Investments: Analysis and Behavior Chapter 10- Financial Statement Analysis ©2008 McGraw-Hill/Irwin

10-2 Learning Objectives Evaluate company profitability. Assess and interpret the return on equity. Determine a firm’s financial liquidity. Compute valuation indicators

10-3 Investing versus Speculating Stock investors own a small part of the companies they hold.  Business ownership  In the long run, the stock will perform as well (or as poorly) as the underlying business. Speculating  Expectation of short-term trading profits from share- price fluctuations.  Underlying business is irrelevant So investors need to know about the underlying business!

10-4 Financial Statements Companies report their business success/failure with quarterly and annual (10-K) financial statements  Balance Sheet “Snapshot” of information at a specific point in time  Income Statement “Video” of business activities over a specific time period  Cash Flow Statement Change in the company’s cash position over a specific period of time

10-5 Microsoft

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10-7 Earning Profits Net income (accounting profits)  Difference between revenues and expenses, often expressed after taxes. Earnings per share (EPS)  Net income divided by the number of shares outstanding Diluted earnings  Net income divided by the number of shares outstanding after consideration for the possible conversion of stock options, buy-backs, etc.

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10-10 Problems with Accounting Information Historical cost versus market value Economic costs versus accounting costs  Depreciation  Cash flow versus earnings Multiple ways under GAAP to treat various assets, revenue, and costs

10-11 Assessing Performance Through Financial Ratios Profitability

10-12 Using Microsoft’s financial statements in Tables 10.1 to 10.3, compute its net profit margin, ROE, and ROA using net cash flow from operations information for 2005.

10-13 Elements of ROE Du Pont formula  Why has ROE changed?  Total Asset Turnover (TAT): ability to generate sales from asset base  Leverage: extent to which debt is used to capitalize the company

10-14 In 2004 and 2005, Microsoft’s ROE was 10.9% and 25.5%, respectively. Why did Microsoft’s ROE increase so dramatically over this year? Solution: Use the Du Pont system equation: For 2004 For 2005 First, Microsoft had a large increase in its profit margin. Second, Microsoft paid a big dividend in November 2004 to distribute excess cash to shareholders. This reduced the assets and equity in the firm, which magnified its asset turnover ratio on leverage ratio.

10-15 Operating Efficiency More Leverage Variables

10-16 Compute the 2005 receivables turnover and inventory turnover for Microsoft. Solution: Use the Balance Sheet and Income Statement information:

10-17 Financial Liquidity current ratio < 1 would signal a potential problem

10-18 Indications of Value Stock price is not an indication of value  i.e., stock splits Price-earnings ratio (P/E)  Earnings yield (E/P)

10-19 Since the market P/E ratio can change dramatically over time, relative P/E ratios are sometimes used: firm P/E divided by benchmark P/E Table 10.4 Compare Financial Ratios with Industry Averages Market Cap ($Billion) Net Profit MarginROE % Debt to Equity Microsoft Technology Sector5, Application Software Internet Software & Services Internet Service Providers Personal Computers Wireless Communications Source: Yahoo! Finance

10-20 Price to book ratio  Sometimes Book to Market (B/M) issued.  Low P/B (high B/M) firms are considered value firms Dividend yield  Last 12 months of dividends / current stock price  Remember, dividends make up roughly one third of a stock investor’s total return!

10-21 Economic Value Added (EVA) Economic wealth added to the firm  business profits less the compensation for debt and equity holders EVA = Net Operating Profit after Taxes (NOPAT) – (Capital of the Firm × Cost of Capital) In 2005, Microsoft’s EVA  NOPAT was $12.25 billion.  It is an all equity firm with market capitalization of about $275 billion.  Assuming a cost of capital of 14%.  Microsoft’s EVA is $–26.25 billion (= $ $275×0.14). Even though Microsoft has an outstanding profit margin and ROE, it has not been generating enough wealth to fully compensate its stockholders for their capital. This may be why Microsoft stock has languished within a range of $24 to $30 for three years.

10-22 Can Financial Statements Be Trusted? Accounting scandals Accounting restatements  Changing the numbers…

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