Fundamental Analysis and Stocks Economics 71a: Spring 2007 Mayo, Chapter 9 Lecture notes 3.3

Why Read or Care? Investment strategies Growth Value Use accounting numbers to estimate growth Value Compare accounting numbers to price

Goals Accounting statements Financial ratios Ratios and valuation

Accounting Statements Income statement Balance sheet Statement of retained earnings Statement of cash flows

Income Statement Flow variables Revenues – Cost of goods sold

Income Statement Example Sales revenues $50 Cost of goods sold $-25 Advertising/Admininstrative expenses $-2 Depreciation $-5 Interest payments $-1 Taxes $-3 Earnings 50-25-2-5-1-3 = $14 EBIT = Earnings before interest and taxes = 50-25-7 = $18 (operating income)

Extraordinary Items: One Time Income and Expenses “Below the line” Should come after other items Part of total earnings Left out of EBIT “core earnings”, “operating earnings” Definitions are blurry on this

Examples Lawsuit settlements One time asset sales (patents/real estate) Pension fund adjustments Changing accounting systems

Income Statement Example Total revenues $50 Cost of goods sold $-25 Advertising + Admin. expenses $-2 Depreciation $-5 Interest payments $-1 Taxes $-3 **Earnings 50-25-2-5-1-3 = $14 (“core earnings”) EBIT = Earnings before interest and taxes = 50-25-7 = $18 (operating income) Lawsuit settlement = $-8 Earnings 50-25-2-5-1-3-8= $6

Balance Sheet Accounting Value of the Firm Assets (things firm owns) Liabilities (Loans) Stockholders’ equity (Assets - Liabilities) Also called Book value Net worth

Assets Cash Accounts receivable Inventories Land Plant and equipment Less: Depreciation

Liabilities Accounts payable Notes payable (short term debt) Long term debt

Balance Sheet Assets Liabilities Shareholder equity 105-76 = $29 Cash $5 Plant and equipment $100 Liabilities Accounts payable $1 Long term debt $75 Shareholder equity 105-76 = $29 Book value

Balance Sheet Shareholders equity Common stock (at issue) $10 Capital surplus $5 Retained earnings 20 Purchased stock (negative) Treasury stock -6 10+5+20-6 = 29

Cash Flow Pure measure of incoming - outgoing cash Differences with income statement No depreciation No accounts payable/receivable Inventories (account for costs of producing and putting in inventory)

Cash Flow Parts Operating Activities Investment Activities Financial Activities

Operating Cash Flow Earnings = $5 Adjust to get to cash flow Depreciation : +5 Why? Remove depreciation adjustments Increase in accounts payable: +5 Why? Haven’t paid this yet. Increase in accounts receivable: -2 Why? Haven’t received this yet. Increase in inventories: -10 Production costs reflect only goods sold. Adjustment: 5+5+5-2-10 = 3 = operating cash flow

Investment Cash Flow Increase in gross fixed assets Purchases of new plant and equipment -30 million : New office building Total investment cash flow = -30 million

Finance Cash Flow Increase in long term debt: Dividends: +50 million of incoming funds Dividends: -20 million payout of divs Total finance cash flow = +30 million

Depreciation Assets “wear out” Firms slowly write them off Balance and income statements Types of depreciation Straight line depreciation Same amount each year Example: 10 years, $100,000 = $10,000 per year Accelerated depreciation More in the early years Production based depreciation

Tax Impact of Depreciation (Timing Effects, 10% tax rate, Asset size = 300) Year (Straight) Earnings Before D Deprec. Tax 1 300 100 20 2 3 (Accel.) 200 10 50 25

Goals Accounting statement Financial Ratios Ratios and valuation

Financial Ratios Ratios of various financial variables Uses Analyze financial well being of a firm Compare different stocks in terms of current values “Find good investments”

Ratios Liquidity ratios Activity ratios Profitability ratios Leverage ratios Coverage ratios Market ratios Dividend payout ratio

Liquidity Ratios Current ratio Quick ratio Current assets / Current liabilities Short term, ability to pay bills Quick ratio (Current assets - inventory) / Current liabilities Take short term inventory out of current assets

Activity Ratios Inventory turnover Receivables turnover Sales/(Average inventory) Receivables turnover (Annual credit sales)/(accounts receivable) High number indicates rapid turnover in credit sales Fixed asset turnover Sales/(fixed assets) (land, plant + equipment)

Profitability Ratios Operating profit margin Net profit margin EBIT/Sales Net profit margin Earnings/Sales Gross profit margin (Revenues-Cost of goods sold)/sales

Profitability Ratios Return on total assets (ROA) Earnings/(total assets) Return on equity (ROE) Earnings/(shareholder equity)

Leverage Ratios Debt to net worth Debt ratio Debt/(share holder equity) Debt ratio Debt/(total assets)

Coverage Ratios Times-interest earned EBIT/ (interest charges)

Market Ratios Share price versus accounting value Very important Examples Price/Earnings ratio Market/Book (M/B) ratio Dividend yield (dividend/Price)

Price Earnings Ratio P/E Ratio

Price Earnings Ratio Price per earnings Example: Microsoft About 20 $20 per $1 of earnings

High Flying P/E’s AOL (1999) near 600 Dell Computer (1999) 100 For many dot com’s no P/E since earnings are zero

PEG Ratio

Market to Book Ratio (M/B)

Market to Book Ratio Market value of the firm relative to its accounting value Key tool for “value investors” Extensive academic evidence that low market to book firms do better on average

Dividend Yield Dividend/Price % payout in dividends relative to price A little like interest, but not really Dividends are not guaranteed

Dividend Payout Net Income Dividend Payout ratio = Divs/Earnings Dividends Retained Earnings Dividend Payout ratio = Divs/Earnings

Goals Accounting statement Financial Ratios Ratios and valuation

Fundamental Analysis Use information about firm to evaluate stock price Growth Estimate earnings growth and future prospects Value Find “undervalued” stocks

Ratio Analysis Many methods Compare ratios to appropriate comparison set Example: P/E ratio for a pharmaceutical firm Compare to industry If low -> buy

Problems With Accounting Information Misses “intangibles” Knowledge base (patents) Customer base Sometimes numbers are zero or negative

More Problems with Accounting Information There are many ways to derive accounting numbers Large “fudge factors” Can clever accountants make things look better?

Accounting “Tricks” Off balance sheet items Expenses to balance sheet Enron Stock options Expenses to balance sheet Worldcom AOL maintenance -> new investment Log revenue forecasts now Xerox Taking over low p/e firms

Goals Accounting statement Financial Ratios Ratios and valuation