1. Chapter 17
Company Analysis

2. Learning Objectives Define fundamental analysis at the company level.
Explain the accounting aspects of a company’s earnings.
Describe the importance of EPS forecasts.
Estimate the P/E ratio of a company.
Use the beta coefficient to estimate the risk of a stock. 2

3. Fundamental Analysis
Last step in top-down approach is individual company analysis
Goal: estimate share’s intrinsic value
Constant growth version of dividend discount model
Value justified by fundamentals 2

4. P0 = estimated EPS  justified P/E ratio
Fundamental Analysis
Earnings multiple could also be used
P0 = estimated EPS  justified P/E ratio
Stock is under- (over-) valued if intrinsic value is larger (smaller) than current market price
Focus on earnings and P/E ratio
Dividends paid from earnings
Close correlation between earnings and stock price changes 3

5. Accounting Aspects of Earnings
How is EPS derived and what does EPS represent?
Financial statements provide majority of financial information about firms
Analysis implies comparison over time or with other firms in the same industry
Focus on how statements used, not made 4

6. Basic Financial Statements
Balance Sheet
Items listed in order of liquidity (assets) or in order of payment (liabilities)
Assets
Cash vs. non-cash assets
Non-cash assets may be worth more or less than the amount carried on the books
Depreciation methods for fixed assets
Inventory evaluation choices 5

7. Basic Financial Statements
Balance Sheet
Liabilities
Fixed claims against the firm
Equity
Residual claims
Adjusts when the value of assets change
Linked to Income Statement
“Snapshot” at one point in time 6

8. Basic Financial Statements
EBT
- Taxes
Net Income available to owners
- Dividends
Addition to Retained Earnings
EPS and DPS
Income Statement
Sales or revenues
- Product costs
Gross profit
- Period Costs
EBIT
- Interest
EBT 7

9. Basic Financial Statements
Earnings per share
EPS = Net Income/average number of shares outstanding
Net Income before adjustments in accounting treatment or one-time events
Certifying statements
Auditors do not guarantee the accuracy of earnings, but only that statements are a fair financial representation 8

10. Problems with Reported Earnings
EPS for a company is not a precise figure that is readily comparable over time or between companies
Alternative accounting treatments used to prepare statements
Difficult to gauge the ‘true’ performance of a company with any one method
Investors must be aware of these problems 9

11. Analyzing a Company’s Profitability
Important to determine whether a company’s profitability is increasing or decreasing and why
Return on equity (ROE) emphasized because it is a key component in finding earnings and dividend growth
EPS = ROE  Book value per share 10

12. DuPont Analysis Share prices depend partly on ROE
Management can influence ROE
Decomposing ROE into its components allows analysts to identify adverse impacts on ROE and to predict future trends
Highlights expense control, asset utilization, and debt utilization 11

13. DuPont Analysis ROE depends on the product of:
Profit margin on sales: EBIT/Sales
Total asset turnover: Sales/Total Assets
Interest burden: Pre-tax Income/EBIT
Tax burden: Net Income/Pre-tax Income
Financial leverage: Total Assets/Equity
ROE = EBIT efficiency  Asset turnover  Interest burden  Tax burden  Leverage 12

14. Obtaining Estimates of Earnings
Expected EPS is of the most value
Stock price is a function of future earnings and the P/E ratio
Investors estimate expected growth in dividends or earnings by using quarterly and annual EPS forecasts
Estimating internal growth rate
EPS1 = EPS0(1+g) 13

15. Estimating an Internal Growth Rate
Future expected growth rate matters in estimating earnings, dividends
g = ROE  (1 – Payout ratio)
Only reliable if company’s current ROE remains stable
Estimate is dependent on the data period
What matters is the future growth rate, not the historical growth rate 14

16. Forecasts of EPS Security analysts’ forecasts of earnings
Consensus forecast superior to individual
Time series forecast
Use historical data to make earnings forecasts
Evidence favours analysts over statistical models in predicting what actual reported earnings will be
Analysts are still frequently wrong 15

17. Earnings Surprises
What is the role of expectations in selecting stocks?
Old information will be incorporated into stock prices if market is efficient
Unexpected information implies revision
Stock prices affected by
Level and growth in earnings
Market’s expectation of earnings 16

18. Earnings Game Analysts attempt to guess earnings
Company provides “guidance” as to what it thinks earnings will be
“Guidance number” plays a major role in the consensus estimate
Variance of the actual reported earnings has constituted the earnings surprise
Earning surprises are guided by companies in the form of earnings preannouncements

19. Using Earnings Estimates
The surprise element in earnings reports is what really matters
There is a lag in adjustment of stock prices to earnings surprises
One earnings surprise leads to another
Watch revisions in analyst estimates
Stocks with revisions of 5% or more – up or down – often show above or below-average performance 17

20. The P/E Ratio
Measures how much investors currently are willing to pay per dollar of earnings
Summary evaluation of firm’s prospects
A relative price measure of a stock
A function of expected dividend payout ratio, required rate of return, expected growth rate in dividends 18

21. Dividend Payout Ratio Dividend levels usually maintained
Decreased only if no other alternative
Not increased unless it can be supported
Adjust with a lag to earnings
In theory, the higher the expected payout ratio, the higher the P/E ratio
However, growth rate will probably decline, adversely affecting the P/E ratio 19

22. Required Rate of Return
A function of the riskless rate of return and a risk premium
k = RF + RP
Constant growth version of dividend discount model can be rearranged so that
k = (D1/P0) + g
Growth forecasts are readily available 20

23. Required Rate of Return
Risk premium for a stock regarded as a composite of business, financial, and other risks
If the risk premium rises (falls), then k will rise (fall) and P0 will fall (rise)
If RF rises (falls), then k will rise (fall) and P0 will fall (rise)
Discount rates and P/E ratios move inversely to each other 21

24. g = ROE  (1 – Payout ratio)
Expected Growth Rate
Function of return on equity and the retention rate
g = ROE  (1 – Payout ratio)
The higher the g, the higher the P/E ratio
P/E ratio depends on
Confidence that investors have in expected growth
Reasons for earnings growth 22

25. Fundamental Security Analysis in Practice
Regardless of detail and complexity, analysts and investors seek an estimate of earnings and a justified P/E ratio to determine intrinsic value
Security analysis always involves predicting an uncertain future; mistakes will be made and outlooks will differ 23

26. Appendix 17-A Financial Ratio Analysis
Used to examine a firm’s financial performance
A ratio on its own has limited value – to be useful, one must examine:
Trends
Ratios of comparable firms or industry benchmarks

27. Appendix 17-A Financial Ratio Analysis
Five types of ratios used to analyze a firm:
Liquidity: ability to generate cash and meet short-term debt
Asset Management: ability to effectively manage its assets to generate sales and profits
Debt Management: ability to effectively handle its debt
Profitability: ability to generate profits
Value: market value versus accounting values

28. Example STATEMENT OF INCOME: 2000 2001 2002 2003 2004
Total Revenue
Cost of Sales
Depreciation/Amortization...
40100
43600
76800
75300
101300
Interest Expense
5300
7500
53200
52600
79000
Research / Exploration......
36300
53700
73100
Other Expense
33100
46100
56400
37900
Unusual Items
Pre-Tax Income
108800
117200
120500
121400
150900
Income Tax
-19900
-25700
-20400
-13700
-18100
Earnings BEFORE Extra. Items
88900
91500
100100
107700
132800
Extraordinary Items
Income AFTER Extra. Items
Dividends - Preferred Shares
3500
3800
4000
2900
2600
Income Available to Common Shares
85400
87700
96100
104800
130200
Earnings /Share
0.68
0.706
0.727
0.85
Common Shares - Year End (1000s)
125658
131398
141443
152337
154280
Common Shares - Average (1000s)
125536
128932
136073
144121
153237
Dividends - Common Shares...
14700
22000
28700
27400
32200
Market Price per Share (Close)
6.69
7.63
7.88
17.13
11.63

29. ASSETS:
2000
2001
2002
2003
2004
Cash & Equivalent
150000
84000
87500
179200
235100
Accounts Receivable
174000
428800
413700
360100
380400
Inventory
220200
583500
992700
Marketable Securities
Other
<TOTAL> Current Assets......
544200
Fixed Assets - Gross
less: Accumulated Depreciation
Fixed Assets - Net
606500
840700
<TOTAL> Assets
LIABILITIES AND EQUITY:
1997
1998
1999
Bank Loans & Equivalent.....
147800
346800
537400
620800
828500
Accounts Payable
347200
684400
831800
901400
Current Portion of L-T Debt.
5400
30000
20800
19300
56400
<TOTAL> Current Liabilities
500400
Long-Term Debt & Debentures.
83500
211000
425500
586600
963700
Deferred Taxes & Credits....
41600
42000
53800
43300
Equity: Preferred Stock.....
158300
157700
37400
35700
34100
Common Stock
190600
223100
347400
476800
465200
Retained Earnings...
176300
242000
309400
386800
484800
Total Equity
525200
622800
694200
899300
984100
<TOTAL> Liabilities + Equity

30. XYZ COMPANY FINANCIAL RATIOS: 2000 2001 2002 2003 2004 Current Ratio
1.09
1.03
1.07
1.14
Acid Test (Quick) Ratio
0.65
0.48
0.36
0.35
0.27
ACP (days)
44.54
73.02
52.21
42.97
31.22
Inventory Turnover
5.62
3.31
2.58
2.22
Total Asset Turnover
1.24
1.11
1.13
1.00
1.04
Debt Ratio
0.51
0.66
0.71
0.69
0.76
Debt-to-Equity Ratio
2.04
2.62
2.37
3.28
Equity Multiplier
2.19
3.11
3.69
3.41
4.34
TIE (or Interest Coverage)
21.53
16.63
3.27
2.91
Net Income Margin
6.23%
4.27%
3.46%
3.52%
2.99%
Return on Assets (ROA)
7.73%
4.72%
3.90%
3.51%
3.11%
Return on Equity (ROE)
16.93%
14.69%
14.42%
11.98%
13.49%
P/E Ratio
9.84
11.21
11.15
23.56
13.68
M/B Ratio
2.29
2.15
1.70
3.02
1.89
Dividend Yield
1.75%
2.24%
2.68%
1.11%
1.81%
Dividend Payout Ratio
0.17
0.25
0.30
0.26

31. INDUSTRY AVERAGES FINANCIAL RATIOS: 2000 2001 2002 2003 2004
Current Ratio
2.12
2.85
2.25
2.01
1.69
Acid Test (Quick) Ratio
1.21
1.97
1.36
1.24
1.09
ACP (days)
35.20
34.09
44.50
45.90
46.90
Inventory Turnover
7.78
8.20
7.68
8.52
8.16
Total Asset Turnover
1.78
1.43
1.37
1.26
1.23
Debt Ratio
0.23
0.33
0.32
0.29
Debt-to-Equity Ratio
0.36
0.61
0.56
0.49
0.55
Equity Multiplier
1.57
1.82
1.70
1.74
TIE (or Interest Coverage)
34.41
42.19
5.95
5.53
8.61
Net Income Margin
8.47%
6.03%
4.34%
4.19%
5.68%
Return on Assets (ROA)
15.08%
8.64%
5.95%
5.27%
7.01%
Return on Equity (ROE)
23.68%
15.72%
10.59%
8.96%
12.20%
P/E Ratio
6.42
9.08
12.13
22.38
15.53
M/B Ratio
1.51
1.42
1.28
2.00
1.88
Dividend Yield
1.71%
1.73%
2.86%
2.67%
2.08%
Dividend Payout Ratio
0.13
0.24
0.35
0.39
0.26

32. A. Liquidity 1. Current Ratio = Current assets / Current liabilities
For XYZ (2004):
= 2,418,600 / 2,265,800 = 1.07
2. Quick Ratio
= [CA – Inventory] / Current liabilities
For XYZ (2004)
= (2,418,600 – 1,803,100) / 2,265,800
= 0.27

33. B. Asset Management 3. Average Collection Period (ACP)
= Account Receivable / (Sales/365days)
For XYZ (2004):
= 380,400 / (4,448,000/365) = days
Note:
A/R Turnover = Sales / Acct Receivable
= 365 / ACP
For XYZ (2004) = 365/31.22 days = times

34. B. Asset Management (Cont’d)
4. Inventory Turnover
= Cost of goods / Inventory
or = Net Sales / Inventory
For XYZ (2004) (using COGS):
= (4,005,800) /1,803,100
= 2.22 times
Days Inventory = Inventory / Daily COGS (or Sales)
= 365 / Inventory Turnover
For XYZ (2004) = 365/2.22 = days
5. Total Asset Turnover = Sales / TA = 4,488,000 / 4,270, = 1.042

35. C. Debt Ratios 6. Debt Ratio = Total Debt / TA
TA = Debt + Equity
6. Debt Ratio = Total Debt / TA
= (2,265, ,700) / 4,270,000
= 0.756
7. Debt-to-Equity = Total Debt / Total Equity
= (2,265, ,700) / 984,100
= 3.282

36. C. Debt Ratios (Cont’d) 8. Leverage Ratio (or Equity Multiplier)
= TA / Equity
= 4,270,000 / (984,100)
= 4.339
Higher values More debt
9. TIE (or Interest Coverage)
= EBIT / Interest
= (150, ,000) / 79,000 = 2.91 times

37. D. Profitability 10. ROE = NI / Equity = 132,800 / 984,100 = 13.49%
11. ROA = NI / TA
= 132,800 / 4,270,000 = 3.11%
12. Net Income Margin = NI / Sales
= 132,800 / 4,448,000 = 2.99%

38. E. Value Ratios 14. P/E = Market Price per Share / EPS
13. Dividends Payout = DPS / EPS or
= Common Dividends / Earnings Available to Common Shareholders
= 32,200 / 130,200 = = 24.73%
14. P/E = Market Price per Share / EPS
= / 0.85 = 13.68

39. E. Value Ratios (Cont’d)
15. Market-to-book (M/B) = Market price per share / Book value per share
= / [(984,100 – 34,100) / 154,280]
= / 6.16 = 1.89
16. Dividend Yield = DPS / Market price per share
= (32,200 / 153,237) / = .21 / = 1.81%

40. DuPont Analysis NI / Sales = Net Income Margin NI / TA = ROA
Tax Burden
Interest Burden
EBIT Efficiency
TA Turnover
LeverageRatio
NI / Sales = Net Income Margin
NI / TA = ROA
Leverage Ratio = TA / Equity

41. Net Profit Margin
Asset Turnover
Leverage Ratio

42. XYZ (2004)
NI / EBT = 132,800 / 150,900 = .880
EBT / EBIT = 150,900 / (150, ,000) = 150,900 / 229,900 = .656
EBIT / Sales = 229,900 / 4,448,000 = .0517
Sales / TA = (previously calculated)
TA / Equity = (previously calculated)
ROE = (.8800)(.6564)(.0517)(1.042)(4.339) = = 13.50%
This differs from the 13.49% we calculated previously due to rounding errors

43. XYZ (2004) NI / Sales = 0.0299 (previously calculated)
Sales /TA = (previously calculated)
Calculate ROA = (.0299)(1.042) = = 3.11% (equals the 3.11% previously calculated)
TA / Equity = (previously calculated)
So, ROE = (.0299)(1.042)(4.339) = 13.52% (differs from 13.49% previously calculated due to rounding errors)

44. Liquidity Below average Bad trend
Current and quick ratios of 1.07 and 0.27 are both well below industry averages of 1.69 and 1.09
Bad trend
Current ratio has been steady, but quick ratio has deteriorated significantly
Low and deteriorating quick ratio is due to high levels of inventory

45. Asset Management
Collections as measured by ACP is above average (31 days versus 47 days) and is improving
Inventory turnover is very low (2.3 versus industry average of 8.2), and has been continually deteriorating, and they maintain high inventory levels
TA turnover is below average, has been over the period, and continues to deteriorate

46. Debt Management
Debt levels have increased steadily and coverage has deteriorated
Debt ratio is 0.76 (from 0.51 in 2000)
Debt-to-equity is 3.28 (from 1.11 in 2000)
Coverage is 2.91 (from in 2000)
Debt capacity and coverage are both below average
Debt ratio is 0.76 versus 0.32 industry average
Debt-to-equity is 3.28 versus 0.55 industry average
Coverage is 2.91 versus 8.61 industry average

47. Profitability
Steady decline in net income margin, ROA, and ROE over period
Below industry averages, except for ROE
ROE is above average due to use of greater leverage (as noted above)

48. DuPont Analysis XYZ (2004) Industry averages (2004)
ROE = (NI/Sales) (Sales/TA) ((TA/Equity)
= (.0299)(1.042)(4.339) = 13.51%
Industry averages (2004)
= (.0568)(1.23)(1.74) = 12.16%
This analysis suggests that XYZ displays an above average ROE due to its higher leverage factor, and despite the fact it has below average profitability and asset turnover

49. Value Ratios
P/E and M/B ratios are close to average, which is also the case for their dividend yields (Note: a lower dividend yield implies a higher price)
They have been close to, or slightly above average over the entire period
This suggests the market views XYZ as an “average” company despite some of the problems we have observed

50. Summary
Below average and deteriorating in terms of liquidity, inventory turnover, and debt management
However, they are profitable, even if they are not up to industry standards, and their profitability is dwindling
The market views XYZ as an “average” company despite its problems
XYZ will probably have to deal with its debt, inventory and liquidity problems in order to maintain an average valuation in the market

51. Copright
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