SECURITY ANALYSISSECURITY ANALYSISLECTURE-05LECTURE-05

Instructor:Ayaz Ali Maitlo

ayazalimaitlo@gmail.com

COMPANY ANALYSIS• Income statement is basic statement for analyzing the

company performance.• The income statement is perhaps used more than any other

to assess the future of the firm, and most important is earning per share has became key figure on this statement.

• Earning power has direct impact on the price of share of the company.

• This chapter has two aims:– Using financial statement we will examine the “chemistry” of earnings. – The traditional methods applied by analysts in assessing the outlook

for Revenue, Expenses and Earnings in the firm over a forward holding period, given the economic and industry outlook.

COMPANY ANALYSIS• The various ingredients in the financial

statement can be related in such a way that the analyst is able to visualize the critical aspects of a firm’s operations that dictate the level, trend, and stability of earnings.

• The methods that will explained are– The return on investment (ROI) approach– The market-share/profit margin approach– An independent, subjective approach to the forecast

of revenues and expenses.

CHEMISTRY OF EARNINGS

• One of the most effective ways of getting “inside” earnings is to explore the financial statement for all possible explanations of a change , or lack of change, in earnings.

• Changes can be resulted from – Operations of the business

And/or– In the financing of the business

• That is changes in productivity or in the resources base.

ASSET PRODUCTIVITY AND EARNINGS

• Assets are used by management to generate revenue and net income.

• Funds are acquired from Debt & Equity modes of financing.

• Return on equity will depend upon the relationship between return on total capital and the cost of borrowed funds.– Return on Assets– Operating cycle of business

ASSET PRODUCTIVITY AND EARNINGS

• The key to overall return on funds committed to the company is– On utilization of asset base– Profit on sale

• We can say that return on assets is the product of the – Turn over of assets – Margin of profit

EARNINGS AND THE ROLE OF FINANCING Cont.

• Company acquire from two ways, they are either borrowed money or equity funds.

• Some of borrowed money is free of cost, like expense accrued, salary/tax payable etc.

• Other borrowed money, such as bank loans and bond issues, has a readily identifiable interest cost.

• Equity financing has two types of cost:– Explicit (Dividend)– Implicit (Capital Gain)

DEBT FINANCING AND EARNINGS

• Debt financing provide Leverage to common-stock holders.

• If the cost of borrowed funds is less then the return on investment, you are ahead of it.

• The productivity of funds is called Return on Assets and the cost of borrowed funds is called the Effective Interest Rate.

EQUITY FINANCING AND EARNINGS• Companies obtain equity financing from:

– Issuance of new shares and/or– Retention of Earnings

• Share can be sold on cash or can exchanges with other company.

• The effect of issuing new shares depends primarily upon the relationship on the sale price to the asset value of outstanding shares.– Asset Value per Share

EQUITY FINANCING AND EARNINGS Cont.

• Share sold on same, over and under Asset value per share.• The return on assets can be increase if share sold over the

asset value per share and vice versa. • Asset value per share can be increase by retiring existing

share. • Earnings retention provides a basic source of earnings

growth.• Corporations in general tend to payout about one-half their

earnings.– Dividend Payout Ratio– Retention Rate

EFFECTS OF TAX

• The effects of taxes on income can be accommodated in our model by making the following transformation;

EAT=(1-T)[R+(R-I)L/E]E

• The notion (1-T) is really indicating what percentage of each $1of income in available after satisfying taxing authorities.

EARNINGS AND DIVIDEND PER SHARE

• To convert EAT to a per-share basis, we need only divide it by the number of common shares outstanding:

EPS =

EPS =

Dividend per share can be calculated DPS=(1-B)(EPS)

EATNumbers of shares outstanding

(1-T)[R+(R-I)L/E]E Numbers of shares outstanding

FORECASTING VIA THE EARNINGS MODEL

• Our emphasis thus far in the presentation of the ROI method has been to view it as a device for analyzing the effects of and interaction between the return a firm earns on its assets and the manner in which it is financed.

• However, this analytical device can be used as a forecasting tool.

FORECASTING VIA THE EARNINGS MODEL Cont.

• For example, assume that a firm’s tax bracket is forecast to be 50 percent in 2004, 15 percent will be earned on its assets, and that it will pay an effective interest rate of 6 percent.

• Further assume that the firm will have $100 million Equity & $100 million of Debt in its capital structure in 2004. if we substitute these values into the model :

EAT=(1-T)[R+(R-I)L/E]E

FORECASTING VIA THE EARNINGS MODEL Cont.

• Subtract any forecast proffered dividend and divide reminder by average outstanding shares to arrive at EPS.

• To continue our example, if our firm is expected to have 3 million share outstanding and a P/E ratio of 15 in 2004 (Market Value / Earning per share) the price per share will be $60

• This can be translated by subtracting the beginning per-share price, adding dividends paid in 2004 and dividing by beginning price per share.

• If the price at the end of 2004 is $50 and no dividends are expected during 2005, then projected return on equity will be 20 percent.

MARKET SHARE/PROFIT MARGIN APPROACH

• The market-share/profit-margin approach emanated directly from the industry analysis.

• If investor has choice, he will undoubtedly select a leader rather than a follower. Thus the next logical step for the analyst is to determine what share of the industry’s total market the firm under analysis can reasonably be expected to achieve.

MARKET SHARE/PROFIT MARGIN APPROACH Cont.

• Assume that the analyst is studying and industry that produces auxiliary swimming-pool equipment.

• The industry sales for 2002 are $10 million and your company has 10 percent share of the total market.

• Forecasted increase in total industry sales is 20 percent because of more favorable economic climate. If your company assume that it will increase its market share by 12 percent due to aggressive market campaign, what will be to total Sales in dollar amount.