Investments: Analysis and Behavior

Chapter 10- Financial

Statement Analysis

©2008 McGraw-Hill/Irwin

10-2

Learning Objectives

Evaluate company profitability. Assess and interpret the return on equity. Determine a firm’s financial liquidity. Compute valuation indicators

10-3

Investing versus Speculating Stock investors own a small part of the

companies they hold. Business ownership In the long run, the stock will perform as well (or as

poorly) as the underlying business.

Speculating Expectation of short-term trading profits from share-

price fluctuations. Underlying business is irrelevant

So investors need to know about the underlying business!

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Financial Statements

Companies report their business success/failure with quarterly and annual (10-K) financial statements

Balance Sheet “Snapshot” of information at a specific point in time

Income Statement “Video” of business activities over a specific time

period

Cash Flow Statement Change in the company’s cash position over a

specific period of time

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Microsoft

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10-7

Earning Profits Net income (accounting profits)

Difference between revenues and expenses, often expressed after taxes.

Earnings per share (EPS) Net income divided by the number of

shares outstanding Diluted earnings

Net income divided by the number of shares outstanding after consideration for the possible conversion of stock options, buy-backs, etc.

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10-9

10-10

Problems with Accounting Information Historical cost versus market value

Economic costs versus accounting costs Depreciation Cash flow versus earnings

Multiple ways under GAAP to treat various assets, revenue, and costs

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Assessing Performance Through Financial Ratios Profitability

Sales Total

IncomeNet Margin Profit Net

Equity rs'Stockholde

IncomeNet Equity on Return

Assets Total

IncomeNet Assetson Return

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Using Microsoft’s financial statements in Tables 10.1 to 10.3, compute its net profit margin, ROE, and ROA using net cash flow from operations information for 2005.

%8.303080.0788,39$

254,12$

Sales Total

IncomeNet Margin Profit Net

%5.252547.0115,48$

254,12$

Equity s r'Stockholde

IncomeNet Equity on Return

%5.232345.0815,70$

605,16$

Assets Total

Operations FromCash Net Assetson Return

10-13

Elements of ROE

Du Pont formula Why has ROE changed?

Total Asset Turnover (TAT): ability to generate sales from asset base

Leverage: extent to which debt is used to capitalize the company

Equity

Assets

Assets

Sales

Sales

IncomeNet

Ratio LeverageTurnoverAsset inargMProfit ROE

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In 2004 and 2005, Microsoft’s ROE was 10.9% and 25.5%, respectively. Why did Microsoft’s ROE increase so dramatically over this year?

Solution: Use the Du Pont system equation:For 2004

For 2005

First, Microsoft had a large increase in its profit margin. Second, Microsoft paid a big dividend in November 2004 to distribute excess cash to shareholders. This reduced the assets and equity in the firm, which magnified its asset turnover ratio on leverage ratio.

%9.101086.0261.1388.0222.0825,74$

368,94$

368,94$

835,36$

835,36$

168,8$

Sales

IncomeNet ROE

Equity

Assets

Assets

Sales

%5.252548.0472.1562.0308.0115,48$

815,70$

815,70$

788,39$

788,39$

254,12$

Sales

IncomeNet ROE

Equity

Assets

Assets

Sales

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Operating Efficiency

More Leverage Variables

sReceivable

ueSalesRevenTurnoversReceivable

Inventory

SoldGoodsofCostTurnoverInventory

EquityTotal

DebtTerm-LongEquitytoDebt

CapitalTotal

DebtTerm-LongCapitalTotaltoDebt

10-16

Compute the 2005 receivables turnover and inventory turnover for Microsoft.

Solution:

Use the Balance Sheet and Income Statement information:

54.5180,7$

788,39$

Re

ReRe

ceivableAccounts

venueTurnoverceivables

63.12491$

200,6$Re

sInventorie

venueCostofTurnoverInventory

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Financial Liquidity

current ratio < 1 would signal a potential problem sLiabilitieCurrent

AssetsCurrent RatioCurrent

sLiabilitieCurrent

sReceivable Securities MarketableCashRatioQuick

ChargeInterest Debt

EBITCoverage nterestI

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Indications of Value

Stock price is not an indication of value i.e., stock splits

Price-earnings ratio (P/E) Earnings yield (E/P)

0

5

10

15

20

25

30

35

1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005

P/E

Rat

io

Figure 10.1 P/E Ratio of the Dow Jones Industrial Average

Data source: Dow Jones and Company (http://w w w .djindexes.com/jsp/index.jsp).

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Since the market P/E ratio can change dramatically over time, relative P/E ratios are sometimes used: firm P/E divided by benchmark P/E

Table 10.4 Compare Financial Ratios with Industry Averages

Market Cap ($Billion)

Net Profit Margin ROE %

Debt to Equity

Microsoft 289.43 30.8 22.5 0.000

Technology Sector 5,059.60 9.5 13.4 0.017

Application Software 495.05 20.9 19.7 0.000

Internet Software & Services 178.06 8.2 6.5 0.267

Internet Service Providers 7.07 -1.4 0.0 0.003

Personal Computers 145.25 6.2 34.6 0.001

Wireless Communications 562.1 2.4 1.8 0.007

Source: Yahoo! Finance

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Price to book ratio Sometimes Book to Market (B/M) issued. Low P/B (high B/M) firms are considered

value firms

Dividend yield Last 12 months of dividends / current

stock price Remember, dividends make up roughly

one third of a stock investor’s total return!

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Economic Value Added (EVA) Economic wealth added to the firm

business profits less the compensation for debt and equity holders

EVA = Net Operating Profit after Taxes (NOPAT) – (Capital of the Firm × Cost of Capital)

In 2005, Microsoft’s EVA NOPAT was $12.25 billion. It is an all equity firm with market capitalization of about $275

billion. Assuming a cost of capital of 14%. Microsoft’s EVA is $–26.25 billion (= $12.25 - $275×0.14).

Even though Microsoft has an outstanding profit margin and ROE, it has not been generating enough wealth to fully compensate its stockholders for their capital. This may be why Microsoft stock has languished within a range of $24 to $30 for three years.

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Can Financial Statements Be Trusted?

Accounting scandals

Accounting restatements Changing the numbers…

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Figure 10.2 The Number of Firms Restating is Increasing

233

270

330 323

414

2000 2001 2002 2003 2004

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

7.0%

Per

cen

t o

f E

xch

ang

e L

iste

d C

om

pan

ies

Restatements

Percent of listed companies

Source: 2004 Annual Review of Financial Reporting Matters, Huron Consulting Group