1. INVESTMENTS | BODIE, KANE, MARCUS Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin CHAPTER 19 Financial Statement Analysis 1

2. INVESTMENTS | BODIE, KANE, MARCUS 19-2 Financial statement analysis can be used to discover mispriced securities. Financial accounting data are widely available, but –Accounting earnings and economic earnings are not always the same thing! Financial Statement Analysis 2

3. INVESTMENTS | BODIE, KANE, MARCUS 19-3 Income Statement: –Profitability over time Balance Sheet: –Financial condition at a point in time Statement of Cash Flows: –Tracks the cash implications of transactions. Financial Statements 3

4. INVESTMENTS | BODIE, KANE, MARCUS 19-4 Table 19.1 Consolidated Statement of Income for Hewlett-Packard, 2009 4

5. INVESTMENTS | BODIE, KANE, MARCUS 19-5 Table 19.2 Consolidated Balance Sheet for Hewlett-Packard, 2009 5

6. INVESTMENTS | BODIE, KANE, MARCUS 19-6 Table 19.3 Statement of Cash Flows for Hewlett-Packard, 2009 6

7. INVESTMENTS | BODIE, KANE, MARCUS 19-7 Accounting Versus Economic Earnings Economic earnings –Sustainable cash flow that can be paid to stockholders without impairing productive capacity of the firm Accounting earnings –Affected by conventions regarding the valuation of assets 7

8. INVESTMENTS | BODIE, KANE, MARCUS 19-8 Profitability Measures ROE measures profitability for contributors of equity capital. –After-tax profit/book value of equity ROA measures profitability for all contributors of capital. –EBIT/total assets 8

9. INVESTMENTS | BODIE, KANE, MARCUS 19-9 Past vs. Future ROE ROE is a key determinant of earnings growth. Past profitability does not guarantee future profitability. Security values are based on future profits. Expectations of future dividends determine today’s stock value. 9

10. INVESTMENTS | BODIE, KANE, MARCUS 19-10 Financial Leverage and ROE ROE can differ from ROA because of leverage. Leverage makes ROE more volatile. Let t=tax rate and r=interest rate, then: 10

11. INVESTMENTS | BODIE, KANE, MARCUS 19-11 Financial Leverage and ROE If there is no debt or ROA = r, ROE will simply equal ROA(1 - t). If ROA > r, the firm earns more than it pays out to creditors and ROE increases. If ROA < r, ROE will decline as a function of the debt-to-equity ratio. 11

12. INVESTMENTS | BODIE, KANE, MARCUS 19-12 Table 19.5 Impact of Financial Leverage on ROE 12

13. INVESTMENTS | BODIE, KANE, MARCUS 19-13 ROE = Net Profit Pretax Profit x EBIT x Sales Assets xx Equity (1) x (2) x (3) x (4) x (5) x Margin x Turnover x Leverage Tax Burden Interest Burden Decomposition of ROE DuPont Method x 13

14. INVESTMENTS | BODIE, KANE, MARCUS 19-14 Decomposition of ROE ROA=EBIT/Sales X Sales/Assets = margin X turnover Margin and turnover are unaffected by leverage. ROA reflects soundness of firm’s operations, regardless of how they are financed. 14

15. INVESTMENTS | BODIE, KANE, MARCUS 19-15 Decomposition of ROE ROE=Tax burden X ROA X Compound leverage factor Tax burden is not affected by leverage. Compound leverage factor= Interest burden X Leverage 15

16. INVESTMENTS | BODIE, KANE, MARCUS 19-16 Table 19.6 Ratio Decomposition Analysis for Nodett and Somdett 16

17. INVESTMENTS | BODIE, KANE, MARCUS 19-17 Choosing a Benchmark Compare the company’s ratios across time. Compare ratios of firms in the same industry. Cross-industry comparisons can be misleading. 17

18. INVESTMENTS | BODIE, KANE, MARCUS 19-18 Table 19.7 Differences between Profit Margin and Asset Turnover across Industries 18

19. INVESTMENTS | BODIE, KANE, MARCUS 19-19 Table 19.9 Summary of Key Financial Ratios 19

20. INVESTMENTS | BODIE, KANE, MARCUS 19-20 Table 19.9 Summary of Key Financial Ratios 20

21. INVESTMENTS | BODIE, KANE, MARCUS 19-21 Table 19.9 Summary of Key Financial Ratios 21

22. INVESTMENTS | BODIE, KANE, MARCUS 19-22 Table 19.9 Summary of Key Financial Ratios 22

23. INVESTMENTS | BODIE, KANE, MARCUS 19-23 Table 19.9 Summary of Key Financial Ratios 23

24. INVESTMENTS | BODIE, KANE, MARCUS 19-24 Figure 19.1 DuPont Decomposition for Hewlett-Packard 24

25. INVESTMENTS | BODIE, KANE, MARCUS 19-25 Economic Value Added EVA is the difference between return on assets (ROA) and the opportunity cost of capital (k), multiplied by the capital invested in the firm. EVA is also called residual income If ROA > k, value is added to the firm. 25

26. INVESTMENTS | BODIE, KANE, MARCUS 19-26 Example 19.4 Wal-Mart In 2009, Wal-Mart’s cost of capital was 5.9%. Its ROA was 9.6% and its capital base was $115 billion. Wal-Mart’s EVA = (0.096-0.059) x $115 billion = $4.25 billion 26

27. INVESTMENTS | BODIE, KANE, MARCUS 19-27 Accounting Differences –Inventory Valuation –Depreciation Inflation and Interest Expense Fair Value Accounting Quality of Earnings International Accounting Conventions Comparability Problems 27

28. INVESTMENTS | BODIE, KANE, MARCUS 19-28 International Accounting Differences Reserves – many other countries allow more flexibility in use of reserves Depreciation – US allows separate tax and reporting presentations Intangibles – treatment varies widely 28

29. INVESTMENTS | BODIE, KANE, MARCUS 19-29 Figure 19.2 Adjusted Versus Reported Price-Earnings Ratios 29

30. INVESTMENTS | BODIE, KANE, MARCUS 19-30 The Graham Technique Rules for stock selection : –Purchase common stocks at less than their working-capital value. –Give no weight to plant or other fixed assets. –Deduct all liabilities in full from assets. 30