Week 3
mloi01
IPPTChap019.pptINVESTMENTS | BODIE, KANE, MARCUS
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Chapter Nineteen
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Financial Statement Analysis
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Financial Statement Analysis
- Financial statement analysis can be used to discover mispriced securities.
- Financial accounting data are widely available; however, accounting earnings and economic earnings are not always the same thing.
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Financial Statements
- Income Statement:
- Profitability over time
- Balance Sheet:
- Financial condition at a point in time
- Statement of Cash Flows:
- Tracks the cash implications of transactions.
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Accounting Versus Economic Earnings
- Economic earnings
- Sustainable cash flow that can be paid to stockholders without impairing productive capacity of the firm
- Accounting earnings
- Affected by conventions regarding the valuation of assets
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Table 19.1 Consolidated Statement of Income for Home Depot, 2012
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Table 19.2 Consolidated Balance Sheet for Home Depot, 2012
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Table 19.3 Statement of Cash Flows for Home Depot, 2012
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Measuring Firm Performance
- Manager responsibilities:
- 1. Investment decisions
- 2. Financing decisions
- Ratios used to show efficiency and profitability of these decisions:
- ROA- income earned per dollar deployed
- ROC- income earned per dollar invested (long term)
- ROE net income realized by shareholders per dollar invested
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Measuring Firm Performance
- ROE is a key determinant of earnings growth.
- Past profitability does not guarantee future profitability.
- Security values are based on future profits.
- Expectations of future dividends determine today’s stock value.
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Financial Leverage and ROE
- ROE can differ from ROA because of leverage.
- Leverage makes ROE more volatile.
- Let t=tax rate and r=interest rate, then:
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Financial Leverage and ROE
- If there is no debt or ROA = r, ROE will simply equal ROA(1 - t).
- If ROA > r, the firm earns more than it pays out to creditors and ROE increases.
- If ROA < r, ROE will decline as a function of the debt-to-equity ratio.
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Table 19.5 Impact of Financial
Leverage on ROE
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INVESTMENTS | BODIE, KANE, MARCUS
Economic Value Added
- EVA is the difference between return on assets (ROA) and the opportunity cost of capital (k), multiplied by the capital invested in the firm.
- EVA is also called residual income
- If ROA > k, value is added to the firm.
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Example 19.2 Intel
- In 2012, Intel’s cost of capital was 7.8%. Its ROA was 13.9% and its capital base was $56.34 billion.
- Intel’s EVA =
(0.139-0.078) x $56.34 billion = $3.44 billion
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Decomposition of ROE
DuPont Method
Tax Burden
Interest Burden
Margin
Turnover
Leverage
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Decomposition of ROE
ROA=EBIT/Sales x Sales/Assets
= margin x turnover
- Margin and turnover are unaffected by leverage.
- ROA reflects soundness of firm’s operations, regardless of how they are financed.
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Decomposition of ROE
ROE=Tax burden x ROA x Compound leverage factor
- Tax burden is not affected by leverage.
- Compound leverage factor= Interest burden x Leverage
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Table 19.7 Ratio Decomposition Analysis for Nodett and Somdett
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Choosing a Benchmark
- Compare the company’s ratios across time.
- Compare ratios of firms in the same industry.
- Cross-industry comparisons can be misleading.
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Table 19.8 Differences between Profit Margin and Asset Turnover across Industries
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Table 19.9 Summary of Key Financial Ratios
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Table 19.9 Summary of Key Financial Ratios
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Table 19.9 Summary of Key Financial Ratios
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INVESTMENTS | BODIE, KANE, MARCUS
Table 19.9 Summary of Key Financial Ratios
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Table 19.10 Summary of Key Financial Ratios
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Figure 19.3 DuPont Decomposition for Home Depot
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Comparability Problems
- Accounting Differences
- Inventory Valuation
- Depreciation
- Inflation and Interest Expense
- Fair Value Accounting
- Quality of Earnings
- International Accounting Conventions
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International Accounting Differences
- Reserves – many other countries allow more flexibility in use of reserves
- Depreciation – US allows separate tax and reporting presentations
- Intangibles – treatment varies widely
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Figure 19.4 Adjusted Versus Reported Price-Earnings Ratios
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The Graham Technique
- Rules for stock selection:
- Purchase common stocks at less than their working-capital value.
- Give no weight to plant or other fixed assets.
- Deduct all liabilities in full from assets.
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