Basics of Financial Statements Alexander Motola, CFA Alexander Motola, 20131.

Alexander Motola, 2013 1

Basics of Financial StatementsAlexander Motola, CFA


Quality of Earnings, IntroPeople who learn more can beat

people who don’tAll earnings are not equal, hence

“Quality of Earnings”There is an extreme bias against

sell recommendations, which doesn’t make sense b/c clearly some stocks go down a lot


Quality of Earnings, Ch. 1 “Don’t Trust Your Analyst” The people that write brokerage reports

ultimately get paid via transactions; the chance you own a given stock (and they convince you to sell) is small, but there is much greater chance they can get you to buy a stock you don’t already own◦ Investment Banking fees are also a

consideration Jim Chanos (mentioned during the

chapter) subsequently became one the great investors of our time, mainly via skepticism

“Caveat Emptor” Who can you trust? Yourself…


Quality of Earnings, Ch. 1Bill Sharpe: “Without short

selling, market prices will be above consensus prices.” (pg. 4)

Sell side and buy side professional can be extremely well compensated◦Often financial careers start after

getting an MBA, where the analyst covers the industry they worked for prior to getting their degree

“Neutral” means sell, or avoid (pg. 7)


Quality of Earnings, Ch. 1“most analysts depend upon the

company as their prime source of information. Often they reheat the data and pass it on as original thinking”◦ This is mostly from earnings calls and

interviews◦ The IAC particularly would like student

analysts to think about the value and veracity of their sources

“Everybody talks to the same investor relations guy, who feeds them the same numbers.” How do you win this way?


Quality of Earnings, Ch. 1Really good (investment) ideas

are extremely hard to find◦No one gets more tips than Buffet◦He claims he’s lucky to get 1 or 2

good ideas per year◦He’s looking for new ideas constantly


Basics of the Basics“Financial Statements” generally

refers to the combination of the 3 most common statements – Balance Sheet, Income Statement, and the Statement of Cash Flows

Balance Sheet measures net worth, assets, and obligations at a single fixed point in time

Income Statement measures (effectively) your change in net worth over a period of time

SCF measures real time cash payments (like your checkbook) over a defined period of time


A Few ThoughtsWhy are you reading financial

statements?The “Author” has a vested

interestFinancial Statements are inter-

related and can provide a “checks and balances” approach

Absolute Numbers (USD $) are meaningless

Numbers can lie or mislead, just as words do


What does a Balance Sheet Look Like?(44, F&A) – “What you have”

◦Assets listed first (on the right, or top)

◦Most liquid assets first, divided in Current Assets and Long Term Assets

◦How valuable are A/R? Inventories?◦PP&E – how accurate is this? (MCD,

and future land example)◦Intangible Assets and Goodwill


What does a Balance Sheet Look Like? (44, F&A) – “What

you owe”◦ Liabilities (“the

right side”)◦ Also listed in order

of liquidity◦ What is Deferred

Revenue?◦ Debts (some are

OBS) “What’s Left”

◦ Shareholder’s Equity = Net Worth

◦ What’s Left is your Net Worth

Think of your own “Net Worth”◦ Everything you

OWN is an asset (including money owed to you, or things financed)

◦ Everything you OWE is a liability (debts, mostly; future expenses DON’T count)

◦ What’s Left is your Net Worth


Fridson & Alvarez, Ch. 2Book Value = Net Worth (A-L)Market Cap(italization) = what

the market values the entire equity of a company at (SO * MP)

Balance Sheet valuations are carried at values generated from a transaction. Does this make sense?

When those values (assets and liabilities, but mostly assets) are tested and fail, huge write downs occur. What is a “write down”?


F&A #2, Continued “Balance Sheet valuations are carried at

values generated from a transaction. Does this make sense?”

Twenty years ago, a company buys $1mm worth of land in Fukushima (Japan) and $1mm in downtown San Francisco. If they are depreciated over 20 years, they were both worth $1mm at the time they were bought (according to the books) and are now both worth $0. One of these numbers might be correct?

In this case, there would have been a small write down of the Japanese real estate (small because there wasn’t much value on the balance sheet left).


Fridson & Alvarez, Ch. 3(47) “The goal of analyzing an

income statement is essentially to determine whether the story it tells is good, bad, or indifferent”

Turn to page #48 (Exhibit 3.1)◦Is Peet’s profitable? (Did they make

money in FY09?) How do you know?Do absolute numbers matter

(USD $)?Turn to page #50-51


F&A #3, ContinuedCommon Sized Income

Statements calculate everything base on sales (revenues)

2 Most common margins used by analysts◦Gross (Profit) Margin◦Operating Margin◦Next month we will drill down on

analyzing these


F&A #3, ContinuedGross Margin

◦Costs associated with creating/providing goods and/or services

◦Marketing not usually included (except rebates)

◦Warehousing, labor for production, D, inputs, energy cost, returns, etc.

Why does SBUX have a better GM% than PEET? (see page 49)◦Do different customers pay different

prices? And have different costs to service?


F&A #3, ContinuedOperating Margin “Above the Line”

◦Operating costs include corporate overhead, R&D, SG&A, and other expenses NOT related to: production, taxes, capital structure (mostly)

◦SBUX has a way better GM, but a barely better OM than PEET – why?

◦Significant latitude in categorizing expenses, checked by auditor, and informally regulated by industry norms

Students provide expense examples


F&A, multi-statement analysis

RoE ties income statement and balance sheet together◦“Return” = net income (I/S), Equity

= Shareholder’s Equity (B/S); equity represents “paid in capital” + “retained earnings” – dividends (mostly)

◦What do you want to make on your investment?


F&A, multi-statement analysisTaxes

◦ Statutory Corporate rate is 39%◦ Median Effective Tax Rate for S&P 500

companies is 30%Tax Rate appears on Income

Statement◦ Differences between cash and accrual

(and other adjustments) appear on Balance Sheet as Assets and/or Liabilities

◦ Cash Flow Statement errata shows actual cash taxes paid (10-K only, optional otherwise)


Other Stuff from Ch#3

Economies◦Scope (pg. 63), breadth of offering

I couldn’t agree more with the comment “Analysts should be forewarned that claims of potential economies of scope often prove, in retrospect, to be exaggerated.” Does it make sense?

◦Scale (pg. 49) – “size matters” ??? Purchasing economies, advertising

leverage, R&D leverage, distribution advantages


Other Stuff from Ch#3Revenue

◦ Linearity – the shape of revenues over a quarter (how “back-end loaded” is the business model). Why does this matter?

◦ Earnings Quality (how real and sustainable are the earnings – this is a key focal point of an analyst’s job) (pg. 54) – “Often, a company’s earnings and cash flow diverge to an extent that becomes unsustainable” – what does this mean?

◦ How can a company manipulate revenue? (pgs. 54-55)


Other Stuff from Ch#3

Revenue (growth)◦This year revenue/Last year revenue

– 1◦F&A, pgs. 59-63; the chances are

very strong that your company has made or has announced a pending acquisition recently, understanding what this means is extremely relevant to your IAC presentation, understand these pages and bring questions to future sessions if something is not clear


Other Stuff from Ch#3 Revenue

◦ “Earnings drive stock prices”, how much your company grows has a lot to do with how valuable (multiple) it is/will be

◦ The amount a company exceeds or misses expectations will directly and dramatically effect stock prices

◦ Investors pay a lot for “Internal Growth” (high multiple) but very little for “External Growth” or “Manufactured Earnings” (low multiple

◦ Huge incentive for MGMT to mislead or blur the line about what’s internal and what’s external; in a few cases, it’s an impossible mystery, but many times a good analyst can determine the truth


In the MarketPandora earnings forecast disappoints, shares drop

Thu, Aug 22 2013

SAN FRANCISCO (Reuters) - Internet radio service Pandora Media Inc (P) said on Thursday that rising expenditures to acquire music and compete with rivals would push fiscal 2014 earnings below analyst expectations, and its shares slumped 5 percent.

Excluding certain items, Pandora said it expected to earn between 0 and 5 cents per share for the year. That was below the 5-cent profit expected by analysts polled by Thomson Reuters I/B/E/S.

Its shares fell 5 percent to $20.50 in extended trade.

For the second quarter ending in June, Pandora exceeded expectations, posting revenue of $162 million, a 58 percent rise, as it continued to pick up listeners. Its earnings of 4 cents also topped Wall Street expectations of 2 cents.

In an interview, Chief Executive Joe Kennedy said he felt confident the company has proven its mobile monetization strategy. But he signaled that earnings would be depressed in the near future as he pursued an aggressive investment strategy. In the past year, for instance, the company has increased its sales force by three-quarters, he said.

"We're taking the increased margin that we're getting and reallocating to invest in future growth," Kennedy said Thursday. "But everything says we're firing on all cylinders. We're still in the earliest days. We have to invest to make the most of a huge opportunity."

Pandora's shares, which fluctuated wildly for the first year after its June 2011 initial public offering, had surged to new highs in 2013. It closed on Thursday at $21.71.

(Reporting by Gerry Shih; Editing by Andre Grenon and Phil Berlowitz)


Questions?


A Day in the Life 5:00 AM – Alarm clock goes off (Mtn Time), in the car by

5:45 6:00 – at my desk, quick look at email, esp. from traders

and other internal people, parse voicemail 6:15 – on the trade desk with my team, reading market,

world, business, industry, and political news; all Street research on 80 or so companies

7:30 US Market starts trading 8:30 – start calling companies, modeling, reading

financials & transcripts 11:15 – Lunch 12:00 – more modeling, talking to the team,

management stuff 1:00 – investment presentation – 2 hours, 30 minutes

presentation followed by long and intensive Q&A session 3:00 – existing coverage, modeling, financials,

conference calls 5:30 – leave, and do it again tomorrow OTHER STUFF: internal firm mgmt. stuff, marketing,

client meetings, travel arrangement/planning, earnings calls, personnel matters (reviews), mentoring

Basics of Financial Statements Alexander Motola, CFA Alexander Motola, 20131.

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