Textbook Cases
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Chapter7.docx7 Analyzing Common Stocks
Learning Goals
After studying this chapter, you should be able to:
1. LG 1 Discuss the security analysis process, including its goals and functions.
2. LG 2 Understand the purpose and contributions of economic analysis.
3. LG 3 Describe industry analysis and note how investors use it.
4. LG 4 Demonstrate a basic appreciation of fundamental analysis and why it is used.
5. LG 5 Calculate a variety of financial ratios and describe how analysts use financial statement analysis to gauge the financial vitality of a company.
6. LG 6 Use various financial measures to assess a company’s performance, and explain how the insights derived form the basic input for the valuation process.
A March 2015 analyst report from the European investment bank, UBS, offered a pessimistic assessment of the semiconductor manufacturer, Advanced Micro Devices (AMD). The analyst report cited overall lackluster macroeconomic performance as well as political turmoil as contributors to slowing sales of AMD’s chips designed for personal computers (PCs). The report noted that sales of desktop and laptop computers had been dwindling, both in the United States and overseas, as consumers showed an increasing preference for smaller mobile devices such as smartphones and tablets. The higher cost of PCs relative to tablets was a particular deterrent to consumer purchases in emerging markets where consumers had less disposable income to buy consumer electronics goods. AMD’s problems weren’t just temporary either. A respected market research group forecasted that global PC shipments would fall from 2015 to 2019. AMD competed head-to-head with its larger rival, Intel, but the analyst’s report suggested that AMD would suffer more from declining PC sales because it focused more heavily on the consumer market, which had been cannibalized by tablets, whereas Intel’s revenues were more heavily weighted toward business customers. The report concluded by predicting that AMD’s stock would underperform the broader market, and that prediction sent the stock tumbling 5.7%.
The report issued by UBS is typical of those produced by professional securities analysts every day. In forming their recommendations to clients, stock analysts have to consider broad macroeconomic trends, industry factors, and specific attributes of individual firms. This chapter, the first of two on security analysis, introduces some of the techniques and procedures you can use to evaluate the future of the economy, of industries, and of specific companies, such as AMD or Intel.
(Source: “Advanced Micro Tumbles 5.7% on Analyst Downgrade to Sell,” March 26, 2015, http://www.zacks.com/stock/news/169063/advanced-micro-tumbles-57-on-analyst-downgrade-to-sell )
Security Analysis
1. LG 1
The obvious motivation for investing in stocks is to watch your money grow. Consider, for example, the case of Google, the hugely successful search engine and software company. If you had purchased $10,000 worth of Google stock when the company had its initial public offering (IPO) on August 19, 2004, 10 years later, in August 2014, that stock would have had a market value of $113,653. That works out to an average annual return of 27.5%; compare that with the 5.9% annual return generated over the same period by the S&P 500. Unfortunately, for every story of great success in the market, there are others that don’t end so well.
More often than not, most of those investment flops can be traced to bad timing, poor planning, or failure to use common sense in making investment decisions. Although these chapters on stock investments cannot offer magic keys to sudden wealth, they do provide sound principles for formulating a successful long-range investment program. The techniques described are proven methods that have been used by millions of successful investors.
Principles of Security Analysis
Security analysis consists of gathering information, organizing it into a logical framework, and then using the information to determine the intrinsic value of common stock. That is, given a rate of return that’s compatible with the amount of risk involved in a proposed transaction, intrinsic value provides a measure of the underlying worth of a share of stock. It provides a standard to help you judge whether a particular stock is undervalued, fairly priced, or overvalued. The entire concept of stock valuation is based on the idea that all securities possess an intrinsic value that their market value will approach over time.
In investments, the question of value centers on return. That is, a satisfactory investment is one that offers a level of expected return proportionate to the amount of risk involved. As a result, not only must an investment be profitable, but it also must be sufficiently profitable—in the sense that you’d expect it to generate a return that’s high enough to offset the perceived exposure to risk.
The problem, of course, is that returns on securities are difficult to predict. One approach is to buy whatever strikes your fancy. A more rational approach is to use security analysis to look for promising candidates. Security analysis addresses the question of what to buy by determining what a stock ought to be worth and comparing that value to the stock’s market price. Presumably, an investor will buy a stock only if its prevailing market price does not exceed its worth—its intrinsic value. Ultimately, intrinsic value depends on several factors:
1. Estimates of the stock’s future cash flows (e.g., the amount of dividends you expect to receive over the holding period and the estimated price of the stock at time of sale)
2. The discount rate used to translate those future cash flows into a present value
3. The risk associated with future performance, which helps define the appropriate discount rate
The Top-Down Approach to Security Analysis
Traditional security analysis often takes a top-down approach. It begins with economic analysis, moves to industry analysis, and then arrives at a fundamental analysis of a specific company. Economic analysis assesses the general state of the economy and its potential effects on businesses. For example, the UBS research report on Advanced Micro Devices pointed out that a weak economy caused consumers to be more price-sensitive when they shopped, so they purchased less expensive tablets or laptops rather than desktop PCs. Industry analysis deals with the industry within which a particular company operates. It looks at the overall outlook for that industry and at how companies compete in that industry. In the case of the computer chip industry, UBS noted that the increasing price sensitivity of consumers favored companies such as Intel, which focused more on business customers than general consumers. Fundamental analysis looks at the financial condition and operating results of a specific company. The fundamentals include the company’s investment decisions, the liquidity of its assets, its use of debt, its profit margins, and its earnings growth. In its fundamental analysis of AMD, the UBS report highlighted AMD’s excessive inventory, but it also noted that the company was trying to design new custom chips for customers that Intel did not serve. Once an analyst, or an investor, has synthesized all of the information from the economic, industry, and fundamental analyses, the analyst uses that information to estimate the intrinsic value of a company’s stock and then compares that intrinsic value to the actual market value of the stock. When the intrinsic value is greater than the market price, an analyst will recommend that clients purchase the stock, and when the opposite is true, the analyst may issue a recommendation to sell. If the market price and intrinsic value are approximately the same, the analyst may issue a “neutral” or “hold” recommendation. In the case of AMD, the UBS report suggested that AMD’s intrinsic value was just $2.40, whereas its market price was $2.79. Hence, UBS expected the stock to underperform, and they did not recommend it to their clients.
Fundamental analysis is closely linked to the notion of intrinsic value because it provides the basis for projecting a stock’s future cash flows. A key part of this analytical process is company analysis, which takes a close look at the actual financial performance of the company. Such analysis is not meant simply to provide interesting tidbits of information about how the company has performed in the past. Rather, company analysis helps investors formulate expectations about the company’s future performance. But to understand the future prospects of the firm, investors should have a good handle on the company’s current condition and its ability to produce earnings. That’s what company analysis does. It helps investors predict the future by looking at the past and determining how well the company is situated to meet the challenges that lie ahead.
Who Needs Security Analysis in an Efficient Market?
The concept of security analysis in general, and fundamental analysis in particular, is based on the assumption that at least some investors are capable of identifying stocks whose intrinsic values differ from their market values. Fundamental analysis operates on the broad premise that some securities may be mispriced in the marketplace at least some of the time. If securities are occasionally mispriced, and if investors can identify mispriced securities, then fundamental analysis may be a worthwhile and profitable pursuit.
To many, those two premises seem reasonable. However, there are others who do not accept the assumptions of fundamental analysis. Instead, they believe that the market is so efficient in processing new information that securities trade very close to their correct values at all times and that even when securities are mispriced, it is nearly impossible for investors to determine which stocks are overvalued and which are
Famous Failures in Finance Staying on Top a Challenge for Fund Managers
Research conducted by Standard & Poor’s asked whether the performance of top mutual funds was due to the skill of fund managers or random luck. The study started with 2,862 actively managed stock mutual funds, and it selected the top 25% from that group based on their 12-month returns starting from March 2009 (the start of the latest bull market). Researchers wanted to know how many of these top-performing funds would remain in the top quartile for each of the next four years. The surprising answer was that only two funds achieved that feat, and neither of those achieved top-quartile performance in the study’s most recent year, 2015. While this study doesn’t prove that it is impossible for a fund manager to deliver market-beating performance year after year, it does seem that very few funds are able to do so.
(Source: “How Many Mutual Funds Routinely Rout the Market? Zero,” Jeff Sommer, March 14, 2015, The New York Times, http://www.nytimes.com/2015/03/15/your-money/how-many-mutual-funds-routinely-rout-the-market-zero.html?smid=nytcore-iphone-share&smprod=nytcore-iphone&_r=0 )
undervalued. Thus, they argue, it is virtually impossible to consistently outperform the market. In its strongest form, the efficient market hypothesis asserts the following:
1. Securities are rarely, if ever, substantially mispriced in the marketplace.
2. No security analysis, however detailed, is capable of consistently identifying mispriced securities with a frequency greater than that which might be expected by random chance alone.
Is the efficient market hypothesis correct? Is there a place for fundamental analysis in modern investment theory? Interestingly, most financial theorists and practitioners would answer “yes” to both questions.
The solution to this apparent paradox is quite simple. Basically, fundamental analysis is of value in the selection of alternative investments for two important reasons. First, financial markets are as efficient as they are because a large number of people and financial institutions invest a great deal of time and money analyzing the fundamentals of most widely held investments. In other words, markets tend to be efficient and securities tend to trade at or near their intrinsic values simply because a great many people have done the research to determine what their intrinsic values should be.
Second, although the financial markets are generally quite efficient, they are by no means perfectly efficient. Pricing errors are inevitable. Those individuals who have conducted the most thorough studies of the fundamentals of a given security are the most likely to profit when errors do occur. We will study the ideas and implications of efficient markets in some detail later in this text. For now, however, we will adopt the view that traditional security analysis may be useful in identifying attractive equity investments.
Concepts in Review
Answers available at http://www.pearsonhighered.com/smart
1. 7.1 Identify the three major parts of security analysis and explain why security analysis is important to the stock selection process.
2. 7.2 What is intrinsic value? How does it fit into the security analysis process?
3. 7.3 How would you describe a satisfactory investment? How does security analysis help in identifying investment candidates?
4. 7.4 Would there be any need for security analysis if we operated in an efficient market environment? Explain.
Economic Analysis
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Stock prices are heavily influenced by the state of the economy and by economic events. As a rule, stock prices tend to move up when the economy is strong, and they retreat when the economy starts to weaken. Figure 7.1 illustrates this pattern. The vertical gray bars in the figure indicate periods when the economy was in recession (i.e., when total output of the economy was shrinking rather than growing), and the blue line shows the level of the S&P 500 stock index. In general, the index falls during the early stages of a recession, and it tends to rebound sometime before the economy does (i.e., sometime before the recession ends). It’s not a perfect relationship, but it is a fairly powerful one.
The reason that the economy is so important to the market is simple. The overall performance of the economy has a significant bearing on the performance and profitability of most companies. As firms’ fortunes change with economic conditions, so do the prices of their stocks. Of course, not all stocks are affected in the same way or to the same extent. Some sectors of the economy, like food retailing, may be only mildly affected by the economy. Others, like the construction and auto industries, are often hard hit when times get rough.
Economic analysis consists of a general study of the prevailing economic environment, often on both a global and a domestic basis (although here we’ll concentrate, for the most part, on the domestic economy). Such analysis is meant to help investors gain insight into the underlying condition of the economy and the impact it might have on the behavior of share prices. It can go so far as to include a detailed examination of
Figure 7.1 The Economy and the Stock Market
The figure shows that during recessions (indicated by the vertical gray bars) the stock market tends to fall, though the stock market usually begins to rebound before the recession ends.
each sector of the economy, or it may be done on a very informal basis. However, from a security analysis perspective, its purpose is always the same: to establish a sound foundation for the valuation of common stock.
An Advisor’s Perspective
Ryan McKeown Senior VP–Financial Advisor, Wealth Enhancement Group
“If GDP is growing, it may be a more favorable time to invest in stocks.”
MyFinanceLab
Economic Analysis and the Business Cycle
Economic analysis is the first step in the top-down approach. It sets the tone for the entire security analysis process. Thus, if the economic future looks bleak, you can probably expect most stock returns to be equally dismal. If the economy looks strong, stocks should do well. The behavior of the economy is captured in the business cycle , a series of alternating contractions and expansions, which reflects changes in total economic activity over time.
Two widely followed measures of the business cycle are gross domestic product and industrial production. Gross domestic product (GDP) is the market value of all goods and services produced in a country over a given period. When economists say that the economy is in recession, this means that GDP has been contracting for at least two consecutive quarters. On the other hand, an economic expansion generally refers to a period when GDP is growing. Industrial production is an indicator of the output produced by industrial companies. Normally, GDP and the index of industrial production move up and down with the business cycle.
Key Economic Factors
The state of the economy is affected by a wide range of factors, from the consumption, saving, and investment decisions made independently by millions of households to major government policy decisions. Some of the most important factors that analysts examine when conducting a broad economic analysis include:
· Government fiscal policy
· Taxes
· Government spending
· Debt management
· Monetary policy
· Money supply
· Interest rates
· Other factors
· Inflation
· Consumer spending
· Business investments
· Foreign trade and foreign exchange rates
Government fiscal policies can influence how fast the economy grows through a variety of channels. When the government increases spending or reduces taxes, it is pursuing an expansionary fiscal policy. Examples of this type of policy are the American Recovery and Reinvestment Act of 2009, a $787 billion stimulus bill, and the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, an $858 billion stimulus bill, passed by Congress and signed by President Barack Obama. Similarly, monetary policy is said to be expansive when interest rates are relatively low and money is readily available. An expanding economy is also characterized by growing spending by consumers and businesses. These same variables moving in a reverse direction can have a contractionary (recessionary) impact on the economy, for example, when taxes and interest rates increase or when spending by consumers and businesses falls off.
The impact of these major forces filters through the system and affects several key dimensions of the economy. The most important of these are industrial production, corporate profits, retail sales, personal income, the unemployment rate, and inflation. For example, a strong economy exists when industrial production, corporate profits, retail sales, and personal income are moving up and unemployment is down.
What Is Congress UP To?
Thus, when conducting an economic analysis, investors should keep an eye on fiscal and monetary policies, consumer and business spending, and foreign trade for the impact they might have on the economy. At the same time, they must stay abreast of the level of industrial production, corporate profits, retail sales, personal income, unemployment, and inflation in order to assess the current state of the business cycle.
Table 7.1 provides a brief description of some key economic measures that would typically be part of a broad analysis of the macroeconomy. These economic statistics are compiled by various government agencies and are widely reported in the financial media. Most of the reports are released monthly. Investors and analysts invest a lot of time to carefully read about the various economic measures and reports cited in Table 7.1 . Over time, they develop an understanding of how each statistical series behaves over the business cycle and how the stock market reacts to movements in these series.
Developing an Economic Outlook
Conducting an economic analysis involves studying fiscal and monetary policies, inflationary expectations, consumer and business spending, and the state of the business cycle. Often, investors do this on a fairly informal basis. As they form their economic judgments, many rely on one or more of the popular published sources (e.g., the Wall Street Journal, Barron’s, Fortune, and Business Week) as well as on periodic reports from major brokerage houses. These sources provide a convenient summary of economic activity and give investors a general feel for the condition of the economy.
Once an investor has developed a general economic outlook, he or she can use the information in one of two ways. One approach is to use the information in the economic outlook to determine where it leads in terms of possible areas for further analysis. For example, suppose an investor uncovers information that strongly suggests the outlook for business spending is very positive. On the basis of such an analysis, the investor might look more closely at capital goods producers, such as office equipment manufacturers. Similarly, if an analyst feels that because of sweeping changes in world politics, U.S. government defense spending is likely to drop off, the analyst might guide clients to avoid the stocks of major defense contractors.
A second way to use information about the economy is to consider specific industries or companies and ask, “How will they be affected by expected developments in the economy?” Suppose that an investor has an interest in business equipment stocks. This industry category includes companies involved in the production of everything from business machines and electronic systems to work lockers and high-fashion office furnishings. This industry includes companies like Pitney Bowes, Diebold, Herman Miller, and Steelcase. These stocks are highly susceptible to changing economic conditions. That’s because when the economy starts slowing down, companies can put off purchases of durable equipment and fixtures. Especially important to this industry, therefore, is the outlook for corporate profits and business investments. As long as these economic factors look good, the prospects for business equipment stocks should be positive.
Table 7.1 Keeping Track of the Economy
|
To help you sort out the confusing array of figures that flow almost daily from Washington, DC, and keep track of what’s happening in the economy, here are some of the most important economic measures and reports to watch. · Gross domestic product (GDP). This is the broadest measure of the economy’s performance. Measured every three months by the Commerce Department, GDP is an estimate of the total dollar value of all the goods and services produced in this country. In particular, watch the annual rate of growth or decline in “real” or “constant” dollars. This number eliminates the effects of inflation and thus measures the actual volume of production. Remember, though, that frequent revisions of GDP figures sometimes change the picture of the economy. · Industrial production. Issued monthly by the Federal Reserve Board, this index shows changes in the physical output of U.S. factories, mines, and electric and gas utilities. The index tends to move in the same direction as the economy, so it is a good guide to business conditions between reports on GDP. Detailed breakdowns of the index give a reading on how individual industries are faring. · The leading economic index This boils down to one number, which summarizes the movement of a dozen statistics that tend to predict—or “lead”—changes in the GDP. This monthly index, issued by the Conference Board, includes such things as average weekly hours worked by employees of manufacturing firms, initial weekly claims for unemployment insurance, stock prices, and consumer expectations. If the index moves in the same direction for several months, it’s a fairly good sign that total output will move the same way in the near future. · Personal income. A monthly report from the Commerce Department, this shows the before-tax income received in the form of wages and salaries, interest and dividends, rents, and other payments, such as Social Security, unemployment compensation, and pensions. As a measure of individuals’ spending power, the report helps explain trends in consumer buying habits, a major part of GDP. When personal income rises, people often increase their buying. · Retail sales. The Commerce Department’s monthly estimate of total retail sales includes everything from cars to groceries. Based on a sample of retail establishments, the figure gives a rough clue to consumer attitudes. · Money supply. The amount of money in circulation as reported weekly by the Federal Reserve is known as the money supply. Actually, there are several measures of the money supply. M1, which is designed to measure the most liquid forms of money, is basically currency, demand deposits, and NOW accounts. M2, the most widely followed measure, equals M1 plus savings deposits, money market deposit accounts, and money market mutual funds. An expanding economy is generally associated with a rising money supply, although when the money supply increases too fast, inflation may result. A reduction in the money supply is often associated with recessions. · Consumer prices. Issued monthly by the Labor Department, the Consumer Price Index (CPI) shows changes in prices for a fixed market basket of goods and services. The CPI is the most widely watched indicator of inflation. · Producer prices. The Labor Department’s monthly Producer Price Index (PPI) shows price changes of goods at various stages of production, from crude materials such as raw cotton to finished goods like clothing and furniture. An upward surge may mean higher consumer prices later. However, the index can miss discounts and may exaggerate rising price trends. Watch particularly changes in the prices of finished goods. These do not fluctuate as widely as the prices of crude materials and thus are a better measure of inflationary pressures. · Employment. The percentage of the workforce that is involuntarily out of work (unemployment) is a broad indicator of economic health. But another monthly figure issued by the Labor Department—the number of payroll jobs—may be better for spotting changes in business. A decreasing number of jobs is a sign that firms are cutting production. · Housing starts. A pickup in the pace of housing starts usually follows an easing in the availability and cost of money and is an indicator of improving economic health. This monthly report from the Commerce Department also includes the number of new building permits issued across the country, an even earlier indicator of the pace of future construction. |
Assessing the Potential Impact on Share Prices
How does an economic outlook translate into a prediction about where stock prices are headed? Suppose that an investor has assessed the current state of the business cycle. Using that insight, he could then formulate some expectations about the future of the economy and the potential impact it holds for the stock market in general and business equipment stocks in particular. Table 7.2 shows how some of the more important economic variables can affect the behavior of the stock market.
To see how this might be done, let’s assume that the economy has just gone through a year-long recession and is now in the recovery stage of the business cycle: Employment
Table 7.2 Economic Variables and the Stock Market
|
Economic Variable |
Potential Effect on the Stock Market |
|
Real growth in GDP |
Positive impact—it’s good for the market. |
|
Industrial production |
Continued increases are a sign of strength, which is good for the market. |
|
Inflation |
Detrimental to stock prices when running high. High inflation leads to higher interest rates and lower price-to-earnings multiples, and generally makes equity securities less attractive. |
|
Corporate profits |
Strong corporate earnings are good for the market. |
|
Unemployment |
A downer—an increase in unemployment means business is starting to slow down. |
|
Federal budget |
Budget surpluses during strong economic times are generally positive, but modest deficits are usually not cause for alarm. Larger deficits during downturns may stimulate the market. |
|
Weak dollar |
Has a complex impact on the market. A weak dollar may increase the value of U.S. firms’ overseas earnings, while at the same time making U.S. investments less attractive to foreigners. |
|
Interest rates |
Another downer—rising rates tend to have a negative effect on the market for stocks. |
|
Money supply |
Moderate growth can have a positive impact on the economy and the market. Rapid growth, however, is inflationary and therefore detrimental to the stock market. |
is starting to pick up. Inflation and interest rates are low. Both GDP and industrial production have experienced sharp increases in the past two quarters. Also, Congress is putting the finishing touches on a major piece of legislation that will lead to reduced taxes. More important, although the economy is now in the early stages of a recovery, things are expected to get even better in the future. The economy is definitely starting to build steam, and all indications are that both corporate profits and business spending should undergo a sharp increase. All of these predictions should be good news for the producers of business equipment and office furnishings, as a good deal of their sales and an even larger portion of their profits depend on the level of corporate profits and business spending. In short, our investor sees an economy that’s in good shape and set to become even stronger—the consequences of which are favorable not only for the market but for business equipment stocks as well.
Note that these conclusions could have been reached by relying on sources such as Barron’s or Business Week. In fact, about the only “special thing” this investor would have to do is pay careful attention to those economic forces that are particularly important to the business equipment industry (e.g., corporate profits and capital spending). The economic portion of the analysis has set the stage for further evaluation by indicating the type of economic environment to expect in the near future. The next step is to narrow the focus a bit and conduct the industry phase of the analysis.
The Market as a Leading Indicator
Before we continue our analysis, it is vital to clarify the relationship that normally exists between the stock market and the economy. As we just saw, investors use the economic outlook to get a handle on the market and to identify developing industry sectors. Yet it is important to note that changes in stock prices normally occur before the actual forecasted changes become apparent in the economy. Indeed, the current trend of stock prices is frequently used to help predict the course of the economy itself.
The apparent conflict here can be resolved somewhat by noting that because of this relationship, it is even more important to derive a reliable economic outlook and to be sensitive to underlying economic changes that may mean the current outlook is becoming dated. Investors in the stock market tend to look into the future to justify the purchase or sale of stock. If their perception of the future is changing, stock prices are also likely to be changing. Therefore, watching the course of stock prices as well as the course of the general economy can make for more accurate investment forecasting.
Concepts in Review
Answers available at http://www.pearsonhighered.com/smart
1. 7.5 Describe the general concept of economic analysis. Is this type of analysis necessary, and can it really help the individual investor make a decision about a stock? Explain.
2. 7.6 Why is the business cycle so important to economic analysis? Does the business cycle have any bearing on the stock market?
3. 7.7 Briefly describe each of the following:
a. Gross domestic product
b. Leading indicators
c. Money supply
d. Producer prices
4. 7.8 What effect, if any, does inflation have on common stocks?
Industry Analysis
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Once an investor has developed an outlook for the overall course of the economy, a logical next step is to begin focusing the analysis on particular industries such as energy, autos, chemicals, consumer products, or technology. Looking at securities in terms of industry groupings is common practice among both individual and institutional investors. This approach makes a lot of sense because stock prices are influenced, to one degree or another, by industry conditions. Indeed, various industry forces, including the level of demand within an industry, can have a real impact on individual companies.
Industry analysis, in effect, sets the stage for a more thorough analysis of individual companies and securities. Clearly, if the outlook is good for an industry, then the prospects are likely to be favorable for many of the companies that make up that industry. In addition, industry analysis also helps the investor assess the riskiness of a company and therefore define the appropriate risk-adjusted rate of return to use in setting a value on the company’s stock. That’s true because there are always at least some similarities in the riskiness of the companies that make up an industry, so if you can gain an understanding of the risks inherent in an industry, you’ll gain valuable insights about the risks inherent in individual companies and their securities.
Key Issues
Because all industries do not perform the same, the first step in industry analysis is to establish the competitive position of a particular industry in relation to others. The next step is to identify companies within the industry that hold particular promise. Analyzing an industry means looking at such things as its makeup and basic characteristics, the key economic and operating variables that drive industry performance, and the outlook for the industry. You will also want to keep an eye out for specific companies that appear well situated to take advantage of industry conditions. Companies with strong market positions should be favored over those with less secure positions. Such dominance indicates an ability to maintain pricing leadership and suggests that the firm will be in a position to enjoy economies of scale and low-cost production. Market dominance also enables a company to support a strong research and development effort, thereby helping it secure its leadership position for the future.
Normally, you can gain valuable insight about an industry by seeking answers to the following questions.
1. What is the nature of the industry? Is it monopolistic or are there many competitors? Do a few set the trend for the rest, and if so, who are those few?
2. Is the industry regulated? If so, how and by what agency is it regulated? How “friendly” are the regulatory bodies?
3. What role does labor play in the industry? How important are labor unions? Are there good labor relations within the industry? When is the next round of contract talks?
4. How important are technological developments? Are any new developments taking place? What impact are potential breakthroughs likely to have?
5. Which economic forces are especially important to the industry? Is demand for the industry’s goods and services related to key economic variables? If so, what is the outlook for those variables? How important is foreign competition to the health of the industry?
6. What are the important financial and operating considerations? Is there an adequate supply of labor, material, and capital? What are the capital spending plans and needs of the industry?
The Industry Growth Cycle
Questions like these can sometimes be answered in terms of an industry’s growth cycle , which reflects the vitality of the industry over time. In the first stage—initial development—investment opportunities are usually not available to most investors. The industry is new and untried, and the risks are very high. The second stage is rapid expansion, during which product acceptance is spreading and investors can see the industry’s future more clearly. At this stage, economic and financial variables have little to do with the industry’s overall performance. Investors will be interested in investing almost regardless of the economic climate. This is the phase that is of substantial interest to investors, and a good deal of work is done to find such opportunities.
Unfortunately, most industries do not experience rapid growth for long. Instead, they eventually slip into the next category in the growth cycle, mature growth, which is the one most influenced by economic developments. In this stage, expansion comes from growth of the economy. It is a slower source of overall growth than that experienced in stage two. In stage three, the long-term nature of the industry becomes apparent. Industries in this category include defensive ones, like food and apparel, and cyclical industries, like autos and heavy equipment.
The last stage is either stability or decline. In the decline phase, demand for the industry’s products is diminishing, and companies are leaving the industry. Investment opportunities at this stage are almost nonexistent, unless you are seeking only dividend income. Certainly, growth-oriented investors will want to stay away from industries at the decline stage of the cycle. Other investors may be able to find some investment opportunities here, especially if the industry (like, say, tobacco) is locked in the mature, stable phase. The fact is, however, that very few really good companies ever reach this final stage because they continually bring new products to the market and, in so doing, remain at least in the mature growth phase.
Developing an Industry Outlook
Individual investors can conduct industry analysis themselves. Or, as is more often the case, it can be done with the help of published industry reports, such as the popular S&P Industry Surveys. These surveys cover all the important economic, market, and financial aspects of an industry, providing commentary as well as vital statistics. Other widely used sources of industry information include brokerage house reports and articles in the popular financial media, as well as industry information from well-known sources of financial analysis such as Morningstar, Value Line, and Mergent. There also are scores of websites (like yahoo.com , zacks.com , http://www.businessweek.com/ , and bigcharts.com ) that provide all sorts of useful information about various industries and subindustries.
Let’s resume our example of the investor who is thinking about buying business equipment stocks. Recall from our prior discussion that the economic phase of the analysis suggested a strong economy for the foreseeable future—one in which corporate profits and business spending will be expanding. Now the investor is ready to focus on the industry. A logical starting point is to assess the expected industry response to forecasted economic developments. Demand for the product and industry sales would be especially important. The industry is made up of many large and small competitors, and although it is labor-intensive, labor unions are not an important force. Thus, our investor may want to look closely at the potential effect of these factors on the industry’s cost structure. Also worth a look is the work being done in research and development (R&D) and in industrial design within the industry. Our investor would also want to know which firms are coming out with the new products and fresh ideas because these firms are likely to be the industry leaders.
Industry analysis yields an understanding of the nature and operating characteristics of an industry, which can then be used to form judgments about the prospects for industry growth. Let’s assume that our investor, by using various types of published and online reports, has examined the key elements of the office equipment industry and has concluded that the industry, particularly the office furnishings segment, is well positioned to take advantage of the rapidly improving economy. Many new and exciting products have come out in the last several years, and more are in the R&D stage. Even more compelling is the current emphasis on new products that will contribute to long-term business productivity. Thus, the demand for office furniture and fixtures should increase, and although profit margins may tighten a bit, the level of profits should move up smartly, providing a healthy outlook for growth.
In the course of researching the industry, the investor has noticed several companies that stand out, but one looks particularly attractive: Universal Office Furnishings. Long regarded as one of the top design firms in the industry, Universal designs, manufactures, and sells a full line of high-end office furniture and fixtures (desks, chairs, credenzas, modular workstations, filing systems, etc.). In addition, the company produces and distributes state-of-the-art computer furniture and a specialized line of institutional furniture for the hospitality, health care, and educational markets. The company was founded over 50 years ago, and its stock has been trading since the late 1970s. Universal would be considered a mid-cap stock, with total market capitalization of around $2 or $3 billion. The company experienced rapid growth in the last decade, as it expanded its product line. Looking ahead, the general consensus is that the company should benefit nicely from the strong economic environment now in place. Everything about the economy and the industry looks good for the stock, so our investor decides to take a closer look at Universal Office Furnishings.
We now turn our attention to fundamental analysis, which will occupy the rest of this chapter.
Concepts in Review
Answers available at http://www.pearsonhighered.com/smart
1. 7.9 What is industry analysis, and why is it important?
2. 7.10 Identify and briefly discuss several aspects of an industry that are important to its behavior and operating characteristics. Note especially how economic issues fit into industry analysis.
3. 7.11 What are the four stages of an industry’s growth cycle? Which of these stages offers the biggest payoff to investors? Which stage is most influenced by forces in the economy?
Fundamental Analysis
1. LG 4
2. LG 5
3. LG 6
Fundamental analysis is the study of the financial affairs of a business for the purpose of understanding the company that issued the common stock. First, we will deal with several aspects of fundamental analysis. We will examine the general concept of fundamental analysis and introduce several types of financial statements that provide the raw material for this type of analysis. We will then describe some key financial ratios that are widely used in company analysis and will conclude with an interpretation of those financial ratios. It’s important to understand that this represents the more traditional approach to security analysis. This approach is commonly used in any situation where investors rely on financial statements and other databases to at least partially form an investment decision.
The Concept
Fundamental analysis rests on the belief that the value of a stock is influenced by the performance of the company that issued the stock. If a company’s prospects look strong, the market price of its stock is likely to reflect that and be bid up. However, the value of a security depends not only on the return it promises but also on its risk exposure. Fundamental analysis captures these dimensions (risk and return) and incorporates them into the valuation process. It begins with a historical analysis of the financial strength of a firm: the company analysis phase. Using the insights obtained, along with economic and industry analyses, an investor can then formulate expectations about the growth and profitability of a company.
In the company analysis phase, the investor studies the financial statements of the firm to learn its strengths and weaknesses, identify any underlying trends and developments, evaluate operating efficiencies, and gain a general understanding of the nature and operating characteristics of the firm. The following points are of particular interest.
· The competitive position of the company
· The types of assets owned by the company and the growth rate of sales
· Profit margins and the dynamics of company earnings
· The composition and liquidity of corporate resources (the company’s asset mix)
· The company’s capital structure (its financing mix)
This phase is in many respects the most demanding and time-consuming. Because most investors have neither the time nor the inclination to conduct such an extensive study, they rely on published reports and financial websites for the background material. Fortunately, individual investors have a variety of sources to choose from. These include the reports and recommendations of major brokerage houses, the popular financial media, and financial subscription services like S&P and Value Line. Also available is a whole array of online financial sources, such as wsj.com, finance.yahoo.com , morningstar.com , money.msn.com , wsj.com , money.cnn.com , and smartmoney.com. These are all valuable sources of information, and the paragraphs that follow are not meant to replace them. Nevertheless, to be an intelligent investor you should have at least a basic understanding of financial reports and financial statement analysis, for ultimately you will be drawing your own conclusions about a company and its stock.
Financial Statements
Financial statements are a vital part of company analysis. They enable investors to develop an opinion about the operating results and financial condition of a firm. Investors use three financial statements in company analysis: the balance sheet, the income statement, and the statement of cash flows. The first two statements are essential to carrying out basic financial analysis because they contain the data needed to compute many of the financial ratios. The statement of cash flows is used primarily to assess the cash/liquidity position of the firm.
Investor Facts
Analysts’ Questions Are Good for Stocks When firms release a new set of financial statements, they typically hold a conference call with stock analysts to provide an overview of the company’s recent performance and to allow analysts to ask questions about the financial statements. A recent study found that when analysts ask no questions at all during these conference calls, the company’s stock price falls by about 1.5% over the subsequent five days.
(Source: “The Price of Silence: When No One Asks Questions During Conference Calls,” http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2449341 )
Companies prepare financial statements quarterly (abbreviated statements compiled for each three-month period of operation) and at the end of each calendar year or fiscal year. (The fiscal year is the 12-month period the company has defined as its operating year, which may or may not end on December 31.) Companies must hire independent certified public accountants (CPAs) to audit their financial statements to confirm that firms prepared those statements in accordance with generally accepted accounting principles. Companies must also file their financial statements with the U.S. Securities and Exchange Commission (SEC). Once filed at the SEC, these documents are available to any investor through the SEC’s Edgar website ( http://www.sec.gov/edgar.shtml ).
By themselves, corporate financial statements are an important source of information to the investor. When used with financial ratios, and in conjunction with fundamental analysis, they become even more powerful. But to get the most from financial ratios, you must have a good understanding of the uses and limitations of the financial statements themselves.
The Balance Sheet
The balance sheet is a statement of what a company owns and what it owes at a specific time. A balance sheet lists a company’s assets, liabilities, and stockholders’ equity. The assets represent the resources of the company (the things the company owns). The liabilities are debts owed to various creditors that have lent money to the firm. A firm’s creditors may include suppliers, banks, or bondholders. Stockholders’ equity is the difference between a firm’s assets and its liabilities, and as such it represents the claim held by the firm’s stockholders. As the term balance sheet implies, a firm’s total assets must equal the sum of its liabilities and equity.
A typical balance sheet appears in Table 7.3 . It shows the comparative 2015–2016 figures for Universal Office Furnishings. Tables 7.3 , 7.4 , and 7.5 illustrate the three main financial statements produced by Universal Office Furnishings. Those statements will be the basis for a fundamental analysis of the company.
The Income Statement
The income statement provides a financial summary of the operating results of the firm over a period of time such as a quarter or year. It shows the revenues generated during the period, the costs and expenses incurred, and the company’s profits (the difference between revenues and costs). Income statements generally list revenues (i.e., sales) first, followed by various types of expenses, and ending
Excel@Investing
Table 7.3 Corporate Balance Sheet
|
Universal Office Furnishings, Inc. Comparative Balance Sheets December 31 ($ in millions) |
||
|
|
2016 |
2015 |
|
Assets |
|
|
|
Current assets |
|
|
|
Cash and equivalents |
$ 95.8 |
$ 80.0 |
|
Receivables |
$227.2 |
$192.4 |
|
Inventories |
$103.7 |
$ 107.5 |
|
Other current assets |
$73.6 |
$ 45.2 |
|
Total current assets |
$500.3 |
$425.1 |
|
Noncurrent assets |
|
|
|
Property, plant, & equipment, gross |
$771.2 |
$696.6 |
|
Accumulated depreciation |
($372.5) |
($379.9) |
|
Property, plant, & equipment, net |
$398.7 |
$316.7 |
|
Other noncurrent assets |
$ 42.2 |
$ 19.7 |
|
Total noncurrent assets |
$440.9 |
$336.4 |
|
Total assets |
$941.2 |
$761.5 |
|
Liabilities and stockholders’ equity |
|
|
|
Current liabilities |
|
|
|
Accounts payable |
$ 114.2 |
$ 82.4 |
|
Short-term debt |
$174.3 |
$ 79.3 |
|
Other current liabilities |
$ 85.5 |
$ 89.6 |
|
Total current liabilities |
$ 374.0 |
$251.3 |
|
Noncurrent liabilities |
|
|
|
Long-term debt |
$177.8 |
$190.9 |
|
Other noncurrent liabilities |
$ 94.9 |
$ 110.2 |
|
Total noncurrent liabilities |
$272.7 |
$ 301.1 |
|
Total liabilities |
$646.7 |
$552.4 |
|
Stockholders’ equity |
|
|
|
Common shares |
$ 92.6 |
$137.6 |
|
Retained earnings |
$ 201.9 |
$ 71.5 |
|
Total stockholders’ equity |
$294.5 |
$209.1 |
|
Total liabilities and stockholders’ equity |
$941.2 |
$761.5 |
Excel@Investing
Table 7.4 Corporate Income Statement
|
Universal Office Furnishings, Inc. Income Statements Fiscal Year Ended December 31 ($ in millions) |
||
|
|
2016 |
2015 |
|
Sales revenue |
$1,938.0 |
$1,766.2 |
|
Cost of goods sold |
$1,128.5 |
$1,034.5 |
|
Gross profit |
$ 809.5 |
$ 731.7 |
|
Selling, general, and administrative, and other operating expenses |
$ 496.7 |
$ 419.5 |
|
Depreciation & amortization |
$ 77.1 |
$ 62.1 |
|
Other expenses |
$ 0.5 |
$ 12.9 |
|
Total operating expenses |
$ 574.3 |
$ 494.5 |
|
Earnings before interest & taxes (EBIT) |
$ 235.2 |
$ 237.2 |
|
Interest expense |
$ 13.4 |
$ 7.3 |
|
Earnings before taxes |
$ 221.8 |
$ 229.9 |
|
Income taxes |
$ 82.1 |
$ 88.1 |
|
Net profit after taxes |
$ 139.7 |
$ 141.8 |
|
Dividends paid per share |
$ 0.15 |
$ 0.13 |
|
Earnings per share (EPS) |
$ 2.26 |
$ 2.17 |
|
Number of common shares outstanding (in millions) |
61.80 |
65.30 |
with profits or net income. In contrast to a balance sheet, which shows a firm’s financial position at a single point in time, the income statement describes what happens over a period of time.
Table 7.4 shows the income statements for Universal Office Furnishings for 2015 and 2016. Note that these annual statements cover operations for the 12-month period ending on December 31, which corresponds to the date of the balance sheet. The income statement indicates how successful the firm has been in using the assets listed on the balance sheet. That is, management’s success in operating the firm is reflected in the profit or loss the company generates during the year.
Watch Your Behavior
Not Counting the Days Some firms define their fiscal quarters as 13-week periods, resulting in a fiscal year of exactly 52 weeks (364 days). These firms must add a “catch-up week” to 1 quarter every five or six years. Recent research indicates that professional stock analysts and investors fail to account for the extra week, meaning that during a 14-week quarter, firms tend to report higher-than-expected earnings, and stock returns are unusually high during these periods.
(Source: Rick Johnson, Andrew J. Leone, Sundaresh Ramnath, Ya-wen Yang,”14-Week Quarters,” Journal of Accounting and Economics, Vol. 53, pp. 271–289.)
The Statement of Cash Flows
The statement of cash flows provides a summary of the firm’s cash flow and other events that caused changes in its cash position. This statement essentially brings together items from both the balance sheet and the income statement to show how the company obtained its cash and how it used this valuable liquid resource.
Unfortunately, because of certain accounting conventions (the accrual concept being chief among them), a company’s reported earnings may bear little resemblance to its cash flow. That is, whereas profits are simply the difference between revenues and the accounting costs that have been charged against them, cash flow is the amount of money a company actually takes in as a result of doing business. For example, if a firm spends $1 billion in cash to build a new factory, the cash flow statement will show a $1 billion cash outflow for this expenditure. However, there will be no corresponding $1 billion expense on the income statement. Accounting rules dictate that when a firm invests in an asset that will provide benefits over many years, the cost of that asset must be spread over many years. Even though a firm might spend $1 billion in cash to build a factory this year, it will only deduct a portion of that as a depreciation expense on this year’s income statement (perhaps $100 million). Additional depreciation deductions will appear on income statements over the next several years until the entire $1 billion cost has been deducted. In other words, the cost of the new factory will not be fully accounted for on a firm’s income statement until several years have passed, even if the firm paid cash for the factory in the year that it was built.
How Depreciation Works
What this means is that the cash flow statement is highly valued because it helps investors determine how much cash a firm actually spent and received in a particular year. This is important because a firm that shows positive profits on its income statement may in fact be spending more cash than it is taking in, and that could lead to financial distress. In addition, accounting rules give managers a great deal of flexibility in how they report certain revenue and expense items. For example, a firm that spends $1 billion to build a new factory can calculate depreciation expenses using several methods. Depending on the method that managers choose, the cost of the factory may be spread equally over many years or the firm’s income statements may show depreciation charges that are very high at first but gradually decline over time. Items on the cash flow statement may also be affected to an extent by these types of accounting choices but not to the same degree as the income statement. We should emphasize here that in our discussion so far, we are emphasizing the legal discretion that accounting rules allow managers when reporting revenues and expenses. (Nevertheless, accounting fraud can occur, as discussed in the Famous Failures in Finance box. As suggested there, audits are an important aspect of a company’s financial statements.)
Table 7.5 presents the 2015 and 2016 statement of cash flows for Universal Office Furnishings. The statement is broken into three parts. The most important part is the first one, labeled “Cash from operating activities.” It captures the net cash flow from operating activities—the line highlighted on the statement. This is what people typically mean when they say “cash flow”—the amount of cash generated by the company and available for investment and financing activities.
Note that Universal’s 2016 cash flow from operating activities was $195.6 million, down slightly from the year before. This amount was more than enough to cover the company’s investing activities ($97.1 million) and its financing activities ($82.7 million). Thus, Universal’s actual cash position—see the line near the bottom of the statement, labeled “Net increase (decrease) in cash”—increased by some $15.8 million. That result was a big improvement over the year before, when the firm’s cash position fell by more than $35 million. A high (and preferably increasing) cash flow means the company has enough money to service debt, finance growth, and pay dividends. In addition, investors like to see the firm’s cash position increase over time because of the positive impact that it has on the company’s liquidity and its ability to meet operating needs in a prompt and timely fashion.
Financial Ratios
To see what accounting statements really have to say about the financial condition and operating results of a firm, we have to turn to financial ratios. Such ratios provide a different perspective on the financial affairs of the firm—particularly with regard to the balance sheet and income statement—and thus expand the information content of the company’s financial statements. Simply stated, ratio analysis is the study of the relationships between various financial statement accounts. Each
Table 7.5 Statement of Cash Flows
|
Universal Office Furnishings, Inc. Statements of Cash Flows Fiscal Year Ended December 31 ($ in millions) |
||
|
|
2016 |
2015 |
|
Cash from operating activities |
|
|
|
Net earnings |
$139.7 |
$ 141.8 |
|
Depreciation and amortization |
$ 77.1 |
$ 62.1 |
|
Other noncash charges |
$ 84.5 |
$ 16.7 |
|
Decrease (increase) in noncash current assets |
($ 59.4) |
$ 14.1 |
|
Increase (decrease) in current liabilities |
$122.7 |
($ 29.1) |
|
Net cash flow from operating activities |
$195.6 |
$205.6 |
|
Cash from investing activities |
|
|
|
Acquisitions of property, plant, and equipment—net |
($ 74.6) |
($ 90.6) |
|
Acquisitions of other noncurrent assets |
($ 22.5) |
($ 0.0) |
|
Net cash flow from investing activities |
($ 97.1) |
($ 90.6) |
|
Cash from financing activities |
|
|
|
Proceeds from long-term borrowing |
$ 0.0 |
$ 79.1 |
|
Reduction in long-term debt |
($ 28.4) |
($ 211.1) |
|
Net repurchase of capital stock |
($ 45.0) |
($ 26.8) |
|
Payment of dividends on common stock |
($ 9.3) |
($ 8.5) |
|
Net cash flow from financing activities |
($ 82.7) |
($ 150.3) |
|
Net increase (decrease) in cash |
$ 15.8 |
($ 35.3) |
|
Cash and equivalents at beginning of period |
$ 80.0 |
$ 115.3 |
|
Cash and equivalents at end of period |
$ 95.8 |
$ 80.0 |
Famous Failures in Finance Cooking the Books: What Were They Thinking?
Recent scandals involving fraudulent accounting practices have resulted in public outrage, not only in the United States but around the world as well. In December 2013, the SEC charged Fifth Third Bank of Cincinnati and its former chief financial officer, Daniel Poston, with improper accounting for commercial real estate loans during the financial crisis. Fifth Third was forced to pay a $6.5 million fine to settle the case, and Poston agreed never to work as an accountant for a publicly traded company, effectively ending his professional career. In February 2012 the San Francisco–based maker of products such as Kettle Chips and Pop Secret Popcorn, Diamond Foods, fired its CEO and CFO after discovering $80 million in payments to walnut growers that had been accounted for improperly. Diamond’s stock fell nearly 40% in a single day on news of the accounting fraud, which led to a $5 million fine from the SEC in 2014.
These were hardly the first cases of accounting fraud leading to financial ruin. Unscrupulous executives used a number of accounting tricks to deceive the public including capitalizing operating expenses on the balance sheet, recognizing fictitious or premature revenues, creating off-balance-sheet liabilities, using off-balance-sheet derivative transactions to understate risk, and writing off goodwill as extraordinary loss rather than amortizing it over time to manipulate future earnings growth.
Critical Thinking Question
1. One of the steps to strengthen corporate reporting is to separate internal and external audits of a company by not permitting an auditor to provide both internal and external audits to the same client. Will this regulation be able to eliminate conflict of interest? Discuss.
measure relates an item on the balance sheet (or income statement) to another or, as is more often the case, a balance sheet account to an operating (income statement) item. In this way, we can look not so much at the absolute size of the financial statement accounts but rather at what they indicate about the liquidity, activity, or profitability of the firm.
What Ratios Have to Offer
Investors use financial ratios to evaluate the financial condition and operating results of the company and to compare those results to historical or industry standards. When using historical standards, investors compare the company’s ratios from one year to the next. When using industry standards, investors compare a particular company’s ratios to those of other companies in the same line of business.
Remember, the reason we use ratios is to develop information about the past that can be used to get a handle on the future. It’s only from an understanding of a company’s past performance that you can forecast its future with some degree of confidence. For example, even if sales have been expanding rapidly over the past few years, you must carefully assess the reasons for the growth, rather than naively assuming that past growth-rate trends will continue into the future. Such insights are obtained from financial ratios and financial statement analysis.
Financial ratios can be divided into five groups: (1) liquidity, (2) activity, (3) leverage, (4) profitability, and (5) common-stock, or market, measures. Using the 2016 figures from the Universal financial statements ( Tables 7.3 and 7.4 ), we will now identify and briefly discuss some of the more widely used ratios in each of these categories.
Liquidity Ratios
Liquidity ratios focus on the firm’s ability to meet its day-to-day operating expenses and satisfy its short-term obligations as they come due. Of major concern is whether a company has adequate cash and other liquid assets on hand to service its debt and operating needs in a prompt and timely fashion. Three ratios that investors use to assess a firm’s liquidity position are the current ratio, the quick ratio, and the working capital ratio.
Current Ratio
One of the most commonly cited of all financial ratios is the current ratio. The current ratio measures a company’s ability to meet its short-term liabilities with its short-term assets and is one of the best measures of a company’s financial health.
Currentratio=CurrentassetsCurrentliabilitiesForUniversal=$500.3$374.0=1.34––––––––––Current ratio=Current assetsCurrent liabilitiesFor Universal =$500.3$374.0=1.34__Equation7.1
This figure indicates that Universal had $1.34 in short-term resources to service every dollar of current debt. That’s a fairly good number and, by most standards today, suggests that the company is carrying an adequate level of liquid assets to satisfy the current period’s obligations.
Quick Ratio
Of all the current assets listed on a firm’s balance sheet, the least liquid is often the firm’s inventory balance. Particularly when a firm is going through a period of declining sales, it can have difficulty selling its inventory and converting it into cash. For this reason, many investors like to subtract out inventory from the current assets total when assessing whether a firm has sufficient liquidity to meet its near-term obligations. Thus, the quick ratio is similar to the current ratio but it excludes inventory in the numerator.
Currentratio=Currentassets-inventoryCurrentliabilitiesForUniversal=$500.3−103.7$374.0=1.06–––––Current ratio=Current assets-inventoryCurrent liabilitiesFor Universal =$500.3−103.7$374.0=1.06_Equation7.2
Even excluding its inventory holdings, Universal appears to have sufficient liquidity.
Net Working Capital
Although technically not a ratio, net working capital is often viewed as such. Actually, net working capital is an absolute measure, which indicates the dollar amount of equity in the working capital position of the firm. It is the difference between current assets and current liabilities. For 2016, the net working capital position for Universal amounted to the following.
Networkingcapital=Currentassets−CurrentliabilitiesForUniversal=$500.3−$374.0=$126.3million––––––––––––––––––––––––––––––Net working capital=Current assets−Current liabilitiesFor Universal =$500.3−$374.0=$126.3 million__Equation7.3
A net working capital figure that exceeds $125,000,000 is indeed substantial (especially for a firm this size). It reinforces our contention that the liquidity position of this firm is good—so long as it is not made up of slow-moving, obsolete inventories and/or past-due accounts receivable.
How much liquidity is enough? What are the desirable ranges for measures such as the current ratio and quick ratio? The answer depends on many factors and will vary across industries. When a company’s business is more volatile, having extra liquidity is more important, so investors would like to see higher values for these ratios for firms in turbulent industries. On the other hand, it is possible to have too much liquidity. Consider a firm that holds vast cash reserves, like Apple Inc. In the quarter ending on March 28, 2015, Apple’s balance sheet indicated that the company held more than $33 billion in cash and marketable securities plus another $160 billion in cash invested in long-term securities. Those cash balances earned a very low rate of return, so investors put pressure on Apple to distribute some of its cash through dividends. In general, investors want firms to maintain enough liquidity to cover their short-term obligations, but they do not want firms to hold excessive amounts of liquid assets because doing so depresses the rate of return that the company earns on its overall asset portfolio.
Activity Ratios
Measuring general liquidity is only the beginning of the analysis. We must also assess the composition and underlying liquidity of key current assets and evaluate how effectively the company is managing these resources. Activity ratios (also called efficiency ratios) compare company sales to various asset categories in order to measure how well the company is using its assets. Three of the most widely used activity ratios deal with accounts receivable, inventory, and total assets. Other things being equal, high or increasing ratio values indicate that a firm is managing its assets efficiently, though there may be instances when activity ratios can be too high, as was the case with liquidity ratios.
Accounts Receivable Turnover
A glance at most financial statements will reveal that the asset side of the balance sheet is dominated by just a few accounts that make up 80% to 90%, or even more, of total resources. Certainly, this is the case with Universal Office Furnishings, where, as you can see in Table 7.3 , three entries (accounts receivable, inventory, and net property, plant, and equipment) accounted for nearly 80% of total assets in 2016. Like Universal, most firms hold a significant accounts receivable balance, and for this reason firms want to monitor their receivables closely. Remember, receivables represent credit that a firm grants to its customers. Other things being equal, firms would like to collect from their customers as quickly as possible, and the sooner the firm’s customers pay their bills, the lower will be the accounts receivable balance. On the other hand, if a firm gives its customers a long time to pay their bills, the receivables balance will be relatively high, but giving customers more time to pay might generate more sales. Therefore, determining the optimal approach to collecting from customers represents a balance between collecting faster (and therefore taking advantage of the time value of money) and using more generous credit terms to attract customers. The accounts receivable turnover ratio captures the relationship between a firm’s receivables balance and its sales. It is computed as follows:
Accountsreceivableturnover=SalesrevenueAccountsreceivableForUniversal=$1,938.0$227.2=8.53–––––Accounts receivable turnover =Sales revenueAccounts receivableFor Universal =$1,938.0$227.2=8.53_Equation7.4
A firm that has a high receivables turnover generates its sales without having to extend customers credit for long periods. In 2016 Universal was turning its receivables about 8.5 times a year. That excellent turnover rate suggests a very strong credit and collection policy. Investors would generally be pleased with this performance as long as they did not believe that Universal’s rapid collection policy did not discourage customers from buying Universal products. The 8.53 turnover ratio means that each dollar invested in receivables was supporting, or generating, $8.53 in sales.
Inventory Turnover
Another important corporate resource—and one that requires a considerable amount of management attention—is inventory. Control of inventory is important to the well-being of a company and is commonly assessed with the inventory turnover measure.
Inventoryturnover=SalesrevenueInventoryForUniversal=$1,938.0$103.2=18.69––––––––––––Inventory turnover =Sales revenueInventoryFor Universal =$1,938.0$103.2=18.69__Equation7.5
In most cases, firms would rather sell their products quickly than hold them in stock as inventory. Some items, such as perishable goods and consumer electronics, lose value the longer they sit on shelves. Besides, a firm cannot make a profit on an item that it has produced until the item sells. All of this means that firms have great incentives to increase inventory turnover. Universal’s 2016 turnover of almost 19 times a year means that the firm is holding inventory for less than a month—actually, for about 20 days (365/18.69 = 19.5). A turnover ratio that high indicates that the firm is doing an excellent job managing its inventory.
Keep in mind that the inventory turnover ratio will be higher if the inventory balance is lower, holding the sales level constant. This suggests that firms could improve their turnover ratio simply by holding less inventory. Here again there is a tradeoff that firms have to manage. If firms are too aggressive at trimming their inventory levels, then they may not be able to fill customers’ orders on time, or they could experience production delays due to raw materials shortages. In general, investors like to see rapid inventory turnover as long as it is not accompanied by any of the problems associated with inventory levels that are too lean.
Note that, rather than sales, some analysts prefer to use cost of goods sold in the numerator of Equation 7.5 , on the premise that the inventory account on the balance sheet is more directly related to cost of goods sold from the income statement. Because cost of goods sold is less than sales, using it will, of course, lead to a lower inventory turnover figure—for Universal in 2016: $1,128.5/$103.7 = 10.88, versus 18.69 when sales is used. Regardless of whether you use sales (which we’ll continue to do here) or cost of goods sold, for analytical purposes you’d still use the measure in the same way.
Total Asset Turnover
Total asset turnover indicates how efficiently a firm uses its assets to support sales. It is calculated as follows:
Total assetturnover=SalesrevenueTotal assetsForUniversal=$1,938.0$941.2=2.06–––––Total asset turnover =Sales revenueTotal assetsFor Universal =$1,938.0$941.2=2.06_Equation7.6
Note in this case that Universal is generating more than $2 in revenues from every dollar invested in assets. This is a fairly high number and is important because it has a direct bearing on corporate profitability. The principle at work here is simple: Earning $100 from a $1,000 investment is far more desirable than earning $100 from a $2,000 investment. A high total asset turnover figure suggests that corporate resources are being well managed and that the firm is able to realize a high level of sales (and, ultimately, profits) from its asset investments.
Leverage Ratios
Leverage ratios (sometimes called solvency ratios) look at the firm’s financial structure. They indicate the amount of debt being used to support the resources and operations of the company. The amount of indebtedness within the financial structure and the ability of the firm to service its debt are major concerns to potential investors. There are three widely used leverage ratios. The first two, the debt-equity ratio and the equity multiplier, measure the amount of debt that a company uses. The third, times interest earned, assesses how well the company can service its debt.
Debt-Equity Ratio
The debt-equity ratio measures the relative amount of funds provided by lenders and owners. It is computed as follows:
Debt-equityratio=Long-term debtStockholders'equityForUniversal=$177.8$294.5=0.60–––––Debt-equity ratio =Long-term debtStockholders'equityFor Universal =$177.8$294.5=0.60_Equation7.7
Because highly leveraged firms (those that use large amounts of debt) run an increased risk of defaulting on their loans, this ratio is particularly helpful in assessing a stock’s risk exposure. The 2016 debt-equity ratio for Universal is reasonably low (at 0.60) and shows that most of the company’s capital comes from its owners. Stated another way, there was only 60 cents’ worth of long-term debt in the capital structure for every dollar of equity. Unlike the other measures we’ve looked at so far, a low or declining debt-equity ratio indicates lower risk exposure, as that would suggest the firm has a more reasonable debt load.
Equity Multiplier
The equity multiplier (also known as the financial leverage ratio) provides an alternative measure of a firm’s debt usage. The formula for the equity multiplier appears below.
Equity multiplier=Total assetsTotal stockholders'equityForUniversal=$941.2$294.5=3.20––––––––––Equity multiplier =Total assetsTotal stockholders' equityFor Universal =$941.2$294.5=3.20__Equation7.8
It may seem odd to say that the equity multiplier measures a firm’s use of debt because debt does not appear directly in Equation 7.8 , but keep in mind that total assets is the sum of liabilities and equity. For a firm that has no liabilities (i.e., no debt) at all, assets will equal stockholders’ equity, and the equity multiplier will be 1.0. Holding equity fixed, the more debt the firm uses, the higher will be its total assets, and the higher will be the equity multiplier. For Universal, the equity multiplier of 3.2 suggests that there is $3.20 of assets for every $1 of equity. Because assets is the sum of debt and equity, an equity multiplier of 3.2 says that Universal has $2.20 of debt (debt of all types, not just long-term debt) for each $1 of equity.
Times Interest Earned
Times interest earned is called a coverage ratio. It measures the ability of the firm to meet (“cover”) its fixed interest payments. It is calculated as follows:
Times interest earned=Earnings before interest and taxesInterest expenseForUniversal=$235.2$13.4=17.55––––––––––––Times interest earned =Earnings before interest and taxesInterest expenseFor Universal =$235.2$13.4=17.55__Equation7.9
The ability of the company to meet its interest payments (which, with bonds, are fixed contractual obligations) in a timely fashion is an important consideration in evaluating risk exposure. Universal’s times interest earned ratio indicates that the firm has about $17.55 of EBIT available to cover every dollar of interest expense. That’s a very high coverage ratio—way above average. As a rule, a ratio eight to nine times earnings is considered strong. To put this number in perspective, there’s usually little concern until times interest earned drops to something less than two or three times earnings.
It has recently become popular to use an alternative earnings figure in the numerator for the times interest earned ratio. In particular, some analysts are adding back depreciation and amortization expenses to earnings and are using what is known as earnings before interest, taxes, depreciation, and amortization (EBITDA). Their argument is that because depreciation and amortization are both noncash expenditures (i.e., they’re little more than bookkeeping entries), they should be added back to earnings to provide a more realistic “cash-based” figure. The problem is that EBITDA figures invariably end up putting performance in a far more favorable light. (Indeed, many argue that this is the principal motivation behind their use.) As a result, EBITDA tends to sharply increase ratios such as times interest earned. For example, in the case of Universal, adding depreciation and amortization (2016: $77.1 million) to EBIT (2016: $235.2 million) results in a coverage ratio of $312.3/$13.4 = 23.31—versus 17.5 when this ratio is computed in the conventional way (with EBIT).
Profitability Ratios
Profitability is a relative measure of success. Each of the various profitability measures relates the returns (profits) of a company to its sales, assets, or equity. There are three widely used profitability measures: net profit margin, return on assets, and return on equity. Clearly, the more profitable the company, the better—thus, other things being equal, higher or increasing measures of profitability are what you’d like to see.
Net Profit Margin
This is the “bottom line” of operations. Net profit margin indicates the rate of profit being earned from sales and other revenues. It is computed as follows:
Net profit margin=Net profit after taxesSales revenueForUniversal=$139.7$1.938.0=0.072=7.2%––––––––––––Net profit margin =Net profit after taxesSales revenueFor Universal =$139.7$1.938.0=0.072=7.2%__Equation7.10
The net profit margin looks at profits as a percentage of sales (and other revenues). Note that Universal had a net profit margin of 7.2% in 2016. That is, for every dollar of revenue that the company generated, it earned a profit of a little more than seven cents. That may be about average for large U.S. companies, but it is well above average for firms in the business equipment industry.
Return on Assets
As a profitability measure, return on assets (ROA) looks at the amount of resources needed to support operations. Return on assets reveals management’s effectiveness in generating profits from the assets it has available, and it is perhaps the most important measure of return. ROA is computed as follows:
ROA=Net profit after taxesTotal assetsForUniversal=$139.7$941.2=0.148=14.8%––––––––––––––ROA =Net profit after taxesTotal assetsFor Universal =$139.7$941.2=0.148=14.8%__Equation7.11
In the case of Universal Office Furnishings, the company earned almost 15% on its asset investments in 2016. That is a very healthy return, and well above average. As a rule, you’d like to see a company maintain as high an ROA as possible. The higher the ROA, the more profitable the company.
An Advisor’s Perspective
Ryan McKeown Senior VP–Financial Advsior, Wealth Enhancement Group
“A simple method that I use is looking at the ROE.”
MyFinanceLab
Return on Equity
A measure of the overall profitability of the firm, return on equity (ROE) is closely watched by investors because of its direct link to the profits, growth, and dividends of the company. Return on equity—or return on investment (ROI), as it’s sometimes called—measures the return to the firm’s stockholders by relating profits to shareholder equity.
ROA=Net profit after taxesstockholders'equityForUniversal=$139.7$294.5=0.474=47.4%–––––––ROA =Net profit after taxesstockholders' equityFor Universal =$139.7$294.5=0.474=47.4%_Equation7.12
ROE shows the annual profit earned by the firm as a percentage of the equity that stockholders have invested in the firm. For Universal, that amounts to about 47 cents for every dollar of equity. That, too, is an outstanding measure of performance and suggests that the company is doing its best to maximize shareholder value. Generally speaking, look out for a falling ROE, as it could mean trouble later on.
Breaking Down ROA and ROE
ROA and ROE are both important measures of corporate profitability. But to get the most from these two measures, we have to break them down into their component parts. ROA, for example, is made up of two key components: the firm’s net profit margin and its total asset turnover. Thus, rather than using Equation 7.11 to find ROA, we can use the net profit margin and total asset turnover figures that we computed earlier ( Equations 7.10 and 7.6 , respectively). Using this expanded format, we can find Universal’s 2016 ROA.
ROA=Net profit margin×Total asset turnoverForUniversal=7.2%×2.06=14.8%–––––––ROA =Net profit margin×Total asset turnoverFor Universal =7.2%×2.06=14.8%_Equation7.13
Note that we end up with the same figure as that found with Equation 7.11 . So why would you want to use the expanded version of ROA? The major reason is that it shows you what’s driving company profits. As an investor, you want to know if ROA is moving up (or down) because of improvement (or deterioration) in the company’s profit margin and/or its total asset turnover. Ideally, you’d like to see ROA moving up (or staying high) because the company is doing a good job in managing both its profits and its assets.
Going from ROA to ROE
Just as ROA can be broken into its component parts, so too can the return on equity (ROE) measure. Actually, ROE is nothing more than an extension of ROA. It brings the company’s financing decisions into the assessment of profitability. That is, the expanded ROE measure indicates the extent to which financial leverage (i.e., how much debt the firm uses) can increase return to stockholders. The use of debt in the capital structure, in effect, means that ROE will always be greater than ROA. The question is how much greater. Rather than using the abbreviated version of ROE in Equation 7.12 , we can compute ROE as follows.
ROE = ROA × Equity multiplierROE = ROA × Equity multiplierEquation7.14
To find ROE according to Equation 7.14 , recall first that Universal’s equity multiplier was 3.2.
We can now find the 2016 ROE for Universal as follows:
ROE=14.8×3.20=47.4––––––––––%ROE=14.8×3.20=47.4__%
Here we can see that the use of debt (the equity multiplier) has magnified—in this case, tripled—returns to stockholders.
An Expanded ROE Equation
Alternatively, we can expand Equation 7.14 still further by breaking ROA into its component parts. In this case, we could compute ROE as
ROE=ROA×Equity multiplier=(Net profit margin×Total asset turnover)×Equity multiplierForUniversal=7.2%×2.06×3.20=47.4%––––––––––––––ROE=ROA×Equity multiplier=(Net profit margin×Total asset turnover)×Equity multiplierFor Universal=7.2%×2.06×3.20=47.4%__Equation7.15
This expanded version of ROE is especially helpful because it enables investors to assess the company’s profitability in terms of three key components: net profit margin, total asset turnover, and financial leverage. In this way, you can determine whether ROE is moving up simply because the firm is employing more debt, which isn’t necessarily beneficial, or because of how the firm is managing its assets and operations, which certainly does have positive long-term implications. To stockholders, ROE is a critical measure of performance. A high ROE means that the firm is currently very profitable, and if some of those profits are reinvested in the business, the firm may grow rapidly.
Common-Stock Ratios
Finally, there are a number of common-stock ratios (sometimes called valuation ratios) that convert key bits of information about the company to a per-share basis. Also called market ratios , they tell the investor exactly what portion of total profits, dividends, and equity is allocated to each share of stock. Popular common-stock ratios include earnings per share, price-to-earnings ratio, dividends per share, dividend yield, payout ratio, and book value per share. We examined two of these measures (earnings per share and dividend yield) earlier in this text. Let’s look now at the other four.
Price-to-Earnings Ratio
This measure, an extension of the earnings per share ratio, is used to determine how the market is pricing the company’s common stock. The price-to-earnings (P/E) ratio relates the company’s earnings per share (EPS) to the market price of its stock. To compute the P/E ratio, it is necessary to first know the stock’s EPS. Using the earnings per share equation, we see that the EPS for Universal in 2016 was
EPS=Net profit after taxes−Preferred dividendsNumber of common shares outstandingFor Universal=$139.7−$061.8=$2.26––––––––––––EPS=Net profit after taxes−Preferred dividendsNumber of common shares outstandingFor Universal=$139.7−$061.8=$2.26__
In this case, the company’s profits of $139.7 million translate into earnings of $2.26 for each share of outstanding common stock. (Note in this case that dividends are shown as $0 because the company has no preferred stock outstanding.) Given this EPS figure and the stock’s current market price (assume it is currently trading at $41.50), we can use Equation 7.16 to determine the P/E ratio for Universal.
P/E=Net price of common stockEPSFor Universal=$41.50$2.26=18.36––––––––––––P/E=Net price of common stockEPSFor Universal=$41.50$2.26=18.36__Equation7.16
In effect, the stock is currently selling at a multiple of about 18 times its 2016 earnings.
Price-to-earnings multiples are widely quoted in the financial press and are an essential part of many stock valuation models. Other things being equal, you would like to find stocks with rising P/E ratios because higher P/E multiples usually translate into higher future stock prices and better returns to stockholders. But even though you’d like to see them going up, you also want to watch out for P/E ratios that become too high (relative either to the market or to what the stock has done in the past). When this multiple gets too high, it may be a signal that the stock is becoming overvalued (and may be due for a fall).
Investor Facts
Record P/E Ratio Signals Bear Market In addition to calculating a P/E ratio for a single stock, you can do the same calculation for a group of stocks such as the S&P 500. In April 1999 the P/E ratio for the S&P 500 reached an all-time high of almost 43. Stocks at the time were valued at nearly 43 times current earnings. About a year later, the S&P 500 began a long slide, losing more than 40% of its value over the next two years. It took more than a decade for the index to recover.
(Source: Robert Shiller, http://www .econ.yale.edu/~shiller/data.htm )
One way to assess the P/E ratio is to compare it to the company’s rate of growth in earnings. The market has developed a measure of this comparison called the PEG ratio . Basically, it looks at the latest P/E relative to the three- to five-year rate of growth in earnings. (The earnings growth rate can be all historical—the last three to five years—or perhaps part historical and part forecasted.) The PEG ratio is computed as:
PEGratio=Stock'sP/Eratio3- to 5-year growth rate in earningsPEG ratio=Stock's P/E ratio3- to 5-year growth rate in earningsEquation7.17
As we saw earlier, Universal Office Furnishings had a P/E ratio of 18.36 times earnings in 2016. If corporate earnings for the past five years had been growing at an average annual rate of, say, 15%, then its PEG ratio would be:
For Universal18.3615.0=1.22–––––For Universal18.3615.0=1.22_
A PEG ratio this close to 1.0 is certainly reasonable. It suggests that the company’s P/E is not out of line with the earnings growth of the firm. In fact, the idea is to look for stocks that have PEG ratios that are equal to or less than 1. In contrast, a high PEG means the stock’s P/E has outpaced its growth in earnings and, if anything, the stock is probably “fully valued.” Some investors, in fact, won’t even look at stocks if their PEGs are too high—say, more than 1.5 or 2.0. At the minimum, PEG is probably something you would want to look at because it certainly is not unreasonable to expect some correlation between a stock’s P/E and its rate of growth in earnings.
Dividends per Share
The principle here is the same as for EPS: to translate total common dividends paid by the company into a per-share figure. (Note: If not shown on the income statement, the amount of dividends paid to common stockholders can usually be found on the statement of cash flows—see Table 7.5 .) Dividends per share is measured as follows:
Dividends per share=Annual dividends paid to common stockNumber of common shares outstandingFor Universal=$9.361.8=$0.51––––––Dividends per share=Annual dividends paid to common stockNumber of common shares outstandingFor Universal=$9.361.8=$0.51_Equation7.18
For fiscal 2016, Universal paid out dividends of $0.15 per share—at a quarterly rate of about 3.75 cents per share.
As we saw earlier in this text, we can relate dividends per share to the market price of the stock to determine its dividend yield: i.e., $0.15 ÷ $41.50 = 0.004, or 0.4%. Clearly, you won’t find Universal Office Furnishings within the income sector of the market. It pays very little in annual dividends and has a dividend yield of less than one-half of 1%.
Payout Ratio
Another important dividend measure is the dividend payout ratio. It indicates how much of its earnings a company pays out to stockholders in the form of dividends. Well-managed companies try to maintain target payout ratios. If earnings are going up over time, so will the company’s dividends. The payout ratio is calculated as follows:
Payout ratio=Dividends per shareEarnings per shareFor Universal=$0.15$2.26=0.07––––––––––Payout ratio=Dividends per shareEarnings per shareFor Universal=$0.15$2.26=0.07__Equation7.19
For Universal in 2016, dividends accounted for about 7% of earnings. Traditionally, most companies that pay dividends tend to pay out somewhere between 30% and 50% of earnings. By that standard, Universal’s payout, like its dividend yield, is quite low. But that’s not necessarily bad, as it indicates that the company is retaining most of its earnings to, at least in part, internally finance the firm’s rapid growth. Indeed, it is quite common for growth-oriented companies to have low payout ratios. Some of the better-known growth companies, like Genentech, Boston Scientific, EchoStar Communications, and Starbucks, all retain 100% of their earnings. (In other words, they have dividend payout ratios of zero.)
Investor Facts
Dividend Payments on the Rise In 2014 almost 85% of the companies in the S&P500 paid dividends, and among those companies the average payout ratio exceeded 30%.
Companies that pay dividends are generally reluctant to cut them, so when earnings fall, dividends usually do not fall right away. This suggests that a rising dividend payout ratio may, counterintuitively, signal trouble. A rising dividend payout is often a sign that a company’s earnings are falling rather than a sign that the company is doing well and increasing its dividend payments. For example, at the end of the last recession, the average dividend payout ratio among companies in the S&P 500 was nearly twice as high as it was when the recession began, so clearly in that period rising payouts signaled bad rather than good times. Once the payout ratio reaches 70% to 80% of earnings, you should take extra care. A payout ratio that high is often an indication that the company may not be able to maintain its current level of dividends. That generally means that dividends will have to be cut back to more reasonable levels unless earnings grow rapidly. And if there’s one thing the market doesn’t like, it’s cuts in dividends; they’re usually associated with big cuts in share prices.
Book Value per Share
The last common-stock ratio is book value per share, a measure that deals with stockholders’ equity. Actually, book value is simply another term for equity (or net worth). It represents the difference between total assets and total liabilities. Note that in this case we’re defining equity as common stockholders’ equity, which would exclude preferred stock. That is, common stockholders’ equity = total equity – preferred stocks. (Universal has no preferred outstanding, so its total equity equals its common stockholders’ equity.) Book value per share is computed as follows:
Book value per share=Common stockholders' equityNumber of common shares outstandingFor Universal=$294.561.8=$4.76––––––––––––Book value per share=Common stockholders' equityNumber of common shares outstandingFor Universal=$294.561.8=$4.76__Equation7.20
Presumably, a stock should sell for more than its book value (as Universal does). If not, it could be an indication that something is seriously wrong with the company’s outlook and profitability.
A convenient way to relate the book value of a company to the market price of its stock is to compute the price-to-book-value ratio.
Price-to-book-value=Market price of common stockBook value per shareFor Universal=$41.50$4.76=8.72––––––––––Price-to-book-value=Market price of common stockBook value per shareFor Universal=$41.50$4.76=8.72__Equation7.21
Widely used by investors, this ratio shows how aggressively the stock is being priced. Most stocks have a price-to-book-value ratio of more than 1.0—which simply indicates that the stock is selling for more than its book value. In fact, in strong bull markets, it is not uncommon to find stocks trading at 4 or 5 times their book values, or even more. Universal’s price-to-book ratio of 8.7 times is definitely on the high side. That is something to evaluate closely. It may indicate that the stock is already fully priced, or perhaps even overpriced. Or it could result from nothing more than a relatively low book value per share.
Interpreting the Numbers
Rather than compute all the financial ratios themselves, most investors rely on published reports for such information. Many large brokerage houses and a variety of financial services firms publish such reports. An example is given in Figure 7.2 . These reports provide a good deal of vital information in a convenient and easy-to-read format. Best of all, they relieve investors of the chore of computing the financial ratios themselves. (Similar information is also available from a number of online services, as well as from various software providers.) Even so, as an investor, you must be able to evaluate this published information. To do so, you need not only a basic understanding of financial ratios but also some performance standard, or benchmark, against which you can assess trends in company performance.
Basically, financial statement analysis uses two types of performance standards: historical and industry. With historical standards, various financial ratios and measures are run on the company for a period of three to five years (or longer). You would use these to assess developing trends in the company’s operations and financial condition. That is, are they improving or deteriorating, and where do the company’s strengths and weaknesses lie? In contrast, industry standards enable you to compare the financial ratios of the company with comparable firms or with the average results for the industry as a whole. Here, we focus on determining the relative strengths of the firm with respect to its competitors. Using Universal Office Furnishings, we’ll see how to use both of these standards of performance to evaluate and interpret financial ratios.
Using Historical and Industry Standards
Look at Table 7.6 . It provides a summary of historical data and average industry figures (for the latest year) for most of the ratios we have discussed. (Industry averages, such as those used in Table 7.6 , are readily available from such sources as S&P, Moody’s, and many industry-specific publications.) By carefully evaluating these ratios, we should be able to draw some basic conclusions about the financial condition, operating results, and general financial health of the company. By comparing the financial ratios contained in Table 7.6 , we can make the following observations about the company:
Investor Facts
Detecting Fraud Researchers have discovered that information published in financial statements can be helpful in predicting which firms are most likely to commit accounting fraud. Firms that are most likely to commit fraud include those with the following characteristics:
· Declining receivables turnover
· Falling gross profit margins
· Rapidly growing sales (because fast-growing firms may face great temptation to commit fraud in order to raise more capital)
· Rising debt ratios
· Net income that exceeds cash flow from operations
(Source: Messod D. Beneish,”The Detection of Earnings Manipulation,” Financial Analysts Journal, Vol. 55, No. 5, pp. 24-36.)
1. Universal’s liquidity position is a bit below average. This doesn’t seem to be a source of major concern, however, especially when you consider its receivables and inventory positions. That is, based on its respective turnover ratios (see item 2 below), both of these current assets appear to turn faster than the industry average, which means that Universal holds lower receivables and inventory balances relative to sales than other firms do. This could explain the relatively low current ratio of this company. That is, the current ratio is a bit below average not because the firm has a lot of current liabilities but because it is doing such a good job in controlling current assets.
2. Universal’s activity measures are all way above average. This company consistently has very high turnover measures, which in turn make significant contributions not only to the firm’s liquidity position but also to its profitability. Clearly, the company has been able to get a lot more from its assets than the industry as a whole.
3. The company’s leverage position seems well controlled. It tends to use a lot less debt in its financial structure than the average firm in the office equipment industry. The payoff for this judicious use of debt comes in the form of a coverage ratio that’s well above average.
Figure 7.2 An Example of a Published Report with Financial Statistics
This and similar reports are widely available to investors and play an important part in the security analysis process.
(Source: Mergent, May 17, 2015. © 2015.)
Table 7.6 Comparative Historical and Industry Ratios
|
|
Historical Figures for Universal Office Furnishings, Inc. |
Office Equipment Industry Average in 2016 |
|||
|
|
2013 |
2014 |
2015 |
2016 |
|
|
Liquidity measures |
|
|
|
|
|
|
Current ratio |
1.55 |
1.29 |
1.69 |
1.34 |
1.45 |
|
Quick ratio |
1.21 |
1.02 |
1.26 |
1.06 |
1.15 |
|
Activity measures |
|
|
|
|
|
|
Receivables turnover |
9.22 |
8.87 |
9.18 |
8.53 |
5.7 |
|
Inventory turnover |
15.25 |
17.17 |
16.43 |
18.69 |
7.8 |
|
Total asset turnover |
1.85 |
1.98 |
2.32 |
2.06 |
0.85 |
|
Leverage measures |
|
|
|
|
|
|
Debt-equity ratio |
0.7 |
0.79 |
0.91 |
0.6 |
1.58 |
|
Equity multiplier |
3.32 |
3.45 |
3.64 |
3.20 |
6.52 |
|
Times interest earned |
15.37 |
26.22 |
32.49 |
17.55 |
5.6 |
|
Profitability measures |
|
|
|
|
|
|
Net profit margin |
6.60% |
7.50% |
8.00% |
7.20% |
4.60% |
|
Return on assets |
9.80% |
16.40% |
18.60% |
14.80% |
3.90% |
|
Return on equity |
25.90% |
55.50% |
67.80% |
47.40% |
17.30% |
|
Common stock measures |
|
|
|
|
|
|
Earnings per share |
$ 1.92 |
$ 2.00 |
$ 2.17 |
$ 2.26 |
N/A |
|
Price-to-earnings ratio |
16.2 |
13.9 |
15.8 |
18.4 |
16.2 |
|
Dividend yield |
0.30% |
0.40% |
0.40% |
0.40% |
1.10% |
|
Payout ratio |
5.20% |
5.50% |
6.00% |
6.60% |
24.80% |
|
Price-to-book-value ratio |
7.73 |
10.73 |
10.71 |
8.72 |
3.54 |
4. The profitability picture for Universal is equally attractive. The profit margin, return on assets, and ROE are all well above the industry norms. Clearly, the company is doing an outstanding job in managing its profits and is getting good results from its sales, assets, and equity.
Ratio Analysis Overview
In summary, our analysis shows that this firm is very well managed and highly profitable. The results of this are reflected in common-stock ratios that are consistently equal or superior to industry averages. Universal does not pay out a lot in dividends, but that’s only because it uses those valuable resources to finance its growth and to reward its investors with consistently high ROEs.
Looking at the Competition
In addition to analyzing a company historically and relative to the average performance of the industry, it’s useful to evaluate the firm relative to two or three of its major competitors. A lot can be gained from seeing how a company stacks up against its competitors and by determining whether it is, in fact, well positioned to take advantage of unfolding developments. Table 7.7 offers an array of comparative financial statistics for Universal and three of its major competitors. One is about the same size (Cascade Industries), one is much smaller (Colwyn Furniture), and one is much larger (High Design, Inc.).
As the data in Table 7.7 show, Universal can hold its own against other leading producers in the industry. Indeed, in virtually every category, Universal’s numbers are
Table 7.7 Comparative Financial Statistics: Universal Office Furnishings and Its Major Competitors (All figures are for year-end 2016 or for the 5-year period ending in 2016; $ in millions)
|
Financial Measure |
Universal Office Furnishings |
Cascade Industries |
Colwyn Furniture |
High Design, Inc. |
|
Total assets |
$ 941.20 |
$ 906.70 |
$342.70 |
$ 3,037.60 |
|
Long-term debt |
$ 177.80 |
$ 124.20 |
$ 73.90 |
$ 257.80 |
|
Stockholders’ equity |
$ 294.50 |
$ 501.30 |
$183.90 |
$1,562.20 |
|
Stockholders’ equity as a % of total assets |
31.30% |
55.30% |
53.70% |
51.40% |
|
Total revenues |
$1,938.00 |
$1,789.30 |
$642.20 |
$3,316.10 |
|
Net earnings |
$ 139.70 |
$ 87.40 |
$ 38.50 |
$ 184.20 |
|
Net profit margin |
7.20% |
4.90% |
6.00% |
5.50% |
|
5-year growth rates in: |
|
|
|
|
|
Total assets |
14.4% |
19.4% |
17.3% |
17.7% |
|
Total revenues |
15.0% |
17.8% |
15.9% |
15.8% |
|
EPS |
56.7% |
38.9% |
21.1% |
24.7% |
|
Dividends |
1.5% |
11.1% |
N/A |
12.0% |
|
Total asset turnover |
2.06 |
1.97 |
1.88 |
1.09 |
|
Debt-equity ratio |
0.60 |
0.43 |
1.46 |
0.17 |
|
Times interest earned |
17.55 |
13.38 |
8.35 |
14.36 |
|
ROA |
14.80% |
9.50% |
6.70% |
6.70% |
|
ROE |
47.40% |
18.80% |
21.80% |
13.00% |
|
P/E ratio |
18.4 |
14.4 |
13.3 |
12.4 |
|
PEG ratio |
1.2 |
2.4 |
2.0 |
1.1 |
|
Payout ratio |
6.60% |
26.20% |
N/A |
32.40% |
|
Dividend yield |
0.40% |
1.80% |
N/A |
2.60% |
|
Price-to-book-value ratio |
8.7 |
2.7 |
2.9 |
1.6 |
about equal or superior to those of its three major competitors. It may not be the biggest (or the smallest), but it outperforms them all in profit margins and growth rates (in revenues and earnings). Equally important, it has the highest asset turnover, ROE, and price-to-earnings ratio. Tables 7.6 and 7.7 clearly show that Universal Office Furnishings is a solid, up-and-coming business that’s been able to make a name for itself in a highly competitive industry. The company has done well in the past and appears to be well managed today. Our major concern at this point is whether Universal can continue to produce above-average returns for investors.
Concepts in Review
Answers available at http://www.pearsonhighered.com/smart
1. 7.12 What is fundamental analysis? Does the performance of a company have any bearing on the value of its stock? Explain.
2. 7.13 Why do investors bother to look at the historical performance of a company when future behavior is what really counts? Explain.
3. 7.14 What is ratio analysis? Describe the contribution of ratio analysis to the study of a company’s financial condition and operating results.
4. 7.15 Contrast historical standards of performance with industry standards. Briefly note the role of each in analyzing the financial condition and operating results of a company.
