CHAPTER 8 FINANCIAL STATEMENT ANALYSIS: APPLICATIONS Presenter’s name Presenter’s title dd Month yyyy

EVALUATION OF A COMPANY’S PAST PERFORMANCE Copyright © 2013 CFA Institute 2

EVALUATION OF A COMPANY’S PAST PERFORMANCE: APPLE Copyright © 2013 CFA Institute 3 $ (millions)

EVALUATION OF A COMPANY’S PAST PERFORMANCE: APPLE Copyright © 2013 CFA Institute 4 Fiscal Year ($ millions) Net sales$65,225$42,905$37,491$24,578 Gross margin25,68417,22213,1978,152 Net income (NI)14,013 8,2356,1193, Gross margin (% sales)39%40%35%33%

EVALUATION OF A COMPANY’S PAST PERFORMANCE: APPLE Copyright © 2013 CFA Institute 5 Panel A: Data for Apple Inc.Fiscal Year ($ millions) Cash and marketable securities $51,011$33,992$24,490$15,386 Total current assets 41,67831,55530,00621,956 Total assets 75,18347,50136,17124,878 Total current liabilities 20,72211,50611,3619,280

EVALUATION OF A COMPANY’S PAST PERFORMANCE: APPLE Copyright © 2013 CFA Institute 6

FORECASTING Copyright © 2013 CFA Institute 7 Sales Forecast Expenses Gross Profit Operating Profit Assets Liabilities Cash Flow

FORECASTING Copyright © 2013 CFA Institute 8 Sales Forecast Expenses Gross Profit Operating Profit Assets Liabilities Cash Flow

FORECASTING Copyright © 2013 CFA Institute 9 Sales Forecast Expenses Gross Profit Operating Profit Assets Liabilities Cash Flow

FORECASTING Copyright © 2013 CFA Institute 10 Sales Forecast Expenses Gross Profit Operating Profit Assets Liabilities Cash Flow

ITERATIONS IN FORECASTING Copyright © 2013 CFA Institute 11 Forecast Debt Forecast Interest Expense Forecast Income and Taxes Forecast Cash Flow Sales Forecast Expenses Gross Profit Operating Profit Assets Liabilities Cash Flow Example 8-5

FORECASTING OPERATING PROFIT BASED ON HISTORICAL MARGINS Johnson & Johnson (NYSE: JNJ) U.S. health care conglomerate, founded in sales of around $61.9 billion from its three main businesses: pharmaceuticals, medical devices and diagnostics, and consumer products. For the four years prior to 2009, average operating profit margin was approximately 25.0%. Baidu (NASDAQ: BIDU) Chinese language internet search engine, established in 2000 and went public on NASDAQ in Revenues for 2009 were 4.4 billion renminbi (RMB), an increase of 40% from 2008 and more than 14 times greater than revenues in For the four years prior to 2009, average operating profit margin was approximately 27.1%. Copyright © 2013 CFA Institute 12

FORECASTING OPERATING PROFIT BASED ON HISTORICAL MARGINS Johnson & Johnson (NYSE: JNJ) 2009 sales were $61.9 billion. For the four years prior to 2009, average operating profit margin was approximately 25.0%. Actual operating profit for 2009 was $15.6 billion. Actual operating profit margin for 2009 was 25.2%. Baidu (NASDAQ: BIDU) 2009 revenues were 4.4 billion renminbi (RMB). For the four years prior to 2009, average operating profit margin was approximately 27.1%. Actual operating profit for 2009 was RMB1.6 billion. Actual operating profit margin for 2009 was 36.4%. Copyright © 2013 CFA Institute 13

ASSESSING CREDIT QUALITY Credit risk: Risk of loss caused by a debtor’s failure to make a promised payment Credit analysis: Evaluation of credit risk -Risk in a particular transaction or for a particular security -Obligor’s overall creditworthiness Copyright © 2013 CFA Institute 14

TECHNIQUES FOR ASSESSING CREDIT QUALITY Credit scoring—statistical techniques Period-by-period cash flow projections Analysis of business and financial risk factors Copyright © 2013 CFA Institute 15

ASSESSING CREDIT QUALITY: EXAMPLE Bombardier Inc. BAE Systems plc EBITDA/Average assets7.5%10.1% Debt/EBITDA Retained cash flow to debt6.1%13.7% Free cash flow to net debt–7.0%7.7% Copyright © 2013 CFA Institute 16

STOCK SCREENING Universe of Stocks Stocks Meeting Criteria Copyright © 2013 CFA Institute 17 Selection

EXAMPLE OF STOCK SCREENS Stocks Meeting Criterion CriterionNumberPercent of Total P/E <151, % Total debt/Assets ≤ % NI/Sales > 02, % Dividend yield > 0.5%1, % Meeting all four criteria simultaneously % Copyright © 2013 CFA Institute 18 Source for data:

SCREENS AND BACK-TESTING Valuation metrics + Accounting metrics Evaluation of screen using “back-testing” Caveats when back-testing: -Survivorship bias -Look-ahead bias -Data-snooping bias Copyright © 2013 CFA Institute 19

TWO HYPOTHETICAL SCREENING STRATEGIES Strategy A Invest in stocks that are components of a global equity index, have an ROE above the median ROE of all stocks in the index, and have a P/E less than the median P/E. Strategy B Invest in stocks that are components of a broad- based U.S. equity index, have a ratio of price to operating cash flow in the lowest quartile of companies in the index, and have shown increases in sales for at least the past three years. Copyright © 2013 CFA Institute 20

TWO HYPOTHETICAL SCREENING STRATEGIES: AVOID UNINTENTIONAL SELECTIONS Strategy A Invest in stocks that are components of a global equity index, have an ROE above the median ROE of all stocks in the index, and have a P/E less than the median P/E. What if Net income was < 0 and Equity < 0? Strategy B Invest in stocks that are components of a broad- based U.S. equity index, have a ratio of price to operating cash flow in the lowest quartile of companies in the index, and have shown increases in sales for at least the past three years. What if operating cash flow was < 0? Copyright © 2013 CFA Institute 21

ANALYST ADJUSTMENTS Importance (materiality). Is an adjustment to this item likely to affect the conclusions? In other words, does it matter? In an industry where companies require minimal inventory, does it matter that two companies use different inventory accounting methods? Body of standards. Is there a difference in the body of standards being used (U.S. GAAP versus IFRS)? If so, in which areas is the difference likely to affect a comparison? Methods. Is there a difference in accounting methods used by the companies being compared? Estimates. Is there a difference in important estimates used by the companies being compared? Copyright © 2013 CFA Institute 22

INVESTMENTS Investments -Unrealized gains and losses on the income statement versus -Unrealized gains and losses not on the income statement but instead recognized in equity. If two otherwise comparable companies have significant differences, it may be useful to adjust. Copyright © 2013 CFA Institute 23

INVENTORY: EXAMPLE Company A (FIFO) Company B (LIFO) Current assets (includes inventory)$300,000$80,000 LIFO reserveNA$20,000 Current liabilities$150,000$45,000 Copyright © 2013 CFA Institute 24 NA = not applicable

INVENTORY: EXAMPLE Company A (FIFO) Company B Unadjusted (LIFO basis) Adjusted (FIFO basis) Current assets (includes inventory)$300,000$80,000$100,000 Current liabilities$150,000$45,000 Current ratio Copyright © 2013 CFA Institute 25

GOODWILL AND INTANGIBLE ASSETS SCHWAMTD Market capitalization on January 2010 (market price per share times the number of shares outstanding)$21,871$11,525 Total shareholders’ equity as of most recent quarter$5,073$3,551 Goodwill$528$2,472 Other intangible assets$23$1,225 Copyright © 2013 CFA Institute 26 The MV/BV for the companies is SCHW$21,871/$5,073 = 4.3 AMTD$11,525/$3,551 = 3.2 Note: MV/BV equals the total market value of the stock (the market capitalization) divided by total stockholders’ equity. It is also referred to as the price-to-book ratio because it can also be calculated as price per share divided by stockholders’ equity per share.

GOODWILL AND INTANGIBLE ASSETS Copyright © 2013 CFA Institute 27 ($ millions) SCHWAMTD Total stockholders’ equity $5,073$3,551 Less goodwill $528$2,472 Book value, adjusted $4,545$1,079 Adjusted MV/BV ($ millions) SCHWAMTD Total stockholders’ equity$5,073$3,551 Less goodwill$528$2,472 Less other intangible assets$23$1,225 Tangible book value$4,522($146) MV/tangible book value4.8NM NM = not meaningful

OFF-BALANCE-SHEET FINANCING Use disclosures to assess a company’s financial position as if off- balance-sheet obligations (e.g., operating leases) were included in its total liabilities. Steps: -Determine present value of future operating lease payments. -Add present value of future operating lease payments to total debt and to total assets. -Adjust expenses to -Include depreciation expense, interest expense. -Exclude rent expense. The adjustments for operating leases essentially treat the transaction as if the asset subject to the operating lease had been purchased rather than leased. Copyright © 2013 CFA Institute 28

SUMMARY Financial statement analysis applications discussed in this presentation include Evaluating a company’s past performance. Projecting a company’s future performance. Assessing the credit quality of a potential debt investment. Screening for potential equity investments. Adjusting a company’s financial statements to facilitate cross-sectional comparison. Copyright © 2013 CFA Institute 29