Financial Statement Analysis

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Financial Statement Analysis

• Lecture 1

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Purpose

• Analysis
• 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 companys 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 RD 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.

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Two examples

• Elan Corporation
• Elan 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.

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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 approach

• Step 1 Identify industry characteristics
• Step 2 Identify company strategy
• Step 3 Analyze financial statements
• Step 4 Forecast future performance and risk
  attributes
• Step 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 RD 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
• Porters 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

• RD Activities
• Report research and development (RD)
  expenditures.
• These industries typically have significant RD
  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 approach

• Step 1 Identify industry characteristics
• Step 2 Identify company strategy
• Step 3 Analyze financial statements
• Step 4 Forecast future performance and risk
  attributes
• Step 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
• GE acquired the commercial lending business of
  Transamerica Finance Corporation.
• GE acquired Australian Financial Investments
  Group.
• GE completed the merger of NBC with Vivendi
  Universal Entertainment LLLP.
• 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 approach

• Step 1 Identify industry characteristics
• Step 2 Identify company strategy
• Step 3 Analyze financial statements
• Step 4 Forecast future performance and risk
  attributes
• Step 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 companys 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,
  PPE, 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 approach

• Step 1 Identify industry characteristics
• Step 2 Identify company strategy
• Step 3 Analyze financial statements
• Step 4 Forecast future performance and risk
  attributes
• Step 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 approach

• Step 1 Identify industry characteristics
• Step 2 Identify company strategy
• Step 3 Analyze financial statements
• Step 4 Forecast future performance and risk
  attributes
• Step 5 Estimate firm value

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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 11-14