Essentials of Investments: Chapter 14 - Financial Statement Analysis

Essentials of Investments: Chapter 14 - Financial Statement Analysis includes Financial Statement Analysis, Financial Statements, Profitability Measures, Financial Leverage and ROE, Decomposition of ROE, Choosing a Benchmark.

Financial Statement Analysis

• Financial statement analysis can be

used to discover mispriced securities

• Financial accounting data are widely

available, but

– Accounting earnings and economic

earnings are not always the same thing!

Financial Statement Analysis

• Income Statement:

– Profitability over time

• Balance Sheet:

– Financial condition at a point in time

• Statement of Cash Flows:

– Tracks the cash implications of

transactions

Financial Statements

Income for Hewlett-Packard, 2009

Hewlett-Packard, 2009

Hewlett-Packard, 2009

Accounting Versus Economic Earnings

• Economic earnings

– Sustainable cash flow that can be paid

to stockholders without impairing productive capacity of the firm

• Accounting earnings

– Affected by conventions regarding the valuation of assets

Profitability Measures

• ROE measures profitability for

contributors of equity capital

– After-tax profit/book value of equity

• ROA measures profitability for all

contributors of capital

– EBIT/total assets

Past vs Future ROE

• ROE is a key determinant of earnings

Financial Leverage and ROE

• ROE can differ from ROA because of

leverage

• Leverage makes ROE more volatile

• Let t=tax rate and r=interest rate, then:

ROA 1

Financial Leverage and ROE

• If there is no debt or ROA = r, ROE will

simply equal ROA(1 - t).

• If ROA > r, the firm earns more than it pays out to creditors and ROE increases.

• If ROA < r, ROE will decline as a function

of the debt-to-equity ratio.

ROA 1

Leverage on ROE

ROE = Net Profit

Pretax Profit

x

Pretax Profit EBIT x

EBIT Sales

Sales Assets

Assets Equity (1) x (2) x (3) x (4) x (5)

x Margin x Turnover x Leverage

Tax Burden

Interest Burden

DuPont Method

x

Decomposition of ROE

ROE=Tax burden X ROA X Compound leverage

factor

• Tax burden is not affected by leverage

• Compound leverage factor= Interest

burden X Leverage

for Nodett and Somdett

and Asset Turnover across Industries

Ratios

Ratios

Ratios

Ratios

Ratios

Hewlett-Packard

Economic Value Added

• EVA is the difference between return on

assets (ROA) and the opportunity cost of

capital (k), multiplied by the capital

invested in the firm.

• EVA is also called residual income

• If ROA > k, value is added to the firm.

Example 19.4 Wal-Mart

• In 2009, Wal-Mart’s cost of capital was

5.9% Its ROA was 9.6% and its capital

base was $115 billion

• Wal-Mart’s EVA =

(0.096-0.059) x $115 billion = $4.25 billion

• Accounting Differences

– Inventory Valuation

– Depreciation

• Inflation and Interest Expense

• Fair Value Accounting

• Quality of Earnings

• International Accounting Conventions

Comparability Problems

International Accounting Differences

• Reserves – many other countries allow

more flexibility in use of reserves

• Depreciation – US allows separate tax

and reporting presentations

• Intangibles – treatment varies widely

Price-Earnings Ratios

The Graham Technique

• Rules for stock selection:

– Purchase common stocks at less than

their working-capital value.

– Give no weight to plant or other fixed

assets.

– Deduct all liabilities in full from assets.