Fundamental Analysis and Stocks

8/14/2019 Fundamental Analysis and Stocks

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Fundamental Analysis andStocks

Economics 71a: Spring 2007

Mayo, Chapter 9

Lecture notes 3.3

Why Read or Care?

Investment strategies

Growth

Use accounting numbers to estimate growth

Value

Compare accounting numbers to price

Goals

Accounting statements

Financial ratios

Ratios and valuation

Accounting Statements

Income statement

Balance sheet

Statement of retained earnings

Statement of cash flows


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Income Statement

Flow variables

Revenues Cost of goods sold

Income Statement Example

Sales revenues $50

Cost of goods sold $-25

Advertising/Admininstrative expenses $-2

Depreciation $-5

Interest payments $-1

Taxes $-3

Earnings 50-25-2-5-1-3 = $14

EBIT = Earnings before interest and taxes = 50-25-7 = $18 (operating income)

Extraordinary Items: OneTime Income and Expenses

Below the line

Should come after other items

Part of total earnings

Left out of

EBIT

core earnings, operating earnings

Definitions are blurry on this

Examples

Lawsuit settlements

One time asset sales (patents/realestate)

Pension fund adjustments

Changing accounting systems


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Income Statement Example

Total revenues $50

Cost of goods sold $-25

Advertising + Admin. expenses $-2

Depreciation $-5

Interest payments $-1

Taxes $-3

**Earnings 50-25-2-5-1-3 = $14 (core earnings)

EBIT = Earnings before interest and taxes = 50-25-7 = $18 (operating income)

Lawsuit settlement = $-8

Earnings 50-25-2-5-1-3-8= $6

Balance SheetAccounting Value of the Firm Assets (things firm owns)

Liabilities (Loans)

Stockholders equity (Assets - Liabilities)

Also called Book value

Net worth

Assets

Cash

Accounts receivable

Inventories

Land

Plant and equipment

Less: Depreciation

Liabilities

Accounts payable

Notes payable (short term debt)

Long term debt


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Balance Sheet

Assets Cash $5

Plant and equipment $100

Liabilities Accounts payable $1

Long term debt $75

Shareholder equity 105-76 = $29 Book value

Balance Sheet

Shareholders equity Common stock (at issue)

$10

Capital surplus $5

Retained earnings 20

Purchased stock (negative) Treasury stock -6

10+5+20-6 = 29

Cash Flow

Pure measure of incoming - outgoingcash

Differences with income statement

No depreciation

No accounts payable/receivable

Inventories (account for costs of producingand putting in inventory)

Cash Flow Parts

Operating Activities

Investment Activities

Financial Activities


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Operating Cash Flow

Earnings = $5 Adjust to get to cash flow

Depreciation : +5 Why? Remove depreciation adjustments

Increase in accounts payable: +5 Why? Havent paid this yet.

Increase in accounts receivable: -2 Why? Havent received this yet.

Increase in inventories: -10 Production costs reflect only goods sold.

Adjustment: 5+5+5-2-10 = 3 = operating cash flow

Investment Cash Flow

Increase in gross fixed assets Purchases of new plant and equipment

-30 million : New office building

Total investment cash flow = -30 million

Finance Cash Flow

Increase in long term debt: +50 million of incoming funds

Dividends: -20 million payout of divs

Total finance cash flow = +30 million

Depreciation

Assets wear out

Firms slowly write them off

Balance and income statements

Types of depreciation Straight line depreciation

Same amount each year

Example: 10 years, $100,000 = $10,000 per year

Accelerated depreciation More in the early years\

Production based depreciation


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Tax Impact of Depreciation(Timing Effects, 10% tax rate,

Asset size = 300)

25503003

25503002

102003001

(Accel.)

201003003

201003002

201003001

TaxDeprec.Earnings

Before D

Year

(Straight)

Goals

Accounting statement

Financial Ratios


Financial Ratios

Ratios of various financial variables

Uses

Analyze financial well being of a firm

Compare different stocks in terms ofcurrent values

Find good investments

Ratios

Liquidity ratios

Activity ratios

Profitability ratios

Leverage ratios

Coverage ratios

Market ratios

Dividend payout ratio


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Liquidity Ratios

Current ratio

Current assets / Current liabilities

Short term, ability to pay bills

Quick ratio

(Current assets - inventory) / Current liabilities

Take short term inventory out of current assets

Activity Ratios

Inventory turnover

Sales/(Average inventory)

Receivables turnover

(Annual credit sales)/(accounts receivable)

High number indicates rapid turnover in creditsales

Fixed asset turnover

Sales/(fixed assets) (land, plant + equipment)

Profitability Ratios

Operating profit margin

EBIT/Sales

Net profit margin

Earnings/Sales

Gross profit margin

(Revenues-Cost of goods sold)/sales

Profitability Ratios

Return on total assets (ROA)

Earnings/(total assets)

Return on equity (ROE)

Earnings/(shareholder equity)


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Leverage Ratios

Debt to net worth

Debt/(share holder equity)

Debt ratio

Debt/(total assets)

Coverage Ratios

Times-interest earned

EBIT/ (interest charges)

Market Ratios

Share price versus accounting value

Very important

Examples

Price/Earnings ratio

Market/Book (M/B) ratio

Dividend yield (dividend/Price)

Price Earnings RatioP/E Ratio

P/ERatio=Market priceper share

Earningspershare


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Price Earnings Ratio

Price per earnings

Example:

Microsoft

About 20

$20 per $1 of earnings

High Flying P/Es

AOL (1999) near 600

Dell Computer (1999) 100

For many dot coms no P/E sinceearnings are zero

PEG Ratio

PEG =P/E

3! 5 year earnings growth

Market to Book Ratio (M/B)

M/B =Marketpriceper share

Bookvaluepershare


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Market to Book Ratio

Market value of the firm relative to itsaccounting value

Key tool for value investors

Extensive academic evidence that lowmarket to book firms do better onaverage

Dividend Yield

Dividend/Price

% payout in dividends relative to price

A little like interest, but not really

Dividends are not guaranteed

Dividend Payout

Net Income

Dividends

Retained Earnings

Dividend Payout ratio = Divs/Earnings

Goals


Financial Ratios



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Fundamental Analysis

Use information about firm to evaluatestock price

Growth

Estimate earnings growth and futureprospects

Value

Find undervalued stocks

Ratio Analysis

Many methods

Compare ratios to appropriatecomparison set

Example:

P/E ratio for a pharmaceutical firm

Compare to industry

If low -> buy

Problems With AccountingInformation

Misses intangibles

Knowledge base (patents)

Customer base

Sometimes numbers are zero ornegative

More Problems withAccounting Information

There are many ways to deriveaccounting numbers

Large fudge factors

Can clever accountants make thingslook better?


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Accounting Tricks

Off balance sheet items Enron

Stock options

Expenses to balance sheet Worldcom

AOL

maintenance -> new investment

Log revenue forecasts now Xerox

Taking over low p/e firms

Goals


Financial Ratios


Fundamental Analysis and Stocks

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