CH 19 Financial Statement Analysis
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Framework of Analysis
Fundamental Analysis– Research to predict stock value that focuses on such
determinants as earnings and dividends prospects, expectations for future interest rates, and risk evaluation of the firm
Top-down approach (“Three-Step” Valuation Approach– Domestic and global economic analysis– Industry analysis– Company analysis
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Investment Process
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FINANCIAL STATEMENT ANALYSIS
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Financial Statement Analysis
Financial statement analysis can be used to discover mispriced securities.
Financial accounting data are widely available, but– Accounting earnings and economic earnings
are not always the same thing!
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Financial Statements
Income Statement: – Profitability over time
Balance Sheet: – Financial condition at a point in time
Statement of Cash Flows: – Tracks the cash implications of
transactions.
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Accounting Versus Economic Earnings
Economic earnings– Sustainable cash flow that can be paid
to stockholders without impairing productive capacity of the firm
Accounting earnings– Affected by conventions regarding the
valuation of assetsExample: LIFO vs. FIFO
Depreciation expense
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Consolidated Statement of Income for Home Depot, 2012
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Consolidated Balance Sheet for Home Depot, 2012
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Statement of Cash Flows for Home Depot, 2012
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Measuring Firm Performance
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Measuring Firm Performance
Manager responsibilities:– 1. Investment decisions– 2. Financing decisions
Ratios used to show efficiency and profitability of these decisions:– ROA- income earned per dollar deployed– ROC- income earned per dollar invested (long term)– ROE net income realized by shareholders per dollar
invested
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Profitability Measures
ROE measures profitability for contributors of equity capital.–After-tax profit/book value of equity
ROA measures profitability for all contributors of capital.–EBIT/total assets
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Past vs. Future ROE
ROE is a key determinant of earnings growth.– Firm’s growth rate = ROE x Retention Ratio
Past profitability does not guarantee future profitability.– Security values are based on future profits.– Expectations of future dividends determine today’s
stock value.
ROA and ROE are linked, but their relationship is affected by the firm’s financial policies.– One should pay attention the firm’s debt-equity mix and
to the interest rate on its debt.
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Financial Leverage and ROE
ROE can differ from ROA because of leverage.
Leverage makes ROE more volatile.
Let t = tax rate and r = interest rate, then:
Equity
DebtROAROA1ROE rt
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Financial Leverage and ROE, cont’d
If there is no debt or ROA = r, ROE will simply equal ROA(1 - t).
If ROA > r, the firm earns more than it pays out to creditors and ROE increases.
If ROA < r, ROE will decline as a function of the debt-to-equity ratio.
Equity
DebtROAROA1ROE rt
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Impact of Financial Leverage on ROE
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Economic Value Added
A firm should be viewed as successful only if– The return on its projects is better than the rate investors could
expect to earn for themselves (on a risk-adjusted basis) in the capital market.
EVA is the difference between return on assets (ROA) and the opportunity cost of capital (k), multiplied by the capital invested in the firm.
EVA is also called residual income
If ROA > k, value is added to the firm.
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Example: Intel
In 2012, Intel’s cost of capital was 7.8%. Its ROA was 13.9% and its capital base was $56.34 billion.
Intel’s EVA = (0.139-0.078) x $56.34 billion = $3.44
billion
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ROE = Net Profit
Pretax Profit
x
Pretax Profit
EBITx
EBIT
Sales
Sales
Assetsx x
Assets
Equity
(1) x (2) x (3) x (4) x (5)
x Margin x Turnover x Leverage Tax
Burden
Interest
Burden
Ratio Analysis:Decomposition of ROE
DuPont Method
x
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Decomposition of ROA
ROA = EBIT/Sales X Sales/Assets
= margin X turnover
Margin and turnover are unaffected by leverage.
ROA reflects soundness of firm’s operations, regardless of how they are financed.
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Decomposition of ROE
ROE
=Tax burden X ROA X Compound leverage factor
Tax burden is not affected by leverage.
Compound leverage factor= Interest burden X Leverage
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Ratio Decomposition Analysis for Nodett and Somdett
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Choosing a Benchmark
Compare the company’s ratios across time.– Time-series analysis
Compare ratios of firms in the same industry.– Peer group analysis
Cross-industry comparisons can be misleading.
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Time-Series Analysis
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Op Income / Sales for Enron
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1984 1986 1988 1990 1992 1994 1996 1998 2000
Time-Series Analysis
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Saxton IndustryCompany Average Conclusion
A. Profitability1. Profit Margin ……………… 5.0% 6.7% Below average2. Return on Assets ………….. 12.5% 10.0% Above
average due to high turnover
3. Return on Equity ………….. 20.0% 15.0% Good
B. Asset Utilization4. Receivables turnover ……. 11.4 10.0 Good5. Average collection period…. 32.0 36.0 Good6. Inventory turnover ………... 10.8 7.0 Good7. Fixed asset turnover ………. 5.0 5.4 Below
average8. Total asset turnover ………. 2.5 1.5 Good
C. Liquidity9. Current ratio ……………… 2.67 2.1 Good10. Quick Ratio ……………….. 1.43 1.0 Good
D. Debt Utilization11. Debt to total assets ……….. 37.5% 33.0% Slightly
more debt12. Times interest earned ……. 11.0 7.0 Good
Peer Group Analysis
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Peer Group Analysis
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Peer Group Analysis
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Differences between Profit Margin and Asset Turnover across Industries
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Industry Differences
Industry Turnover-profit margin tradeoff
Industries with high turnover such as groceries retail apparel tend to have low profit margins, while industries with high margins such as utilities tend to have low turnover.
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Industry Differences
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Summary of Key Financial Ratios
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Summary of Key Financial Ratios
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Summary of Key Financial Ratios
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Summary of Key Financial Ratios
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Summary of Key Financial Ratios
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Ratio Analysis
Which ratio measures the financial or credit risk?
Which ratio measures the company’s ability to service its fixed interest payment?
Which ratio measures the company’s ability to pay off short-term obligations like notes payables and accounts payables?
Which ratio measures how well the company generates revenues and controls costs and expenses (i.e., overall operating effectiveness)?
Which ratio measures the company’s ability to deliver the shareholder’s value?
Which ratio measures the company’s market price relative to $1 of capital that was invested by shareholders?
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Accounting Differences– Inventory Valuation– Depreciation
Inflation and Interest Expense
Fair Value Accounting
Quality of Earnings
International Accounting Conventions
Comparability Problems
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International Accounting Differences
Reserves – many other countries allow more flexibility in use of reserves
Depreciation – US allows separate tax and reporting presentations
Intangibles – treatment varies widely
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Adjusted Versus Reported Price-Earnings Ratios
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The Graham Technique
Rules for stock selection:– Purchase common stocks at less than
their working-capital value.– Give no weight to plant or other fixed
assets.– Deduct all liabilities in full from assets.
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