Chapter 17

Company Analysis

Chapter 17

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Financial Statement Analysis

• Financial information presented in the form of financial statements

• Income statement• Balance sheet

• Analyst must be able to interpret the information provided on the statements

• Look at example: XYZ Company…

STATEMENT OF INCOME: 1997 1998 1999 2000 2001

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

ASSETS: 1997 1998 1999 2000 2001

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

<TOTAL> 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

<TOTAL> 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

<TOTAL> 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

<TOTAL> Liabilities + Equity 1150700 1937000 2563500 3070700 4270000

XYZ Company

FINANCIAL RATIOS: 1997 1998 1999 2000 2001

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

INDUSTRY AVERAGES

FINANCIAL RATIOS: 1997 1998 1999 2000 2001

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

Ratio Analysis

• Used to examine a firm’s financial performance

• A ratio on its own has limited value – to be useful, one must examine:– Trends– Ratios of comparable firms or industry

benchmarks

Ratio Analysis (cont’d)

Five types of ratios used to analyze a firm:

1. Liquidity: ability to generate cash and meet s/t debt

2. Asset Management: ability to effectively manage its assets to generate sales and profits

3. Debt Management: ability to effectively handle its debt

4. Profitability: ability to generate profits

5. Value: market value versus accounting values

A. Liquidity

1. Current ratio = current assets / current liabilities

For XYZ (2001):= 2,418,600 / 2,265,800 = 1.07

2. Quick ratio = [CA - Inventory] / current liabilities

For XYZ (2001)= (2,418,600 – 1,803,100) / 2,265,800= 0.27

B. Asset Management

3. Average Collection Period (ACP) = Account Receivable / (Sales/365days)

For XYZ (2001):

= 380,400 / (4,448,000/365) = 31.22 days

Note:

A/R Turnover = Sales / Acct Receivable

= 365 / ACP

For XYZ (2001) = 365/31.22 days = 11.69 times

B. Asset Management (cont.)

4. Inventory Turnover = Cost of goods / Inventory

or = Net Sales / InventoryFor XYZ (2001) (using CoGS):

= (4,005,800) /1,803,100 = 2.22 times

Days Inventory = Inventory / Daily COGS (or Sales)

= 365 / Inventory Turnover For XYZ (2001) = 365/2.22 = 164.4 days

5. Total Asset Turnover = Sales / TA = 4,488,000 / 4,270,000 = 1.042

C. Debt Ratios

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

TA = Debt + Equity

C. Debt Ratios (cont.)

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

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%

E. Value Ratios

13. Div. Payout = DPS / EPS

= 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

E. Value Ratios (cont’d)

15. 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%

DuPont Analysis

ROE = NI / Equity

Eqty

TA

TA

Sales

Sales

EBIT

EBIT

EBT

EBT

NI

Tax Burden

Interest Burden

EBIT Efficiency

TA Turnover

NI / Sales = Net Income Margin

NI / TA = ROA

Equity

TA ROA

Leverage Ratio = TA / Equity

LeverageRatio

EQUITY

TA

TA

Sales

SALES

NI

Equity

NI

Net Profit margin

Asset Turnover

Leverage Ratio

EQUITY

TAROAROE

XYZ (2001)

• 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.

XYZ (2001)

• 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)

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

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

Debt Management

• Debt levels have increased steadily and coverage has deteriorated– Debt ratio is 0.76 (from 0.51 in 1997)– Debt-to-equity is 3.28 (from 1.11 in 1997)– Coverage is 2.91 (from 21.53 in 1997)

• 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

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)

DuPont Analysis

• XYZ (2001)– ROE = (NI/Sales)(Sales/TA)((TA/Eqty)

= (.0299)(1.042)(4.339) = 13.51%

• Industry averages (2001) – ROE = (NI/Sales)(Sales/TA)((TA/Eqty)

= (.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.

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

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

Notes to Financial Statements

• Provide important details about the company’s financial condition

• Often included in the notes are:– Accounting policies– Description of fixed assets, share capital

and LTD– Commitments and contingencies

• Financial Statements should also disclose information by segments (i.e., by industry and by location)

Management’s Discussion and Analysis

• Important source of information

• Provides overview of factors/issues affecting firm’s performance

• May contain explanations of issues uncovered in an analysis of the financial ratios

• It is the management’s point of view

Estimating Earnings Per Share

Estimating EPS

• Security valuation often depends on having an estimate of EPS for the next year (or next several years)

• To use the forward P/E multiple, you need an estimate of the multiple and an estimate of EPS1

• To use DCF methods, it is common to estimate the FCFE (or FCFF or Dividends) directly for the first few years and then assume a stable growth rate

Estimating EPS

• In order to estimate EPS, the easiest method is to simply remember that what you are analyzing is a business – it has revenues and costs. Estimates of future revenues and costs will translate into estimates of EPS (and with a little more work, estimates of free cash flow)

• Appropriate methods for forecasting revenues and costs depend heavily on what type of company (i.e. what industry) you are looking at

Estimating EPS

• Consider a simple income statement:

• An estimate of N.I. can be used to get EPS, or as a starting point for a free cash flow estimate

Revenues

-Costs

EBITDA

-Depreciation & Amort.

EBIT

-Interest

EBT

-tax

Net Income

Estimating EPS

• To estimate NI for next year, simply estimate each piece of the income statement.

• Revenues: a revenue estimate is extremely important!

• The way to estimate depends on the type of firm

• Examples of factors to consider in revenues: – For a firm with a few major products (e.g. pharmaceuticals) –

estimate sales for each product –will they grow/decline from last year?

– Retail firms – what will be the growth in “same store sales” over last year from existing stores? Are they opening new stores and what will their sales be?

– Raw materials producers – need estimate of the output price (e.g. price of nickel, price of oil, etc.). Also need estimate of total output – will the mines start to produce more or less? Will new mines be opened?

– Consumer or industrials – What is growth rate in overall product market? Will this company’s market share increase/decrease next year? Combine to estimate revenues.

– Statistical techniques – Could use regression to estimate revenues. e.g. regress past sales on some variable thought to be related (maybe regress department store sales on GDP growth). The parameters from the regression, and an estimate of the economic variable for next year will give an estimate of next year’s sales.

– Many other factors that you might consider. The point is to think of the company being analyzed as a business – what factors will affect its sales, what do you think will happen with those factors? Is the firm’s strategy going to result in increased or decreased sales? What about state of economy/industry etc.

– Estimating revenues should use expertise you have gained in all your courses (marketing/strategy/stats etc.) and a lot of common sense.

Estimating EPS

• Based on estimate of sales, now estimate EBITDA• Often this is done by forecasting next year’s Gross

Margin (a.k.a. the EBTIDA ratio (EBITDA/Revenues))

• Could take average of last few years’ margins – Ave. Gross Margin X Rev = EBITDA

• Note: this assumes that next year’s cost structure will be similar to the past

• If you think that costs may increase or decrease for some reason, must adjust this

Estimating EPS

• Depreciation: usually, starting point is last year’s depreciation. Then adjust for declining balance of value of assets, and adjust for any new capital expenditures that will generate depreciation.

• Interest: estimate based on debt outstanding, level of interest rates (if some debt must be renogiated), effect of any new borrowings

Estimating EPS

• Tax: estimate an effective tax rate paid by company.

• Combine the above estimates to get an estimate of Net Income

• An estimate of basic EPS is obtained by subtracting preferred dividends from NI and dividing by the number of common shares outstanding

Using EPS estimate in DCF Valuation

• An estimate of next year’s EPS could be translated into an estimate of div1 if the firm uses a fixed payout ratio

• Commonly, an estimate of FCFE could be obtained based on an estimate of EPS by looking at the extra pieces needed for FCFE

• Note: it is normal to directly estimate FCFE (or FCFF) out for several years, and then assume a growth rate after that

Estimating FCFE

• Remember:

FCFE = Net Income

+ Depreciation

– Capital Expenditures

– Change in non-cash Working Capital

+ Net New Debt Issued• Given estimate of NI, an estimate of the last 4

factors are necessary

Estimating FCFE

• Sometimes, your knowledge of the firm will help a lot: are they expanding and planning on large capital expenditures? Are they planning on increasing/decreasing debt load? Are they increasing/decreasing inventory? etc.

• Often, simplifying assumptions are used:

Estimating FCFE

• Examples of common assumptions:• For a firm that is not in a major growth phase, often

assumed that capital expenditures = depreciation (e.g. they are simply replacing equipment as it wears out)

• Often accounts receivable (part of working capital) is assumed to be a constant percentage of sales (unless a component of the firm’s strategy is to change this)

• Often accounts payable (part of working capital) is assumed to be a constant percentage of costs

Estimating FCFE

• Common assumptions (cont.)• Inventory sometimes assumed to be a percentage

of sales (but note that often firms are trying to build up inventory, or sell it down)

• Investments in cap ex. or working capital must be financed – if the firm has a target debt/asset ratio then this is often used to determine how much of these investments will be finned with debt vs equity (which gives an estimate of debt issuance in the future)

• There are other assumptions that you might make in your forecast, the appropriate ones depend on the situation and should be based on your knowledge of the firm and its industry

Estimating Growth Rates

• dividends are related to profitability• in particular, EPS are important

• If the firm tries to maintain a constant payout ratio:• growth rate in dividends = growth rate in EPS

• estimate future growth rate based on past growth rate in dividends or EPS?

• Appropriate?

• estimate sometimes used is “sustainable” growth rate

• growth rate in Div’s = growth rate in EPS= (1 - payout ratio) ROE

• need estimate of future ROE

• the sustainable growth rate is the growth expected with no further investment of capital into the firm• Sustainable growth only appropriate as g if payout and ROE are both stable over time (mature industry)

Estimating “g”

1. Use historical information regarding growth in earnings + dividends:

a. Arithmetic averages over some past interval e.g. 3yrs/5yr/10yr/last year

b. Geometric averages

c. Regressions (e.g. div’s on some econ/industry/firm attribute)

2. Use analyst forecasts

3. Estimate “Sustainable Growth Rate” (see above)

4. Combine #1-3 with judgement to reach final estimate (or range of estimates)

• Other issues in estimating future growth rate:

– growth in industry overall– is firm gaining/losing market share in its industry?

– Growth rate of economy overall– the long term, stable growth rate for the firm cannot be larger than the long term growth rate of the overall economy

• For long term growth, often an estimate of long term economic growth is used – or something lower if the industry is expected to grows slower than overall economy

• In short term, growth rates often based on year by year forecasts of earnings for firm

• Forecasts based on many factors, including growth of industry, growth of market share, revenue growth and costs changes etc.