Accounting and Investment

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Accounting and Investment
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What is Accounting?

• The systematic recording, reporting, and analysis
  of financial transactions of a business.
• Managerial Accounting vs. Financial Accounting

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Product of Financial Accounting

• Financial Statements
• Where to find them? (Edgar, Mergent Online,
  CapitalIQ, etc)
• What are the components?
• How can we use them?
• Limitation

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Analysis of the Statements

• Quality of the statements
• Decoding the business by analyzing financial
  statements
• Business Growth Model ( identify key drivers and
  segments)
• Business Profitability ( profitability ratios)
• Business Risks (Analysis of liquidity, inventory,
  cash flow, capital structure, etc)
• Comparing horizontally and vertically
• Limitation of FSA Reflecting only financial
  aspects, only the end result, only past results
  and may have been manipulated

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• Lets have a look at the real financial
  statements.
• Example

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The Use of Financial Statements

• The purpose of your analysis
• To Predict, to evaluate
• MA, privatization
• Internal growth (geographically, horizontally,
  vertically or new model? )
• Cost and Profitability
• Bankruptcy or Default
• Based on your purpose, decide which items and
  what analysis you should do

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Financial Analysis

• Earnings Growth
• Ability to cover debts (short and long-term)
• Degree of leverage
• Ratios comparable to industry peers

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Earnings Growth

• P/E Price/Earnings
• Stock Price / EPS
• Market Cap / Net Income
• PEG P/E / Earnings Growth
• Divide P/E ratio by estimated growth in EPS
• Based on Comps, but generally less than 1 is good

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Return on Capital

• ROS Profit Margin
• Net Profit After Taxes / Revenue
• ROA Return on Assets
• Net Profit After Taxes / Total Assets
• ROE Return on Equity
• Net Profit After Taxes / Shareholder Equity

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Other Comps

• Price / Book How aggressively the market values
  the firm
• Price / Cash Flow Actual cash as compared to NI
  (which can be influenced by companys accounting)
• Price / Sales If company not yet profitable

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Solvency Ratios

• Quick Ratio Cash Accts Receivable / Total
  Current Liabilities
• Ability to cover debts in crisis
• Current Ratio Total CA / Total CL
• Margin of safety for slightly longer time period
• Fixed Assets / SE
• Smaller Better Measures liquidity

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Efficiency Ratios

• Collection Period AR x 365 / Revenue
• Avg. days to collect AR
• Turnover Revenue / Inventory
• How quickly they move products, and how it
  translates into
• AP x 365 / Revenue
• How long it takes to repay suppliers
• Affects credit

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Free Cash Flow Valuation

• FCF EBIT (1 tax rate) Depreciation
  Capital Expenditures Increase NWC

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Gordon Growth Model

• Vo D1 / k-g
• Value at time 0 Dividend at time 1 /
  Capitalization rate constant growth
• D1 Do x (1 g) 1.52 (1.05)
• Vo 1.60 / .10 - .05
• Vo 1.60 / .05
• Vo 32.00

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Full DCF Model

• Step 1 Assumptions about growth / Discount rate
• Step 2 Compute FCF
• Derive Discount rate CAPM
• CAPM Re rf B (rm-rf)
• WACC (E/DE)(re) (D/DE)(1-t)(rd)
• Derive terminal value of cash flows
• FCF1/WACC1 FCF2/WACC2..

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• Question Can EBIT be used in for any company?

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Customize your analysis

• EBIT cannot be used for financial industry,
  because interest income is the major income for
  those commercial banks
• To have an accurate analysis of the companies,
  you need to
• tailor your analysis and modify the ratios
• Adjust the reported items
• according to the business model of the company

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FSA in Use

• Type in tickers in Bloomberg
• Go to FA to view financial statements
• There are many historical ratios available
• EEB and EEA (or just go to EE for the general
  categories) are the estimates of some financial
  data based on the past statements and assumptions
  made depending on the analysts understanding of
  the business and environment

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FSA in Use 2

• Go to CapitalIQ -gt screening
• Try screen companies by Financial Accounting
  records to find
• 1) the companies under serious financial
  stress
• 2) the companies that are very profitable
• 3) the companies that have lots of cash
  sitting on their book
• 4) the companies that have high leverage
• 5) the companies that have a stable profit
  margin
• 6) the companies that have improved their
  margin dramatically last year
• How do you make a profit using those result from
  the screening?

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FSA in use 3

• Find a company
• Download the financial statements of past 3 years
• Which ratios and items have changed dramatically?
• Are the growth rate of most items consistent?
• Which parts of the major source of financing?
• Guess out and check in the analysts report and
  10Q 10K the reasons behind those
  differences/inconsistencies and check what
  influence those items had upon the stock price
  when the FA were released

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Questions?