1. INVESTMENTS: Analysis and Management Third Canadian Edition
W. Sean Cleary
Charles P. Jones
Prepared by
Khalil Torabzadeh
University of Lethbridge

2. Chapter 17
Company Analysis

3. 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.
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 17 2

4. Fundamental Analysis
The third 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
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 17 2

5. 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
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 17 3

6. 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
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 17 4

7. 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
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 17 5

8. Financial Statements Balance Sheet Liabilities Equity
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
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 17 6

9. Financial Statements Income Statement EPS and DPS 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
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 17 7

10. 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
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 17 8

11. 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
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 17 9

12. 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
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 17 10

13. Analyzing a Company’s Profitability: Return on Equity
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
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 17 11

14. Analyzing a Company’s Profitability: Return on Equity
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
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 17 12

15. 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)
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 17 13

16. 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
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 17 14

17. 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
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 17 15

18. 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
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 17 16

19. 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
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 17

20. 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
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 17 17

21. 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
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 17 18

22. 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
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 17 19

23. 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
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 17 20

24. 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
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 17 21

25. 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
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 17 22

26. The PEG Ratio where , g = The company’s earnings growth rate.
Firms with low PEG ratios offer the “cheapest profit growth.”
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 17

27. 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
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 17 23

28. Appendix 17A 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
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 17

29. Appendix 17A 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
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 17

30. Example: XYZ Company
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 17

31. Example: XYZ Company
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 17

32. Example: XYZ Company
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 17

33. Example: XYZ Company
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 17

34. 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
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 17

35. 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
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 17

36. 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
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 17

37. 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
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 17

38. 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
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 17

39. 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%
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 17

40. 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
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 17

41. 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%
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 17

42. 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
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 17

43. DuPont Analysis Net Profit Margin Asset Turnover Leverage Ratio
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 17

44. XYZ (2008)
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
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 17

45. XYZ (2008) 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)
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 17

46. 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
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 17

47. 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
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 17

48. Debt Management
Debt levels have increased steadily and coverage has deteriorated
Debt ratio is 0.76 (from 0.51 in 2004)
Debt-to-equity is 3.28 (from 1.11 in 2004)
Coverage is 2.91 (from in 2004)
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
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 17

49. 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)
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 17

50. DuPont Analysis XYZ (2008) Industry averages (2008)
ROE = (NI/Sales) (Sales/TA) ((TA/Equity)
= (.0299)(1.042)(4.339) = 13.51*%
Industry averages (2008)
= (.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
*Rounded
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 17

51. 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
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 17

52. 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
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 17

53. Copyright
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