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Chapter 17

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Chapter 17

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  1. Chapter 17 Company Analysis

  2. 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.

  3. Fundamental Analysis • Last step in EIC is individual company analysis • Goal: estimate share’s intrinsic value • Constant growth version of dividend discount model • Value justified by fundamentals

  4. 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

  5. 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

  6. 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

  7. 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

  8. Income Statement Sales or revenues - Product costs Gross profit - Period Costs EBIT - Interest EBT EBT - Taxes Net Income available to owners - Dividends Addition to Retained Earnings EPS and DPS Basic Financial Statements

  9. 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

  10. 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

  11. 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

  12. 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

  13. DuPont Analysis • Three components of return on equity: • Net Margin = Net Income / Sales. The higher a company’s profit margin the better. • Asset Turnover = Sales / Total Assets. The higher the number the better. • Leverage Factor = Total Assets / SEquity. The higher the number, the more debt the company has.

  14. DuPont Analysis Tax Burden Interest Burden EBIT Efficiency TA Turnover LeverageRatio NI / Sales = Net Income Margin NI / TA = ROA Leverage Ratio = TA / Equity

  15. Net Profit Margin Asset Turnover Leverage Ratio

  16. 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)

  17. 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

  18. 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

  19. Earnings Surprises • What is the role of expectations in selecting stocks? • Old information is already incorporated into stock prices (market is efficient) • Unexpected information implies revision • Stock prices affected by • Level and growth in earnings • Market’s expectation of earnings

  20. 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

  21. 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

  22. 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

  23. 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

  24. 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

  25. 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 • www.netadvantage.standardpoor.com

  26. 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

  27. 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 accountingvalues

  28. Example

  29. 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

  30. 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

  31. 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

  32. C. Debt Ratios 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

  33. 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

  34. 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%

  35. E. Value Ratios 13. Dividends Payout = DPS / EPSor = 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

  36. 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%

  37. 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

  38. 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)

  39. Liquidity • Below average • 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

  40. 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

  41. 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

  42. 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)

  43. DuPont Analysis • XYZ (2004) • ROE = (NI/Sales) (Sales/TA) ((TA/Equity) = (.0299)(1.042)(4.339) = 13.51% • Industry averages (2004) • ROE = (NI/Sales) (Sales/TA) ((TA/Equity) = (.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

  44. 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

  45. 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