financial’analysis’ - hec paris€™ 1 financial’statements:’the’economic’view’ 2...

Financial analysis

What is this? •  Goal of this lecture: learn how to make a financial analysis –  Focus on corporate accounts… – …To obtain a photograph of the firms’ economics – Not real valuaAon, but good first pass

•  sources: –  Financial statements – Market info (-‐ Info on comparable companies – Market studies, analyst research – Direct contact with the company)

Outline

1  Financial statements: the economic view

2  The 4 step method

3  ExtracAng info from the stockmarket

Textbook references

•  Economic view of financial statements –  Vernimmen: chapters 2-‐10

•  4 steps method –  Vernimmen: chapters 11-‐16

•  Financial analysis is NOT accounAng –  I am no accountant ! –  AccounAng from a finance perspecAve

•  I don’t want to be as precise and exhausAve as an accountant •  Want to focus on big items that are economically meaningful

Financial statements: a refresher

•  Three main statements –  Income statement

•  « meaningful » cash movements

– Cash flow statement •  True cash movements

– Balance sheet •  Cumulated investments and their financing (through retained earnings or security issues)

Income Statement, « by Nature » + Net Sales + change in inventories of finished goods

= Produc=on -‐ purchase of raw materials + change in inventories of raw materials -‐ personnal expenses -‐ taxes other than corporate income tax -‐ write downs / offs of trade assets & inventories

= EBITDA -‐ amorAzaAon, depreciaAon of fixed assets

= EBIT -‐ Financial expenses + Financial income = Profit before tax and non recurrent items +/-‐ Non recurring items -‐ Corporate Income Tax ( T ) = Net income ( r E .E ) -‐ Dividends = Retained earnings ( Δ RE )

~ τ x (profit before tax) à  deprecia=on is tax free à  interest is tax free

« theore=cal » cash flow statement

+ operaAng receipts -‐ operaAng expenses = Opera=ng Cash flows -‐ capital expenditure + fixed assets disposals = Free cash flow before tax -‐ Financial expenses + Financial income -‐ Dividends + proceeds from share issues

-‐ Corporate Income Tax = net decrease in debt / net incr. in cash

-‐ Share Buybacks

… but in prac=ce different presenta=on à

PresentaAon #1 From EBITDA to operaAng cash flows

•  OCF = EBITDA -‐ ΔWC

•  OperaAng receipts = Net sales – change in trade receivables •  OperaAng expenses = operaAng costs (excl. DepreciaAon) –

change in trade payables + change in inventories (material) è OCF = operaAng receipts – operaAng expenses = net sales – operaAng costs + ΔTrade Pay. -‐ ΔTrade rec. -‐ ΔInv(mat.)

= EBITDA – ΔInv(finished Goods) + ΔTrade Pay. – ΔTrade rec. -‐ ΔInv(mat.) = EBITDA -‐ (-‐ΔTrade pay. + ΔTrade rec. + ΔInv)

Δ Working Capital

EBITDA

-‐ ΔWC = Opera=ng Cash flows -‐ capital expenditure + fixed assets disposals = Free cash flow before tax -‐ Financial expenses + Financial income -‐ Dividends + proceeds from share issues

-‐ Corporate Income Tax = Net decrease in debt

-‐ Share Buybacks

cash flow statement presenta=on #1: « star=ng » from EBITDA

PresentaAon #2 From Net Inc to CF from op.

someAmes: we use Net Inc. to compute cash flows, & use a different CF concept CF from op. = operaAng receipts – operaAng expenses – interest expenses = EBITDA -‐ ΔWC – interest expenses = Net Inc + D&A -‐ cap. gains -‐ ΔWC

+ Amor=za=on and Provision -‐ ΔWC = Cash flows from opera=ons -‐ capital expenditure + fixed assets disposals = Free cash flow before tax -‐ Financial expenses + Financial income -‐ Dividends + proceeds from share issues

-‐ Corporate Income Tax = Net decrease in debt

-‐ Share Buybacks

Net income

cash flow statement presenta=on #2: « star=ng » from Net inc.

Examples

•  on the web

– Look at Starbuck’s or General motors

•  Gremlin case

Balance sheet: details

-‐ Prepaid products -‐ Trade payables -‐ Tax liabiliAes

-‐ Commercial paper -‐ short term bank debt

-‐ Long term bank debt -‐ Bonds -‐ ConverAble bonds

-‐ Preferred stock -‐ Common stock -‐ Retained earnings -‐ Net Income

-‐  trade receivables -‐  inventories of:

-‐ Finished product -‐ Semi finished -‐ Materials

-‐ Intangible fixed assets

-‐ Patents -‐ Brands

-‐ Tangible fixed assets -‐ Land&buildings -‐ Machines

The “economic” balance sheet

•  Assets are a bad indicator of “employed capital” – assets increase when suppliers are paid later, and the firm stores addi4onal inputs

– assets increase when the firm retains earnings to hold more cash

è to remove these OPTICAL ILLUSIONS remove cash on both sides remove trade payables on both sides è idea: focus on “financial investors”

Equity

Bank debt

Fixed Assets

Trade recevables

Assets Liabilities

Convertible debt

Trade payables, prepaids

inventories

Cash&equivalents

Fixed Assets: (machines, land, patents)

Operating capital Capital invested

NET DEBT

Equity

Working Capital

WC = Inventories + trade receivables - trade payables - prepaids NET DEBT = DEBT – cash – cash equivalents

Removing ficiAous assets&liabiliAes

examples

•  Deutsche telekom

•  Microsok

•  Walmart

Pilalls of simplificaAon

•  aggregaAng balance sheet items requires assumpAons – compuAng equity is harder than you think – CompuAng debt is harder than you think – CompuAng assets is harder than you think è let’s discuss some of these assumpAons

It’s hard to compute equity

•  From a financial viewpoint – converAble bonds are partly equity – preferred stock is equity

•  Only do the adjustment when this is worth it – When this is BIG

It’s hard to compute debt

•  Some liabiliAes are off balance sheet –  Info in the footnotes of the financial statements

•  Examples –  Leased assets: commitment to rent an asset

•  is big: 16% of assets (~ long term debt) •  if operaAng lease: off balance sheet •  If capital lease: on balance sheet but creditors cannot seize it

– Defined benefit pension obligaAons •  Pension funds = 30% of large firms’ financial debt •  Backed by assets, but firm has to inject capital if underfunded è = added leverage

example

10K filing, footnote 18

It’s hard to compute fixed assets: goodwill

Debt = 50

Equity = 100 Fixed assets = 120

W.cap. = 30

Acquiror

Equity = 80 Fixed assets = 80

Target Buys at price 200

Debt = ???

Equity = ??? Fixed assets = ??

W.cap. = ??

Merged en=ty

Assume acquiror issues 200 of new stock, or 200 of new debt what is the important convention??? How does it affect measured leverage?

The 4 step method 1.   Value crea=on: à trends in sales&margins

2. Investment Analysis: à trends in CAPX& working capital

3. Financing Analysis: à trends in cash flows&balance sheet fragility

4. Profitability Analysis: à compute profitability raAos: ROE, ROCE

… while we walk through the steps: Gremlin case

Step #1: value creaAon •  Goal: isolate trends in EBITDA

•  Start with some broad economic analysis – On the environment:

•  Is it a mature or growing industry? •  Is it a cyclical or stable industry? •  Any pressure to consolidate? •  Any regulatory risk?

– On the firm •  How does it deal with compeAAon? •  Who owns the firm? A family, the public, a fund?

Value creaAon: the scissors effect

•  Insight: look at the trends in sales & costs separately

•  Nega=ve cissors effect – When costs grow faster than sales –  EBITDA decreases –  EBITDA/sales (« EBITDA margin ») decreases

•  Posi=ve cissors effect –  The opposite

Value creaAon: breakeven point

•  Insight: – find the level of sales required to make profit = 0 – & see how far the firm is from that level

•  To do this, need a model of how costs depend on sales: Costs = Fixed + c.Sales

Value creaAon: breakeven point

•  breakeven point: Sales that lead to profit = 0 0 = SalesBE – Fixed Cost – c x SalesBE è SalesBE = Fixed cost / (1-‐c)

•  Higher if Fixed cost is big, or if c is big

Value creaAon breakeven point

•  In pracAce, how do I compute the cost funcAon?

•  Use the income statement by funcAon – Cost of goods sold : mostly variable – R&D, SG&A: mostly fixed – MartkeAng&sales : both

•  The horizon maters –  In the long run, more costs are variable

Value creaAon: operaAng leverage

•  Impact of a 1% change in sales on profits –  If sales are close to BE point?

–  If sales >> BE point?


•  If firm close to BE point, profits are volaAle – Conversely: volaAle profits è close to BE

•  MathemaAcally:

€

EBITDA = Sales − c × Sales −Fixed cost= (1− c) × sales − 1− c( )salesBE

⇒ΔEBITDAEBITDA

=ΔSalesSales

×Sales

Sales − SalesBE

&

' (

)

* +

Big if sales ~ salesBE


•  Explain:

Company in 2003 Sales growth

Net income growth

Tesco + 18 % + 22 %

Roche + 11 % + 24 %

Heidelberg Cement + 9 % + 215 %


•  Which company has the biggest fixed costs?

Company in 2003 Sales growth

Net income growth

Volkswagen - 2 % - 4 %

BMW - 2 % - 48 %

Step #2: investment analysis

•  Discusses trends in overall assets

•  First, look at bumps and trends in fixed assets •  cash flows from investment •  CAPEX – depreciaAon •  goodwill

•  Second, look at working capital: WC = Inventories + Receivables – Payables -‐ prepaid

Fixed assets: an example

Explain what is happening to Danone

Working capital

•  Working capital pros and cons: Cons

– Needs to be financed with costly debt or equity Pros

– avoids botlenecks in producAon –  trade credit more expensive than bank debt

•  Classical arrangement in US manufacturing: “2/10 net 30” •  2% discount if paid < 10 days, else full price paid in 30 days •  Equivalent interest rate of the loan … 70% annual !!! why? •  This cost is oken implicitly omited in WC analysis

working capital

•  In general: low WC is considered as good – WC analysis classic tool to detect anomalies & management quality

•  But keep in mind that: – WC depends on the industry – WC depends on the business cycle – WC may have strong seasonal paterns

Investment analysis: working capital raAos

•  Typical raAos

€

WC Turnover = 365 × WCAnnual Sales

Receivables = 365 ×Accounts Receivables

Annual Sales

Payables = 365 × Accounts PayablesAnnual Purchases

Inventories =365 ×Inventories

Annual Sales

#

$

% % %

&

% % %

Step #3: financing analysis

•  Two quesAons related to firm survival: Are cash flows large enough to pay interest on debt ? Is there a liquidity risk ?

Perspec0ve of bondholder, not shareholder

•  Tools: –  analysis of cash flow statement à Compare operaAng cash flows & financial expenses

–  compare dura4ons of assets and liabili4es à Compare WC & short term debt net of cash

Financing analysis the cash flow statement

•  First, look at all components of “decrease in net Debt” and their evoluAon:

Net Inc. + Deprec. – ΔWC (=CF from Op.)

-‐ (CAPEX – Asset sales) (=CF from inv.) – dividends + proceeds from equity issues (=CF from fin.) = Decrease in Net Debt

Financing analysis: raAos

•  Leverage (not very informaAve) informaAve

•  Credit analysts prefer “cash flow-‐based” measures

InterestsEBITDACoverageInterest

EBITDADebtNet Coverage ServiceDebt

=

=

Leverage = Financial DebtTotal Assets

Why leverage ra=o is not so reliable: The Tale of Two Companies

Company in 2003 Net Debt / Assets

Net Debt / EBITDA

Unilever 71 % 2.2

Rémy Cointreau < 50 % 3.8 !

Unilever’s operations are so profitable that it can afford more debt !

è Prefer Net Debt / EBITDA to leverage !!!


è How much should Net Debt / EBITDA be worth ?

•  Standards: <= 3 years : Healthy situaAon 4 years : CriAcal (but also LBOs) 5,6 years : Debt becomes « junk », distress likely

•  Beware ! à stable industries may tolerate raAos of 4,5 or 6 à firms with « good collateral » (land) also ! à private equity typically takes 6 (more before crisis)

Financing analysis: balance sheet liquidity

•  Risk of liquidity mismatch – Even if PV of assets > PV of liabiliAes – Assets mature in the long run (investment) – LiabiliAes mature in the short run (short term debt) (give examples of industries where this is common)

•  In theory, not a problem if rollover is possible •  But in pracAce: « Rollover risk »

– Creditors have doubts, they want to cash in & run – Cheap short run credit can dry up suddenly (Crisis)

Rollover risk in the banking system

tradiAonal banking system

large depositors,

retail investors

bank borrower

loans

US shadow banking system

large depositors,

retail investors

money market

mutual funds

ABCP conduit

CDO

ABS vehicle, fanny mae, freddy mac

shares CP

CDO originator

loans

broker -‐ dealers

hedge funds prop trading

securiAes lenders

borrower

repo

Rollover risk in shadow banks

•  Three ra4os to measure maturity mismatch:

year) 1( sLiabilitieCurrent CashRatioCash

year) 1( sLiabilitieCurrent sInventorieyear) 1( AssetsCurrent RatioQuick

year) 1( sLiabilitieCurrent year) 1( AssetsCurrent RatioCurrent

<=

<

−<=

<

<=


Liquidity risk

•  How to deal with it? – Secure LT financing – Backstop liquidity: credit lines – Hold cash / short term assets

Which firms hold more cash ?

Step #4: profitability analysis

•  QuesAon: is the firm profitable enough? –  Is EBIT high enough? –  Is Net Income high enough?

Profitability analysis: ROCE

•  Is EBIT high enough? •  Compute Return on Capital Employed:

ROCE = (1-‐τ) x EBIT / CE where τ = corporate income tax rate

•  Idea: « operaAng return » •  (1-‐τ) x EBIT = « Net OperaAng Profit Aker Tax » •  ROCE overesAmates taxes

Profitability analysis: ROE

•  Is Net Income high enough? •  Compute Return on Equity:

ROE = Net Income / Equity

•  IntuiAon: – Normalize Net Income by the investment of those who receive it (shareholders only)

Profitability analysis: leverage effect

•  SubsAtute debt for equity: which effect on ROE ?

•  2 opposite forces 1.  Reduces shareholders’ investment 2.  Reduces Net Income (more interest)

•  In pracAce, (1.) dominates à ROE goes up. – b/c interest income < ROCE (see later) – This is the « leverage effect » à

100 110

A project, of operating return (ROCE) = 10% costs 100 and pays 110:

There is no debt: ROE =(110 – 100)/100 = 10/100

=10%


50 50

59 51

Entrepreneur borrows 50, with interest rate 2% ROE =(110 – 50 – 50*(1+0.02))/50 = 9/50

= 18% !!!!

A money machine ?


Bad luck: the project is not profitable (ROCE=0%) costs 100 et generates 100 only :

100 100

When there is no debt: ROE =(100 – 100)/100 = 0

=0%


50 50

49 51

Entrepreneur has borrowed 50, with interest rate 2% ROE =(100 – 50 – 50*(1+0.02))/50 = -1/50

= -2% !!!!

Even though project is not loss making !!!


Very bad luck: the project only makes ROCE = - 10% costs 100 et generates 90 only :

100 90

When there is no debt: ROE =(90 – 100)/100 = -10/100

=-10%


50 50

39 51

Entrepreneur has borrowed 50, with interest rate 2% ROE =(90 – 50 – 50*(1+0.02))/50 = -11/50

= -22% !!!!

Leverage = more risk !!!



•  Leverage makes ROE much more volaAle – Debtholders are always senior to shareholders – first dollars of EBIT are pledged to debtholders

•  In exchange for their contribuAon to capital •  In exchange for low interest rate

•  If success, shareholders get big profit for small investment

•  If failure, shareholders absorb all the loss


•  Easy to show that:

ROE = ROCE + (NetDebt / Equity) x ( ROCE – (1-‐τ)xinterest )

– Net Debt / Equity : « gearing raAo » – ROE increases with gearing if interest is low – ROE more sensiAve to ROCE shocks if gearing is big

raAo analysis to evaluate solvency (back to step #3)

ROCE ROE

Firm A 7% 20% Firm B 10% 10% Firm C 10% 6% Firm D 12% 20%

•  each of these firms issue bonds. which one will have the lowest spread?

Leverage effect: A numerical example

•  MegaBank: – Lends @ 4% to its borrowers – Borrows @ 2% from money markets & depositors – Has a leverage raAo of 90% – A corporate tax rate of 50%

How large is the leverage effect at

MegaBank? (i.e. what is its contribution to ROE ?)

Hidden vs Official Leverage: Back to shadow banks

Sponsoring bank: guarantees that ABCP issued by conduit will pay off (gets a fee in exchange) what is the effect sponsoring bank ROE?

Total ABCP issuances

Total ABCP issuances

what is the effect on sponsoring bank ROE?

ABCP investors exert put option conduits go back to balance sheet

Using market informaAon: raAos

•  Stock price = PV of expected future dividends

•  Three raAos: – PER: stock price scaled by earnings – Price to Book: stock price scaled by book equity – Dividend Yield: dividends scaled by stock price

•  All three ra4os serve to measure market expecta4ons of future growth

Using market informaAon: PER

•  Price Earnings raAo (or « P/E raAo ») PER = Stock Price / Expected earnings Per Share

•  Gordon-‐Shapiro formula PER = b / (re – g)

–  re = cost of equity –  g = expected (constant) growth rate –  b = payout raAo = Dividends / Net Income

•  High P/E means «low risk» or «high growth» –  In 2003, Renault = 7, Google = 76 !!!

•  Is the market forming good expectaAons ? NO à

average PER varies over Ame (source: bob shiller’s website)

0

5

10

15

20

25

30

35

40

45

50

1860 1880 1900 1920 1940 1960 1980 2000 2020

Pric

e-Ea

rnin

gs R

atio

(CA

PE)

Year

CAPE Price E10 Ratio

1901 1966

2000

Price-Earnings Ratio

1981

1921

1929

21.45

0

10

20

30

40

50

60

70

1952 1954 1956 1958 1960 1962 1964 1966 1968 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012

Cumula=ve Return of P/E strategy Long low P/E, Short high P/E

market neutral – Sharpe ra4o = 0.9

Real estate market: price-‐to-‐rent raAo in the US

2.00%

2.50%

3.00%

3.50%

4.00%

4.50%

5.00%

5.50%

6.00%

6.50%

1960.1 1966.1 1972.1 1978.1 1984.1 1990.1 1996.1 2002.1 2008.1

•  Price to rent raAo in France

Using market informaAon Price to Book

•  Price to Book PB = Stock Price / Equity per share

•  Price to book is related to PER PB = PER x ROE

– What firms typically have a high PB ?

Using market informaAon Dividend Yield

•  Dividend Yield DY = Dividend per Share / Stock Price

•  Which firms typically have a high DY ?

how well have dividend paying stocks been doing recently?

•  look @ a specialized mutual fund, to monitor performance – Acker: VHDYX

•  htp://www.google.com/finance?q=VHDYX&ei=KlWlUODrJer1wAOlTg

-‐0.6

-‐0.4

-‐0.2

0

0.2

0.4

0.6

0.8

1

1928

1930

1932

1934

1936

1938

1940

1942

1944

1946

1948

1950

1952

1954

1956

1958

1960

1962

1964

1966

1968

1970

1972

1974

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1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

2010

2012

Cumula=ve Return of DY strategy market neutral -‐ sharpe ra4o = 0.1

Using market informaAon: example

Compute PER, DY, PB, ROE for both corporations Comment on the differences…

which stock is this?

Financial analysis: wrapping up

•  Use financial statements to understand the dynamics of: – value creaAon – assets (in parAcular WC) – Net cash holdings – Profits

•  Use market prices to understand market expectaAon of future profits

financial’analysis’ - hec paris€™ 1 financial’statements:’the’economic’view’ 2...

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