Fundamental Analysis and Stocks

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Fundamental Analysis and Stocks

• Economics 71a Spring 2007
• Mayo, Chapter 9
• Lecture notes 3.3

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Why Read or Care?

• Investment strategies
• Growth
• Use accounting numbers to estimate growth
• Value
• Compare accounting numbers to price

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Goals

• Accounting statements
• Financial ratios
• Ratios and valuation

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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

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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)

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Extraordinary Items One Time 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

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Examples

• Lawsuit settlements
• One time asset sales (patents/real estate)
• 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

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Balance SheetAccounting Value of the Firm

• Assets (things firm owns)
• Liabilities (Loans)
• Stockholders equity
• (Assets - Liabilities)
• Also called
• Book value
• Net worth

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Assets

• Cash
• Accounts receivable
• Inventories
• Land
• Plant and equipment
• Less Depreciation

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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

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Balance Sheet

• Shareholders equity
• Common stock (at issue)
• 10
• Capital surplus
• 5
• Retained earnings
• 20
• Purchased stock (negative)
• Treasury stock -6
• 10520-6 29

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Cash Flow

• Pure measure of incoming - outgoing cash
• Differences with income statement
• No depreciation
• No accounts payable/receivable
• Inventories (account for costs of producing and
  putting in inventory)

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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 555-2-10 3 operating cash flow

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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

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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

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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)
Year (Straight) Earnings Before D Deprec. Tax
1 300 100 20
2 300 100 20
3 300 100 20
(Accel.)
1 300 200 10
2 300 50 25
3 300 50 25
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Goals

• Accounting statement
• Financial Ratios
• Ratios and valuation

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Financial Ratios

• Ratios of various financial variables
• Uses
• Analyze financial well being of a firm
• Compare different stocks in terms of current
  values
• Find good investments

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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

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Activity Ratios

• Inventory turnover
• Sales/(Average inventory)
• Receivables turnover
• (Annual credit sales)/(accounts receivable)
• High number indicates rapid turnover in credit
  sales
• Fixed asset turnover
• Sales/(fixed assets) (land, plant equipment)

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Profitability Ratios

• Operating profit margin
• EBIT/Sales
• Net profit margin
• Earnings/Sales
• Gross profit margin
• (Revenues-Cost of goods sold)/sales

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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)

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Coverage Ratios

• Times-interest earned
• EBIT/ (interest charges)

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Market Ratios

• Share price versus accounting value
• Very important
• Examples
• Price/Earnings ratio
• Market/Book (M/B) ratio
• Dividend yield (dividend/Price)

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Price Earnings RatioP/E Ratio
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Price Earnings Ratio

• Price per earnings
• Example
• Microsoft
• About 20
• 20 per 1 of earnings

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High Flying P/Es

• AOL (1999) near 600
• Dell Computer (1999) 100
• For many dot coms no P/E since earnings are zero

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PEG Ratio
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Market to Book Ratio (M/B)
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Market to Book Ratio

• Market value of the firm relative to its
  accounting value
• Key tool for value investors
• Extensive academic evidence that low market to
  book firms do better on average

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Dividend Yield

• Dividend/Price
• payout in dividends relative to price
• A little like interest, but not really
• Dividends are not guaranteed

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Dividend Payout

• Net Income
• Dividends
• Retained Earnings
• Dividend Payout ratio Divs/Earnings

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Goals

• Accounting statement
• Financial Ratios
• Ratios and valuation

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Fundamental Analysis

• Use information about firm to evaluate stock
  price
• Growth
• Estimate earnings growth and future prospects
• Value
• Find undervalued stocks

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Ratio Analysis

• Many methods
• Compare ratios to appropriate comparison set
• Example
• P/E ratio for a pharmaceutical firm
• Compare to industry
• If low -gt buy

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Problems With Accounting Information

• Misses intangibles
• Knowledge base (patents)
• Customer base
• Sometimes numbers are zero or negative

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More Problems with Accounting Information

• There are many ways to derive accounting numbers
• Large fudge factors
• Can clever accountants make things look better?

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Accounting Tricks

• Off balance sheet items
• Enron
• Stock options
• Expenses to balance sheet
• Worldcom
• AOL
• maintenance -gt new investment
• Log revenue forecasts now
• Xerox
• Taking over low p/e firms

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Goals

• Accounting statement
• Financial Ratios
• Ratios and valuation