Contents - I • External Environment • Financial System • Financial sector • The mechanics of moving resources • Economic forces • Industry factors • Internal Environment • Inputs, Operations, Outputs and supporting activities • The various departments • Corporate governance and agency problems • Company risk and return • The Future • Forecasted cash flows • Forecasted growth rates
Contents II • Types of Financial Analysis • Fundamental Analysis • Profit Maximization. • ROE (Du Pont) Analysis • Factors That Affect Stock Value • Fundamental Valuation Models • Technical Analysis • Use of Exotics in Financial Analysis and valuation • Use of Mathematics in Financial Analysis • Forecasting in financial Analysis • PE and PB Rations in Depth Analysis
Review -What is Financial Analysis • Financial analysis: • To evaluate and valuate. • Evaluate determinants of financial performance • Determine and put a value to performance parameters • Make a decision
Review of the First Session • Introduction to the financial system including an explanation of the financial sector, participants in the financial system and interest and money as the driver and lubricants of the economy. • Reviewed the external and internal environment and their effects as determinants of forecasting and drivers of value. • Reviewed the basics of financial analysis like its scope and content and some new trends in financial analysis that are becoming the new tools that are increasingly used especially in valuation of financial derivatives and other structured financial instruments.
Manager – Shareholder • Agents--managers with a fiduciary duty to act in the best interests of owners • Agency problem--managers maximize their own self-interests at the expense of owners • High salaries of CEOs • Emphasis on short-term performance at expense of long-term performance • Empire building for status • perquisites • The burden is to align the interests of the manager with those of the shareholders • This puts a DRAIN on the performance and value of the firm. • Tactics used to align interest: • Manager part owner • Stock options • Bonuses • Cash dividends • Debt • Monitoring • Corporate control markets
Shareholder – Debt holder • The conflict of interest arises here when the firm is over indebted. • Shareholders will get into high risk – high return investments, if such investments materialize, shareholders will reap most of the benefit (debt holders are paid a fixed percentage and the residual goes to the shareholders), if not most of the loss will be on the side of the debt holders. • The solution is covenants • The financial analyst needs to assess such situation in the process of determining a risk premium among other things.
Shareholder - Shareholder • A rises in companies with subsidiaries and affiliates • The interests of the subsidiary shareholders are not in line with those of the shareholders of the parent companies • Appears in capital budgeting decisions especially when the parent and the subsidiary are in two different tax and regulatory regimes
Auditors • Auditors are prone to be lenient in auditing financial statements and in valuing business because they are paid by the very same party they are auditing or do not want to lose future business opportunities. • Such considerations need to be taken into account when financially analyzing a firm.
Regulators • The regulators interests may be different from those of the company being analyzed • The regulator may enact regulations that hurt the company for the public good; levying taxes is an example.
The Market for Corporate Control • Participants in the financial markets are monitoring each other to capitalize on opportunities of buying an undervalued firm. • Firms that have corporate governance problems are prone to incur higher rate of return due to the risk premium added from such problems. • The financial analyst needs to incorporate such factors in estimating and forecasting required rates of return and future cash flows.
Company Risk and Return • The analyst needs to incorporate specific analysis of the riskness of the company to reflect that on the required rate of return on investing sums of money in such company. • Many measures of risk, the most important ones are the most simple ones, because they are the ones used most in industry practice. • Beta • Sigma • VaR • Many more like: down side risk, coefficient of variation, regressions, time series, FF two factor model, FF multi factor models, Merton intertemporal model, stochastic models, stress tests under various distributions …..
Types of Financial Analysis • Fundamental: use of all relevant information and to predict value – assumes markets efficiency. • Technical: use of past price, trading volume and people behavior to predict value – assumes market inefficiency. • Naïve: Financial ratios and some calculated indicators – limited usefulness.
Fundamental Analysis • The value of an asset is equal to the present value of all of its future net cash flow. • Need to take previous factors into account when forecasting cash flows, growth rates and required rates of return. • Depends on all relevant information • Believes in Semi strong form market efficiency.
Is stock price maximization the same as profit maximization? • No, despite a generally high correlation amongst stock price, EPS, and cash flow. • Current stock price relies upon current earnings, as well as future earnings and cash flow. • Some actions may cause an increase in earnings, yet cause the stock price to decrease (and vice versa).
Profit Maximization • Example: Equity = 10 million shares @ DHS1 a share book value, no RE, no PIC and no reserves. Profits = DHS10 million CEO and CFO claim that they can maximize profits by increasing them to DHS10.5 million if they company would issue 1 million new shares. In this case profits are maximized however profitability is lowered
Profit Maximization • Well, what happened to profitability?
Profit and Profitability Maximization • Example: Equity = 1 million shares @ DHS1 a share book value, no RE, no PIC and no reserves. Profits = DHS1 million CEO and CFO claim that they can maximize profits by increasing them to DHS1.5 million if they company would retain all of last year’s earnings, i.e. DHS1 million . In this case profits and profitability are maximized
Profit and Profitability Maximization • How would this affect return on equity?
Maximizing Profits, Profitability and Return on Equity! • Use leverage to increase the return on equity • However this will increase the riskness of the firm • Increasing risk lowers the price. • Furthermore, the return on total assets will decline
Maximizing Profits, Profitability and Return on Equity! • Example same as last example, but instead of retaining earnings, finance growth operations and profits by borrowing from the bank at 10%.
What would happen to the Return on total assets? Maximizing Profits, Profitability and Return on Equity!
Factors that affect stock price • Projected cash flows to shareholders • Timing of the cash flow stream • Riskiness of the cash flows
Basic Valuation Model • To estimate an asset’s value, one estimates the cash flow for each period t (CFt), the life of the asset (n), and the appropriate discount rate (k)
Dividend Discount Models • Constant growth • Two growth • Multi growth • Stochastic • Additive w and w/o bankruptcy • Geometric w and w/o bankruptcy
Multipliers • PE • PB • V/EBIT • P/S • P/CF
Technical analysis • Depends on past prices and trading volumes to predict price and performance • Markets are inefficient • Prices are trendy • Can be very mathematical
Technical Charts • Point and figure • Candlesticks • OHLC • Price lines • Moving averages • ……
Technical Indicators • Candlesticks: hammer, bullish engulfing, morning star, bearish engulfing, hanging man, harami, Marubozu, three white soldiers, …. Many more. • Technical indicators: moving averages, exponential moving averages, Bollinger bands, slow stochastic, fast stochastic, Trin, Trix, Money flow index, RSI, Average directional index, Williams %R, Price rate of change, Oscillators, …. Many more.
Exotic Financial Analysis • Stochastic models in forecasting items and future interest rates and discount rates, and the previously mentioned stochastic dividend discount models. • Real Options • Abandonment Options
Use of Mathematics • Towards the end of this program and as an introduction to future programs we will look into the mathematics of financial analysis and their numerical solutions especially for derivatives and their use in equity and other securities financial analyses.
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
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
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%)
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.
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.
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
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
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.
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.
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.
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
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
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, ….