Why Read or Care?

Fundamental Analysis and

Stocks  Investment strategies
 Growth
Economics 71a: Spring 2007  Use accounting numbers to estimate growth
Mayo, Chapter 9  Value
 Compare accounting numbers to price
Lecture notes 3.3

Goals Accounting Statements

 Accounting statements  Income statement
 Financial ratios  Balance sheet
 Ratios and valuation  Statement of retained earnings
 Statement of cash flows

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 Income Statement Income Statement Example
 Flowvariables  Sales revenues $50
 Revenues – Cost of goods sold  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)

Extraordinary Items: One

Examples
Time Income and Expenses
 “Below the line”  Lawsuit settlements
 Should come after other items  One time asset sales (patents/real
 Part of total earnings estate)
 Left out of  Pension fund adjustments

 EBIT  Changing accounting systems

 “core earnings”, “operating earnings”
 Definitions are blurry on this

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 Balance Sheet
Income Statement Example
Accounting Value of the Firm
 Total revenues $50  Assets (things firm owns)
 Cost of goods sold $-25
 Advertising + Admin. expenses $-2  Liabilities (Loans)
 Depreciation $-5  Stockholders’ equity
 Interest payments $-1  (Assets - Liabilities)
 Taxes $-3
 Also called
 **Earnings 50-25-2-5-1-3 = $14 (“core earnings”)
 Book value
 EBIT = Earnings before interest and taxes
 Net worth
 = 50-25-7 = $18 (operating income)
 Lawsuit settlement = $-8
 Earnings 50-25-2-5-1-3-8= $6

Assets Liabilities
 Cash  Accounts payable
 Accounts receivable  Notes payable (short term debt)
 Inventories  Long term debt
 Land
 Plant and equipment
 Less: Depreciation

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 Balance Sheet Balance Sheet
 Assets  Shareholders equity
 Cash $5  Common stock (at issue)
 $10
 Plant and equipment $100  Capital surplus
 Liabilities  $5
 Accounts payable $1  Retained earnings
 20
 Long term debt $75  Purchased stock (negative)
 Shareholder equity 105-76 = $29  Treasury stock -6
 Book value  10+5+20-6 = 29

Cash Flow Cash Flow Parts

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

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 Operating Cash Flow Investment Cash Flow
 Earnings = $5  Increase in gross fixed assets
 Adjust to get to cash flow
 Depreciation : +5  Purchases of new plant and equipment
– Why? Remove depreciation adjustments  -30 million : New office building
 Increase in accounts payable: +5
– Why? Haven’t paid this yet.  Total investment cash flow = -30 million
 Increase in accounts receivable: -2
– Why? Haven’t received this yet.
 Increase in inventories: -10
– Production costs reflect only goods sold.
 Adjustment: 5+5+5-2-10 = 3 = operating cash flow

Finance Cash Flow Depreciation

 Increase in long term debt:  Assets “wear out”
 +50 million of incoming funds  Firms slowly write them off
 Balance and income statements
 Dividends:
 Types of depreciation
 -20 million payout of divs
 Straight line depreciation
 Total finance cash flow = +30 million  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, Goals
Asset size = 300)
Year Earnings Deprec. Tax  Accounting statement
(Straight) Before D  Financial Ratios
1 300 100 20
 Ratios and valuation
2 300 100 20
3 300 100 20
(Accel.)
1 300 200 10
2 300 50 25
3 300 50 25

Financial Ratios Ratios

 Ratios of various financial variables  Liquidity ratios
 Activity ratios
 Uses
 Profitability ratios
 Analyze financial well being of a firm
 Leverage ratios
 Compare different stocks in terms of
 Coverage ratios
current values
 Market ratios
 “Find good investments”
 Dividend payout ratio

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 Liquidity Ratios Activity Ratios
 Current ratio  Inventory turnover
 Current assets / Current liabilities  Sales/(Average inventory)
 Short term, ability to pay bills  Receivables turnover
 Quick ratio  (Annual credit sales)/(accounts receivable)
 (Current assets - inventory) / Current liabilities  High number indicates rapid turnover in credit
 Take short term inventory out of current assets sales
 Fixed asset turnover
 Sales/(fixed assets) (land, plant + equipment)

Profitability Ratios Profitability Ratios

 Operating profit margin  Return on total assets (ROA)
 EBIT/Sales  Earnings/(total assets)
 Net profit margin  Return on equity (ROE)
 Earnings/Sales  Earnings/(shareholder equity)
 Gross profit margin
 (Revenues-Cost of goods sold)/sales

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 Leverage Ratios Coverage Ratios
 Debt to net worth  Times-interest earned
 Debt/(share holder equity)  EBIT/ (interest charges)
 Debt ratio
 Debt/(total assets)

Price Earnings Ratio

Market Ratios
P/E Ratio
 Share price versus accounting value
 Very important
Market price per share
 Examples P/E Ratio =
Earnings per share
 Price/Earnings ratio
 Market/Book (M/B) ratio
 Dividend yield (dividend/Price)

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 Price Earnings Ratio High Flying P/E’s
 Price
per earnings  AOL (1999) near 600
 Example:  Dell Computer (1999) 100
 Microsoft  For many dot com’s no P/E since
 About 20 earnings are zero
 $20 per $1 of earnings

PEG Ratio Market to Book Ratio (M/B)

P/E Market price per share

PEG = M/B =
3 ! 5 year earnings growth Book value per share

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

Dividend Payout Goals

 Net Income  Accounting statement
 Dividends  Financial Ratios
 Retained Earnings  Ratios and valuation
 Dividend Payout ratio = Divs/Earnings

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 Fundamental Analysis Ratio Analysis
 Use information about firm to evaluate  Many methods
stock price  Compare ratios to appropriate
 Growth comparison set
 Estimate earnings growth and future  Example:
prospects  P/E ratio for a pharmaceutical firm
 Value  Compare to industry
 Find “undervalued” stocks  If low -> buy

Problems With Accounting More Problems with

Information Accounting Information
 Misses “intangibles”  There are many ways to derive
 Knowledge base (patents) accounting numbers
 Customer base  Large “fudge factors”
 Sometimes numbers are zero or  Can clever accountants make things
negative look better?

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 Accounting “Tricks” Goals
 Off balance sheet items  Accounting statement
 Enron
 Financial Ratios
 Stock options
 Expenses to balance sheet  Ratios and valuation
 Worldcom
 AOL
 maintenance -> new investment
 Log revenue forecasts now
 Xerox
 Taking over low p/e firms

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