CHAPTER SEVENTEEN Company Analysis

Cleary / Jones Investments: Analysis and

Management

Learning ObjectivesLearning Objectives To define fundamental analysis at the To define fundamental analysis at the

company levelcompany level To explain the accounting aspects of a To explain the accounting aspects of a

company’s earningscompany’s earnings To describe the importance of EPS To describe the importance of EPS

forecastsforecasts To estimate the P/E ratio of a companyTo estimate the P/E ratio of a company To use the beta coefficient to estimate the To use the beta coefficient to estimate the

risk of a stockrisk of a stock

Fundamental AnalysisFundamental Analysis Last step in top-down approach is Last step in top-down approach is

individual company analysisindividual company analysis Goal: estimate share’s intrinsic Goal: estimate share’s intrinsic

valuevalue– Constant growth version of dividend Constant growth version of dividend

discount modeldiscount modelg-k

DP value Intrinsic 10

– Value justified by fundamentalsValue justified by fundamentals

Fundamental AnalysisFundamental Analysis Earnings multiple could also be usedEarnings multiple could also be used

PP0 0 = estimated EPS = estimated EPS justified P/E ratio justified P/E ratio Stock is under- (over-) valued if intrinsic Stock is under- (over-) valued if intrinsic

value is larger (smaller) than current value is larger (smaller) than current market pricemarket price

Focus on earnings and P/E ratioFocus on earnings and P/E ratio– Dividends paid from earningsDividends paid from earnings– Close correlation between earnings and Close correlation between earnings and

stock price changesstock price changes

Accounting Aspects of Accounting Aspects of EarningsEarnings

How is EPS derived and what does EPS How is EPS derived and what does EPS represent?represent?

Financial statements provide majority Financial statements provide majority of financial information about firmsof financial information about firms

Analysis implies comparison over time Analysis implies comparison over time or with other firms in the same industryor with other firms in the same industry

Focus on how statements used, not Focus on how statements used, not mademade

Basic Financial StatementsBasic Financial Statements Balance SheetBalance Sheet

– Items listed in order of liquidity (assets) Items listed in order of liquidity (assets) or in order of payment (liabilities)or in order of payment (liabilities)

– AssetsAssets Cash vs. non-cash assetsCash vs. non-cash assets

– Non-cash assets may be worth more or less than Non-cash assets may be worth more or less than the amount carried on the booksthe amount carried on the books

Depreciation methods for fixed assetsDepreciation methods for fixed assets Inventory evaluation choices Inventory evaluation choices

Basic Financial StatementsBasic Financial Statements Balance SheetBalance Sheet

– LiabilitiesLiabilities Fixed claims against the firmFixed claims against the firm

– EquityEquity Residual claimsResidual claims Adjusts when the value of assets changeAdjusts when the value of assets change Linked to Income StatementLinked to Income Statement

– ““Snapshot” at one point in timeSnapshot” at one point in time

Income StatementIncome StatementSales or revenuesSales or revenues

- Product costs- Product costsGross profitGross profit

- Period Costs- Period CostsEBITEBIT

- Interest- InterestEBTEBT

EBTEBT- Taxes- Taxes

Net Income Net Income available to ownersavailable to owners

- Dividends- DividendsAddition to Addition to Retained EarningsRetained Earnings

EPS and DPSEPS and DPS

Basic Financial StatementsBasic Financial Statements

Basic Financial StatementsBasic Financial Statements Earnings per shareEarnings per share

EPS = Net Income/average number of EPS = Net Income/average number of shares outstandingshares outstanding

– Net Income before adjustments in Net Income before adjustments in accounting treatment or one-time eventsaccounting treatment or one-time events

Certifying statementsCertifying statements– Auditors do not guarantee the accuracy Auditors do not guarantee the accuracy

of earnings, but only that statements are of earnings, but only that statements are a fair financial representationa fair financial representation

Problems with Reported Problems with Reported EarningsEarnings

EPS for a company is not a precise EPS for a company is not a precise figure that is readily comparable over figure that is readily comparable over time or between companiestime or between companies– Alternative accounting treatments used Alternative accounting treatments used

to prepare statementsto prepare statements– Difficult to gauge the ‘true’ performance Difficult to gauge the ‘true’ performance

of a company with any one methodof a company with any one method– Investors must be aware of these Investors must be aware of these

problemsproblems

Analyzing a Company’s Analyzing a Company’s ProfitabilityProfitability

Important to determine whether a Important to determine whether a company’s profitability is company’s profitability is increasing or decreasing and whyincreasing or decreasing and why

Return on equity (ROE) emphasized Return on equity (ROE) emphasized because it is a key component in because it is a key component in finding earnings and dividend finding earnings and dividend growthgrowth

EPS = ROE EPS = ROE Book value per share Book value per share

Share prices depend partly on ROEShare prices depend partly on ROE Management can influence ROEManagement can influence ROE Decomposing ROE into its Decomposing ROE into its

components allows analysts to components allows analysts to identify adverse impacts on ROE and identify adverse impacts on ROE and to predict future trendsto predict future trends

Highlights expense control, asset Highlights expense control, asset utilization, and debt utilizationutilization, and debt utilization

Du Pont AnalysisDu Pont Analysis

ROE depends on the product of:ROE depends on the product of:– Profit margin on sales: EBIT/SalesProfit margin on sales: EBIT/Sales– Total asset turnover: Sales/Total AssetsTotal asset turnover: Sales/Total Assets– Interest burden: Pre-tax Income/EBITInterest burden: Pre-tax Income/EBIT– Tax burden: Net Income/Pre-tax IncomeTax burden: Net Income/Pre-tax Income– Financial leverage: Total Assets/EquityFinancial leverage: Total Assets/Equity

ROE = EBIT efficiency ROE = EBIT efficiency Asset turnover Asset turnover Interest burden Interest burden Tax burden Tax burden LeverageLeverage

Du Pont AnalysisDu Pont Analysis

Obtaining Estimates of Obtaining Estimates of EarningsEarnings

Expected EPS is of the most valueExpected EPS is of the most value Stock price is a function of future Stock price is a function of future

earnings and the P/E ratioearnings and the P/E ratio– Investors estimate expected growth in Investors estimate expected growth in

dividends or earnings by using dividends or earnings by using quarterly and annual EPS forecastsquarterly and annual EPS forecasts

Estimating internal growth rateEstimating internal growth rate– EPSEPS1 1 = EPS= EPS00(1+g) (1+g)

Estimating an Internal Estimating an Internal Growth RateGrowth Rate

Future expected growth rate matters Future expected growth rate matters in estimating earnings, dividendsin estimating earnings, dividends

g = ROE g = ROE (1- Payout ratio) (1- Payout ratio)– Only reliable if company’s current ROE Only reliable if company’s current ROE

remains stableremains stable– Estimate is dependent on the data periodEstimate is dependent on the data period

What matters is the future growth What matters is the future growth rate, not the historical growth raterate, not the historical growth rate

Forecasts of EPSForecasts of EPS Security analysts’ forecasts of earningsSecurity analysts’ forecasts of earnings

– Consensus forecast superior to individualConsensus forecast superior to individual Time series forecastTime series forecast

– Use historical data to make earnings Use historical data to make earnings forecastsforecasts

Evidence favours analysts over Evidence favours analysts over statistical models in predicting what statistical models in predicting what actual reported earnings will beactual reported earnings will be– Analysts are still frequently wrongAnalysts are still frequently wrong

Earnings SurprisesEarnings Surprises What is the role of expectations in What is the role of expectations in

selecting stocks?selecting stocks?– Old information will be incorporated into Old information will be incorporated into

stock prices if market is efficientstock prices if market is efficient– Unexpected information implies revisionUnexpected information implies revision

Stock prices affected byStock prices affected by– Level and growth in earningsLevel and growth in earnings– Market’s expectation of earningsMarket’s expectation of earnings

Using Earnings EstimatesUsing Earnings Estimates The surprise element in earnings reports The surprise element in earnings reports

is what really mattersis what really matters There is a lag in adjustment of stock There is a lag in adjustment of stock

prices to earnings surprisesprices to earnings surprises One earnings surprise leads to anotherOne earnings surprise leads to another

– Watch revisions in analyst estimatesWatch revisions in analyst estimates Stocks with revisions of 5% or more - up Stocks with revisions of 5% or more - up

or down - often show above or below-or down - often show above or below-average performanceaverage performance

The P/E RatioThe P/E Ratio Measures how much investors currently Measures how much investors currently

are willing to pay per dollar of earningsare willing to pay per dollar of earnings– Summary evaluation of firm’s prospectsSummary evaluation of firm’s prospects– A relative price measure of a stockA relative price measure of a stock

A function of expected dividend payout A function of expected dividend payout ratio, required rate of return, expected ratio, required rate of return, expected growth rate in dividendsgrowth rate in dividends

g)k/()/E(DP/E 11

Dividend Payout RatioDividend Payout Ratio Dividend levels usually maintainedDividend levels usually maintained

– Decreased only if no other alternativeDecreased only if no other alternative– Not increased unless it can be supportedNot increased unless it can be supported– Adjust with a lag to earningsAdjust with a lag to earnings

In theory, the higher the expected In theory, the higher the expected payout ratio, the higher the P/E ratiopayout ratio, the higher the P/E ratio– However, growth rate will probably However, growth rate will probably

decline, adversely affecting the P/E ratio decline, adversely affecting the P/E ratio

Required Rate of ReturnRequired Rate of Return A function of the riskless rate of A function of the riskless rate of

return and a risk premiumreturn and a risk premiumk = RF + RPk = RF + RP

Constant growth version of dividend Constant growth version of dividend discount model can be rearranged discount model can be rearranged so thatso that

k = (Dk = (D11/P/P00) + g) + g– Growth forecasts are readily availableGrowth forecasts are readily available

Risk premium for a stock regarded as a Risk premium for a stock regarded as a composite of business, financial, and composite of business, financial, and other risksother risks

If the risk premium rises (falls), then k If the risk premium rises (falls), then k will rise (fall) and Pwill rise (fall) and P00 will fall (rise) will fall (rise)

If RF rises (falls), then k will rise (fall) and If RF rises (falls), then k will rise (fall) and PP00 will fall (rise) will fall (rise)

Discount rates and P/E ratios move Discount rates and P/E ratios move inversely to each otherinversely to each other

Required Rate of Required Rate of ReturnReturn

Expected Growth RateExpected Growth Rate Function of return on equity and the Function of return on equity and the

retention rateretention rateg = ROE g = ROE (1- Payout ratio) (1- Payout ratio)

– The higher the g, the higher the P/E ratioThe higher the g, the higher the P/E ratio P/E ratio depends onP/E ratio depends on

– Confidence that investors have in Confidence that investors have in expected growthexpected growth

– Reasons for earnings growthReasons for earnings growth

Fundamental Security Fundamental Security Analysis in PracticeAnalysis in Practice

Regardless of detail and complexity, Regardless of detail and complexity, analysts and investors seek an analysts and investors seek an estimate of earnings and a justified estimate of earnings and a justified P/E ratio to determine intrinsic valueP/E ratio to determine intrinsic value

Security analysis always involves Security analysis always involves predicting an uncertain future; predicting an uncertain future; mistakes will be made and outlooks mistakes will be made and outlooks will differwill differ