1. EQUITY ANALYSIS: FINANCIAL STATEMENT ANALYSIS FNCE 455 Class Session #12 Lloyd Kurtz Santa Clara University 1

2. Topics Quality of Earnings The Dupont Equation EVA Concept 2

3. Quality of Earnings 3

4. What does that mean? Quality of earnings is a judgmental measure of how well a company’s reported earnings reflect economic reality. When the market discovers earnings aren’t real, stocks go down. My first question in all equity analysis: “are the earnings real?” 4

5. Oxford Healthcare, 1997 5

6. McKesson, 1997 - 2000 6

7. Lehman 5/02 - Present 7

8. Two earnings conventions GAAP Earnings Include special charges. Include options expense. Earnings from continuing operations may or may not be included. Definition changes over time. Wall Street Earnings Also called “Proforma”, “Operating” or “FirstCall” earnings Exclude special charges. Often exclude options expense. Usually include earnings from continuing operations. 8

9. Google earnings per share 9 Source: Bloomberg, Company Reports

10. Regulation G “[R]equires public companies that report non-GAAP financial measures to present with those measures the both the most directly comparable GAAP measure as well as a reconciliation of those measures with the comparable GAAP figure.” 10

11. Manipulating GAAP: choices Allowance for bad debts Non-recurring items Reserves management Stock options Revenue recognition Off-balance sheet assets and liabilities 11

12. Quality of earnings tests Ratio of Cash Flow from Operations (CFFO) to Net Income Over multiple periods Cash Flow From Operations (CFFO) should exceed GAAP Net Income “Owner Earnings” (CFFO-Capex) Over multiple periods owner earnings should equal or exceed GAAP Net Income Earnings Growth vs. CFFO Growth Measured over several quarters (at least!) If earnings are really growing over time, so should CFFO Exception: Hyper-growth phase Use of Cash Does the company pay a regular dividend? (Graham) Does the company regularly repurchase stock? Doesn’t count if they issue stock to pay for it! (look at share count) 12

13. Google earnings and cash flows 13

14. The Dupont Equation 14

15. The ROE  growth connection For a firm that pays no dividend Growth in book value = Return on Equity (ROE)* For a firm paying a dividend Growth in book value = ROE* x Retention Rate Retention rate = % of earnings not paid out in dividends 15 * GAAP-based ROE, not ‘Operating’

16. Book value growth at Google 16 Compound annual growth rate (CAGR) of 53% from 2004-2011

17. Importance of the tool The Dupont equation can help you… Evaluate how a company has grown Identify what has changed in the business Examine whether the company can continue its success in the future 17

18. ‘Five ratio’ model 1 = Tax Burden 2 = Interest Burden Ratio 3 = Operating Profit Margin (“Return on Sales”) 4 = Total Asset Turnover (“ATO”) 5 = Leverage Ratio (a.k.a Financial Leverage or ‘Gearing’) 18 ROE = Net Profit Net Profit Pretax Profit EBIT EBIT x EBITSalesSalesAssets xx AssetsEquity (1) x (2) x (3) x (4) x (5) x See BK&M section 14.4 for more on the Dupont Equation.

19. A simpler decomposition 19 ROE = Net Profit Net Profit Pretax Profit EBIT EBIT x EBITSalesSalesAssets xx AssetsEquity (1) x (2) x (3) x (4) x (5) x 1 = Tax Burden 2 = Interest Burden Ratio 3 = Operating Profit Margin (“Return on Sales”) 4 = Total Asset Turnover (“ATO”) 5 = Leverage Ratio (a.k.a Financial Leverage or ‘Gearing’)

20. ‘Three-ratio’ model 20 ROE = Net Profit Net Profit Sales Sales SalesAssets xx AssetsEquity Margins Total Asset Turnover (“ATO”) Financial Leverage

21. Buffett’s criteria (1982) 1) Large purchases (at least $5 million of after-tax earnings), 2) demonstrated consistent earning power (future projections are of little interest to us, nor are “turn-around” situations), 3) businesses earning good returns on equity while employing little or no debt, 4) management in place (we can’t supply it), 5) simple businesses (if there’s lots of technology, we won’t understand it), 6) an offering price (we don’t want to waste our time or that of the seller by talking, even preliminarily, about a transaction when price is unknown). “We can promise complete confidentiality and a very fast answer as to possible interest - customarily within five minutes.” 21 Source: Berkshire Hathaway

22. Dell ROE, fiscal 2007 22 66% = 4.6% 4.6%2.5xx5.75 Net Margin Total Asset Turnover (“ATO”) Financial Leverage

23. High ROEs over many years 23

24. Warren’s kind of company 24

25. Economic Value Added 25

26. EVA concept Unprofitable growth does not add to shareholder value 26

27. The EVA concept 27 “A firm should only be viewed as successful if the return on its projects is better than investors could expect to earn for themselves (on a risk- adjusted basis) in the capital market. “…[P]lowing back funds into the firm increases share value only if the firm earns a higher rate of return on the reinvested funds than the opportunity cost of capital, that is, the market capitalization rate. “To account for this opportunity cost, we might measure the success of the firm using the difference between the return on assets, ROA, and the opportunity cost of capital. Economic Value Added (EVA) is the spread between ROA and the cost of capital multiplied by the capital invested in the firm. Another term for EVA is residual income.” - BK&M p. 457-458

28. The EVA concept EVA Margin is the difference between ROA and the firm’s cost of capital. EVA Calculation Using Equity Cost of Capital J&J’s ROA = 16-17% Current Cost of Equity Capital ≈ 9% EVA Margin of 7-8% This is all pre-tax and does not include important adjustments made by EVA research services, such as the after-tax cost of borrowing and treating R&D investments as an asset. 28

29. A tool, not a strategy “A portfolio of the 50 firms that had the highest absolute levels of economic value added earned an annual return of 12.9% between February 1987 and February 1997, while the S&P index returned 13.1% a year over the same period.” “A portfolio of the 50 firms that had the highest growth rates in economic value added over the previous year earned an annual return of 12.8% over the same period.” 29 Aswath Damodaran, Investment Fables