Teva

12


Amdocs

• Look at the Amdocs Balance Sheet [pages 25 -28]

• Find Inventory.

13


Pepsi

• Look at the Pepsi Balance Sheet [page 20 -23].

• Find Inventory. What is the nature of Pepsi’s inventory?

14


Value

15

A father said to his daughter “You graduated with honors, here is a car I acquired many years ago. It is several years old. But before I give it to you, take it to the used car lot downtown and tell them I want to sell it and see how much

they offer you.

The daughter went to the used car lot, returned to her father and said, “They offered me $1,000 because it looks very worn out.”

The father said,”Take him to the pawn shop.” The daughter went to the pawn shop, returned to her father and said,”The pawn shop offered $100 because it

was a very old car.”

The father asked his daughter to go to a car club and show them the car. The daughter took the car to the club, returned and told her father,” Some people in

the club offered $100,000 for it since it’s a Nissan Skyline R34, an iconic car and sought out after by many.”


Intangibles

Identifiable IntangiblesFiniteIndefinite

UnidentifiableGoodwill

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A New York City taxi medallion sold for $241,000 in 2017; In 2013, some medallions sold for more than $1.3 million. There are currently 13,587 yellow-taxi medallions in the Big Apple — and more than 50,000 Uber and Lyft cars. On July 11, 2019 sixteen medallions were offered at auction. Three sold for $137,000, $136,000 and $138,000. the other thirteen had no bidders


In 1971, Phil Knight decided to start making his own shoes. His company, now known as Nike, didn't have a name at the time. It also needed a logo.

Knight found his designer on the Portland State campus whereKnight was teaching accounting: Carolyn Davidson, a graphics design student.

Knight overheard Davidson talk about how she couldn't afford to take a painting class, so he approached her with a pitch, asking if she'd like to do some freelance design work for the young company. The agreed-upon rate: $35.

Keenly aware of the difficulty of making something static appear fluid, she went to work. She kept doodling, and two or three weeks later, Davidson presented a handful of designs to Knight and his business partners. They didn't adore any of them, but one curvy check mark seemed better than the others.

"Well, I don't love it," Knight said, "but maybe it will grow on me."By June 18, 1971, the logo was registered with the U.S. Patent Office.

Nike, Valuation


Valuation, Book Value and Market Value


TEVA

• Look at the Teva Balance Sheet [page 11]

• Find Goodwill

• Goodwill is an intangible asset coming from a business combination. Goodwill is recorded when a company acquires (purchases) another company and the purchase price is greater than the net of 1) the fair value of the identifiable tangible and intangible assets acquired, and 2) the liabilities that were assumed.

Goodwill is reported on the balance sheet as a noncurrent asset. Since 2001, U.S. companies are no longer required to expense [amortize] the recorded amount of goodwill.

• Look at the Teva, Amdocs and Delek Balance Sheets.

• Is Goodwill significant [material] on the balance sheet of each firm?

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http://www.accountingcoach.com/blog/intangible-asset

http://www.accountingcoach.com/blog/amortize-goodwill


Pepsi

• Look at the Pepsi Balance Sheet [pages 20 – 23]

• Find Intangible Assets

• An intangible asset is an asset that is not physical in nature; it represents a legal right. Corporate intellectual property, including items such as patents, trademarks, copyrights and business methodologies, are intangible assets. Intangible assets exist due to acquisitions, it is very difficult find self created intangibles. [Intangibles are assets and the definition of an asset is a resource providing a future economic benefit].

• Intangible assets are either finite [a specific economic life] or indefinite.

• Intangibles are reported on the balance sheet as a noncurrent asset. Since 2001, U.S. companies are no longer required to expense [amortize] the indefinite lifed-intangibles.

• Look at the Pepsi.

• Find Goodwill and Indentifiable Intangible Assets

21

http://www.investopedia.com/terms/a/asset.asp

http://www.investopedia.com/terms/i/intellectualproperty.asp

http://www.investopedia.com/terms/t/trademark.asp

http://www.investopedia.com/terms/c/copyright.asp

http://www.investopedia.com/video/play/what-are-intangible-assets/


Basic Elements of Financial Statements

• Balance Sheet– Assets: Future Economic Benefits [F.E.B.]

• Resources owned or controlled– Liabilities: Future sacrifices of assets

• Claims on the assets– Equity: Residual ownership interest

– Assets are the investment and Liabilities and Equity represent the financing of the business

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• Balance Sheet– Assets: Future Economic benefits

• The change from year to year can be an [increase] or a decrease• On the Statement of Cash Flow, assets increases are shown in [

], asset decreases are shown without brackets• Contra Assets are credits that are placed on the asset side of the

balance sheet– Contra Assets for:

» Accounts Receivables» Loans» Inventory» Plant and Equipment» Intangibles» Natural Resources» Deferred Tax Assets

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• Balance Sheet– Liabilities: Future sacrifices of assets

• The change from year to year can be a increase or a [decrease], the [decrease] is shown in brackets on the Statement of Cash Flow

– Equity: Residual ownership interest

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• Balance Sheet– Equity: Residual ownership interest

• Comprised of four components– Contributed Capital– Retained Earnings – Treasury Stock– Other Comprehensive Income

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• Balance Sheet [Equity: Residual ownership interest]• Contributed Capital [Common Stock and Additional Paid in Capital]

– Must have a positive balance • Retained Earnings

– Can have a positive or a negative balance • Treasury Stock

– Must have a negative balance• Other Comprehensive Income

– Can have a positive or negative balance

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Balance Sheet


The Balance Sheet, what is it?Balance Sheet Equation

Balance Sheet

Current Assets

Non CurrentAssets

Current Liabilities

Equity

Non CurrentLiabilities


The Balance Sheet, what is it?

Balance Sheet

Cash

Monetary [AR]

Non Monetary[Inventory,Prepaids, PPE and Intangibles]

Payables

Debt

Equity


The Balance Sheet, what is it?Valuation

Balance Sheet

Cash

Operating Assets[Accounts Receivables,Inventory, Prepaids, PPE and Intangibles]

Payables

Debt

Equity


The Balance Sheet, what is it?[valuation]

Balance Sheet

Cash

5 Operating

Assets

Supplier Financing

Total Equity

Total Debt


The Balance Sheet, what is it? [Valuation]

Balance Sheet

Cash

Net Operating Assets Total Equity

Total Debt


The Balance Sheet, what is it? [Valuation]

Balance Sheet

Cash

Net Operating Assets

Total Capital


The Balance Sheet, what is it?[Valuation]

Balance Sheet

Net Operating Assets Invested Capital


The Balance Sheet, what is it? [Accounting? Liquidity?]

Balance Sheet

Current Assets 100

Non CurrentAssets

350

Current Liabilities70


The Balance Sheet, what is it? [Accounting? Liquidity?]

Balance Sheet

Current Assets 100

Non CurrentAssets

350

Current Liabilities70

Capital


Apple

• Look at the Apple Balance Sheet [page 24]

• Find Goodwill and Identifiable Intangible Assets

• The amounts are relatively small. Explain why Apple has small intangibles assets.

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Assume the following:• You purchased an apartment on September 22, 2010and paid $120,000.

• The apartment is identical to your neighbors who sold their apartment today for $90,000.

• What is the value of your apartment?

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Accounting Rules

• _____________________________________• _____________________________________• _____________________________________• _____________________________________• _____________________________________• _____________________________________• _____________________________________• _____________________________________


Teva Financial Statements

40

Look at the Teva Balance Sheet [page 11]

At FYE 2015, find

Total Assets _______________

Total Liabilities _______________

Equity _______________


Income Statement

An income statement is a financial statement that reports a company's financial performance over a specific accounting period, generally one year [annual] or one quarter.

Financial performance is assessed by reporting its revenues and expenses through both operating and non-operating activities.

Key numbers are revenue [top line or headline], operating profit [not a GAAP required disclosure], EBITDA [non-GAAP] and Net Income Available to the Common Shareholders.


Accrual and Cash Accounting

• When should the following transaction be recorded as revenue according to accrual accounting for Boeing:

• Receives an order on July 5, 2019 for 10 777’s• Receives payment for the 10 777’s on July 25, 2019• Starts production of the aircraft on January 15, 2021 and builds

one aircraft per month• Delivers all the aircraft on November 15, 2021


Accounting

• Boeing receives an order on July 5, 2019 for 10 777’s, receives payment for the 10 777’s on July 25, 2019, Starts production of the aircraft on January 15, 2021 and builds one aircraft per month and delivers all the aircraft on November 15, 2021.

1. On July 5, 2019 Boeing orders 20 engines from GE.2. On April 22, 2020, Boeing receives the engines3. On June 3, 2020, Boeing pays GE for the engines.

• When should Boeing record the expense for the engines?


Accrual Accounting:Revenue Recognition Principle

• Revenue Recognition Principle– Revenue is recognized when it is earned, not when the cash is collected.

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Accrual Accounting:The Matching Principle

• Expenses are matched to revenues of the same period.

45


Five transactions and the related balance sheet impacts

• Revenue• Expense• Cash Inflow• Cash Outflow• Cost

46


Five transactions

• Revenue

! 1! 2! 3! Revenue [IS=> Retained Earnings]

47


Dual Entry System

Key: Every transaction must

impact the Balance Sheet in 2 places [some bypass the income statement]

But every income statement transactionmust also impact the Balance Sheet, in 2 places


Dual Entry System

The system records the two-sided effect of transactions

Transaction Two-sided effect

Buy Inventory

Prepay Salary Expense


Dual Entry System

The system records the two-sided effect of transactions


Buy Inventory Increase one asset [inventory]Increase a liability

[accounts payable]

Prepay Salary Cost Increase in an asset [prepaid]Decrease an asset [cash]


Dual Entry System


Ship a product and record revenue Increase Equity [through the IS]Increase in another asset

[accounts receivable]

Record Salary Expense Decrease Equity [through the IS]Increase in a liability [payable]


The Balance Sheet, what is it?

Balance Sheet

Cash

Monetary

Non Monetary

Payables

Debt

Unearned Revenue

Equity


Five transactions

• Expense

! Expense [IS]! 1! 2! 3! 4

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Five transactions

• Cash Inflow

! Increase [BS] Cash! 1 ! 2! 3! 4! 5

54


Five transactions

• Cash Outflow

! 1! 2! 3! 4! Reduce [BS] Cash

55


Five transactions

• Cost

! 1! 2! [BS] Payable increase or Cash decrease

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Revenue Recognition

• Review Revenue Recognition of Teva [page 17]

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Industry Characteristics

• Business– C&I [Commercial & Industrial] – FI [Financial Institution]

• Commercial & Industrial [C&I]• Extractive Industries• Utilities• Transportation Industries• Manufacturing• Distribution• Retail• Media • Telecom• Services

• Business– C&I [Commercial & Industrial] – FI [Financial Institution]

• Financial Institutions [FI]• Commercial Banks• Finance Companies• Broker Dealers• Insurance

– Life– P&C– Reinsurance

• Funds– Fund Managers


C&I firms

You should know the following characteristics of businesses: Firms involved in broadcasting, cable and publishing do not have inventory or cost of sales Telecommunications companies have significant investment in fixed assets and large depreciation expense and low profitability in recent years Supermarket chains have high cost of sales and high fixed assets, with little cash or accounts receivables Manufacturers of paper have high fixed assets and also large receivables and inventory Toy manufacturers have receivables, high marketing costs with significant cash at year end and the industry has had considerable acquisitions Many Internet Retailers have just become profitable and have accumulated much cash Newspaper publishers have low inventory and the industry has had considerable acquisitions Integrated energy companies have large investments in fixed assets Metal working machines producers have had significant profitability problems Distributors of food have low profit margins and large accounts receivable and inventory The express delivery service business has significant cost of delivering packages, with significant investment in delivery vehicles. Mining companies have very large investments in fixed assets with large operating margins The majority of engineering and construction companies' expenses are in cost of sales and most do not borrow

In Addition, you should understand the following C&I balance sheets Resource Transport Manufacture Wholesale Retail Service Media

Accounts Receivables 15% 20% 33% 45% 1% 90% 30%

Inventory 15% 0% 33% 45% 75% 0% 0% Fixed Assets 70% 80% 34% 10% 24% 10% 70%

100% 100% 100% 100% 100% 100% 100%


C&I firms

A B C D E F G H I J K L M Sales

Cost of Revenue 51.0% 92.3% 73.6% 5.9% 85.0% 37.6% 69.5% 40.2% 0.0% 93.9% 0.0% 65.0% 76.1% Depreciation 15.2% 2.3% 5.0% 9.7% 0.9% 3.5% 1.0% 8.8% 7.0% 1.3% 0.4% 4.2% 0.2% Selling and

Administrative 20.6% 1.9% 7.0% 74.3% 15.0% 52.2% 28.6%

17.4% 86.9% 1.6% 88.7% 14.5% 19.0% Operating Profit 13.2% 5.1% 14.4% 10.1% -0.9% 6.6% 1.0% 33.6% 6.1% 3.2% 10.9% 16.3% 4.7%

Cash 2% 1% 0% 1% 7% 13% 3% 3% 1% 7% 3% 6% 78%

Accounts Receivable 17% 1% 8% 15% 35% 28% 37% 6% 19% 34% 8% 13% 3% Inventory 1% 9% 17% 1% 15% 8% 43% 4% 3% 0% 1% 5% 12%

Fixed Assets 69% 81% 69% 40% 11% 9% 10% 69% 61% 10% 18% 55% 6% Other Assets,

primarily intangibles 11% 7% 6% 43% 33% 41% 7%

18% 15% 49% 70% 21% 2% Payables 11% 28% 33% 47% 43% 35% 17% 15% 42% 55% 26% 47% 55%

Debt 25% 14% 17% 12% 3% 4% 57% 21% 20% 0% 28% 5% 61% Equity 64% 59% 50% 41% 55% 61% 27% 64% 38% 45% 46% 47% -16%

Operating

Profit/Assets 7.1% 7.4% 15.4% 13.5% NM 7.0% 3.3% 12.8%

9.3% 6.9% 5.9% 21.7% 14.1% Return on Equity 9.9% 11.3% 17.7% 21.9% NM 6.0% 0.0% 13.6% 11.9% 9.3% 10.4% 33.3% NM

Disney is involved in broadcasting, cable and publishing with many acquisitions Tesco is a UK supermarket chain. Stora Enso is the largest Finnish paper producer Hasbro is a major toy manufacturer Amazon is an Internet Retailer Dow Jones publishes the Wall Street Journal Total is a global integrated energy company Monarch Machine Tool produces metal working machines for manufactures Haddon is a Dutch food distributor. Vale is a Brazilian mining company. Fed Ex provides express delivery services Vodafone is a global telecommunications company. MK is a global engineering and construction company


3 Primary Financial Statements

• Income Statement

– Performance over a period of time

– Accrual Accounting

• Statement of Cash Flows

– Performance over a period of time

– Cash Accounting

Balance Sheet– Financial

Position of the firm

– This statement bridges the income statement and cash flow

61


Income Statement

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Revenue is the monetary measure of goods delivered and/or services provided during a period.

Revenue is also referred to as sales, or the top line.

Revenue is reported net of sales returns

Cost of goods sold is the product cost [inventory cost] related to the revenue recorded during the period. In a service business, the cost of revenue or services is considered to be the labor and benefits of those people who generate billable hours (though the term may be changed to "cost of services").

In the income statement presentation, the cost of goods sold is subtracted from revenues to arrive at the gross margin of a business.

The selling, general and administrative expense (also known as SG&A) is comprised of all operating costs of a business that are not included in the cost of goods sold. SG&A appears in the income statement, below the cost of goods sold. It may be broken out into a number of expense line items, or consolidated into a single line item (which is more common when the condensed income statement is presented).


Accrual Accounting

• Revenue, generally creates accounts receivables• Expense, generally creates accruals [liabilities]

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Basic Accounting Equations

• Balance Sheet– The basic accounting equation is:

• Assets [dr] = Liabilities [cr] and Owners’ Equity [cr or dr]

• Income Statement– The key equation is:

• Revenue [cr] – Expenses [dr] = Net Income [cr or dr]

• Statement of Cash Flow– The equation is:

• Cash Flow from Operations plus Cash Flow from Investing Activities plus Cash Flow from Financing Activities = Change in Cash

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Basic Accounting Interrelationship

• Balance Sheet– The basic accounting equation is:

• Assets [dr] = Liabilities [cr] and Owners’ Equity [cr or dr]

• Income Statement– The key equation is:

• Revenue [cr] – Expenses [dr] = Net Income [cr or dr]

65


Methods of Accounting:Accrual and Cash Accounting

• Accrual Accounting– A method that measures the

performance of a company by recognizing events regardless of when cash transactions occur.

– Accrual accounting records revenues at the time in which the transaction occurs rather than when payment is received.

• Cash Accounting– A method that measures the

performance of a company by recognizing events when cash transactions occur.



67

Look at the Teva Income Statement [page 14]

For FY 2015, find and explain the meaning of each row

Total Revenue _______________

Cost of Good Sold _______________

Research & Development _______________

Selling and Marketing _______________

General & Administrative _______________

Net Income _______________


Teva Tax

68

The United States Has the Third Highest Corporate Tax Rate among 173 NationsThe top marginal corporate tax rate among the 173 countries surveyed was the United Arab Emirates, which has a top rate of 55 percent followed by the African nation Chad (40 percent) and the United States, with a combined top marginal tax rate of 39 percent (consisting of the federal tax rate of 35 percent plus the average tax rate among the states), has the third highest corporate income tax rate in the world, along with Puerto Rico.

In contrast, the average across all 173 countries is 22.9 percent,

Other large nations in the top twenty countries besides the United States are France (34.4 percent), Brazil (34 percent), and India (34 percent).

We calculate effective [average] tax rate by dividing tax expense/pretax profit

Calculate the effective tax rate for Teva for 2015


Statement of Cash Flow

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Companies are required to present a Statement of Cash Flows (cash statement) for each period with the cash flows classified into three categories:

Operating activities--all activities that are not specifically included in the other two categories; generally, activities involved in producing and delivering goods and providing services. (Includes cash dividends & interest income received from investing activities and interest paid for financing activities.)

Investing activities--lending; investing in debt & equity instruments; investing in productive assets other than inventory (e.g., property, plant & equipment).

Financing activities--borrowing & repaying debt (short- or long-term); issuing or reacquiring equity; dividends.

There are two methods for preparing a cash statement.Direct method--show the cash inflows and cash outflows from the cash T-

account.Indirect method--show the changes in all T-accounts.

Most firms present an indirect Statement of Cash Flow



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Free Cash Flow

Some analysts give too much importance to cash provided by operating activities. [Find Operating Cash Flow for Teva for 2015 on page 16]

The subtotal for cash provided by operating activities represents only a portion of a company's cash flows that are necessary to operate the business. In addition, the company must make capital expenditures (shown as investing activities) and, if planned, pay dividends (shown as financing activities).

The concept of free cash flow defined as (i) cash provided by operating activities less (ii) capital expenditures and less (iii) dividends provides a very useful reminder for the financial analyst--don't stop at

the subtotal for cash provided by operating activities.

For some purposes, the analyst may define free cash flow without subtracting dividends.


Statement of Cash Flow [Various Definitions of Cash Flows

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Many companies use their own definitions of cash flow to enhance the reader’s understanding of the firm’s ability to generate cash, provide liquidity and satisfy rating agency and creditor requirements.

These measures are not defined by GAAP. Some common measures of financial results are:

Earnings Before Interest Expense, Tax Expense, Depreciation, Depletion and Amortization (EBITDA)

Another common definition of Cash Flow is

Cash Available for Distribution (CAD) is Cash Provided by Operating Activities less capital spending.

Many firm define Capital Spending as Mandatory [or Maintenance or Custodial] Capital Spending, a non-GAAP measure, as capital expenditures, net of proceeds from sales and retirements, required to maintain its current earnings level over the cycle and to keep facilities and equipment in safe and reliable condition as well as in compliance with regulatory requirements. The measure is important to properly evaluate the Company’s cash requirements, to forecast potential uses of cash and for use in valuation models. Capital spending over the custodial level is often called discretionary capital spending.

Owner’s Cash Flow [this is a Warren Buffett definition of CFO – Cap X].



72

Turn to page 45 & 46

Review the Statement of Cash Flow

Recognize the following:

The First line is Net IncomeAfter Net Income we adjust for DepreciationThen, the changes in the balance sheet accounts



73




The First line is Net IncomeNet Income or the first row of the Statement of

Cash Flow, consists of every transaction from the Income Statement.

Revenue and all expenses are part of Net Income. Depreciation Expenses is included in this first line.



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After Net Income we adjust for DepreciationDepreciation is adjusted in the second row as it

Is part of the first row but never has an impact on Net Cash Flow from Operating Activities. Depreciation in the currentPeriod reflects the expense of Capital Spending from past years.



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After Net Income we adjust for DepreciationThen, the changes in the balance sheet accounts; these changes are changes in 6 balance sheet accounts [AR, inventory, prepaids, Acc Payables, Accruals and tax payable]. These are the working capital accounts. They convert accrual to cash accounting



76

Look at the Teva Statement of Cash Flow

For FY 2015, find

Net Cash Flow from Operations _______________

Capital Spending _______________


Cash Flows

Teva Amdocs DelekNet Cash Flow from OperationsCapital Spending

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2 Other Financial Statements

• Statement of Changes in Equity

– Reports the changes in a part of the balance sheet

• Statement of Other Comprehensive Income

– A subset of the Changes in Equity

78



• Statement of Other Comprehensive Income• Review Delek Statement of Comprehensive Income [p 42]

– Find Net Income– Find Other Comprehensive Income– Find Comprehensive Income

79



• Statement of Changes in Equity for 2015 for Teva[pages 12 & 15]

• Find Total Equity at FYE 2014 • Find Total Equity at FYE 2015

• What explains the increase?

80


Financing, Debt

81

Debt is an amount of money borrowed by one party from another. Debt is used by many corporations as a method of making large purchases that they could not afford under normal circumstances.

These purchases normally include! Property, Plant and Equipment! Acquisitions! Share Repurchase

A debt arrangement gives the borrowing party permission to borrow money under the condition that it is to be paid back at a later date, usually with interest.


Financing of Assets

Teva Amdocs Delek

Total Assets

Supplier FinancingDebt FinancingEquity Financing

82


Answer the following:• If an asset increases, then what must also change on the balance sheet?

• WHY?


Answer the following:• Look at Teva balance sheet.• Find the account named “inventory”.• What will the firm report on its balance sheet next to

“inventory”? Be as specific as possible.

Teva

Inventory ______________

• WHY?


Users of Financial Information and the Books

Users BooksShareholders Financial

Books

Creditors Financial Books

Legal Entities

Government Legal Entities

Tax Returns

Management Financial Books

Legal Entities

Tax Returns Management Reports


FINANCIAL STATEMENT INTERRELATIONSHIPS;

The key issue is the structure of the Balance SheetAll income statement items to the Retained EarningsAll cash transactions go to the cash account.


Analytics

• What is it?• Financial analytics applies tools to financial statements to derive

inferences useful in making business decisions. • There are many classes of external users of financial statements.

– Creditors look for the ability of the borrower to pay interest and repay debt. – Shareholders need information to help in choosing among competing alternative

investments.


Financial Analytics

• The comparison of financial statements is accomplished by – setting up financial statements side by side– using common size numbers [%]

• Level [current year] [vertical analysis]– and reviewing the changes from year to year

• Trend [YoY] [horizontal analysis]• There is a four step process used for financial analysis:

– Profitability [earnings]– Liquidity

• Balance Sheet Management• Cash Flow Analysis

– Solvency • Capital Structure

– Valuation


Level and Trend

2016 2017 2018 2019FB, goals per season 78 77 75 72BB, average, season .455 .454 .452 .448C, runs [test match] 45 46 47 52BB, [pts+r+ asst], playoffs

48.7 48.5 48.2 47.7

89


Level and Trend, Relative numbers

90

During 2020, unlawful possession of firearms in Singapore increased 24% from 2019, while in the United States, it decreased by 9%.

During 2020, Singapore had 95 automobile thefts, while the Isle of Man had only 3 automobile thefts.


Financial Analytics and Interpretation

– Financial Analysis is using the correct numbers and Interpretation is explaining why the numbers are where/what they are

– Assume class starts at 9AM. You arrive at 9.10 AM. You are late

– Analysis tells me you are late. Analysis is quantitative.

– If I said you at breakfast at 7.45AM and class starts at 9AM and you are late for class, that is neither analysis nor interpretation, as it is not relevant data.

– Interpretation is why are you late. Interpretation is qualitative• You are late because you arrived 10 minutes after 9AM [wrong]• You are late because, the subway stalled, or you took the wrong train

or you are always late or you had a job interview


Financial Decision Making

• Analysis with done with– Common size statements

• Level [the most recent year] –sometimes referred as vertical analysis– and the changes from year to year

• Trend [sometimes referred to as horizontal analysis

• The process is• First step is mechanical, obtain the correct numbers• Second step is analysis, what the numbers tell us• Third step is interpretation, why the numbers show a particular results• Fourth step is implication, what do the numbers imply about valuation


Profitability Analysis

• Profitability is the result of a large number of management policies and decisions.

• Analyze the financials from top down.– Start with revenues and move down the income statement to operating profit

• Why is Operating Profit so important?

• Distinguish clearly between level and trend analysis• Make sure you understand the definitions of ratios

– Operating Profit is the most important subtotal on the income statement as it is• Unleveraged • Core Business


Financial Analytics

• Measuring Profits• Understanding sustainable and operating earnings


Analysis, Measurement of Earnings

• Do level first, the most recent year– You must prepare an adjusted income statement

• Remove any unusual/non recurring items [one time]• Ratios

• Level analysis [vertical] entails– relative analysis [peers is key] – Segments [granular]– absolute [intrinsic] analysis [benchmarks]

• After level, then do trend analysis– Trend needs to be an entire business cycle

• 50 bp, generally for materiality.


Profitability Metrics

• Key Profitability Metrics are:– Revenue Growth [% growth, year over year Y-o-Y]– Gross Profit Margin [Gross Profit/Revenue]– Operating Profit Margin [Operating Profit/Revenue]– RROIC [NOPAT/Invested Capital]– Return on Equity [ROE] Net Income to Common Shareholders/Common Equity

96


Microsoft [Income Statement]

2014 CommonSize

2013 Common Size

2012 Common Size

Revenue $86,833 100.0% $77,849 100.0% $73,723 100.0%

Operating expenses:Cost of revenue 26,934 31.0% 20,249 26.0% 17,530 23.8%Research and development 11,381 13.1% 10,411 13.4% 9,811 13.3%Sales and marketing 15,811 18.2% 15,276 19.6% 13,857 18.8%

General and administrative 4,821 5.6% 5,149 6.6% 4,569 6.2%

Operating income 27,886 32.1% 26,764 34.4% 27,956 37.9%

Other Income 66 0.1% -288 -0.4% 5,689 7.7%Tax Expense 5,746 6.6% 5,189 6.7% 5,289 7.2%Net Income $22,074 25.4% 21863 28.1% $16,978 23.0%


Microsoft [segments]

2014 2013 2012

RevenueDevices and Consumer

37,674 32,100 32,438

Commercial 49,574 45,346 41,770

OPMDevices and Consumer

23.1% 29.3% 18.7%

Commercial 47.3% 46.6% 47.8%


GAAP Materiality 5%

Revenue 30,000

Operating Profit 3,000 150 [unusual]

OPM 10.0% 0.5%

50 bp?


Microsoft [Peers]

OPM 2014 2013 2012

Peers 32.4% 35.5% 37.1%

Microsoft 32.1% 34.4% 37.9%


Peers

• Operational Characteristics– Industry– Products & Distribution Channel– Markets & Customers– Seasonality– Cyclicality– Strategy

• Financial Characteristics– Size– Leverage– Growth and/or Margins – Dividend Policy

101


Microsoft, Intrinsic [BS]

2014 2010

Cash 100,306 44,511

Operating Assets 72,078 41,602

Total Assets 172,384 86,113

Suppliers 59,955 33,999

Debt Financing 22,645 5,939

Owners 89,784 46,175

Total Financing 172,384 86,113

Operating Profit 27,886 [NOPAT_________]

24,157 [NOPAT________]

RROOA [OP/Op Assets]

Net Operating Assets

RROIC [NOPAT/Net Op Assets]


Microsoft [BS] Intrinsic

2014Cash 100,306 Suppliers 59,955Operating Assets

72,078 Debt Financing

22,645

Equity 89,784

Total Assets 172,384 Total Financing

172,384

Operating Profit 27,886 Interest Exp

RROOA [OP/Op Assets]

Cost of Debt


Microsoft [BS] Intrinsic

2014Cash 100,306Net Operating Assets

12,123 Debt Financing

22,645

Equity 89,784

NOPAT 18,126 IC=

ROIC


Absolute Profitability

Scenario Op Profit Op Assets

NOPAT Op liabilities

IC RROOA Pretax borrowing costs

ROIC WACC

1 (500) 4,500 NM 1,000 3,500 -11.1% nm

3.6% NM 7.8%

2 200 6,700 150 1,400 5,300 3.0% 3.5% 2.8% 7.7%

2a 200 6,700 150 5,000 1,700 3.0% 3.3% 8.8% 7.5%

3 500 8,300 375 2,300 6,000 6.0% 3.2% 6.3% 7.5%

4 600 7,200 450 3,000 4,200 8.3% 3.0% 10.7% 7.3%

5 800 6,000 600 5,200 800 13.3% 2.9% 75% 7.0%

105


Salary

$ USdollars 2020 2021 trend

IB $800,000 $808,000 1%

Average IB $900,000 $927,000 3%

SW $4,000 $4,200 5%

Average SW $3,400 $3,400 0%


Analytically Adjusted Income Statement

• Companies use different presentation formats for their income statements. • In addition, the accounting rules for the income statement do not always reflect

comparability with – prior years or – forecasts or – with other firms.

• The analyst/associate must adjust the income statement


Reformatting

• REFORMATTING – places amounts from the income statement into one of five sections:

• Operating • Non-Operating• Interest Expense, Gross• Tax Provision• Items Segregated for Analysis [net of tax]:

– Equity Income [leveraged after tax income]– NonControlling Interest [financial cost]– Items that Relate to More than One Year [non recurring] gains & losses that

relate to more than one year (or to a different year),– cumulative effect of change in accounting; – gain (loss) from of discontinued operations;– loss on early retirement of long-term debt; – Lifo liquidation gains; – Asset or goodwill impairment, writedowns, restructuring charges,

acquisition related charges, litigations, and gain and loss on the sale of assets.


A typical income statement

Sales Revenue 10,000

Cost of Sales (6,000)

Selling and General Expenses (2,000)

SUBTOTAL [not GAAP] EBITDA

Depreciation and Amortization (400)

Amortization (60)

Stock Based Compensation (40)

SUBTOTAL Operating Profit

Interest Expense (500)

Earnings Before Tax 1,000

Tax Expense (350)

Net Income 650


Format

Income statement Reported

1 Sales 10,000

2 COGS (3,500)

3 Selling, general, and administrative costs (4,500)

4 Other operating expenses (100)

5 = Other operating expenses

6 Other operating expenses

7 = Operating Profit 1,900

8 Interest income 40

9 Other non-operating income (expense) (20)

10 Other non-operating income (expense)


12 = EBIT 1,920

13 Gross interest expense (300)

14 = EBT 1,620

15 Total tax expense (450)

16 = Income from continuing operations before equity income 1,170

17 Equity income 50

18 (Income attributable to non-controlling interest) (10)

19 (Preferred dividends) (5)

20 Discontinued operations (100)

21 Reclassified items

22 = Net income 1,105


FormatIncome statement Reported

1 Sales 10,000

2 COGS -3,500

3 Selling, general, and administrative costs -4,500

4 Other operating expenses -100

5 = Other operating expenses

6 Other operating expenses

7 = Operating Profit 1,900

8 Interest income 40

9 Other non-operating income (expense) -20



12 = EBIT 1,920

13 Gross interest expense -300

14 = EBT 1,620

15 Total tax expense -450

16 = Income from continuing operations before equity income 1,170

17 Equity income 50

18 (Income attributable to non-controlling interest) -10

19 Discontinued operations -100

20 Reclassified items

21 = Net income 1,110

22 Depreciation 200

23 Amortization 50

24 Stock Based Compensation 40

26 Operating EBITDA 2,190


Adjust

Income statement Reported 1 Recurring

1 Sales 10,000 10,000

2 COGS (3,500) (3,500)

3 Selling, general, and administrative costs (4,500) (4,500)

4 Other operating expenses (100) 100 0

5 = Other operating expenses 0

6 Other operating expenses 0

7 = Operating Profit 1,900 100 2,000

8 Interest income 40 40

9 Other non-operating income (expense) (20)


11 Other non-operating income (expense) 0

12 = EBIT 1,920 100 2,020

13 Gross interest expense (300) (300)

14 = EBT 1,620 100 1,720

15 Total tax expense (450) (450)

16 = Income from continuing operations before equity income 1,170 100 1,270

17 Equity income 50 50

18 (Income attributable to non-controlling interest) (10) (10)

19 Discontinued operations (100) (100)

20 Reclassified items (100) (100)

21 = Net income 1,110 0 1,110

22 Depreciation 200 200

23 Amortization 50 50

24 Stock Based Compensation 40 40

25 Credit EBITDA 2,210 100 2,310

26 Operating EBITDA 2,190 100 2,290

27 Credit EBIT 1,970 100 2,070

28 Funds Flow 1,460 100 1,560


Explorations in EBITDA.

• EBITDA is one of the most widely used financial metrics.



• EBITDA is one of the most widely used financial metrics. – However, there is much confusion about the calculation, the use and the

interpretation of EBITDA.• What does EBITDA measure?

– Profits?– Liquidity?– Solvency?



• EBITDA is one of the most widely used financial metrics. • First, we need to understand what EBITDA measures:

• EBITDA measures the• Unleveraged [before interest cost]• Pretax• Expected [Potential] Operating Cash Flow of the Firm

• It is considered to be a “proxy” of Cash Flow from Operations.

• Many analysts calculate firm value [Enterprise Value] as a function [multiple] of EBITDA.



• History of EBITDA– EBIT has been used as an analytic tool for decades

• It measures earnings without regard to the capital structure– Before January 1982, there were very few leveraged buyouts

• Pan Atlantic Steamship - 1955• Orkin - 1964• Borin - 1973

– In January 1982, former Treasury Secretary William Simon acquired Gibson Greetings for $80 million, with only $1 million in equity [$330,000 from Simon].

– Within one year, Gibson completed a $290 million IPO and Simon made $66 million

– Over the next 10 years, there were more than 2,000 LBOs


EBITDA History

• These buyouts often created significant goodwill• In the 1980’s, goodwill was expensed [amortized]

• Many financial sponsors of these buyouts complained that the amortization of goodwill should be ignored when calculating EBIT

• The argument was the Amortization [A] of Goodwill had no impact on • Real Cash Earnings• Firm Liquidity• Debt Servicing Capabilities

• EBITA soon replaced EBIT• Then, analysts started adjusted for Depreciation and now, many also adjust for

Stock Based Compensation, which is EBITDA.


EBITDA

Teva Amdocs DelekRevenueOperating ProfitDepreciationAmortizationStock Based CompensationEBITDAEBITDA margin toSales

118


Pepsi [entire firm], Profits

119

2014 2014 CS

Revenue 66,683 100.0%

Cost of Sales 30,884 46.3%

SGA 25,842 38.8%

Operating Profit 9,957 14.9%


Pepsi, Comment on Profits, You need to know that the average OPM for food and beverage companies is 15.3%

120

2014 CSRevenue 66,683 100.0%Cost of Sales 30,884 46.3%SGA 25842 38.8%Operating Profit 9,957 14.9%


Pepsi, segment analysis

121

RevenueOperating Profit

FLNA 14,502 4,102 QFNA 2,568 635 LA Foods 8,442 1,236 Pepsi NA Beverage 21,154 3,007 Europe 13,290 1,402 Asia 6,727 1,080

66,683 11,462

Corporate Expenses 1,505


Pepsi You need to know that the average OPM for food companies is 11.9% and beverage companies is 18.6%

122

Revenue Common Size Operating Profit OPM

FLNA 14,502 22% 4,102 28.3%

QFNA 2,568 4% 635 24.7%

LA Foods 8,442 13% 1,236 14.6%

Pepsi NA Beverage 21,154 32% 3,007 14.2%

Europe 13,290 20% 1,402 10.5%

Asia 6,727 10% 1,080 16.1%

66,683 100% 11,462 17.2%

Corporate 1,505


Segment, Revenue

FLNA, 14,502

QFNA, 2,568

LA Foods, 8,442

Pepsi NA Beverage,

21,154

Europe, 13,290

Asia, 6,727

123


OPM Pepsi

0%

5%

10%

15%

20%

25%

30%

FLNA QFNA LA Foods Pepsi NABeverage

Europe Asia

OPM

124


Pepsi

125

Revenue CS Operating Profit OPM Assets OP/Assets

FLNA 14,502 22% 4,102 28.3% 5,307 77.3%

QFNA 2,568 4% 635 24.7% 982 64.7%

LA Foods 8,442 13% 1,236 14.6% 4,760 26.0%

Pepsi NA Beverage 21,154 32% 3,007 14.2% 30,188 10.0%

Europe 13,290 20% 1,402 10.5% 13,902 10.1%

Asia 6,727 10% 1,080 16.1% 5,887 18.3%

66,683 100% 11,462 17.2%

Corporate 1,505 9,483


Pepsi

0%10%20%30%40%50%60%70%80%90%

FLNA QFNA LA Foods Pepsi NABeverage

Europe Asia

ROA-Segment

126


Financial Analytics, Earnings

•How is Teva doing financially?– Always start with profits


Measurement of Earnings

• Profitability Analysis– Mechanics, Analysis and Interpretation


• Prepare an Adjusted Income Statement for Teva– Remove the two items of noise from the page after the next, in red

• Common Size• Compare to Peers• Comment on Teva’s Performance

129


Prepare Adjusted Income Statement for Amdocs 2015Common Size Amdocs Income StatementCompare GPM, OPM to peersCompare ROE to peers


Teva Profits

131

Teva2015 adjusted IS Common Size

Revenue 19,652Cost of Good Sold 8296Gross Profit 11,356R&D 1,525Selling and Marketing 3,478General and Administrative 1,239Impairment 1,131Legal Settlements 631Operating Profit 3,352


Teva Comps [9]

132

Symbol: ABT ABBV AGN BMY LLY MRK GSK SNY MYL AveragePeriod Ending: 12/31/15 12/31/15 12/31/15 12/31/15 12/31/15 12/31/15 12/31/15 12/31/15 12/31/15Fiscal Year 31-Dec 31-Dec 31-Dec 31-Dec 31-Dec 31-Dec 31-Dec 31-Dec 31-DecTotal Revenue $20,405,000 $22,859,000 $15,071,000 $16,560,000 $19,958,700 $39,498,000 $35,260,000 $37,870,000 $9,429,300Cost of Revenue $8,747,000 $4,500,000 $4,810,400 $3,909,000 $5,037,200 $14,934,000 $13,048,000 $11,861,000 $5,213,200

Gross Profit $11,658,000 $18,359,000 $10,260,600 $12,651,000 $14,921,500 $24,564,000 $22,212,000 $26,008,000 $4,216,100Operating ExpensesResearch and Development $1,405,000 $4,285,000 $2,358,500 $5,920,000 $4,796,400 $6,704,000 $5,247,000 $5,521,000 $671,900Sales, General and Admin. $6,785,000 $6,387,000 $4,679,600 $4,841,000 $6,432,400 $10,313,000 $1,751,000 $10,361,000 $2,180,700

Operating Income $3,468,000 $7,687,000 $3,222,500 $1,890,000 $3,692,700 $7,547,000 $15,214,000 $10,126,000 $1,363,500

Gross Profit Margin 57.1% 80.3% 68.1% 76.4% 74.8% 62.2% 63.0% 68.7% 44.7% 66.1%R&D/Sales 6.9% 18.7% 15.6% 35.7% 24.0% 17.0% 14.9% 14.6% 7.1% 17.2%Operating Profit Margin 17.0% 33.6% 21.4% 11.4% 18.5% 19.1% 43.1% 26.7% 14.5% 22.8%


Credit Mindset, Debt Sizing and Service

Income Statement Balance Sheet #1 #2 #3Revenue 20,000 Cash 0 0 0

Cost of Sales 11,000 Operating Assets 20,000 20,000 20,000

S, G, Admin 6,000 Total Assets 20,000 20,000 20,000Operating Profit 3,000 Payables 3,000 3,000 3,000

Interest Income 0 Debt 5,000 10,000 15,000EBIT/Operating Profit 3,000 Equity 12,000 7,000 2,000Interest Expense Cost of Debt 3% 6% 10%

Operating Profit/Operating Assets

Debt/Assets 25% 50% 75%

EBIT 3,000 3,000 3,000

Interest 150 600 1,500

EBT 2,850 2,400 1,500Tax [30%] 855 720 450

Net Income 1,995 1,680 1,050

ROE 24.0% 52.5%

Interest Coverage 5.0X 2.0X


Ratio Medians, these ratios indicate a firms debt rating—AAA is best, The most important ratio is Debt/EBITDA for ratingsDebt/EBITDA is a measure of risk or financial leverage

AAA AA A BBB BB B CCC EBIT interest coverage 23.8 19.5 8.0 4.7 2.2 1.2 [0.1]

EBITDA interest coverage 25.5 24.6 10.2 6.5 3.5 1.9 0.7 Funds from operations/total debt 203% 80% 48% 36% 22% 12% 3%

Free operating cash flow/total debt 128% 45% 25% 17% 8% 3% [3%] Pretax return on capital 28% 27% 18% 13% 11% 8% 1%

EBITDA/sales 23% 24% 18% 16% 15% 15% 9% Long term debt/capital 0% 21% 34% 40% 54% 73% 78%

Total debt/capitalization 5% 36% 43% 47% 58% 75% 92% Debt/EBITDA 0.8 1.2 1.8 2.8 3.8 4.5 4.8

EBITDA/Assets 29% 24% 19% 15% 14% 11% 4% Number of companies 6 20 121 224 279 264 56


Historical Default Rates - 1970 - 2010

Average cumulative default rates

1 year 5 years 10 years

AAA .00% .10% .49%

AA .02% .27% .62%

A .06% .76% 2.14%

BBB .18% 1.95% 4.90%

BB 1.16% 10.45% 20.10%

B 4.47% 26.17% 44.57%

CCC 18.16% 53.77% 72.38%

IG .09% 1.00% 2.57%

NIG 4.67% 21.80% 34.44%


Teva

136


Revenue 19,652 19,652 100.0%Cost of Good Sold 8296 8,296 42.2%Gross Profit 11,356 11,356 57.8%R&D 1,525 1,525 7.8%Selling and Marketing 3,478 3,478 17.7%General and Administrative 1,239 1,239 6.3%Impairment 1,131 -1,131 0Legal Settlements 631 -631 0Operating Profit 3,352 1,762 5,114 26.0%


Teva

137


Revenue 20,272 20,272 100.0%Cost of Good Sold 9216 9,216 45.5%Gross Profit 11,056 11,056 54.5%R&D 1,488 1,488 7.3%Selling and Marketing 3,861 3,861 19.0%General and Administrative 1,217 1,217 6.0%Impairment 650 -650 0Legal Settlements -111 111 0Operating Profit 3,951 539 4,490 22.1%


Revenue 20,314 20,314 100.0%Cost of Good Sold 9607 9,607 47.3%Gross Profit 10,707 10,707 52.7%R&D 1,427 1,427 7.0%Selling and Marketing 4,080 4,080 20.1%General and Administrative 1,239 1,239 6.1%Impairment 788 -788 0Legal Settlements 1,524 -1,524 0Operating Profit 1,649 2,312 3,961 19.5%



• The following variables contribute to earnings:– environment [external]– operations [internal]– capital structure (debt vs. equity)– infrequent transactions


Comment on Trend

139

TEVA 2015 2014 2013revenue growth -3.1% -0.2%Gross Profit Margin 57.8% 54.5% 52.7%R&D 7.8% 7.3% 7.0%Selling and Marketing 17.7% 19.0% 20.1%General and Administrative 6.3% 6.0% 6.1%OPM 26.0% 22.1% 19.5%


Comment on Trend

140

2016 2015 2014 2013 2012 2011 2009 2008revenue growth 11.5% -3.1% -0.2% 0.0% 10.9% 13.6% 16.0%gross profit margin 57.2% 57.8% 54.5% 52.7% 52.4% 52.0% 56.2% 53.0%R&D/ sales 9.6% 7.8% 7.3% 7.0% 6.7% 6.0% 5.9% 5.9%Selling 17.6% 17.7% 19.0% 20.1% 19.1% 19.0% 18.4% 19.3%G&A 5.6% 6.3% 6.0% 6.1% 6.1% 5.1% 5.4% 5.9%OPM 24.3% 26.0% 22.1% 19.5% 20.6% 21.9% 26.6% 21.9%


Prepare Adjusted Income Statement for Amdocs 2015Common Size Amdocs Income StatementCompare GPM, OPM to peersCompare ROE to peers


Amdocs

142

2015 adjusted IS Common Size

Revenue 3,643,538

Cost of Good Sold 2349488

Gross Profit 1,294,050

R&D 254,944

Selling and Marketing 440,085

Amortization 70,073

Restructuring 13,000

Operating Profit 515,948

Interest 2,544

Tax 67,241

Net Income 446,163

Equity 3,406,842

ROE


Amdocs [Peers]

143

Symbol: HPQ IBM ORCL ACN averagePeriod Ending: 10/31/15 12/31/15 5/31/16 8/31/15Fiscal Year 31-Oct 31-Dec 31-May 31-AugTotal Revenue $103,355,000 $81,741,000 $37,047,000 $32,914,424Cost of Revenue $78,596,000 $41,057,000 $7,479,000 $23,105,185

Gross Profit $24,759,000 $40,684,000 $29,568,000 $9,809,239Operating ExpensesResearch and Development $3,502,000 $5,247,000 $5,787,000 $0Sales, General and Admin. $13,612,000 $19,748,000 $9,039,000 $5,373,370Operating Income $7,645,000 $15,689,000 $14,742,000 $4,435,869Interest Expense $0 $468,000 $1,467,000 $14,578Income Tax $1,780,000 $2,581,000 $2,541,000 $1,136,741Net Income $5,865,000 $12,640,000 $10,734,000 $3,284,550

Total Equity $27,768,000 $14,262,000 $47,289,000 $6,133,725

Gross Profit 24.0% 49.8% 79.8% 29.8% 45.8%R&D 3.4% 6.4% 15.6% 0.0% 6.4%Operating Profit Margin 7.4% 19.2% 39.8% 13.5% 20.0%

ROE 21.1% 88.6% 22.7% 53.5% 46.5%


A typical balance sheet: assets

2015 ASSETS

Cash $204 Accounts Receivable - Trade 16,931 Inventory 1,984 TOTAL CURRENT ASSETS 19,119 Gross Fixed Assets 4,129 less: Accumulated Depreciation (1,200) Net Fixed Assets 2,929 Other Assets 764 Intangibles 45,431 less: Accumulated Amortization (0) Net Intangible Assets 45,431 TOTAL ASSETS $68,243

Liquid assets

Net property plant & equipment

Goodwill & Identifiable Intangibles

Trading assets


A typical balance sheet: Financing [liabilities and net worth]

Equity capital

2015 LIABILITIES

Notes Payable $0 Current Maturity Long-Term Debt 7,600 Accounts Payable - Trade 7,130 Accrued Liabilities 563 TOTAL CURRENT LIABILITIES 15,293 Long Term Debt 12,400 Subordinated Debt 8,400 TOTAL LIABILITIES $36,039

NET WORTH Common Stock $1,000 Paid In Capital 12,541 Retained Earnings 18,609 NET WORTH $32,150

TOTAL LIABILITIES & NET WORTH $68,243

Subordinated debt

Senior debt

Working Liabilities


Balance Sheets

146

There are three major parts of a balance sheet which need to be financed

[1] Working Capital NeedsAccounts Receivables + Inventory net of

Accounts Payables and Accruals

[2] PPE

[3] Intangibles


Balance Sheets

147

Working Capital Needs

From the balance sheets the working capital needs are

Accounts Receivables 16,931Inventory 1,984 Accounts Payables 7,130 Accruals 563

Working Capital Need= 11,222


Liquidity and Balance Sheet Analysis• Liquidity is the ability to meet short term financial obligations:

• By having cash on hand in excess of short term financial claims• Or Generating Cash Flow from Operations

• One tool for analyzing Liquidity is:

– Dynamic• Find the Cash Flow from Operations• Capital Expenditures• Dividends

– Calculate– Free Cash Flow [CFO - CapX – Dividends] and also the long run


Cash Flows

Teva Amdcos DelekCFOpsCapXDividendsResidual

150


C&I Balance Sheets, Asset Profiles

A B C D

Operating Working Capital [need]

Low High Low High

PPE High High Low Low

Intangible Low Low Low Low

Example


Cash Flows

Teva Amdcos DelekCFOps 5,542 772.6 180.0CapX -772 -120.5 -214.1Dividends -1,115 -100.8 -37.1Residual

152


Tesla

• We design, develop, manufacture and sell high-performance fully electric vehicles and advanced electric vehicle powertrain components.

• We are the first company to commercially produce a electric vehicle, the Tesla Roadster.

• The Tesla Roadster’s proprietary electric vehicle powertrain system is the foundation of our business.


Tesla

• In November 2016, Tesla acquired Solar City, an installer of rooftop solar panels, in an all stock transaction.

• Elon Musk owns 21 percent of Tesla and 22 percent of SolarCity, making him the largest shareholder of both companies.

• SolarCity stock price rose over 35% since the transaction was first announced in late June 2016.

https://www.bloomberg.com/quote/TSLA:US

https://www.bloomberg.com/quote/SCTY:US


Income Statement, Tesla[millions] 2020 2019 2018 2017 2016 2015 2014 2013 2012 2011 2010 2009

Revenue 31,536 24,578 21,461 11,759 7,000 4,046 3,192 1,998 413 204 117 112

Cost of Sales

-21,850 -18,102 -15,518 -7,900 -4,750 -2,696 -2,122 -1,452 -313 -102 -66 -172

R&D -1,491 -1,343 -1,460 -1,378 -834 -718 -465 -232 -274 -209 -93 -19

SGA -2,145 -2,153 -2,221 -2,010 -802 -734 -248 -104 -96 -58 -55 -26

Stock based comp

-1,734 -898 -749 -467 -334 -198 -156 -81 -30 -22

Depreciation

-2,322 -2,151 -1,901 -1,636 -947 -426 -388 -190 -80 -65 -50 -46

Operating Profit

1,994 -69 -388 -1,632 -667 -717 -187 -61 -392 -252 -147 -51

Other -92 89 45 -106 119 -40 2 22 -2 -2 -6 -1

Interest Expense

-748 -685 -663 -471 -199 -119 -100 -33 0 0 -1 -3

Income Before Tax

1,154 -665 -1,004 -2,209 -747 -875 -285 -71 -394 -254 -154 -55

Tax -292 -110 -57 -31 -27 -13 -9 -3 0 0 0 0

Net Income

862 -775 -1,062 -2,241 -773 -888 -294 -74 -394 -254 -154 -55

EBITDA


Balance Sheet, Tesla

millions 2020 2019 2018 2017 2016 2015 2014 2013 2012 2011 2010 2009

Cash 19,384 6,154 3,877 3,522 3,498 1,219 1,922 850 202 255 100 70

Accounts Receivables

1,886 1,324 949 515 499 169 227 50 26 10 7 3

Inventory 4,101 3,552 3,113 2,263 2,067 1,278 954 340 269 50 45 23

PPE 12,747 17,809 17,601 16,374 11,903 3,403 1,830 740 552 298 115 23

Operating Leases

1,558 2,447 2.090 4,117 3,134 1,791 767 299

Other 12,472 3,023 2,109 1,864 1,563 232 149 138 65 100 118 11

Total Assets 52,148 34,309 29,739 28,655 22,664 8,092 5,849 2,417 1,114 713 385 130

Payables 16,781 12,780 13,213 12,813 10,008 4,288 1,495 1,157 538 211 107 65

Debt 12,292 14,062 10,770 10,311 7,118 2,715 2,488 593 451 278 72 0

Convertible Pfd 0 0 0 0 0 0 319

Equity 23,075 7,467 5,756 5,531 5,538 1,089 912 667 125 224 206 -254

Shares [million] 933 181 172 169 161 131 126 123 114 105 95 7

Share price [12/31/2010]

$35

IPO price [7/19/2010]

$17

Share price $735 $449 $338 $316 $214 $212 $255 $211 $103


Cash Flows, Tesla

2020 2019 2018 2017 2016 2015 2014 2013 2012 2011 2010 2009

Net Income

862 -775 -1,062 -2,241 -773 -888 -294 -74 -396 -254 -154 -55

Depreciation

2,322 2,151 1,901 1,636 947 426 390 190 80 65 10 7

Stock Based

1,734 898 749 467 334 198 156 81 30 22

Balance Sheet Changes

1,025 131 509 78 -631 -260 -309 70 20 38 16 -33

Cash Flow from Ops

5,943 2,405 2,097 -60 -123 -524 -57 265 -266 -128 -128 -81

Capital Spending

-3,157 -1,432 -2,100 -3,415 -1,280 -1,635 -970 -264 -239 -184 -105 -12

Borrowing -1,910 1,190 231 3,140 1,775 365 1,753 140 190 204 72 0

Issuance of Equity

12,269 340 295 260 1,844 1,150 390 490 245 240 289 0

Other 27 3 -168 50 571 -65 -56 26 20 32 -98 153

Change in Cash

13,118 2,506 355 -25 2,279 -709 1,060 650 -50 160 30 60


Tesla, Enterprise Value 2020

Market ValueDebt [par]

Market Value Equity

Less cash EV

Market Survey

Earnings [EBITDaS]

Multiple EV

Multiple of Earnings

Earnings [EBITDaS]

Multiple EV

Multiple of Earnings [A]

$94,605 $1,663,000

Multiple of Earnings [F]

$15,200 $211,300

Multiple of Earnings [T]

$39,123 $457,900

CS $346 $2,900Trina $412 $2,600 158


Performance, 2015 MSFT Apple

Cash 108,579 205,666


Total Assets 176,223 290,479

Suppliers 60,848 106,662

Lenders 35,292 64,462

Equity 80,083 119,355

Revenue 93,580 233,715

Operating Profit 28,161 71,230

NOPAT 18,305 46,300

Book Invested Capital [book value of equity plus book value of debt less cash]

6,796 -21,849

Enterprise Value [market value of equity plus market value of debt less cash]

340,000 553,000


Yahoo

160

2014 2015 Fair Valuecash and mkt securities 10,222 6833Accounts Receivable 1,033 1,048Prepaids 420 603PPE, net 1,488 1,547Goodwill 5,152 808Intangibles 1,033 690Investment in Alibaba 39,868 31,172Investment in Affiliates 2,490 2,503Total Assets 61706 45204

Accounts Payables 1,232 1,278Tax payable on Alibaba ADSs 3,282 0Convertible Notes 1,170 1,233LT Liabilities 1,083 1,003Deferred Tax Alibaba Investment 16,154 12,611Common Equity 38,785 29,079Total Liabilites and Equity 61706 45204

Shares Outstanding 937 946Revenue 4,618 4,963Operating Profit 235 -233DA 1,027 1,070Share Price $50.11 $33.26 Enterprise Value


Financial Analytics, Earnings

•How is Avon doing financially?– Always start with profits


Financial Analytics

•Who are the peers [comparable companies] of Avon?

•Unlike most of Avon’s CPG competitors, which sell their products through third-party retail establishments (e.g., drug stores, department stores),

– Avon’s business is conducted worldwide primarily in one channel, direct selling


Common Size

Avon Peers

2005 2004 2005 2004

Sales 8,150 7,748 XXXX XXXX

Profit 846 846 XXXX XXXX

Margin 9.7% 9.8%



• Profitability is the result of a large number of management policies and decisions.

• Analyze the financials from top down.– Start with revenues and move down the income statement to operating profit– Operating Profit is the most important subtotal on the income statement as it is

• Unleveraged • Core Business


Ratio Analysis

• Start with Operating Profit [Operating EBIT] for profitability ratios • Why is Operating Profit so important?

• The use and definition of ratios should be relevant for the purpose used and valid for the specific company

– Cross-check with • planned ratio and rules of thumb• industry averages and key competitors

• Distinguish clearly between level and trend analysis• Make sure you understand the definitions of ratios• Make sure you analyze segments• Make sure you understand the rating agency view• Credit Mindset:

– RROOA is more important than OPM


Measurement of Earnings

• Profitability Analysis– Mechanics, Analysis and Interpretation


The business cycle

• Define Seasonal and Cyclical businesses– Cyclicality is a profitability issue

• Carparts.com• Zondervan

– Seasonality is a liquidity issue


Business Response to Economy

Expansion Recession RecoveryStrong CreditGrowth

Credit DriesUp

Credit Begins to Grow

Sales Grow Sales Declines

Sales Improve

Business Profits Improve

BusinessProfits Declines

BusinessProfits Improve

168


Economies grow unevenly

169

-2.0%

-1.0%

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

7.0%

8.0%

1977197819791980198119821983198419851986198719881989199019911992199319941995199619971998199920002001200220032004200520062007200820092010201120122013201420152016

Change in GDP Recession

1977-2016 average


Sales and profits in a recession

• Understanding Operating Leverage is Critical. Define Operating Leverage:

_________________________________________________________

_________________________________________________________


Operating leverage

2020 2021

Revenue 10,000

Growth XXXXXXX 20%

Fixed costs 9,000

Variable costs 500

Op Profit

Operating Margin


Operating leverage

2020 2021

Revenue 10,000 8,000

Growth XXXXXXX -20%

Fixed costs 9,000 9,000

Variable costs 500 400

Op Profit 500 -1,400

Operating Margin 5%


Operating leverage

2020 2021

Revenue 10,000

Growth XXXXXXX 20%

Fixed costs 500

Variable costs 9,000

Op Profit 500

Operating Margin 5%


Operating leverage

2020 2021

Revenue 10,000 8,000

Growth XXXXXXX -20%

Fixed costs 500 500

Variable costs 9,000 7,200

Op Profit 500 300

Operating Margin 5% 4%


Sales & Earnings

• What happens in a recession to a procyclical business

– Sales?

– Earnings?

– Operating Cash Flow?


McDonald’s [other operating and non operating]

176


McDonald’s

177


McDonald’s

178


Avon 2005

179

Income statement Reported 1 2 3 4 5 Recurring1 Sales 8,150 8,150 2 COGS (3,134) 8 (3,125)

3 Selling, general, and administrative costs (3,867) 48 (1) (3,820)

4 Other operating expenses 0 5 Other operating expenses 0 6 Other operating expenses 0 7 Operating Profit 1,149 57 0 0 0 (1) 1,205 8 Interest income 37 37

9 Other non-operating income (expense) (8) (3) 9 (3) (4)

12 EBIT 1,178 57 (3) 9 (3) (1) 1,238


Avon 2008

180

2008 Income statement Reported 1 2 3 Recurring1 Sales 10,690 10,690 2 COGS (3,949) 3 (13) (3,959)

3 Selling, general, and administrative costs (5,402) 58 (5,344)

6 Other operating expenses 0 7 Operating Profit 1,339 61 (13) 0 1,387 8 Interest income 37 37

9 Other non-operating income (expense) (38) (38)

12 EBIT 1,339 61 (13) 0 1,386


Avon 2014

181

2014 Income statement Reported 1 2 3 4 5 6 Recurring1 Sales 8,851 (85) 8,766 2 COGS (3,499) 116 (3,383)

3 Selling, general, and administrative costs (4,952) 21 114 46 36 (4,734)

4 Other operating expenses 0 5 Other operating expenses 0 6 Other operating expenses 0 7 Operating Profit 400 137 114 46 36 (85) 0 649 8 Interest income 15 15

9 Other non-operating income (expense) (140) 54 (86)

12 EBIT 275 137 114 46 36 (85) 54 578


Avon

2005 CS 2008 CS 2014 CS

Revenue

Operating Profit

EBIT

Depreciation 107 142 141 Amortization 33 45 51 Stock Based Compensation 0 55 39 Operating EBITDA

EBITDA

182


Avon

183

2014 2013 2012 2011 2010 2009 2008 2007 2006 2005 2004Revenue 8,766 9,926 10,717 11,292 10,863 10,205 10,690 9,939 8,764 8,150 7,748 Gross Profit 5,383 6,194 6,546 7,154 6,831 6,386 6,731 6,186 5,429 5,024 4,815 Operating Profit 649 762 693 1,158 1,233 1,177 1,387 1,219 1,093 1,205 1,226 Operating EBITDA 880 1,030 963 1,434 1,486 1,412 1,629 1,453 1,315 1,344 1,360 Funds Flow 513 722 587 1,106 1,008 1,026 1,165 1,113 1,034 1,045 1,001 Gross Profit Margin 61.4% 62.4% 61.1% 63.4% 62.9% 62.6% 63.0% 62.2% 61.9% 61.7% 62.2%Operating Profit Margin 7.4% 7.7% 6.5% 10.3% 11.4% 11.5% 13.0% 12.3% 12.5% 14.8% 15.8%EBITDA margin 10.0% 10.4% 9.0% 12.7% 13.7% 13.8% 15.2% 14.6% 15.0% 16.5% 17.5%NI for common equity owners 278 450 312 825 751 788 923 877


Avon

184

2014 2013 2012 2011 2010 2009 2008 2007Operating Assets 4,479 5,319 5,998 6,255 6,483 5,323 4,717 4,609 Net Operating Assets 1,888 2,675 3,044 3,414 3,419 2,275 1,805 1,702 Equity 290 1,128 1,217 1,570 1,657 1,273 675 712 Return on Operating Assets 14.5% 14.3% 11.5% 18.5% 19.0% 22.1% 29.4% 26.4%Return on Invested Capital 22.3% 18.5% 14.8% 22.0% 23.4% 33.6% 49.9% 46.5%ROCE 96.0% 39.9% 25.6% 52.5% 45.3% 61.9% 136.7% 123.2%Revenue/Op Assets 1.96 1.87 1.79 1.81 1.68 1.92 2.27 2.16Revenue/IC 4.64 3.71 3.52 3.31 3.18 4.49 5.92 5.84Supplier Financing 2590.5 2644.1 2953.3 2841.4 3064.7 3048.6 2911.5 2907.2

Change in revenue -11.7% -7.4% -5.1% 3.9% 6.4% -4.5% 7.6% 13.4%Change in operating profit -14.9% 10.0% -40.2% -6.1% 4.8% -15.2% 13.8% 11.6%change in operating assets -15.8% -11.3% -4.1% -3.5% 21.8% 12.9% 2.3%Change in Invested Capital -29.4% -12.1% -10.8% -0.1% 50.3% 26.0% 6.1%

Supplier Financing/Operating Assets 58% 50% 49% 45% 47% 57% 62% 63%


Avon Segments

185

2014 2013 2012 2011 2010CS OPM CS OPM CS OPM CS OPM CS OPM

Latin America 47.4% 8.6% 48.6% 11.1% 46.6% 9.3% 45.7% 12.3% 42.7% 15.4% North America 13.7% (1.4%) 14.6% (3.3%) 17.8% 1.3% 18.3% 4.8% 20.2% 8.6% Europe 30.9% 12.0% 29.1% 14.6% 27.2% 11.1% 13.7% 12.1% 13.5% 12.2% Central, Eastern 14.0% 18.8% 14.6% 19.1% Asia 8.0% 4.3% 7.6% 4.6% 8.4% 7.5% 8.3% 8.6% 9.0% 8.4% China

2009 2008 2007 2006 2005CS OPM CS OPM CS OPM CS OPM CS OPM

Latin America 40.2% 16.6% 36.3% 17.8% 33.2% 16.0% 31.3% 18.1% 27.9% 22.7% North America 22.5% 6.6% 23.3% 9.0% 26.4% 11.8% 29.1% 10.9% 30.8% 14.1%Europe 12.5% 9.0% 12.6% 10.2% 13.2% 12.7% 12.8% 5.6% 28.1% 21.2%

Central, Eastern 14.7% 18.3% 16.1% 20.3% 15.9% 20.0% 15.1% 23.6% Asia 10.1% 9.9% 8.3% 11.7% 8.6% 11.4% 9.3% 8.6% 13.2% 13.2% China 3.3% 5.0% 2.8% 1.2% 2.4% (4.1%)


Operating Profit Margins

186

2014 2013 2012 2011 2010 2009 2008 2007 2006 2005 2004Nu Skin 13.7% 17.4% 15.7% 13.4% 14.1% 11.8% 10.3% 10.7% 11.0% 11.4% 11.5%Estee Lauder 16.7% 14.9% 13.5% 12.4% 10.1% 5.7% 10.3% 10.7% 11.0% 11.4% 11.4%PG Beauty 18.1% 16.1% 15.7% 17.1% 18.8% 18.9%Revlon 11.1% 15.1% 14.7% 14.7% 15.1% 14.8% 10.9% 9.1% -1.9% 5.0% 7.3%L'Oreal 16.7% 16.6% 16.5% 15.2% 15.7% 14.8% 15.5% 16.5% 16.1% 15.6% 15.3%Tupperware 14.4% 12.1% 11.9% 14.8% 14.8% 13.6% 11.3% 10.2% 8.4% 8.4% 8.4%

Colgate Palmolive 22.4% 24.1% 23.5% 23.0% 22.4% 23.6% 19.8% 19.2% 17.7% 19.4% 20.4%Clorox 17.4% 16.9% 16.5% 17.2% 18.6% 17.7% 16.8% 17.9% 16.8% 18.7% 18.8%Kimberly Clark 16.1% 14.5% 12.8% 11.7% 14.0% 14.8% 13.4% 14.3% 12.7% 17.4% 17.0%

Mean 16.3% 16.4% 15.6% 15.5% 16.0% 15.1% 13.5% 13.6% 11.5% 13.4% 13.8%Median 16.7% 16.1% 15.7% 14.8% 15.1% 14.8% 12.4% 12.5% 11.9% 13.5% 13.4%

Standard Deviation 3.2% 3.3% 3.4% 3.4% 3.5% 4.9% 3.5% 3.9% 6.3% 5.2% 4.8%


A typical income statement

Sales Revenue 10,000

Cost of Sales (6,000)

Selling and General Expenses (2,000)

SUBTOTAL

Depreciation (400)

Amortization (60)

Stock Based Compensation (40)

SUBTOTAL

Interest Expense (500)

Earnings Before Tax 1,000

Tax Expense (350)

Net Income 650


Profitability Ratios

• Sales Growth– Increase in sales from one year to the next

• Margin– Income statement amount related to sales

• Gross Profit Margin– Gross margin is the “value added" provided by the firm.

• [Revenues - Cost of Sales]• Operating Profit Margin

– An indication of the firm's true profitability. – This is considered one of the purest measure of the operating performance of the company, reflective of its recurring capabilities.

• [Revenues - Cost of Sales-Selling, Gen and Administrative Costs]• EBITDA [Earnings Before Interest, Tax and Depreciation and Amortization Expenses]

– Same as Operating Profit, but before depreciation and amortization expenses.• Total Asset Turnover [Sales/Assets]

– A measure of the amount of business [revenue] relative to assets• Return on Assets [this must be unleveraged] [RROOA]

– This is a measure of the profit relative to the firm’s assets • Operating Profit/Operating Assets

• Return on Invested Capital[this must be unleveraged]– This is a measure of the profit relative to the firm’s assets, financed by capital

• Net Operating Profit after tax/net Operating Assets• Return on Common stockholder's Equity

– This is a measure of the return on owner's investment in the firm. • NI to Common Owner /Common Equity


Profitability Measures

Sales

Sales Growth

Gross Profit Margin

Operating Profit Margin

EBITDA

Total Asset Turnover

Return on operating assets

Return on Invested CapitalReturn on equity


Common Size [OPM in 2014 11.8% and 12.3% in 2019]

Operating EBITDA margins

1995 2000 2005 2006 2007 2008 2009 2010 2011 2014 2019

18.2% 18.0% 17.8% 18.1% 18.4% 18.9% 16.2% 19.0% 18.9% 18.1% 18.4%


Cash Flows

191


Net IncomeDepreciationAmortization

Chg in WC needChg in Acc RecChg in InventoryChg in PrepaidsChg in Acc PayChg in AccrualsChg in Tax Payable

Cash Flow from Operations


Sales Growth [10%]

192

2019 2020revenue 10,000EBITDA 1,000Funds Flow 600CFO

2019 2020

acc receivables 1,000inventory 800prepaids 100

acc payables 800accruals 900tax payable 150

Non cash WC [WCR]


Sales Growth [10%]

193

2019 2020revenue 10,000EBITDA 500Funds Flow 300CFO

2019 2020



Non cash WC [WCR]


Sales Growth [1%]

194

2019 2020revenue 10,000EBITDA 500Funds Flow 300CFO

2019 2020



Non cash WC [WCR]


Financial Market Fundamental

• Industry Cycles• Interest Rates• Currencies• Business Key Success Factors

195


Economies grow unevenly

196

-2.0%

-1.0%

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

7.0%

8.0%

1977197819791980198119821983198419851986198719881989199019911992199319941995199619971998199920002001200220032004200520062007200820092010201120122013201420152016

Change in GDP Recession

1977-2016 average


Business Response to Economy

Expansion Recession RecoveryStrong CreditGrowth

Credit DriesUp

Credit Begins to Grow

Sales Grow Sales Declines

Sales Improve

Business Profits Improve

BusinessProfits Declines

BusinessProfits Improve

197


Business Response to Economy [Share Prices]

Expansion Recession RecoveryFinancials Negative Positive

ConsumerDiscretionary

Positive

Technology Negative Positive

Industrials Negative Positive

Health Care Positive

Energy Positive

Utilities Positive Negative

198


Interest Rates

• Interest reflects the cost [payment] to a lender for extending a loan• Interest rates vary according to:

– the government's directives to the central bank to accomplish the government's goals [monetary policy]

– the currency of the borrowing– the term to maturity of the borrowing

• Longer term generally correlates to higher rates– the probability of default [PoD] of the borrower

• The higher the probability, the higher the interest rate

199


What is a Bond?

• A bond is an instrument that represents a debt owed to the investor by the issuer. • Most commonly, bonds pay interest periodically (usually semiannually) and then return

the principal at maturity.• Bond values are discussed in one of two ways:

– The dollar price– The yield to maturity

• These two methods are equivalent since a price implies a yield– and vice-versa

200


Important Terms

• Face Value: amount of money that bond issuer borrows; bonds are usually issued with a face value of $1,000

– also known as par value or principal amount• Coupon Rate: periodic rate on a bond the issuer promises to pay the bondholder at

regular intervals until maturity (usually on a semi-annual basis)– coupon payments are calculated as an annual percentage of face value– coupon rate does not equal the yield

• When the bond/note trades at a premium or discount to the face

201


Important Terms

• Maturity Date: date when the face value of the bond becomes payable to the bondholder.

• Yield: The annual rate of return on the note/bond, expressed as a percentage.

• The coupon rate of a bond is the stated rate of interest that the bond will pay

• The coupon rate does not normally change during the life of the bond [fixed rate instruments], instead the price of the bond changes as the coupon rate becomes more or less attractive relative to other interest rates

202

http://www.investorwords.com/4037/rate_of_return.html


Bond Prices

• Bond prices vary inversely with yields• The longer the term to maturity, the larger the change in price for a

given change in yield• The lower the coupon, the larger the percentage change in price for a

given change in yield

203


Risk and Return

• In TVM, we discount future cash flows.– Assume that ExxonMobil [AA+ rated] and Manitowic [BB- rated] both have

10 year Notes outstanding • with a face amount of $1 billion. • Both bonds have coupons of 5% p.a.

• Are the present values of these two bonds identical?

204


Risk and Ratings

205


Treasury Securities

• A Treasury security is a promissory note issued by the U.S. government. • Treasury securities are considered “default Risk Free”• We use the yield on government debt as the Risk Free Return.

206


Risk and Return

• The price of a bond/note is the present value of the bonds cash flow– Discounted at a rate– The discount rate must include risk.

• Risk is the degree of certainty or uncertainty as to the realization of expected cash flows

• The discount rate is a sum of two factors: – A risk-free rate– A premium for risk

• Discount rate is also called:– the required rate of return – the total rate of return

207


Corporate Debt

• Corporate borrowing is not default risk-free• Rating agencies (Moody’s , S&P, Fitch) rate the bonds according to the

borrower’s ability to repay the loan• Banks also rate [risk ratings] their clients• Investment grade debt is judged to have adequate capacity to repay the

interest and the principal;• Non-investment grade debt is judged to be speculative; ability to repay the

interest and the principal is problematic• A company’s cost of debt is the yield on that firm’s (or its comparable’s) debt

• The determinants of a bond’s yield are:– Risk-free rate of return (Rf): the medium-term (ie, 10-year) US gov’t bond

rate– Credit spread: the incremental return required by investors to

compensate for the credit (default) risk of the bond

208


Risk, Ratings and Spreads

• These are representative historic spreads over Treasuries based upon Credit Ratings: AAA/Aaa 80 bp

AA/Aa 130 bp

A/A 160 bp

BBB/Baa 210 bp

BB/Ba 320 bp

209


Higher interest rates are generally viewed as bad for the stock market.

Investor Marty Zweig popularized the the Wall Street adage '3 Steps and a Stumble, the tendency of stocks to sell off after the 3rd Fed rate hike in the cycle. The only exception was in 2004, when stocks rallied for another three years before the Great Recession. The S&P 500 has endured significantly below average results from 1 to 12 months after 3rd rate hikes since 1955.

The effect of a interest rate tightening policy is different for various sectors. For banks, higher rates generally mean they are compensated more for lending. But for companies that make consumer discretionary goods, or things that aren't essential, higher borrowing costs imply that shoppers' spending habits may be reined in.

Interest Rates and Stock Market


The factors that influence currency exchange rates include inflation, interest rates, trade balance and investor confidence [political concerns]level of debt

An exceptions to this are in countries with pegged currency--currency that is artificially kept at the same value as the other currency.

Usually, this currency is a dollar or a euro. While this gives the currency a measure of stability in the short run, it has the potential to create financial strain in the long run as government keeps using its funds to keep the value pegged without getting any returns.

Currencies


Inflation, the presence of inflation will cause the value of the currency to go down compared to the currencies of other countries with less inflation

Interest rates, generally, higher interest rates have led to demand for that currency, increasing the price [value], relative to other currencies.

Trade balance, When a country exports more than it imports, the demand for its currency will be higher. By the same token, if the country imports more than it exports, the demand for its currency is lower, with a loss in the value of the currency.

Investor confidence [political concerns], When investors are not confident, they won't buy as much currency, and the demand will go down as will the exchange rate, relative to other currencies

High levels of debt, which often leads to higher inflation rates and may ultimately trigger an devaluation of a country's currency.

Currencies [drivers]


Accounting for Foreign Operations

•When a company engages in foreign operations, the accounting system must deal with the effects of changing foreign currency exchange rates. .

– There are currencies that are considered:1. The Reporting Currency2. The Functional Currency

• The Reporting Currency – This is the currency in which the ultimate financial statements are written. For U.S. companies, the reporting currency is the U.S. dollar.

• The Functional Currency – This is the currency in which the results of a foreign subsidiary are measured. The functional currency of each foreign subsidiary is based upon its operation environment. It should be chosen to reflect that currency in which the foreign subsidiary carries on most of its transactions.

© Barry M Frohlinger, Inc. copyright 1981 – 2017 Use of these materials are protected by copyright law214

Translation• Converting financial transactions from the functional currency into the

reporting currency is called translation. See the income statement below of a subsidiary of a US firm operating in Europe [i.e. Coca Cola Europe]. Revenue and profit increase in 2016 in Euro terms but falls in US Dollar term, and then reverse in 2017. The key is the dollar/Euro exchamge rate.


F/X Exposure - Sales

215

0%10%20%30%40%50%60%70%

Techn

ology

Materia

ls

Energy

Indus

trials

Financ

ials

Teleco

m


Key Success Factor

• Prior to the Analysis of a firm, it is critical to analyze the business/industry key success factor[s].

• The KSFs are the critical factors in the industry’s economic performance.

216


KSF

Pharma R&D Regulatory Environment

Automobile Manufacture Dealer Network ProductionEfficiency

R&D

Soft Drink Production Brand Loyalty Size Global Expansion

Apparel Industry Design Low CostManufacturing

Utilities Regulation

Fast Food Price Speed Location

217


Market Metrics, Valuations

• Market Capitalization– Calculations

• Market Multiples– P/E– Price/Book– Growth and Value Stocks– 52 week high and low

• Equity Valuation– Volatility, Correlations, Beta, Cost of Equity

218


Finance

• A firm’s financing choice is called its capital structure. • This generally consists of:

– Debt– Equity

• A firm’s capital structure decision should achieve the following:– Reduce financing costs– Maintain adequate liquidity

219


Fundamental Valuation Issue

• Remember:– Every asset is financed – The financing choices are found on the right side of the balance sheet.

• The financing of assets is generally divided into three subsets:– Operating Payables– Debt– Equity

• The Debt and Equity comprise the capital [or capitalization] of the firm. • The cost of debt and the cost of equity are critical.

220


Valuation

Many decisions are based on some valuation amount and management decisions effect the firm’s valuation. The applications of valuation analysis includes:

Debt financing: [how much debt can the business support]Acquisitions [how much should management pay for assets or a company?]Divestitures [how much could we sell our company or business for?]Fairness Opinion [is the price offered for the company fair, or the price determined for a

buy-sell arrangement]


Summary of Valuation Techniques

• Market Capitalization

• The mechanics for performing a market survey is to add up the market value of all the capital for the firm [net of cash]

– all debt and equity – and compare this to the valuation amounts as performed under the alternative methods.

• This is useful for those publicly traded firms


Market Capitalizations, Tevaand Amdocs

Book Value, Teva[millions]

Market Value Book Value,Amdocs [thousands]

Market Value

Cash 6,946 1,354,012Debt 9,968 220,000Common Equity

29,769 3,406,842

Non ControllingInterests

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Number of Shares Outstanding

1016-108=908

151,150

Share Price $65.64 [Dec 31 2015]

$54.57 [December 31, 2015 223


Key Finance Issue

• Lenders and Shareholders take risks in providing financing [capital] to the firm

• Therefore:– Debt has a cost

• Lenders demand to earn a return– Equity has a cost

• Shareholders demand to earn a return

• The weighted average cost of debt and cost of equity is referred to as the Weighted Average Cost of Capital or the WACC

• The WACC is the rate that a company is expected to pay, on average, to all its capital providers to finance its assets

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WACC

• Assume that:

– Goodyear Tire’s bonds [debt] trade at YTM of 10.3% [pretax yield, cost]

– Goodyear’s cost of equity is 13%

– Goodyear’s is financed by 55% debt and 45% equity [market values]

• The WACC for Goodyear is

Cost of Debt Tax Rate Cost of Equity WACC

Cost 10.30% 35% 13%% in Capital 55% 45%

After tax cost 6.70% 13.00%Contribution to WACC 3.68% 5.85% 9.53%

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Valuation

•There are numerous techniques for performing valuation analysis including:– Comparative Company Analysis [relative]

• Similar publicly traded companies– Comparative Transaction Analysis

• Prices paid in recent transactions in similar or related industries– Income Approach [Discounted Cash Flow]

• Present Value of the firms “cash flows”– Sum of the Parts– Market Capitalization– Cost Approach

• Based upon balance sheet• May be applicable for firms where off balance sheet intangibles are not

significant

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Summary of Valuation Techniques

• Comparable Company Analysis– The mechanics for performing comparable company valuation is to

find comparable companies [peers] and – calculate the multiple of valuation to earnings [or valuation to some

other accounting number] for those comparable companies – and then apply that multiple to the firm under analysis

• typically a multiple of EBITDA or it could be EBIT• EBITDA or EBIT should be the projected results [one year

forward]– As Comparable Company Analysis is relative,

• it is key to find the appropriate peers


Market Approach to Valuation

– Comparative Company Analysis [relative]• Establishes a benchmark for the value of a non-controlling stake in a firm based upon

similar businesses– Comparative Transaction Analysis

• Establishes a benchmark for the value of a controlling stake in a firm based upon implied valuations of Comparative Transactions where the targets are similar businesses

– There are two inputs• Valuation Multiple• Detectable Value

– Examples of Detectable Values are:• EBITDA or EBIT or Revenue

– Examples of Multiples are:• Enterprise Value/Revenue• Enterprise Value/EBITDA• Enterprise Value/EBIT• Price/Earnings• Price/Book Equity

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Relative Valuation

• When using a measure like EBITDA to derive value, the value we derive is the value of the firm

– Called Enterprise Value.– This is the value of the entire firm, or the value of the net operating assets or the

market value of the firms equity plus debt net of cash

• When using a measure such as Price/Earnings, the value we derive is the value of the equity [or the firms net assets].

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Pepsi

230

Pepsi Valuation

DCF [1] $94,819

DCF [2] $108,394

EBITDA 12,371 multiple 8.55EV 105,772

We calculated Enterprise Value of Pepsi by the DCF and derived a value of $94,819 or $108,394, depending on how we calculate the Terminal Value [either by growing perpetuity or exit at a multiple of EBITDA]

Alternatively, Pepsi has a current EBITDA of 12,371 and the peers have a multiple of 8.55X; this relative value of $105,772


Performance, 2015 MSFT Apple

Cash 108,579 205,666


Total Assets 176,223 290,479

Suppliers 60,848 106,662

Lenders 35,292 64,462

Equity 80,083 119,355

Revenue 93,580 233,715

Operating Profit 28,161 71,230

NOPAT 18,305 46,300

Book Invested Capital [book value of equity plus book value of debt less cash]

6,796 -21,849

Enterprise Value [market value of equity plus market value of debt less cash]

340,000 553,000


Peers, Relative Analysis, the Key is finding the right comparable firms• Operational Characteristics

– Industry– Maturity– Products & Distribution Channel– Markets & Customers Served– Seasonality– Cyclicality– Strategy

• Financial Characteristics– Size– Leverage– Growth Prospects – Margins – Dividend Policy

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P/E

The Price/Earnings Ratio looks at the relationship between the stock price and the company’s earnings per share.The P/E ratio is calculated by taking the share price and dividing it by the company’s EPS.For example, a company with a share price of $40 and an EPS of $5 would have a P/E of 8 times ($40 / $5 = 8).What does P/E tell you?

The P/E gives you an idea of what the market will pay today for the company’s earnings [which will continue into the future]The higher the P/E the more the market will pay for the firms earnings. Some investors read a high P/E as an overpriced stock. That may be the case. But it can also indicate the market has hopes for this stock’s future performance.

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P/E

• A low P/E may indicate a “vote of no confidence” by the market ... or it could mean this is a sleeper that the market has overlooked. Known as value stocks, many investors made their fortunes spotting these “diamonds in the rough” before the rest of the market discovered their true worth.

• What is the “right” P/E? The answer depends on your willingness to pay for earnings. The more you are willing to pay--which means you believe the company has good long term prospects over and above its current position--the higher the “right” P/E is for that particular stock in your decision-making process. Another investor may not see the same value and think your “right” P/E is all wrong.

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Market Cap Current Current LTM [TTM] LTM [TTM] Projected Projected

Total Debt Equity EV Revenue EBITDA Revenue EBITDA Revenue EBITDAFirm A 415 566 981 566 155 580 161 587 170Firm B 877 2117 2994 1477 422 1489 431 1506 444Firm C 888 765 1653 981 255 999 261 1006 268Firm D 902 2456 3358 1765 511 1804 522 1822 533Firm E 166 790 956 543 141 559 144 572 147Firm F 692 3111 3803 1876 509 1900 521 1922 529Firm G 1,155 4,670 5825 3055 790 3099 802 3111 811

Comparative Company Analysis

EV EV EV EV EV EVCurrent Revenue

TTMRevenue

Projected Revenue

Current EBITDA TTM EBITDA

Projected EBITDA

1.73 1.69 1.67 6.33 6.09 5.772.03 2.01 1.99 7.09 6.95 6.741.69 1.65 1.64 6.48 6.33 6.171.90 1.86 1.84 6.57 6.43 6.301.76 1.71 1.67 6.78 6.64 6.502.03 2.00 1.98 7.47 7.30 7.191.91 1.88 1.87 7.37 7.26 7.18


EV EV EV EV EV EVCurrentRevenue

TTM Revenue

Projected Revenue

CurrentEBITDA TTM EBITDA

Projected EBITDA

1.73 1.69 1.67 6.33 6.09 5.772.03 2.01 1.99 7.09 6.95 6.741.69 1.65 1.64 6.48 6.33 6.171.90 1.86 1.84 6.57 6.43 6.301.76 1.71 1.67 6.78 6.64 6.502.03 2.00 1.98 7.47 7.30 7.191.91 1.88 1.87 7.37 7.26 7.18

high 2.03 2.01 1.99 7.47 7.30 7.19median 1.90 1.86 1.84 6.78 6.64 6.50mean 1.86 1.83 1.81 6.87 6.72 6.55low 1.69 1.65 1.64 6.33 6.09 5.77



low High Low HighCurrent Revenue 903 1.86 1.90 1,682 1,718 Current EBITDA 205 6.78 6.87 1,390 1,409

LTM FY Revenue 917 1.83 1.86 1,678 1,707 LTM FY EBITDA 211 6.64 6.72 1,401 1,417

Projected Revenue 933 1.81 1.84 1,688 1,720 Projected EBITDA 219 6.50 6.55 1,424 1,435

Implied Range 1,544 1,567



Comparative Transactions

The value of a controlling interest based upon acquisition price

TTM TTM Multiple Multiple

Deal Size Revenue EBITDA TTM revenue TTM EBITDAFirm A 144 86 15.9 1.67 9.06Firm B 420 266 45.7 1.58 9.19Firm C 80 68 8.9 1.18 8.99

High 1.67 9.19Median 1.58 9.06Mean 1.48 9.08Low 1.18 8.99

Low HighSales 90 1.48 1.58 EBITDA 11.8 9.06 9.08

133 142 107 107

Implied Value 120 125

Accounting, Analysis and Valuation Fundamentals

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