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FIN405-01-Topic2Presentation-ScottFungSpringSemester20191.pdf
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FIN 405-01 Corporate Finance Topic #2
Corporate Financial Analysis
Dr. Scott Fung
California State University, East Bay
Spring Semester 2019
Overview of Topic #2
Learning Objectives: Principles and elements of financial analyses and financial planning models. Analyzing firm performance with corporate finance theories.
Important Concepts: Objectives and information content of financial analysis. Measures of a firm’s financial characteristics and performance. Integration of business activities and financial analysis.
Tools/Learning Outcomes: Financial planning models and sustainable growth rate. External financing needs. Corporate financial analyses and financial ratios.
Step-by-Step Learning Activities of Topic #2:
I. “Building Blocks” of Financial Analyses II. Major Elements of Financial Planning Models III. Relationships and Information Content of Financial Statements. IV. Financial Analyses
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1. Objectives of Financial Analysis Firm Value and Asymmetric Information: Financial information is imperfect.
There are fundamental differences between Firm Value Creation Process and Financial Information:
Financial analysis is essentially the integrated system of tools to generate, understand, and act upon key financial information. Financial analysis provides the transformation of imperfect information into meaningful solutions for firm valuation and financial management (see Financial Analysis System below).
Develop Financial Planning Model: Investment and Operating Strategy; Capital Structure Choice; Control and Governance.
Insights of Corporate Financial Analysis: Financial analyses should be systematic, efficient, and forward-looking in nature. Financial analyses provide quantitative assessment and qualitative insight of firm characteristics and performance.
Value Creation Imperfect Information Informative Signals Valuation
Non -verifiable CF Financial Analysis Financial Management
Growth Options Corporate Strategy
Goal of Financial Analysis: Improve Financial Transparency (Reduce Information Asymmetry)
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2. Financial Planning Models
The objective is to ensure that firm can coordinate its investment and financing activities (i.e., projected and coordinated funds required for firm’s future investment needs).
Financial Planning Models rely on sources and uses of fund to project external financing requirements:
Total external financing needs = Total uses of funds – Operating cash flow
Total uses of funds = Investment in fixed assets + Investment in NWC + Dividends
Insight: External financing needs are related to a firm’s growth opportunities and have implications related to the corporate financial system (see Topic #1).
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3. Major Elements of Completed Financial Planning Models
(1) Pro Forma Financial Statements (1.1) Balance Sheets (1.2) Income Statements (1.3) Sources and Uses of Cash
(2) Description of Planned Capital Expenditures
(3) Summary of Planned Financing
Develop Financial Planning Model: Investment and Strategy Leverage, Liquidity, External Financing Needs
Financial Statements are published and available online. For publicly traded firm, you can search for annual 10-K report and quarterly 10-Q with SEC’s EDGAR database.
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3.1. Relationships (Stock vs. Flow) in Financial Statements
Cash Flow Statement
Cash from operations
Cash from financing
Net Change in Cash
Beginning B/S Statement of Equity Ending B/S
Cash - Net payout to SH Cash
+Other Assets + Net Income +Other Assets
-Liabilities -Liabilities
Owner’s Equity Net Change in Equity Owner’s Equity
Income Statement
Revenues
Expenses
Net Income
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3.2. Steps in Financial Planning Models
Step 1: Project operating CFs based on projected sales and cost assumptions, using Pro Forma Income Statement.
Step 2: Project uses of funds (increase in net WC, fixed assets, dividends), by estimating investments in fixed and current assets needed to meet the sales projection.
Step 3: Calculate External Financing Needs:
Total external financing needs = Total uses of funds – Operating cash flow
where:
Total uses of funds = Investment in fixed assets + Investment in NWC + Dividends
Step 4: Construct Pro Forma Balance Sheet based on projected increase in assets, the needed financing, and determine financing structure - “balancing items” (unconstrained financial variables).
Step 5: Perform sensitivity/scenario analyses.
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4. “Building Blocks” of Corporate Financial Analyses Step (1) Business Strategy Analysis: Firm’s core competency and managing
business as a system. Understanding value creation and risk drivers. (1.1) Corporate strategy and firm type analysis (1.2) Industry and competitive analysis (1.3) Economic environment analysis
Step (2) Accounting Analysis: Factors affecting the informative content, flexibility, and distortion of accounting information.
(2.1) Comparable analysis across firm types and over time (2.2) Removing accounting distortion, managerial bias, and estimation errors
Step (3) Financial Analysis: Financial statement models. Ratio analysis. Cash flow analysis. Funds cycles for manufacturing, sales, and services. Cash management.
(3.1) Efficiency, profitability and growth analysis (3.2) Financing and liquidity analysis (3.3) Risk analysis
Step (4) Prospective Analysis: Forecasting firm values. (4.1) Free Cash Flows valuation (4.2) Other valuation methods: Economic Profits, EVA, etc. (4.3) Sensitivity/scenario analyses and simulations.
Step (5) Integrative Analysis: Policy implications for corporate financial management and strategy.
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4.1. Tools and Techniques of Financial Analysis
Comparative (Horizontal) Analysis Evaluate consecutive financial statements. Time-series performance of the firm (e.g., quarterly, semi-
annual, and annual).
Common Size (Vertical) Analysis Evaluate financial performance across firms (e.g., cross-
sectional comparison with comparable firms, competitors, and industry averages).
Ratio Analysis Variables computed from mathematical (economic)
relationships between financial variables. Evaluate performance and understand future prospect, yet
ratios only provide the basis for interpretation and analysis.
Cash Flow Analysis Valuation of the firm (FCF) – determine intrinsic (true) value of
the firm.
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5. Growth Measures and Projections: Sustainable Growth and Financing Needs
Financial planning examines the relationship between growth, investment, and financing – e.g., sustainable growth and external financing needs.
Managers can estimate future growth for financing needs: Case (1) Without external financing, internal growth measures can be used to estimate the internal growth rate and the sustainable growth rate – the growth that can be pursued without external financing or without additional equity financing. Case (2) With external financing, other growth measures can be used.
Internal Growth Rate (Growth measures without any External Financing): Internal Growth Rate = Retained Earnings / Total Assets = (Retained Earnings/Net Income) * (Net Income/Equity) * (Equity/Total Assets) = Plowback ratio * Return on Equity * (Equity / Total Assets)
Note: Plowback ratio = (1 Payout ratio); Payout ratio = Dividends/Net Income Interpretation: the Internal Growth Rate is the maximum growth rate a firm can achieve without external financing.
Sustainable Growth Rate (Growth measures without additional Equity Issues): Sustainable Growth Rate = Plowback ratio * Return on Equity = (Retained Earnings/Net Income) * (Net Income/Equity)
Equivalently, Sustainable Growth Rate = (1 Payout ratio) * Return on Equity Interpretation: the Sustainable Growth Rate is the highest growth rate without additional equity issues. It is also the highest growth rate without increasing the firm’s financial leverage (i.e., steady growth rate with optimal capital structure).
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6. Measures of Firm Size (NOT Firm Value!)
Measures of Firm Size: (i) Total Assets (ii) Total Sales (iii) Market Capitalization (Market Cap = Stock Price * Shares
Outstanding) Categorization of companies by capitalization Smaller companies tend to be riskier In general:
• Micro-Cap: capitalization below $250 million. • Small-Cap: capitalization between approximately $250
million and $1 billion • Mid-Cap: capitalization between approximately $1 billion
and $10 billion • Large-Cap or blue chip: capitalization over approximately
$10 billion
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7. Financial Ratios Analysis Objectives of financial ratio analysis: to provide informative signals
about a firm’s fundamental characteristics, financial conditions, and performance.
Major Financial Ratios and Measurements:
(1) Leverage Ratios: assessing long-term/debt financing decision and risk of financial distress.
(2) Liquidity Ratios: assessing corporate liquidity, financial distress, and financing-investment interactions.
(3) Efficiency Ratios: understanding operating efficiency, operation decision, expansion, shut-down, etc.
(4) Profitability Ratios: assessing a firm’s profitability and operating performance.
(5) Market Valuation Measures: understanding market valuation, risk, growth opportunities, etc.
(6) The Du Pont System: interrelation and decomposition of ratios.
Important Framework: The 2-Step Approach to Financial Ratios
Objective: learning how to use financial ratios to assess a firm’s characteristics, financial conditions, and performance.
Insights (“story”): focusing on the economic insights and applications of key financial ratios in the context of firm performance analysis; e.g., we focus on drawing insights and inference from ratios based on overall market averages and industry/comparable benchmarks.
Methodology (important): for the following financial ratios, we will apply the “2-Step Approach” to financial ratio analyses:
Step (1): Comparing with overall market averages across all firms/industries and/or critical values;
Step (2): Comparing with specific industry/comparable benchmarks.
Note: you will be required to use the “2-Step Approach” for vertical ratio analysis in your Individual Research Assignments – Part 1 (Equity Research). In parallel, time-series (horizontal) ratio analysis can be used to examine changes in financial ratios over time.
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(I) Leverage Ratios
Debt Ratio = (Long-term Debt + Value of Leases) / (Long-Term Debt + Value of Leases + Equity)
Most frequently used Leverage Ratios: Long-Term Debt Ratio = Long-Term Debt / (Long-
Term Debt + Equity) Debt / Equity Ratio = Debt / Equity Time Interest Earned = (EBIT + Depreciation) /
Interest
Long-Term Solvency/ Default Risk Ratios: Interest Coverage Ratio = EBIT / Interest Expense CFs from Operations / Capital Expenditures
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How to Use/Apply Leverage Ratios One major leverage ratio is:
Long-Term Debt Ratio = Long-term Debt / (Long-Term Debt + Equity)
Long-Term Debt Ratio (above) reflects a firm’s capital structure.
Step (1): Overall Firm Average: U.S. firms have an average Long-Term Debt Ratio of
approximately 20% to 30% (average) over time. Firms that have Long-Term Debt Ratio greater than 40%
(critical value) should be interpreted with caution – this could be a sign of financial distress risk.
Step (2): Industry Average: High tech industry has no/low debt ratio. Supermarkets, and Airline Industries persistently have high
debt ratio (as high as 60 to 70% or more).
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Example of Leverage Ratio ABC is a manufacturing company with:
Long-Term Debt Ratio = 70%
What can we say about ABC’s leverage ratio here?
Step (1): Overall Firm Average: U.S. firms have an average Long-Term Debt Ratio of 20 to 30%
(average) over time. Firms that have Long-Term Debt Ratio greater than 40% (critical
value) should be interpreted with caution – this could be a sign of financial distress risk.
ABC seems to have excessively high leverage – a sign of financial distress as the firm over-borrows. Before we draw the conclusion, let’s compare ABC’s leverage ratio with its industry benchmarks.
Step (2): Industry Average: Let’s compare ABC with its industry competitors: Manufacturing
firms have some debt. Assume we find that the average long-term debt ratio of the manufacturing industry is 40%. In this case, we can conclude that ABC has high leverage and potentials of financial distress problem.
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(II) Liquidity Ratios
Liquidity Ratios NWC-to-Total Assets = NWC / Total Assets Current Ratio = Current Asset / Current Liabilities Quick/Acid Ratio = (Cash + Marketable Securities +
Receivables) / Current Liabilities Cash Ratio = (Cash + Marketable Securities) /
Current Liabilities
Working Capital Turnover Ratios Accounts Receivable Turnover = Sales / Average
Account Receivable Inventory Turnover = Cost of Goods Sold / Average
Inventory
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How to Use/Apply Liquidity Ratios
One major liquidity ratio is:
Current Ratio = Current Asset / Current Liabilities
Step (1): Overall Firm Average: Overall average current ratio is about 2 to 2.5
(average). A healthy firm should have a current ratio of at
least 1 to 1.25 (critical value). Low current ratio may suggest corporate liquidity problem and high risk of financial distress.
Step (2): Industry Average: Firms in Finance industry should have higher
liquidity ratios.
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Example of Liquidity Ratio ABC is a manufacturing company with:
Current Ratio = 0.7
What can we say about ABC’s current ratio here?
Step (1): Overall Firm Average: ABC has current ratio that is lower than average value
of 2 to 2.5. ABC has corporate liquidity problem and risk of distress
(significantly below the critical value of 1 to 1.25).
Step (2): Industry Average: Let’s compare ABC with its industry competitors:
Assume we find that the industry average liquidity ratio is about 2; now, we can conclude that ABC has liquidity problem.
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(III) Efficiency Ratios Measures how efficiently the firm uses in assets and
capacity utilization.
Sales-to-Assets (Asset Turnover) = Sales / Average Total Assets
Note: Average Total Assets is the sum of the Total Assets (beginning and end of fiscal period) divided by 2:
Average Total Assets = [Total Assets(beginning of fiscal period) + Total Assets(end of fiscal period)] / 2.
Days in Inventory = (Average Inventory / Cost of Goods Sold) * 365
Average Collection Period = Average Receivables / Average Daily Sales
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How to Use/Apply Efficiency Ratios
One major efficiency ratio is:
Sales-to-Assets (Asset Turnover) = Sales / Average Total Assets
Step (1): Overall Firm Average: U.S. firms have an wide range of average Asset
Turnover of approximately 0.5 to 2 (average) over time, with significant variations across different industries.
Step (2): Industry Average: Manufacturing industries tend to have low Asset
Turnover ratios. Mature firms tend to have low Asset Turnover too.
High tech and service industries tend to have high Asset Turnover ratios.
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Example of Efficiency Ratio
ABC is a manufacturing company with:
Asset Turnover Ratio = 0.7
What can we say about ABC’s Asset Turnover ratio here?
Step (1): Overall Firm Average: Hard to say here because industries have significant
difference in term of efficiency ratios. We need to examine the industry benchmark for ABC.
Step (2): Industry Average: Manufacturing firms have low Asset Turnover ratios. For
example, ABC’s competitors have Asset Turnover ratios of 0.5. Based on this comparison, we can say that ABC operates more efficiently than its industry peers.
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(IV) Profitability Measures Profitability Ratios ROA = EBIT*( 1 – tax) / Average Total Assets Net Profit Margin = EBIT*(1 – tax) / Sales Profit Margin = Net Income / Sales Pretax Operating Margin = EBIT / Sales Operating Leverage = Percentage Change in Operating Profits /
Percentage Change in Sales
Return on Equity ROE = Net Income / Book Value of Equity ROE = [(EBIT– interest Expense)*(1 – tax)] / Book Value of Equity Alternative measure: ROE = Net Income / Market Value of Equity (note: ratio using market
value can be more difficult to interpret)
Payout Ratio Payout Propensity Ratio = Dividend per share / Earnings per share Dividend Yield = Dividend per share / Price per share Dividend-to-Book = Dividend / Book Value of Equity
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How to Use/Apply Profitability Ratios Major Profitability Ratios are:
ROA = EBIT*( 1 – tax) / Average Total Assets ROE = [(EBIT– interest Expense)*(1 – tax)] / Book Value of Equity
Step (1): Overall Firm Average: The critical value for ROA is: +9% to +10% (critical value) The critical value for ROE is: +10% to +11% (critical value) Firms that have ROA and ROE above these critical values can
be identified as companies with good operating performance. Further, we need to examine if firms perform better than their industry peers in terms of ROA and ROE.
Step (2): Industry Average: General rule: firms that have some competitive advantages
(sustainable monopoly power) often have high ROA or ROE (even after adjusted for industry peers). In contrast, mature firms or firms do not have competitiveness (or a highly competitive industry) often have low ROA or ROE.
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Example of Profitability Ratio
ABC is a manufacturing company with:
ROA = 7% ROE = 5%
What can we say about ABC’s Profitability ratio here?
Step (1): Overall Firm Average: ABC does not demonstrate strong operating performance,
because ROA is lower than the critical value of 9% to 10% and ROE are lower than the critical value of 10% to 11%.
Step (2): Industry Average: ABC’s competitors have ROA of 8% and ROE of 5%. Here
we conclude that ABC operates in a highly competitive industry, as its ROA and ROE are low and ABC does not perform better than its industry peers.
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How to Use/Apply Profitability Ratios
Other useful Profitability Ratios are:
Payout Ratio Payout Propensity Ratio = Dividend per share / Earnings per
share Dividend Yield = Dividend per share / Price per share Dividend-to-Book = Dividend / Book Value of Equity
Useful Averages: Average Payout Propensity Ratio = 30% to 40% (average)
Important Note: the average payout ratio above is computed based on firms that pay dividends; however, only about 1/3 of publicly traded firms paid dividends.
Average Dividend Yield = 2% to 3% (average) Average Dividend-to-Book = 5% to 10% (average)
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(V) Market Valuation Measures Price-to-Book Ratios: P/B = Stock price / Book value per share
Note: Value of Equity = Value of Firm – Value of Debt Market Premium = Market Value of Equity – Book Value of Equity P/B ratios are often used to understand anticipated growth
opportunities.
Price-Earnings Ratios: P/E = Stock price / Earning per share
Note: P/E ratios are often used to understand anticipated growth opportunities, risk and market multiple. Analysts often use expected growth rate to estimate intrinsic P/E.
In US, P/E is around 10 in 1970s, and P/E is more than 20 in 1990s. Note: Forward P/E should be used (see next page).
Tobin’s q = Market Value of Assets / Estimated Replacement Costs
Dividend Yield = Dividend per share / Price per share (Dividend yield is used to differentiate high vs. low yield stocks)
Variations of the P/E Ratio Trailing P/E or rolling P/E = price per share / sum of earnings
per share for most recent 4 quarters
Forward/Leading P/E = price per share / forecast of future earnings per share
Dividend-adjusted P/E = (price per share + annual dividend per share) / earnings per share
IMPORTANT NOTE about P/E Ratio: Forward/Leading P/E is more reliable (conceptually correct) than Trailing/Rolling P/E. Why? Based on Dividend Growth Model, we should use the “forward” dividends/earnings in valuing present stock price. In practice, how to find “future” earnings to compute Forward/Leading P/E? For example, we can use forecasted earnings including professional analysts’ earnings forecasts (see, e.g., Yahoo.finance for IBM’s earnings forecasts: http://finance.yahoo.com/q/ae?s=ibm).
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How to Use Market Valuation Ratios Major Market Valuation Ratios are: P/E = Price to (Forward) Earnings Ratio P/B = Price to Book Ratio; Book is the Book Value of Equity
Step (1): Overall Firm Average: Average P/E of US firms is: 13 to 15 (average; important) Average P/B of US firms is: 1 to 1.5 (average; important) Usually, we use both P/E and P/B together to have better assessment
of the firm: firms with high P/E and P/B ratios often have higher growth opportunities, lower risk, or higher relative market valuation.
Note: the overall averages above are based on samples of long time- series and large cross-sectional data. There are large variations in these ratios over time and across different industries (see Step (2)).
Step (2): Industry Average: P/E and P/B varies significantly across industries. See examples
provided in this presentation. High tech firms or IPO firms during the internet bubble have extremely
high P/E ratios (e.g., > 20). Mature firms often have lower P/E. Important Note: P/E cannot be negative or too high. P/E will become
difficult to interpret (not informative) when P/E is negative or too high (e.g., > 40).
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Example of P/E Ratios: Selected Firms vs. Competitors/Comparable/Industry
(source: http://financials.morningstar.com)
Forward P/E Ratios (as of July, 2014)
Firm
Step (1) Step (2)
Market Competing/Comparable
Firms
Industry Average (Trailing P/E reported
here)
Apple AAPL: 13.6 S&P: 17.4 Overall: 13‐15
GOOG: 19.0 HPQ: 8.7 SMSN: 6.0
Consumer Electronics: 16.7
Amazon AMZN: 68.5 S&P: 17.4 Overall: 13‐15
BKS: 23.7 EBAY: 15.7 WMT: 14.9
Specialty Retail: 45.9
Goldman Sachs GS: 10.0 S&P: 17.4 Overall: 13‐15
MS: 11.2 SCHW: 23.9 JPM: 9.4
Capital Markets: 15.7
Google GOOG: 19.0
S&P: 17.4 Overall: 13‐15
FB: 36.9 BIDU: 23.8 YHOO: 22.2
Internet Content & Information: 43.9
IBM IBM 9.5 S&P: 17.4 Overall: 13‐15
ACN: 16.2 HPQ: 8.7 MSFT: 14.3
Information Technology Services: 16.2
Source: http://financials.morningstar.com
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Other Measures: Market-to-Book and Market Value Added
Market-to-Book Ratio = Market value of equity/ Book value of equity
Market Capitalization
– Total market value of equity, equal to share price times number of shares outstanding.
Market Value Added
– Market capitalization minus book value of equity.
share)per (priceshares) of (no. tion CapitalizaMarket
ValueBook Equity -tion CapitalizaMarket MVA
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(VI) The Du Pont System Ratios are typically determined by industry characteristics, level of
competition, firm’s own profitability or competitive strength, and financing structure/leverage.
The Du Pont System shows linkage between financial ratios – i.e., relationships between profitability and efficiency ratios.
ROA = (EBIT – Tax) / Assets = Sales/Asset * (EBIT – Tax)/Sales = Asset Turnover * Net Profit Margin
ROE = (EBIT – Tax – Interest)/Equity = Asset/Equity * Sales/Asset * (EBIT – Tax)/Sales
* (EBIT – Tax – Interest)/(EBIT – Tax) = Leverage * Asset Turnover * Net Profit Margin
* (EBIT – Tax – Interest)/(EBIT – Tax)
The Du Pont system provides decompositions of firm performance and characteristics. It can be used as a tool for comparative performance evaluation between firms/industries.
8. Application of Financial Ratio Analyses: Case Study of Toyota
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Financial Ratios
Toyota Honda Industry Interpretations
Leverage ratio 0.29 0.27 0.10
Step (1) lower than general distress threshold of 40%. Step (2) however, Toyota has higher leverage than industry average and key competitor.
Current Ratio 1.1 1.35 1 Step (1) and Step (2) indicate that liquidity of Toyota is close to critical value and industry average but lower than key competitor .
Quick Ratio 1 1.1 0.9 Step (1) and Step (2) indicate that liquidity of Toyota is close to critical value and industry average but lower than key competitor.
Asset Turnover
0.64 0.8 0.7
Step (1) lower than general threshold. We rely more on Step (2) here as ATO ratio is affected by industry. Lower than competitor and industry average. Low efficiency.
Return on Assets (ROA)
0.01 0.04 0.05
Step (1) lower than general threshold of 9%. Step (2) lower than competitor and industry average. We conclude that Toyota has low operating performance.
Return on Equity (ROE)
0.04 0.12 0.12
Step (1) lower than general threshold of 10%. Step (2) lower than competitor and industry average. We conclude that Toyota has low operating performance.
P/E ratio 25.5 10.6 13.9 Step (1) higher than general threshold of 13-15. Step (2) much higher than competitor and industry.
Price to Book Ratio
1.01 1.26 3.6
Step (1) similar to general threshold of 1. Step (2) lower than competitor and industry. Here P/B reveals a different result comparing to P/E ratio.
9. Application of Financial Ratio Analyses: Case of Twitter (TWTR)
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Financial Ratios of Twitter, Inc. (TWTR): Using morningstar.com (http://financials.morningstar.com/ratios/r.html?t=TWTR®ion=usa&culture=en-US), we found the following financial ratios of TWTR (as of July, 2014):
Financial Ratio/Information
Information from Morningstar.com
Interpretations
(1) Market Cap Market Cap = 21.53B Firm Size? Large-Cap, because Market Cap is greater than $10B (see Class #2).
(2) Leverage Ratio = Long-term Debt/(Long-term Debt + Equity) Note: here we apply long-term debt ratio as measure of leverage ratio.
Note: for TWTR, Long-term Debt = 0 As such, Leverage Ratio = 0
Apply the 2-step approach of financial ratio analyses: For Step (1) TWTR’s Leverage ratio is zero while the average leverage ratio of
20-30%. This finding does not suggest risk of financial distress for TWTR (less than the critical value of 40%).
For Step (2) To illustrate, we pick “FB”, “GOOG”, and “LNKD” as comparable firms.
FB: Leverage Ratio = 0 GOOG: Leverage Ratio = 2.78/(2.78+78.7) = 3.4% LNKD: Leverage Ratio = 0 Overall Interpretations: Step (1) suggests that TWTR’s leverage ratio does not suggest high risk of financial distress. Step (2) further reveals that TWTR has similar financial leverage when we compared TWTR with “FB” and “LNKD”. The zero leverage of TWTR is consistent with the industry comparable firms that have zero/low leverage ratio. TWTR does not have high risk of financial distress problem.
(3) Current Ratio Current Ratio = 9.59 Apply the 2-step approach of financial ratio analyses: For Step (1) TWTR’s current ratio is above the average of US firms (overall
average of 2 to 2.5 across US firms). This finding suggests that TWTR does not have corporate liquidity and financial distress problems as the current ratio is above the critical threshold of 1 to 1.25.
For Step (2) we use comparable firms (competitors): FB: Current Ratio = 13.56 GOOG: Current Ratio = 4.63 LNKD: Current Ratio = 3.96 Overall Interpretations: Step (1) shows that TWTR does not have corporate liquidity problem. However, Step (2) reveals that TWTR has higher current ratio compared with GOOG, and LNKD, but lower current ratio compared with FB.
Financial Ratio Analyses: Twitter (continued)
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(4) Asset Turnover
Asset Turnover = 0.24
Apply the 2-step approach of financial ratio analyses: For Step (1) Asset turnover has large variations across firms/industries. It is
important to compare TWTR’s asset turnover with its comparable firms. For Step (2) we use comparable firms (competitors): FB: Asset Turnover = 0.52 GOOG: Asset Turnover = 0.58 LNKD: Asset Turnover = 0.66 Overall Interpretations: TWTR has lower operating efficiency than other competitors, including FB, GOOG and LNKD.
(5) ROA
ROA = -22.37%
We perform the 2-step approach of financial ratio analyses: For Step (1) compared to average US firms, TWTR’s operating performance
(ROA) is negative and much lower than the critical value of ROA (9-10%) across average US firms.
For Step (2) we compare performance of TWTR with its comparable firms: FB: ROA = 11.19% GOOG: ROA = 12.22% LNKD: ROA = -0.37% Overall Interpretations: TWTR has poor operating performance (in terms of its negative and low ROA) compared with average US firm. When examining industry- level performance (Step (2)), we also find that TWTR has poorer (negative) operating performance compared with its competitors FB and GOOG, which have higher and positive operating performance.
(6) ROE
ROE = -25.56%
We perform the 2-step approach of financial ratio analyses: For Step (1) compared to average US firms, TWTR’s operating performance
(ROE) is negative and much lower than the critical value of ROE (10-11%) across average US firms.
For Step (2) we compare performance of TWTR with its comparable firms: FB: ROE = 13.40% GOOG: ROE = 15.58% LNKD: ROE = -0.50% Overall Interpretations: TWTR has poor operating performance (in terms of its negative and low ROE) compared with average US firm. For Step (2), we also find that TWTR has much lower (negative) ROE compared with its competitors that have higher and positive operating performance (except for LNKD).
Financial Ratio Analyses: Twitter (continued)
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(7) Payout Ratio Payout Ratio = 0 Apply the 2-step approach of financial ratio analyses: For Step (1) TWTR does not pay dividends. This finding is consistent with the low/no
payout propensity for recent IPO firms with possible high growth and uncertainty. For Step (2) we compare performance of TWTR with its comparable firms: FB: Payout Ratio = 0 GOOG: Payout Ratio = 0 LNKD: Payout Ratio = 0 Overall Interpretations: TWTR has no dividend payout (comparable firms in similar industry have no payout as well). These results suggest that TWTR is still subject to low profitability and high firm uncertainty. No payout may suggest information asymmetry and weak corporate governance.
(8) Forward P/E 1783.0 (See http://quotes.morning star.com/stock/s?t=T WTR®ion=usa&c ulture=en- US&ownerCountry= USA) Note: finance.yahoo reports Forward P/E = 143.37
Apply the 2-step approach of financial ratio analyses: For Step (1) TWTR’s forward P/E is significantly higher than the average P/E ratio of 13-
15 of U.S. firms. In general, a high P/E usually suggests high growth opportunities, low risk, and/or high market valuation. However, TWTR’s P/E ratio seems too high to be properly interpreted (the high P/E is likely due to very low earnings).
For Step (2) we compare performance of TWTR with its competitors, including: FB: P/E = 41.7 GOOG: P/E = 19.6 LNKD: P/E = 76.6 Overall Interpretations: For Step (1), TWTR’s P/E ratio is much higher than overall average of 13 to 15 yet the P/E ratio is too high to be properly interpreted. For Step (2), TWTR has a P/E ratio that is much higher than the P/E ratios of FB, GOOG, and LNKD.
(9) Price/Book Ratio
7.8 (See http://quotes.morning star.com/stock/s?t=T WTR®ion=usa&c ulture=en- US&ownerCountry= USA)
Apply the 2-step approach of financial ratio analyses: For Step (1) TWTR’s P/B is significantly higher than the average P/B ratio of 1-1.5 of
U.S. firms. A high P/B usually suggests high growth opportunities. For Step (2) we compare performance of TWTR with its comparable firms: FB: P/B = 11.5 GOOG: P/B = 4.4 LNKD: P/B = 7.8 Overall Interpretations: For Step (1), TWTR’s P/B ratio is significantly higher than the overall average of 1 to 1.5. For Step (2), TWTR has higher P/B ratio than GOOG, the same P/B ratio as LNKD, but lower P/B ratio than FB.
Useful Readings for This Class BMA (Brealey, Myers, Allen, 11th or 10th edition):
Ch. 28: focus on section 28-1, 28-4, 28-5, 28-6, 28-7, 28-8.
OR
BMA (Brealey, Myers, Allen, 9th edition):
Ch. 29: focus on section 29.1, 29.3.
Make sure you understand the following concepts and tools during your review:
1. Objectives and “Building Blocks” of Financial Analysis
2. Financial Planning Models
3. Financial analyses – learn how to use financial ratios and information to infer firm characteristics and performances
4. Next topic will be Free Cash Flow (FCF) valuation – learn how to compute FCF of the firm and its implications on firm value to shareholders and agency problem.
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Homework #2 and #3 (See Blackboard “Course Materials” for Homework)
The Homework documents will be available in Blackboard (under “Course Materials”):
Homework #2: due Sunday, Feb 10, 2019 Homework #3: due Sunday, Feb 17, 2019
IMPORTANT Note: The homework is an individual homework that will be important for your study of class materials and your class participation scores.
The homework must be prepared and completed individually. No group work and collaboration will be allowed for individual homework. Failure to follow these requirements may result a final grade of an "F". Please prepare the homework all by yourself and submit your own/original answers to the following email address: [email protected]
The due date of Homework #2 will be: Sunday, Feb 10, 2019. The due date of Homework #3 will be: Sunday, Feb 17, 2019.
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