FNCE 625 – Investment Analysis and Management

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Investments: Analysis and Management

Fourteenth Edition

Gerald R. Jensen and Charles P. Jones

Chapter 15

Company Analysis

Fundamental Analysis

Last step in top-down approach is company analysis

Goal: estimate company’s intrinsic value

Investors can use discounted cash flow approach or multiplier approach

Investors typically rely on the multiplier approach

Future profitability is most fundamental factor affecting stock prices

Accounting Aspects of Earnings

Investors should understand earnings

Various uses of the term

How E P S is determined

What it represents

Its components

Financial statements provide majority of financial information about firms

Accounting Standards

Financial Accounting Standards Board (F A S B)

Establishes Generally Accepted Accounting Principles (G A A P) in the U.S.

International Accounting Standards Board (I A S B)

Establishes International Financial Reporting Standards (I F R S)

* F A S B is working toward convergence with I F R S

Basic Financial Statements 1

Balance Sheet

Shows position at one point in time: assets, liabilities, owner’s equity

Assets

Liabilities

Retained earnings = previous earnings not paid as dividends

Investors should carefully analyze

Balance Sheet (in 000’s): Huskie Toys 1

ASSETS	2018	2019
Cash & Marketable Sec.	$41,325	$46,562
Accounts Receivable	152,976	161,025
Inventory	185,489	186,281
Total Current Assets	379,790	393,868
Gross Fixed Assets	126,974	131,271
Accumulated Depreciation	36,497	38,952
Net Fixed Assets	90,477	92,319
Total Assets	470,267	486,187

Balance Sheet (in 000’s): Huskie Toys 2

Liabilities & Equity	2018	2019
Accounts Payable	$49,761	$53,124
Accrued Expenses	59,992	61,347
Notes Payable	84,273	82,149
Total Current Liab.	194,026	196,620
Long-term Debt	110,368	92,982
Common Stock ($2 par)	6,160	6,240
Paid in Capital (PIC)	18,978	19,642
Retained Earnings	140,735	170,703
Total Liabilities & Equity	470,267	486,187

Basic Financial Statements 2

Income Statement

Sales or revenues

− Product costs

Gross profit

− Period Costs

Operating Income

− Interest

Income before tax

− Taxes

Net Income

E P S = net income/average shares outstanding

Income statement shows financial flows

Investors should pay attention to charges to earnings because of accounting changes

Income Statement (in 000’s): Huskie Toys

	2018	2019
Sales	$1,127,315	$1,339,736
COGS	676,389	803,842
Gross Profit	450,926	535,894
SG&A	259,282	301,345
EBIT	191,644	234,549
Interest Expense	89,891	92,341
EBT	101,753	142,208
Taxes	39,684	59,892
Net Income	62,069	82,316
Common Dividends	48,975	52,348
Addition to RE	13,094	29,968

The Financial Statements 1

Statement of Cash-Flows

Incorporates elements of both balance sheet and income statement

Cash from operating, investing, financing activities

Helps investors examine quality of earnings

Investors should examine write-offs

Companies may “massage” data

The Financial Statements 2

Certifying statements

Auditors do not guarantee the accuracy of earnings but only that statements are fair financial representation

Footnotes

Important for investors to examine

Provide information on accounting methods, ongoing litigation, revenue recognition, and more

Problems with Reported Earnings 1

E P S is not a precise figure that is readily comparable over time or between firms

Alternative accounting treatments used to prepare statements

Difficult to gauge the “true” performance of a company with only one method

Accountants caught between investors and management

Investors must be aware of these problems

Problems with Reported Earnings 2

F A S B’s accounting principles often result of compromises

Sarbanes-Oxley Act (S O X) passed in 2002 in response to accounting scandals

Reported earnings versus pro forma earnings

Financial standards offer flexibility in reporting items

Problems with Reported Earnings 3

Investors can

Examine 10-Ks

Read footnotes to financial statements

Obtain other opinions

Study statement of cash flows

Harder to disguise problems

Negative cash flows in mature companies signals problems

Analyzing Company Profitability 1

Return on Assets (R O A)

Measures profitability

Product of net income margin and asset turnover

Net income margin = net income/sales

Measures firm’s earning power in terms of sales

Asset turnover = sales/total assets

Measures efficiency

Shows how effectively and efficiently assets are utilized

Analyzing Company Profitability 2

Return on Equity (R O E)

Decomposed into two components to predict trends

Leverage = Total assets/Stockholders’ equity

R O E = R O A × Leverage (Equity multiplier)

R O E will be larger than R O A for typical profitable company that uses debt financing

Analyzing Company R O E & E P S

E P S

Bottom line measure of profitability

E P S = R O E × Book value per share

DuPont analysis:

N P M = Net profit margin (N I/Sales)

T A T = Total asset turnover (Sales/T A)

E M = Equity multiplier (T A/Equity)

Free Cash Flow Estimates

F C F F: cash flows to all the firm’s claimholders

F C F F = C F O – F C Inv. + interest(1 − t)

F C F E: cash flows to the firm’s common equity

F C F E = C F O – F C Inv. + Borrowings

* Where, C F O is cash flow from operations, F C Inv. is investment in fixed assets, Interest(1 − t) is interest expense times × (1 − tax rate), Borrowings is net change in debt

Estimating an Internal Growth Rate

Sustainable growth rate: rate at which company can grow from internal sources

Provides benchmark for assessing actual growth

g = (1 − Dividend payout ratio) × R O E

Estimate fluctuates considerably over time

Only reliable if company’s current R O E remains stable

What matters is future growth rate, not historical growth rate

Forecasts of E P S

Expected E P S is of the most value

Security analysts’ forecast of earnings

Consensus forecast superior to individual

Analysts often over- or underestimate earnings

Inaccurate earnings estimates can provide investors opportunities

If investors can better estimate earnings, they can profit

Earnings Surprises

Expectations affect stock prices

Difference between what investors expect and what company actually reports is important

Actual earnings > market expectation, price rises

Actual earnings < market expectation, price falls

Investors should assess both forecasts and actuals

Some companies no longer offer earnings guidance

The Earnings Game

Estimating, announcing, determining earnings has become a managed process

Company guides analysts’ expectations down

Company then likely to beat expectations

Less impact of positive earnings surprise now than in past

“Whisper forecasts”

Investors must understand the game in order to understand impact on stock prices

Using Earnings Forecasts

There appears to be a lag in stock price adjustment to earnings surprises

Investors can use revisions in analysts’ estimates

Steady upward adjustments indicate a buy signal

Steady downward adjustments indicate a sell signal

Investors should wait to purchase firms reporting bad news

Investors often look at sales growth also

Justified P/E Ratio 1

Indicates the P/E multiple justified by the firm’s fundamentals

A function of expected dividend payout ratio, required rate of return, and expected growth rate in dividends

Justified P/E Ratio 2

The higher the expected payout ratio, the higher the P/E, ceteris paribus

Higher payout → lower growth rate; however, which adversely affects the P/E

Less funds available to reinvest in business

Required return and P/E inversely related

Expected growth rate in dividend and P/E ratio directly related

The P/E Ratio

P/E ratios vary among companies

Investor expectations differ

Large spread between highest and lowest P/Es

Forward P/E

Uses estimated earnings in formula

Higher numbers indicate higher expectations

Investors often overestimate earnings growth

Investors must be increasingly concerned with effect of earnings game on P/E ratio

Justified P/B Ratio

Determinants of justified P/B:

Positively affected by higher growth, higher profitability, and lower required return (k)

The crucial relationship is R O E versus required return

Justified P/S Ratio

Where, (E0/S0) and (D0/E0) equal current net profit margin and dividend payout ratio, respectively

Determinant of P/S:

Positively affected by higher profit margin, higher growth, and lower required return

The P E G Ratio

Relates P/E ratio to earnings growth

Relating P/E ratio to growth may be better than P/E ratio alone

Only a rule of thumb

Different earnings growth rates can be used to calculate P E G ratio

Fundamental Analysis in Practice

Analysts and investors seek

Estimate of company’s earnings and P/E ratio

Determination of whether stock is under- or over-valued

Both return and risk are functions of systematic and company-unique components

Security analysis involves predicting an uncertain future

Mistakes are certain, outlooks differ by investor

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FNCE 625 – Investment Analysis and Management

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