Download Presentation
## Chapter 17

- - - - - - - - - - - - - - - - - - - - - - - - - - - E N D - - - - - - - - - - - - - - - - - - - - - - - - - - -

**Chapter 17**Company Analysis**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.**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**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**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**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**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**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**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**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**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**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**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.**DuPont Analysis**Tax Burden Interest Burden EBIT Efficiency TA Turnover LeverageRatio NI / Sales = Net Income Margin NI / TA = ROA Leverage Ratio = TA / Equity**Net Profit Margin**Asset Turnover Leverage Ratio**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)**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**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**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**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**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**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**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**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**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**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**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**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**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**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**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**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**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%**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**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%**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**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)**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**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**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**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)**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**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**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