Chapter 10.ppt
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Investments: Analysis
and Behavior
Chapter 10- Financial
Statement Analysis
©2008 McGraw-Hill/Irwin
Learning Objectives
Evaluate company profitability.
Assess and interpret the return on equity.
Determine a firm’s financial liquidity.
Compute valuation indicators
10-2
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 shareprice fluctuations.
Underlying business is irrelevant
So investors need to know about the
underlying business!
10-3
Financial Statements
Companies report their business
success/failure with quarterly and annual
(10-K) financial statements
Balance
“Snapshot” of information at a specific point in time
Income
Statement
“Video” of business activities over a specific time
period
Cash
Sheet
Flow Statement
Change in the company’s cash position over a
specific period of time
10-4
Microsoft
10-5
10-6
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.
10-7
10-8
10-9
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
10-10
Assessing Performance Through
Financial Ratios
Profitability
Net Income
Net Profit Margin
Total Sales
Net Income
Return on Equity
Stockholde rs' Equity
Return on Assets
Net Income
Total Assets
10-11
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.
Net Profit Margin
Net Income $12,254
0.3080 30.8%
Total Sales $39,788
Net Income
$12,254
Return on Equity
0.2547 25.5%
Stockholde r' s Equity
$48,115
Return on Assets
Net Cash From Operations $16,605
0.2345 23.5%
Total Assets
$70,815
10-12
Elements of ROE
Du Pont formula
Why
has ROE changed?
ROE Profit M arg in Asset Turnover Leverage Ratio
Net Income
Sales
Sales
Assets
Assets
Equity
Total Asset
Turnover (TAT): ability to generate sales
from asset base
Leverage: extent to which debt is used to capitalize
the company
10-13
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
ROE
Net Income Sales Assets
$8,168 $36,835 $94,368
0.222 0.388 1.261 0.1086 10.9%
Sales
Assets Equity $36,835 $94,368 $74,825
For 2005
ROE
Net Income Sales Assets $12,254 $39,788 $70,815
0.308 0.562 1.472 0.2548 25.5%
Sales
Assets Equity $39,788 $70,815 $48,115
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.
10-14
Operating Efficiency
Receivable s Turnover
SalesReven ue
Receivable s
Cost of Goods Sold
Inventory Turnover
Inventory
More Leverage Variables
Debt to Equity
Long - Term Debt
Total Equity
Long - Term Debt
Debt to Total Capital
Total Capital
10-15
Compute the 2005 receivables turnover and
inventory turnover for Microsoft.
Solution:
Use the Balance Sheet and Income Statement
information:
Re venue
$39,788
Re ceivables Turnover
5.54
Accounts Re ceivable $7,180
Costof Re venue $6,200
Inventory Turnover
12.63
Inventories
$491
10-16
Financial Liquidity
Current Ratio
Current Assets
Current Liabilitie s
current ratio < 1 would signal a potential problem
Quick Ratio
Cash Marketable Securities Receivable s
Current Liabilitie s
EBIT
Interest Coverage
Debt Interest Charge
10-17
Indications of Value
Stock price is not an indication of value
i.e.,
Price-earnings ratio (P/E)
Earnings
yield (E/P)
Figure 10.1 P/E Ratio of the Dow Jones Industrial Average
35
30
25
P/E Ratio
stock splits
20
15
10
5
0
1940
1945
1950
1955
1960
1965
Data source: Dow Jones and Company (http://w w w .djindexes.com/jsp/index.jsp).
1970
1975
1980
1985
1990
1995
2000
2005
10-18
Since the market P/E ratio can change dramatically over
time, relative P/E ratios are sometimes used:
firm P/E divided by benchmark P/E
Table 10.4 Compare Financial Ratios with Industry Averages
Market Cap
($Billion)
Net Profit
Margin
ROE %
289.43
30.8
22.5
0.000
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
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
Microsoft
Technology Sector
Internet Service Providers
Source: Yahoo! Finance
Debt to
Equity
10-19
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!
10-20
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.
10-21
Can Financial Statements Be Trusted?
Accounting scandals
Accounting restatements
Changing
the numbers…
10-22
Figure 10.2 The Number of Firms Restating is Increasing
7.0%
Restatements
6.0%
Percent of listed companies
330
323
5.0%
270
4.0%
233
3.0%
2.0%
1.0%
Percent of Exchange Listed Companies
414
0.0%
2000
2001
2002
2003
2004
Source: 2004 Annual Review of Financial Reporting Matters, Huron Consulting Group
10-23