Investments: Analysis and Management, Second Canadian Edition

1
Chapter 17
Company Analysis
2
Learning Objectives

• Define fundamental analysis at the company level.
• Explain the accounting aspects of a companys
  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.

3
Fundamental Analysis

• Last step in EIC is individual company analysis
• Goal estimate shares intrinsic value
• Constant growth version of dividend discount model

• Value justified by fundamentals

4
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

5
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

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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

7
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

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Basic Financial Statements

• EBT
• - Taxes
• Net Income available to owners
• - Dividends
• Addition to Retained Earnings
• EPS and DPS

• Income Statement
• Sales or revenues
• - Product costs
• Gross profit
• - Period Costs
• EBIT
• - Interest
• EBT

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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

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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

11
Analyzing a Companys Profitability

• Important to determine whether a companys
  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

12
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

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DuPont Analysis

• Three components of return on equity
• Net Margin Net Income / Sales. The higher a
  companys 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.

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DuPont Analysis
Tax Burden
Interest Burden
EBIT Efficiency
TA Turnover
LeverageRatio
NI / Sales Net Income Margin
NI / TA ROA
Leverage Ratio TA / Equity
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Net Profit Margin
Asset Turnover
Leverage Ratio
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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(1g)
  

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Internal Growth Rate

• Future expected growth rate matters in estimating
  earnings, dividends
• g ROE ? (1 Payout ratio)
• Only reliable if companys current ROE remains
  stable
• Estimate is dependent on the data period
• What matters is the future growth rate, not the
  historical growth rate

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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

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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
• Markets expectation of earnings

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The P/E Ratio

• Measures how much investors currently are willing
  to pay per dollar of earnings
• Summary evaluation of firms prospects
• A relative price measure of a stock
• A function of expected dividend payout ratio,
  required rate of return, expected growth rate in
  dividends

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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

22
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

23
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

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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

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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

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Appendix 17-A Financial Ratio Analysis

• Used to examine a firms financial performance
• A ratio on its own has limited value to be
  useful, one must examine
• Trends
• Ratios of comparable firms or industry benchmarks

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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 accounting values

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Example
STATEMENT OF INCOME 2000 2001 2002 2003 2004
Total Revenue............... 1426000 2143300 2892300 3058600 4448000
Cost of Sales............... 1238700 1931400 2559400 2699200 4005800
Depreciation/Amortization... 40100 43600 76800 75300 101300
Interest Expense............ 5300 7500 53200 52600 79000
Research / Exploration...... 0 0 36300 53700 73100
Other Expense............... 33100 43600 46100 56400 37900
Unusual Items............... 0 0 0 0 0
Pre-Tax Income.............. 108800 117200 120500 121400 150900
Income Tax.................. -19900 -25700 -20400 -13700 -18100
Earnings BEFORE Extra. Items 88900 91500 100100 107700 132800
Extraordinary Items......... 0 0 0 0 0
Income AFTER Extra. Items 88900 91500 100100 107700 132800
Dividends - Preferred Shares 3500 3800 4000 2900 2600
Income Available to Common Shares 85400 87700 96100 104800 130200
Earnings /Share............. 0.68 0.68 0.706 0.727 0.85
Common Shares - Year End (1000s) 125658 131398 141443 152337 154280
Common Shares - Average (1000s) 125536 128932 136073 144121 153237
Dividends - Common Shares... 14700 22000 28700 27400 32200
Market Price per Share (Close) 6.69 7.63 7.88 17.13 11.63
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ASSETS 2000 2001 2002 2003 2004
Cash Equivalent........... 150000 84000 87500 179200 235100
Accounts Receivable......... 174000 428800 413700 360100 380400
Inventory................... 220200 583500 992700 1215700 1803100
Marketable Securities....... 0 0 0 0 0
Other....................... 0 0 0 0 0
ltTOTALgt Current Assets...... 544200 1096300 1493900 1755000 2418600
Fixed Assets - Gross 1372700 1650500 1956200 2277600 2914600
less Accumulated Depreciation -766200 -809800 -886600 -961900 -1063200
Fixed Assets - Net.......... 606500 840700 1069600 1315700 1851400
ltTOTALgt Assets.............. 1150700 1937000 2563500 3070700 4270000
LIABILITIES AND EQUITY 1997 1998 1999 2000 2001
Bank Loans Equivalent..... 147800 346800 537400 620800 828500
Accounts Payable............ 347200 684400 831800 901400 1380900
Current Portion of L-T Debt. 5400 30000 20800 19300 56400
ltTOTALgt Current Liabilities........ 500400 1061200 1390000 1541500 2265800
Long-Term Debt Debentures. 83500 211000 425500 586600 963700
Deferred Taxes Credits.... 41600 42000 53800 43300 56400
Equity Preferred Stock..... 158300 157700 37400 35700 34100
Common Stock........ 190600 223100 347400 476800 465200
Retained Earnings... 176300 242000 309400 386800 484800
Total Equity........ 525200 622800 694200 899300 984100
ltTOTALgt Liabilities Equity 1150700 1937000 2563500 3070700 4270000
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XYZ COMPANY XYZ COMPANY
FINANCIAL RATIOS 2000 2001 2002 2003 2004
Current Ratio 1.09 1.03 1.07 1.14 1.07
Acid Test (Quick) Ratio 0.65 0.48 0.36 0.35 0.27
ACP (days) 44.54 73.02 52.21 42.97 31.22
Inventory Turnover 5.62 3.31 2.58 2.22 2.22
Total Asset Turnover 1.24 1.11 1.13 1.00 1.04
Debt Ratio 0.51 0.66 0.71 0.69 0.76
Debt-to-Equity Ratio 1.11 2.04 2.62 2.37 3.28
Equity Multiplier 2.19 3.11 3.69 3.41 4.34
TIE (or Interest Coverage) 21.53 16.63 3.27 3.31 2.91
Net Income Margin 6.23 4.27 3.46 3.52 2.99
Return on Assets (ROA) 7.73 4.72 3.90 3.51 3.11
Return on Equity (ROE) 16.93 14.69 14.42 11.98 13.49
P/E Ratio 9.84 11.21 11.15 23.56 13.68
M/B Ratio 2.29 2.15 1.70 3.02 1.89
Dividend Yield 1.75 2.24 2.68 1.11 1.81
Dividend Payout Ratio 0.17 0.25 0.30 0.26 0.25
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INDUSTRY AVERAGES INDUSTRY AVERAGES INDUSTRY AVERAGES

FINANCIAL RATIOS 2000 2001 2002 2003 2004
Current Ratio 2.12 2.85 2.25 2.01 1.69
Acid Test (Quick) Ratio 1.21 1.97 1.36 1.24 1.09
ACP (days) 35.20 34.09 44.50 45.90 46.90
Inventory Turnover 7.78 8.20 7.68 8.52 8.16
Total Asset Turnover 1.78 1.43 1.37 1.26 1.23
Debt Ratio 0.23 0.33 0.32 0.29 0.32
Debt-to-Equity Ratio 0.36 0.61 0.56 0.49 0.55
Equity Multiplier 1.57 1.82 1.78 1.70 1.74
TIE (or Interest Coverage) 34.41 42.19 5.95 5.53 8.61
Net Income Margin 8.47 6.03 4.34 4.19 5.68
Return on Assets (ROA) 15.08 8.64 5.95 5.27 7.01
Return on Equity (ROE) 23.68 15.72 10.59 8.96 12.20
P/E Ratio 6.42 9.08 12.13 22.38 15.53
M/B Ratio 1.51 1.42 1.28 2.00 1.88
Dividend Yield 1.71 1.73 2.86 2.67 2.08
Dividend Payout Ratio 0.13 0.24 0.35 0.39 0.26
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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

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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

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B. Asset Management (Contd)

• 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

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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

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C. Debt Ratios (Contd)

• 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

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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

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E. Value Ratios

• 13. Dividends Payout DPS / EPS or
• 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

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E. Value Ratios (Contd)

• 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

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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

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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)

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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

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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

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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

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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)

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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

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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

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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