FINANCIAL STATEMENT ANALYSIS

A Valuation Approach

by

Leonard Soffer and Robin Soffer

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An Introduction to Security Analysis

We will discuss the jobs of various financial reporting professionals, sources of information and the financial reporting environment

Chapter 1

Where We Are Going

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Buy-side analystsBuy-side analysts Sell-side analystsSell-side analysts

Corporate finance specialists

Corporate finance specialists

Merger & acquisition analysts

Merger & acquisition analysts

Venture capitalistsVenture capitalists EmployeesEmployees Potential investorsPotential investors

Investment bankersInvestment bankers

Individual investorsIndividual investors

Who Does Security Analysis?

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Where Do Analysts Get Information? Financial statements Related disclosures of firm under

analysis Stock analyst reports Newspaper & magazine articles

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Other Sources of Information

Economic data Economic data

Industry experts Industry experts

Competitors & customers

Competitors & customers

Purchased data Purchased data

Competitors' annual & quarterly reports Competitors' annual & quarterly reports

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Financial Reporting Environment

Managers need a way to convince investors of the fairness of financial reports

To do this…

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Financial Reporting Environment Continued

Reporting rules and mandated audits of publicly held companies have been established

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Analysts Rely on

Generally Accepted Accounting Principles (GAAP)

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GAAP

Ensures that information in financial statements is useful to investors

Analysts understand information is not perfect

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The Content of a Financial Report is Determined by

RegulatorsRegulatorsAuditorsAuditors

ManagersManagers

EBITDA

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The Securities and Exchange Commission (SEC) Has Power to

Prescribe accounting methods Specify disclosure requirements

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The FASB is Responsible for

Establishing accounting standards in the U.S.

Issuing pronouncements Giving interpretations

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The FASB Does Not Have

Authority or responsibility to enforce compliance with these standards

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The Auditor

Determines that financial statement methods are consistent with GAAP

Verifies financial statement assertions Limits distortions to financial

reporting Tests firm's internal control systems

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Security Analysis in 4 Phases

1. Business Analysis

2. Financial Statement Analysis 3. Forecasting

4. Valuation

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GAAPFinancial

Statements

GAAPFinancial

Statements

Financial StatementAnalysis

Financial StatementAnalysis

Business AnalysisBusiness Analysis

ForecastAssumptions

ForecastAssumptions

ValuationValuation

Security Analysis Process

Time Historical Periods Valuation DateForecast Periods

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In Business Analysis, the Analyst . . .

Tries to understand the key business drivers of firm

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In Financial Statement Analysis, the Analyst . . .

Profitability Growth Resource needs

Uses historical financial statements to learn about a firm’s:

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In Forecasting, the Analyst . . .

Uses previous phases information to predict future financial results

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In Valuation, the Analyst . . .

Uses forecasting and a valuation model to determine value for firm's equity

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Summary Many people do security analysis Analysts rely on a variety of

sources Analysts rely on GAAP financial

reports Analysts use four phases in their

security analysis

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ENRONIncome Statement 1996 1997 1998 1999 2000 2001 Q1 2001 Q2 2001 Q3

Sales-Net 13,289 20,273 31,260 40,112 100,789 50,129 Operating Income 690 15 1,378 802 1,953 676 Net Income (Loss) 584 105 703 893 979 425 404 (618) As restated Nov, 8, 2001 9 590 643 847 442 409 (635) % increase (decrease) -91.4% -16.1% -28.0% -13.5% 4.0% 1.2% -2.8%

Cash Flow Operating Activities 141 (86) (59) 177 1,086 (288) (527) (239) Investing Activities (1,074) (2,146) (3,965) (3,507) (4,264) (1,124) (1,161) (1,366) Financing Activities 331 1,849 2,266 2,456 571 1,300 1,971 1,880 Cash at Year Start 115 256 170 111 288 1,374 1,374 1,240 Cash at Year End 256 170 111 288 1,374 1,086 847 1,001

Market DataBeta 0.78 0.46 0.80 0.84Basic EPS 1.16 0.16 1.07 1.17 1.22Price Close Calendar Year 21.56 20.78 28.53 44.381 Year Total Return (in %) 15.5 -1.4 40.1 57.7

Selected Financial RatiosTotal Debt/Total Equity 3.33 3.17 3.16 2.49 4.71 4.74 4.40 5.44As restated Nov, 8, 2001 3.32 3.46 2.80 5.29 5.19 4.79 5.45Net Profit Margin 4.4% 0.5% 2.2% 2.2% 1.0%Sales/Total Assets 0.82 0.87 1.07 1.20 1.54Return on Assets 3.6% 0.4% 2.4% 2.7% 1.5%Return on Equity 15.7% 1.9% 10.0% 9.3% 8.5%