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Financial Analysts Awareness Program

Financial Analysts Awareness Program. Dr. Mounther Barakat Securities and Commodities Authority. برنامج المحللين الماليين. د. منذر بركات العمري هيئة الاوراق المالية والسلع. Forecasting Example. Balance sheet, in millions of dollars. Cash & sec. $ 20 Accts. pay. & accruals $ 100

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Financial Analysts Awareness Program

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  1. Financial Analysts Awareness Program Dr. Mounther Barakat Securities and Commodities Authority

  2. برنامج المحللين الماليين د. منذر بركات العمري هيئة الاوراق المالية والسلع

  3. Forecasting Example Balance sheet, in millions of dollars Cash & sec. $ 20 Accts. pay. & accruals $ 100 Accounts rec. 240 Notes payable 100 Inventories 240 Total CL $ 200 Total CA $ 500 L-T debt 100 Common stock 500 Net fixed Retained assets 500 earnings 200 Total assets $1,000 Total claims $1,000

  4. Forecasting Example Income statement, in millions of dollars Sales $2,000.00 Less: Var. costs (60%) 1,200.00 Fixed costs 700.00 EBIT $ 100.00 Interest 16.00 EBT $ 84.00 Taxes (40%) 33.60 Net income $ 50.40 Dividends (30%) $15.12 Add’n to RE $35.28

  5. Key assumptions • Operating at full capacity in 2006. • Each type of asset grows proportionally with sales. • Payables and accruals grow proportionally with sales. • 2006 profit margin (2.52%) and payout (30%) will be maintained. • Sales are expected to increase by $500 million. (%GS = 25%)

  6. Determining additional funds needed AFN AFN = (A*/S0)ΔS – (L*/S0) ΔS – M(S1)(RR) = ($1,000/$2,000)($500) – ($100/$2,000)($500) – 0.0252($2,500)(0.7) = $180.9 million.

  7. How shall AFN be raised? • The payout ratio will remain at 30 percent (d = 30%; RR = 70%). • No new common stock will be issued. • Any external funds needed will be raised as debt, 50% notes payable and 50% L-T debt.

  8. Forecasted Income Statement 2006 Forecast Basis 2007 Forecast Sales $2,000 1.25 $2,500 Less: VC 1,200 0.60 1,500 FC 700 0.35 875 EBIT $ 100 $ 125 Interest 16 16 EBT $ 84 $ 109 Taxes (40%) 34 44 Net income $ 50 $ 65 Div. (30%) $15 $19 Add’n to RE $35 $46

  9. Forecasted Balance Sheet (2007) - Assets Forecast Basis 2007 1st Pass 2006 Cash $ 20 0.01 $ 25 Accts. rec. 240 0.12 300 Inventories 240 0.12 300 Total CA $ 500 $ 625 Net FA 500 0.25 625 Total assets $1,000 $1,250

  10. Forecasted Balance Sheet (2007) - Liabilities and Equity Forecast Basis 2007 1st Pass 2006 AP/accruals $ 100 0.05 $ 125 Notes payable 100 100 Total CL $ 200 $ 225 L-T debt 100 100 Common stk. 500 500 Ret.earnings 200 +46* 246 Total claims $1,000 $1,071 * From income statement.

  11. What is the additional financing needed (AFN)? • Required increase in assets = $ 250 • Spontaneous increase in liab. = $ 25 • Increase in retained earnings = $ 46 • Total AFN = $ 179 The company must have the assets to generate forecasted sales. The balance sheet must balance, so we must raise $179 million externally.

  12. How will the AFN be financed? • Additional N/P • 0.5 ($179) = $89.50 • Additional L-T debt • 0.5 ($179) = $89.50 • But this financing will add to interest expense, which will lower NI and retained earnings. This will lower equity financing and increase debt financing, and so on. We will generally ignore financing feedbacks.

  13. Forecasted Balance Sheet (2007) - Assets 2007 1st Pass 2007 2nd Pass AFN Cash $ 25 - $ 25 Accts. rec. 300 - 300 Inventories 300 - 300 Total CA $ 625 $ 625 Net FA 625 - 625 Total assets $1,250 $1,250

  14. Forecasted Balance Sheet (2007) - Liabilities and Equity 2007 1st Pass 2007 2nd Pass AFN AP/accruals $ 125 - $ 125 Notes payable 100 +89.5 190 Total CL $ 225 $ 315 L-T debt 100 +89.5 189 Common stk. 500 - 500 Ret.earnings 246 - 246 Total claims $1,071 $1,250

  15. Advanced Forecasting • Use of regressions for each item • Use of iterations in finding interest income and expense • Forecasting with stock dividends, stock repurchase, stock issuance, stock splits, ….

  16. Analyzing PE and PB and its UsagesCase I

  17. Analyzing PE and PB and its UsagesCase I

  18. Analyzing PE and PB and its UsagesCase II

  19. Analyzing PE and PB and its UsagesCase II

  20. Analyzing PE and PB and its UsagesCase III

  21. Analyzing PE and PB and its UsagesCase III

  22. Analyzing PE and PB and its UsagesCase IV

  23. Analyzing PE and PB and its UsagesCase IV

  24. Analyzing PE and PB and its UsagesConclusions • Reinvestment of free cash flow at rates of return in excess of capital costs creates growth in abnormal earnings, resulting in valuation multiple expansion. • The PE is a function of the prospective growth in future abnormal earnings. • Usages of PE in any other cases will result in mispricing and arbitrage opportunities. • This huge limitation should be considered among many other ones.

  25. Analyzing PE and PB and its UsagesConclusions • Which PE to use the historical average of the same firm’s PE’s, OR • The PE of similar firms, OR • The PE of the industry • How are PE’s used for companies that have more than one division (weighted average?!)

  26. Analyzing PE and PB and its UsagesConclusions • PE does take risk into account indirectly (i.e. through the used pricing model’s discount rate). • PE gives the dollar amount (Price) the investor is willing to pay for one dollar of continued earnings. PE is the reciprocal of the required rate of return. • Empirical studies show that the required rate of return (calculated using other return models like the market model or CAPM) is usually different from the one calculated by PE ratios. • Only sustainable earnings are used, transitory or non recurring earnings must be excluded.

  27. Analyzing PE and PB and its UsagesRecommendations • Use PE ratios with maximum caution • Know when it is used and what it means • PB is also problematic some times, it is used when there are abnormal returns regardless whether they grow or not.

  28. 2006 7,282 632,160 1,287,360 1,926,802 1,202,950 263,160 939,790 2,866,592 2005 57,600 351,200 715,200 1,124,000 491,000 146,200 344,800 1,468,800 Balance Sheet: Assets Cash A/R Inventories Total CA Gross FA Less: Dep. Net FA Total Assets

  29. 2006 524,160 636,808 489,600 1,650,568 723,432 460,000 32,592 492,592 2,866,592 2005 145,600 200,000 136,000 481,600 323,432 460,000 203,768 663,768 1,468,800 Balance sheet: Liabilities and Equity Accts payable Notes payable Accruals Total CL Long-term debt Common stock Retained earnings Total Equity Total L & E

  30. Income statement Sales COGS Other expenses EBITDA Depr. & Amort. EBIT Interest Exp. EBT Taxes Net income 2006 6,034,000 5,528,000 519,988 (13,988) 116,960 (130,948) 136,012 (266,960) (106,784) (160,176) 2005 3,432,000 2,864,000 358,672 209,328 18,900 190,428 43,828 146,600 58,640 87,960

  31. 2006 100,000 -DHS1.602 DHS0.11 DHS2.25 2005 100,000 DHS0.88 DHS0.22 DHS8.50 Other data No. of shares EPS DPS Stock price

  32. Statement of Retained Earnings (2006) Balance of retained earnings, 12/31/05 Add: Net income, 2006 Less: Dividends paid Balance of retained earnings, 12/31/06 DHS203,768 (160,176) (11,000) $32,592

  33. Statement of Cash Flows (2006) OPERATING ACTIVITIES Net income Add (Sources of cash): Depreciation Increase in A/P Increase in accruals Subtract (Uses of cash): Increase in A/R Increase in inventories Net cash provided by ops. (160,176) 116,960 378,560 353,600 (280,960) (572,160) (164,176)

  34. Statement of Cash Flows (2006) (711,950) 436,808 400,000 (11,000) 825,808 (50,318) 57,600 7,282 L-T INVESTING ACTIVITIES Investment in fixed assets FINANCING ACTIVITIES Increase in notes payable Increase in long-term debt Payment of cash dividend Net cash from financing NET CHANGE IN CASH Plus: Cash at beginning of year Cash at end of year

  35. Notes from the statement of CFs? • Net cash from operations = -$164,176, mainly because of negative NI. • The firm borrowed $825,808 to meet its cash requirements. • Even after borrowing, the cash account fell by $50,318.

  36. Did the expansion create additional net operating after taxes (NOPAT)? NOPAT = EBIT (1 – Tax rate) NOPAT06 = -$130,948(1 – 0.4) = -$130,948(0.6) = -$78,569 NOPAT05= $114,257

  37. What effect did the expansion have on net operating working capital? NOWC = Current - Non-interest assets bearing CL NOWC06 = ($7,282 + $632,160 + $1,287,360) – ( $524,160 + $489,600) = $913,042 NOWC05 = $842,400

  38. What effect did the expansion have on operating capital? Operating capital = NOWC + Net Fixed Assets Operating Capital06= $913,042 + $939,790 = $1,852,832 Operating Capital05 = $1,187,200

  39. What is your assessment of the expansion’s effect on operations? Sales NOPAT NOWC Operating capital Net Income 2006 $6,034,000 -$78,569 $913,042 $1,852,832 -$160,176 2005 $3,432,000 $114,257 $842,400 $1,187,200 $87,960

  40. What effect did the expansion have on net cash flow and operating cash flow? NCF06 = NI + Dep = ($160,176) + $116,960 = -$43,216 NCF05 = $87,960 + $18,900 = $106,860 OCF06 = NOPAT + Dep = ($78,569) + $116,960 = $38,391 OCF05 = $114,257 + $18,900 = $133,157

  41. What was the free cash flow (FCF) for 2006? FCF = OCF – Gross capital investment - OR - FCF06 = NOPAT – Net capital investment = -$78,569 – ($1,852,832 - $1,187,200) = -$744,201 Is negative free cash flow always a bad sign?

  42. Economic Value Added (EVA) EVA = After-tax __ After-tax Operating Income Capital costs = Funds Available __ Cost of to Investors Capital Used = NOPAT – After-tax Cost of Capital

  43. EVA Concepts • In order to generate positive EVA, a firm has to more than just cover operating costs. It must also provide a return to those who have provided the firm with capital. • EVA takes into account the total cost of capital, which includes the cost of equity.

  44. What is the firm’s EVA? Assume the firm’s after-tax percentage cost of capital was 10% in 2005 and 13% in 2006. EVA06 = NOPAT – (A-T cost of capital) (Capital) = -$78,569 – (0.13)($1,852,832) = -$78,569 - $240,868 = -$319,437 EVA05 = $114,257 – (0.10)($1,187,200) = $114,257 - $118,720 = -$4,463

  45. Did the expansion increase or decrease MVA? MVA = Market value __ Equity capital of equity supplied During the last year, the stock price has decreased 73%. As a consequence, the market value of equity has declined, and therefore MVA has declined, as well.

  46. Pure Expectations Hypothesis MaturityYield 1 year 6.0% 2 years 6.2% 3 years 6.4% 4 years 6.5% 5 years 6.5% If PEH holds, what does the market expect will be the interest rate on one-year securities, one year from now? Three-year securities, two years from now?

  47. Spot and forward rates 6.2% = (6.0% + x%) / 2 12.4% = 6.0% + x% 6.4% = x% PEH says that one-year securities will yield 6.4%, one year from now.

  48. Spot and forward rates 6.5% = [2(6.2%) + 3(x%) / 5 32.5% = 12.4% + 3(x%) 6.7% = x% PEH says that one-year securities will yield 6.7%, one year from now.

  49. Returns The rate of return on an investment can be calculated as follows: (Amount received – Amount invested) Return =________________________ Amount invested For example, if $1,000 is invested and $1,100 is returned after one year, the rate of return for this investment is: ($1,100 - $1,000) / $1,000 = 10%.

  50. What is Risk? • Two types of investment risk • Stand-alone risk • Portfolio risk • Investment risk is related to the probability of earning a low or negative actual return. • The greater the chance of lower than expected or negative returns, the riskier the investment.

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