Chapter 17 Company Analysis.

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Presentation transcript:

Chapter 17 Company Analysis

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Example STATEMENT OF INCOME: 2000 2001 2002 2003 2004 Total Revenue............... 1426000 2143300 2892300 3058600 4448000 Cost of Sales............... 1238700 1931400 2559400 2699200 4005800 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

ASSETS: 2000 2001 2002 2003 2004 Cash & Equivalent........... 150000 84000 87500 179200 235100 Accounts Receivable......... 174000 428800 413700 360100 380400 Inventory................... 220200 583500 992700 1215700 1803100 Marketable Securities....... Other....................... <TOTAL> Current Assets...... 544200 1096300 1493900 1755000 2418600 Fixed Assets - Gross 1372700 1650500 1956200 2277600 2914600 less: Accumulated Depreciation -766200 -809800 -886600 -961900 -1063200 Fixed Assets - Net.......... 606500 840700 1069600 1315700 1851400 <TOTAL> Assets.............. 1150700 1937000 2563500 3070700 4270000 LIABILITIES AND EQUITY: 1997 1998 1999 Bank Loans & Equivalent..... 147800 346800 537400 620800 828500 Accounts Payable............ 347200 684400 831800 901400 1380900 Current Portion of L-T Debt. 5400 30000 20800 19300 56400 <TOTAL> Current Liabilities........ 500400 1061200 1390000 1541500 2265800 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

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

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

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

B. Asset Management 3. Average Collection Period (ACP) = Account Receivable / (Sales/365days) For XYZ (2004): = 380,400 / (4,448,000/365) = 31.22 days Note: A/R Turnover = Sales / Acct Receivable = 365 / ACP For XYZ (2004) = 365/31.22 days = 11.69 times

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 = 164.4 days 5. Total Asset Turnover = Sales / TA = 4,488,000 / 4,270,000 = 1.042

C. Debt Ratios 6. Debt Ratio = Total Debt / TA TA = Debt + Equity 6. Debt Ratio = Total Debt / TA = (2,265,800 + 963,700) / 4,270,000 = 0.756 7. Debt-to-Equity = Total Debt / Total Equity = (2,265,800 + 963,700) / 984,100 = 3.282

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 = (150,900 + 79,000) / 79,000 = 2.91 times

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%

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 = .2473 = 24.73% 14. P/E = Market Price per Share / EPS = 11.63 / 0.85 = 13.68

E. Value Ratios (Cont’d) 15. Market-to-book (M/B) = Market price per share / Book value per share = 11.63 / [(984,100 – 34,100) / 154,280] = 11.63 / 6.16 = 1.89 16. Dividend Yield = DPS / Market price per share = (32,200 / 153,237) / 11.63 = .21 / 11.63 = 1.81%

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

Net Profit Margin Asset Turnover Leverage Ratio

XYZ (2004) NI / EBT = 132,800 / 150,900 = .880 EBT / EBIT = 150,900 / (150,900 + 79,000) = 150,900 / 229,900 = .656 EBIT / Sales = 229,900 / 4,448,000 = .0517 Sales / TA = 1.042 (previously calculated) TA / Equity = 4.339 (previously calculated) ROE = (.8800)(.6564)(.0517)(1.042)(4.339) = .1350 = 13.50% This differs from the 13.49% we calculated previously due to rounding errors

XYZ (2004) NI / Sales = 0.0299 (previously calculated) Sales /TA = 1.042 (previously calculated) Calculate ROA = (.0299)(1.042) = .0311 = 3.11% (equals the 3.11% previously calculated) TA / Equity = 4.339 (previously calculated) So, ROE = (.0299)(1.042)(4.339) = 13.52% (differs from 13.49% previously calculated due to rounding errors)

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

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

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 21.53 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

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)

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

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

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

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