Financial Statement Analysis

Lecture 1 1

Financial Statement Analysis

Lecture 1

Lecture 1 2

PurposeAnalysis To analyze the information in financial

reports in order to assess how well a business is doing

Forecasting To project future performance based on

past and current performance and other available information

Valuation To evaluate a company’s investment

potential

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Role of Security Analysts Analysis, forecasting, valuation are the

three roles security analysts perform in capital markets

They analyze financial reports, and other information like industry trends, product markets, general economic information

They forecast earnings, revenues, cashflows, long-term growth

They value investment potential and issue stock recommendations (buy, hold, sell)

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Importance of FSA Financial reports are a primary source of

information Improper analysis could mislead investors

into making wrong investment decisions Analysts often differ in their interpretations

and recommendations. Why? Because they differ in ability Because they differ in how they analyze

information Because some aspects of analysis require

qualitative and subjective assessments. Examples?

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Two examples Hewlett Packard

HP delivers vital technology for business and life. The company's solutions span IT infrastructure, personal computing and access devices, global services and imaging and printing for consumers, enterprises and small and medium business. Our $3.5 billion annual R&D investment fuels the invention of products, solutions and new technologies, so that we can better serve customers and enter new markets. We invent, engineer and deliver technology solutions that drive business value, create social value and improve the lives of our customers. HP has a dynamic, powerful team of 150,000 employees with capabilities in 170 countries doing business in more than 40 currencies and more than 10 languages. Revenues were $79.9 billion for the fiscal year that ended October 31, 2004.

Current JaywalkConsensus

LatestReport

2.45                                                                          

IRP Rating Distribution for HPQ

Lecture 1 6

Two examples Elan

CorporationElan Corporation, plc is a neuroscience-based biotechnology company that is focused on discovering, developing, manufacturing and marketing advanced therapies in neurology, autoimmune diseases, and severe pain.

Current JaywalkConsensus

LatestReport

3.08                                                                          

IRP Rating Distribution for ELN

Lecture 1 7

Where do we start? Develop a systematic approach to

understanding and analyzing financial reports Just knowing how to prepare is not enough Need to understand accounting policies and

procedures Need to understand managerial incentives

Develop the necessary tools to evaluate financial performance in conjunction with other information such as industry trends, the nature of products and product markets, firm strategy relative to competition

Are interested in building a “tool” kit

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FSA using a Five step approachStep 1 Identify industry

characteristicsStep 2 Identify company strategyStep 3 Analyze financial statementsStep 4 Forecast future performance

and risk attributesStep 5 Estimate firm value

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Step 1 Identify industry characteristics Nature of the product

Good or a service Differentiated versus commodity product Product life cycle Diversity of product offerings

Nature of technology Mix of human resources versus technology Capital intensity Level of R&D and product development required

Nature of the Value chain Position in the value chain Value added by the company to the value chain Relative bargaining power in the value chain

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Step 1 Identify industry characteristics Nature of market

Extent of competition Porter’s five forces

Buyer power Supplier power Rivalry among existing firms Threat of new entrants Threat of substitute products

Inherent demand attributes Primary versus derived demand Demand growth Seasonal/cyclical demand patterns Staple versus convenience/luxury item

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Problem 1.12 Let us do problem 1.12 from the book. Can you match the firms to the

common-size financial statements? Some tips

Use your knowledge about the industry and the nature of the product. How would you expect these to show up in relationships between financial statement elements?

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Problem 1.12 Some industry characteristics

For example: Financing Industry

High proportion of receivables among its assets. Substantial borrowing in the capital structure.

Service Industry Unlikely to have much inventory. The higher percentages for receivables and current

liabilities (indicate the agency nature of advertising firms).

Restaurants: High inventory turn over. High receivables. High proportion of assets in property, plant and

equipment

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Problem 1.12 Some industry characteristics R&D Activities

Report research and development (R&D) expenditures.

These industries typically have significant R&D expenditures for discovering new technologies or developing new products

Insurance Industry A high proportion of cash and marketable securities

among its assets. A high proportion of liabilities in its capital structure. There is high potential for low quality earnings.

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Problem 1.12 Some product characteristics

Commodity products: High cost of goods sold to operating

revenues. Relatively low selling and administrative

expense percentage to consumer products.

Consumer products: High profit margin. High selling and administrative expense.

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FSA using a Five step approachStep 1 Identify industry

characteristicsStep 2 Identify company strategyStep 3 Analyze financial statementsStep 4 Forecast future performance

and risk attributesStep 5 Estimate firm value

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Step 2 Identify company strategy Corporate strategy

Criteria for corporate resource allocation Investment choice

Across industry diversification Degree of vertical integration Degree of geographical diversification

Business strategy Narrow product line or a diverse product line? Product differentiation strategy or a cost

leadership strategy

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Step 2 Identify company strategy Example: General Electric, Dell Products? Degree of industry diversification? Degree of geographical diversification? Degree of vertical integration? Business strategy?

Degree of product diversity Product differentiation or cost leadership?

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General Electric Product: A wide variety of products for the generation,

transmission, distribution, control and utilization of electricity.

Degree of industry diversification: The Company operated in 11 segments which are in six

industry-focused businesses which are GE Infrastructure, GE Industrial, GE Commercial Financial Services, GE NBC Universal, GE Healthcare and GE Consumer Finance.

Degree of vertical integration: Engaged in developing, manufacturing and marketing.

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General Electronic Recent Activities:1. GE acquired the commercial lending business of

Transamerica Finance Corporation.

2. GE acquired Australian Financial Investments Group.

3. GE completed the merger of NBC with Vivendi Universal Entertainment LLLP.

4. GE Infrastructure completed the acquisition of InVision Technologies, Inc. Also in December 2004, GE sold a majority interest in Gecis.

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Dell Inc. Product: Enterprise systems (servers, storage, workstations and

networking products), client systems (notebook and desktop computer systems), printing and imaging systems, software and peripherals, and global services.

Degree of industry diversification: Not too much.

Degree of geographical diversification: Regional headquarters include England, Europe, Middle East ,

Africa, Singapore, Japan, India, China, Australia and New Zealand. The company manufactures its computer systems in seven

locations: Austin, Texas; Nashville, Tenn.; Winston-Salem, North Carolina; Eldorado do Sul, Brazil (Americas); Limerick, Ireland (Europe, Middle East and Africa); Penang, Malaysia (Asia Pacific and Japan) and Xiamen, China (China). Dell sells its products and services worldwide.

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Dell Inc. Degree of vertical integration: The company designs, develops, manufactures, markets,

sells and supports a range of products and services. Product Differentiation: The products and services enable customers to build their

information technology (IT) and Internet infrastructures. Dell offers a portfolio of services that help customers

maximize the value of their information technology investments, rapidly deploy systems, and educate IT professionals and consumers.

The Company also offers various financing alternatives, asset management services and other customer financial services.

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FSA using a Five step approachStep 1 Identify industry

characteristicsStep 2 Identify company strategyStep 3 Analyze financial statementsStep 4 Forecast future performance

and risk attributesStep 5 Estimate firm value

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Step 3 Analyze financial statements Balance sheet

Statement of financial position – a snapshot as of a particular date

Asset portion reflects investment decisions Liability and shareholders’ equity portion reflects financing

decisions

Income statement Performance report The importance of the matching principle Earnings quality – How well does reported income convey a

company’s “true” performance?

Statement of Cashflows Statement of sources and uses of cash Connects operating, investing and financing activities

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Balance sheet Assets

Estimates of future economic benefits Could be monetary or non-monetary. Non-monetary assets stated at

acquisition cost? Could be tangible or intangible Classified into current assets, investments, PP&E, Intangibles Some assets never make it to the balance sheet. Examples? How to deal

with them in valuation?

Liabilities Future obligations Most liabilities monetary Some liabilities never make it on the balance sheet. Examples?

Shareholders’ equity Residual claim of shareholders as of the balance sheet date. Is it a measure of the value of the company to shareholders? Why or why

not?

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Income statement The capital market views income as an important

measure of performance for evaluation Accrual basis of accounting vs cash basis of accounting

Revenue recognition and the matching principle Analysts look at different measures of income

depending on the nature of business, industry. Net income, EBITDA, EBIDA, NOPAT

Income does not include some items that are relevant for valuation – certain equity adjustments that do not relate directly to operating performance

Included directly in comprehensive income in shareholders’ equity section

Analysts have to assess the quality of earnings Managers (are said to) have incentives to manage earnings

to project their companies in the most favorable light!

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FSA using a Five step approachStep 1 Identify industry

characteristicsStep 2 Identify company strategyStep 3 Analyze financial statementsStep 4 Forecast future performance

and risk attributesStep 5 Estimate firm value

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Step 4 Forecast future performance and risk attributes Forecast future performance

Use of common size statements Project financial statement elements

into the future Assess risk

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Project financial statement elements into the future Use past trends and industry comparisons

Has the company exhibited steady earnings growth in the past? Have other “peer” companies been able to do so?

What trends do profitability ratios in the past reflect? Asset turnover ratios? Inventory turnover

What is the industry experience? Make assumptions about key financial ratios

Liquidity ratios Profitability ratios Capital structure

Project changes in financial statement elements

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Assess risk Earnings volatility

Some companies exhibit more volatility in performance than others

Some industries are less stable than others Volatility imposes risk

Inability to generate enough cashflows to finance operations and growth

High levels of debt in capital structure

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FSA using a Five step approachStep 1 Identify industry

characteristicsStep 2 Identify company strategyStep 3 Analyze financial statementsStep 4 Forecast future performance

and risk attributesStep 5 Estimate firm value

Lecture 1 31

Valuation models Based on forecasts, analysts decide

what recommendations to issue to the investment community

This involves deciding whether the current market price is in line with the forecasts or not. If the market is under-pricing a stock, then

the stock is a “bargain.” Ball and Brown study quoted in the book. The role of capital market efficiency.

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Ball and Brown (1968) Study Their empirical study shows: On average, the firm announced an increase in

earnings experienced positive abnormal stock returns.( roughly 7%).

On average, the firm announced a decrease in earnings experienced negative abnormal stock returns. (roughly 9%).

The results suggest that merely the sign of the change in earnings is associated with a 16% stock returns.

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Valuation models There are many valuation models

and techniques Dividend discount models Residual income models Free cash flow models Use of simple indicators such PE and

PEG ratios. We will cover these in chapters 11-

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