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ASSET MANAGEMENT

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7 December 2006

LECTURE II

ASSET MANAGEMENT

Last

Mod

ified

: 7 D

ec 2

006

12:

23 P

M

7 December 2006

LECTURE II

The Analysis of Financial Statements

Major financial statements

• Evaluate management performance in three areas: profitability, efficiency and risk

• Corporate shareholder annual and quarterly reports must include

• Balance sheet

• Income statement

• Statement of cash flows

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• Accounting principles are formulated by standard boards and financial statements footnotes must disclose which accounting principles are used by the firm

• The balance sheet

• Shows resources (assets) of the firm and how it has financed these resources

• Indicates current and fixed assets available at a point in time

• Financing is indicated by its mixture of current liabilities, long-term liabilities, and owners’ equity

Reference: BROWN & REILLY, Chapter X

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Major financial statements

• The income statement

• Contains information on the profitability of the firm during some period of time

• Indicates the flow of sales, expenses, and earnings during the time period

• The statement of cash flows

• Integrates the information on the balance sheet and income statement

• Shows the effects on the firm’s cash flow of income flows and changes in various items on the balance

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• Shows the effects on the firm’s cash flow of income flows and changes in various items on the balance sheet

• The statement of cash flows has three sections

• Cash Flow from Operating Activities – the sources and uses of cash that arise from the normal operations of a firm

• Cash Flow from Investing activities – change in gross plant and equipment plus the change in the investment account

• Cash Flow from Financing activities– financing sources minus financing uses


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Financial ratios

• Ratios are more informative that raw numbers since they provide meaningful relationships between individual values in the financial statements. Relative financial ratios are important. The performance is compared to the aggregate economy, its industry or industries, its major competitors within the industry and its past performance (time-series analysis)

• Most firms are influenced by economic expansions and contractions in the business cycle. A relative analysis helps you estimate the future performance of the firm during subsequent business cycles

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• Industries affect the firms within them differently, but the relationship is always significant. The industry effect is strongest for industries with homogenous products

• When comparing within the industry, simple averages may not be representative. Select a subset of competitors to compare to using cross-sectional analysis, or construct a composite industry average from industries the firm operates in

• When comparing to historical performance, you may determine whether it is progressing or declining. It is helpful for estimating future performance and one can consider trends as well as averages over time


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Financial ratios and financial statements analysis

• Main topics

• Internal liquidity (solvency)

• Operating performance (operating efficiency and operating profitability)

• Risk analysis (business risk and financial risk)

• Growth analysis

• External liquidity

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• Internal liquidity (solvency) ratios indicate the ability to meet future short-term financial obligations. The current ratio examines current assets and current liabilities while the quick ratio adjusts current assets by removing less liquid assets. The cash ratio is the most conservative liquidity ratio

• Receivables turnover examines the quality of accounts receivable. Receivables turnover can also be converted into an average collection period. Inventory turnover relates inventory to sales or cost of goods sold

• Cash conversion cycle combines information from the receivables turnover, inventory turnover, and accounts payable turnover


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Internal liquidity ratios formulas

• Current ratio

• Quick ratio

• Cash ratio

abilitiesCurrent Li

setsCurrent As tio Current Ra =

abilitiesCurrent Li

ceivabless SecuritieMarketableCashoQuick Rati

Re++=

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• Cash ratio

• Receivables turnover

• Inventory turnover

abilitiesCurrent Li

s SecuritieMarketableCashCash Ratio

+=

sReceivable Average

SalesAnnual NetTurnover sReceivable =

Inventory Average

SoldGoods of CostTurnoverInventory =


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Evaluating operating perfomance

• Ratios that measure how well management is operating a business

• Operating efficiency ratios: examine how the management uses its assets and capital, measured in terms of sales dollars generated by asset or capital categories

• Operating profitability ratios: analyze profits as a percentage of sales and as a percentage of the assets and capital employed

• Operating efficiency ratios – total asset turnover ratio indicates the effectiveness of a firm’s use of its total asset base (net assets equals gross assets minus depreciation on fixed assets)

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asset base (net assets equals gross assets minus depreciation on fixed assets)

• Operating efficiency ratios – net fixed asset turnover reflects utilization of fixed assets

Assets Net Total Average

SalesNetTurnover Asset Total =

Assets Fixed Net Average

SalesNetTurnover Asset Fixed =


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Operating profitability ratios

• Gross profit margin measures the rate of profit on sales (gross profit equals net sales minus the cost of goods sold)

• Operating profit margin measures the rate of profit on sales after operating expenses (operating profit is gross profit minus sales, general and administrative expenses)

SalesNet

Profit Gross MarginProfit Gross =

SalesNet

Profit Operating MarginProfit Operating =

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• Net profit margin relates net income to sales

• Return on total capital relates the firm’s earnings to all capital in the enterprise

SalesNet MarginProfit Operating =

SalesNet

Income Net MarginProfit Net =

Capital Total Average

Expense InterestIncome NetCapital Total on Return

+=


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Operating profitability ratios

• Return on owner’s equity (ROE) indicates the rate of return earned on the capital provided by the stockholders after paying for all other capital used

• ROE can be computed for the common shareholder’s equity

Equity Total Average

Income NetEquity Total on Return =

Equity Common Average

Dividend Preferred-Income NetEquity sOwner' on Return =

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• The DuPont System divides the ratio into several components that provide insights into the causes of a firm’s ROE and any changes in it

Equity Common

SalesNet

SalesNet

Income Net

Equity Common

Income NetROE ×==

Equity

Assets Total

Assets Total

Sales

Equity

Sales ×=

Equity Common

Assets Total

Assets Total

Sales

Sales

Income Net

Equity Common

Income Net ××=


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The extended Dupont system

• An extended DuPont System provides additional insights into the effect of financial leverage on the firm and pinpoints the effect of income taxes on ROE

Assets Total

EBIT

Assets Total

Sales

Sales

EBIT =×Assets Total

Tax Before Net

Assets Total

Expense Interest

Assets Total

EBIT =−

Equity Common

(NBT) Tax Before Net

Equity Common

Assets Total

Assets Total

(NBT) Tax Before Net =×

Income Net Taxes IncomeTax Before Net = −×

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• In summary, we have the following five components of return on equity (ROE)

MarginProfit OperatingSales

EBIT = Turnover Asset TotalAssets Total

Sales =

Rate Expense InterestAssets Total

Expense Interest = r MultiplieLeverage Financial

Equity Common

Assets Total =

Rate Retention TaxTax Before Net

Taxes Income =

−%100

Equity Common

Income Net

Tax Before Net

Taxes Income

Equity Common

Tax Before Net =

−× %100


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Risk analysis using ratios

• The total risk of a firm has two components:

─ Business risk

• The uncertainty of income caused by the firm’s industry

• Generally measured by the variability of the firm’s operating income over time

─ Financial risk

• Additional uncertainty of returns to equity holders due to a firm’s use of fixed obligation debt

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• Additional uncertainty of returns to equity holders due to a firm’s use of fixed obligation debt securities

• The acceptable level of financial risk for a firm depends on its business risk

• Two factors contribute to the variability of operating earnings: sales variability and operating leverage

• Earnings can be as volatile as sales and some industries are quite cyclical. Production has fixed and variable costs. Fixed production costs cause profit volatility with changes in sales and are operating leverage


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• Bonds interest payments come before earnings are available to stockholders. Similar to fixed production costs, these lead to larger earnings during good times, and lower earnings during a business decline

• This type of debt financing increases the financial risk and possibility of default

• Two sets of financial ratios help measure financial risk: balance sheet ratios and earnings or cash flow ratios

Financial risk analysis using ratios

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• Common balance sheet ratios capturing financial risk


Equity Total

Debt Term-Long TotalRatioEquity -Debt =

Capital Term-Long Total

Debt Term-Long TotalRatio Capital L.T. Total-Debt L.T. =

Capital Total

Debt Interest TotalCapital Debt/Total Bearing -Interest Total =

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• Common (financial risk capturing) earnings ratios

Expense Interest

Expense Interest Taxes Income Income Net

Charges Interest Debt

(EBIT) Taxes and Interest Before Incomecoverage Interest

++==

Rate) Tax-1Dividend/( PreferredPayments LeaseInterest Debt

Payments Lease and Taxes, Interest, Before IncomeCoverage Charge Fixed

++=

Financial risk analysis using financial ratios

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• Common (financial risk capturing) cash flow ratios


Payments Lease Interest

Payments Lease 1/3InterestFlow Cash lTraditionaCoverage Flow Cash

3/1+++=

Debt Term-Long of Value Book

Tax Deferred in ChangeExpense onDepreciatiIncome NetDebt Term-Long / Flow Cash

++=

Debt Total

Tax Deferred in ChangeExpense onDepreciatiIncome NetDebt Total / Flow Cash

++=

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Liquidity risk and growth potential

• Market liquidity is relaetd to the ability to buy or sell an asset quickly with little price change from a prior transaction assuming no new information. External market liquidity is clearly a major source of risk to investors (a direct measure of market liquidity is the bid-ask spread)

• Determinants of external liquidity are

─ The value of shares traded

• This can be estimated from the total market value of outstanding securities

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• It will be affected by the number of security owners

─ Trading turnover (percentage of outstanding shares traded during a period of time)

• Analysis of growth potential (resources retained and reinvested in the entity by the rate of return earned on the resources retained)

─ Creditors are interested in the firm’s ability to pay future obligations

─ Value of a firm depends on its future growth in earnings and dividends

• As you already know, ROE is a function of net profit margin, total asset turnover and financial leverage


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General considerations on financial statements analysis and ratios

• Quality of financial statements: numbers should reflect reality rather than use accounting tricks or one-time adjustments to make things look better than they are

• High-quality balance sheets typically have conservative use of debt, assets with market value greater than book, no liabilities off the balance sheet

• High-quality income statements reflect repeatable earnings. Gains from nonrecurring items should be ignored when examining earnings. High-quality earnings result from the use of conservative accounting

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ignored when examining earnings. High-quality earnings result from the use of conservative accounting principles that do not overstate revenues or understate costs

• Financial statements, by their nature, are backward-looking. An efficient market will have already incorporated these past results into security prices, so why analyze the statements? Analysis provides knowledge of a firm’s operating and financial structure and this aids in estimating future returns

• Specific uses of financial ratios include stock valuation, identification of corporate variables affecting a stock’s systematic risk (beta), assigning credit quality ratings on bonds, predicting insolvency (bankruptcy) of firms


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Uses of financial ratios

• Stock valuation models, for example, attempt to derive a value based upon one of several cash flow or relative valuation models All valuation models are influenced by

• Expected growth rate of earnings, cash flows or dividends

• Required rate of return on the stock

• Financial ratios can help in estimating the above parameters for stocks or in valuing interest bearing securities, assessing investment risk and predicting insolvency

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• Equity ratios include debt/equity, return on equity, market price to book value, market price to cash flow, market price to sales

• Ratios related to systematic risk are dividend payout, total debt/total assets, cash flow/total debt, interest coverage, working capital/total assets, current ratio

• Ratios useful in assigning bond ratings include: long-term debt/total assets, total debt/total capital, net income plus depreciation (cash flow)/long term senior debt, cash flow/total debt, net income plus interest/interest expense (fixed charge coverage), cash flow/interest expense, market value of stock/par value of bonds

• For predicting insolvency you may use cash flow/total debt, cash flow/long-term debt, sales/total assets, net income/total assets, EBIT/total assets, total debt/total assets, market value of stock/book value of debt, working capital/total assets, retained earnings/total assets, cash/current liabilities,worrking capital/sales


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Limitations of financial ratios and web resources

• Accounting treatments may vary among firms which may have divisions operating in different industries making it difficult to derive industry ratios. Results may not be consistent and ratios outside an industry range may be cause for concern

• Ratios should also be used together with different methods and additional information must be added. In valuing bonds, for example, information like the subordination of the issue, the size of the firm (total assets), the issue size and the par value of all publicly traded bonds of the firm are also of fundamental importance

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• Useful websites related to the analysis of financial statements

• www.walgreens.com

• www.cvs.com

• www.riteaid.com

• www.longs.com

• www.sec.gov/edgarhp.htm

• www.hoovers.com

• www.dnb.com


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FictitiousRevenue/AccountsReceivable

Fraudulent

UnderstatedLiabilities/Expenses

OverstatedAssets/Income

Some practical examples… beyond financial ratios…

Timing OrClassification

Issues

Other

FraudulentFinancialStatement

Issues

Inventory/Cost of Goods Sold

Disclosure/Lack Of

Transparency

ImproperAsset

Valuation19

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• Methods:

– Vertical Analysis: involves measuring relationships between items for a single year. For example, % of sales on an income statement; % of total assets & % of total Liabilities & Stockholders’ Equity on a balance sheet

– Horizontal Analysis: involves calculating the Dollar change and the Percent change for each line item on the Income Statement or Balance Sheet from the previous year to the current year. Current year –Previous year/Previous year x 100 = % change

… Some practical examples…Financial statement analysis …Methods and Why

Previous year/Previous year x 100 = % change– Ratio Analysis: Various ratios

• Why Ratios:

– Ratios can standardize numbers and facilitate comparisons.– Ratios can be used to highlight weaknesses and strengths.– Ratio comparisons should be over a period of time and with competitors in the same industry– Trend analysis– Industry analysis

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• Liquidity (Solvency) : Can the company meet its short-term obligations?

• Asset management (Operating Efficiency) : Is the company using its assets to generate sales?

• Debt Management : Does the company have the right mix of debt and equity? Is the company highly leveraged?

… Some practical examples…Financial statement analysis …Five Qs

• Profitability : Is the company consistently making a profit? Is the company managing its expenses?

• Market Value : Do investors like what they see?

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… Some practical examples…Financial statement analysis …Be systematic

SUMMARY OF RATIOS

Liquidity Asset Management Debt Management Profitability Market Value

Current Ratio

(Current Assets/Current Liabilities)

Accounts Receivable Turnover

(Net Sales/Net Accounts

Receivable)

Debt/Equity (Debt Ratio)

(Total Liabilities/Total

Stockholders' Equity

Gross Profit Margin

(Gross Profit/Sales)

Earnings Per Share (EPS)

(Net Earnings/Average Shares

Outstanding)

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(Current Assets/Current Liabilities) Stockholders' Equity (Gross Profit/Sales) Outstanding)

Quick Ratio

(CA-Inventory/CL)

Inventory Turnover

(Sales/Inventories)

Debt/Assets

(Total Liabilities/Total

Assets)

Operating Profit Margin

(Operating Profit/Sales)

Price/ Earnings (PE)

(Market Price of Common

Stock/EPS)

Cash Flow Liquidity Ratio

Cash Flow From Operating

Activities/Total Assets)

Fixed Asset Turnover

(Sales/Fixed Assets)

Times Interest Earned

(EBIT/Interest Expense)

Net Profit Margin

(Net Profit/Sales)

Dividend Payout

(Cash Dividends Per Share/EPS)

Days Sales Outstanding (DSO)

or Average Collection Period

(AR/Average Sales Per Day)

Total Asset Turnover

(Sales/Total Assets)

Return on Assets (ROA)

(Net Income/Total Assets)

Dividend Yield

(Cash Dividends Per

Share/Market Price of Common

Stock Per Share)

Return on Equity (ROE)

(Net Income/Total

Stockholders' Equity)

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… Some practical examples… ABC BALANCE SHEET…

ABC. Balance Sheet 2008 2007Assets

Cash 100.800 8.000Accts. Receivable 900.800 630.000Inventories 2.148.800 1.300.000 Total Current Assets 3.150.400 1.938.000

Gross L-T Assets 1.800.000 1.300.900Less: Acc. Depreciation -899.400 -400.000

Net L-T Assets 900.600 900.900

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Net L-T Assets 900.600 900.900

Total Assets 4.051.000 2.838.900

ABC. Balance Sheet 2008 2007Liabilities

Accts. payable 430.700 530.100Notes payable, current 250.000 600.800Unearned Revenue 450.000 490.000

Total Current Liab 1.130.700 1.620.900Long-term debt 500.000 800.000

Total Liabilities 1.630.700 2.420.900Stockholders’ Equity:Common stock 2.084.574 387.500Retained earnings 335.726 30.500

Total Stkhldrs Equity 2.420.300 418.000Total Liab. & Equity 4.051.000 2.838.900

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ABC. INCOME 2008 2007STATEMENT

Sales 7.000.600 4.500.000COGS -5.800.990 -3.500.000

Gross Profit (GM) 1.199.610 1.000.000Other expenses -500.000 -500.900

EBITDA 699.610 499.100Depr. & Amort. -110.900 -100.900

… Some practical examples… ABC INCOME STATEMENT…

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Depr. & Amort. -110.900 -100.900EBIT 588.710 398.200

Interest Exp. -80.000 -130.000Earnings Before Taxes 508.710 268.200Taxes (40% tax rate) -203.484 -107.280

Net income 305.226 160.920

No. of shares 150.000 100.000EPS $2.035 $1.609Stock price $12.57 $8.85

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… Some practical examples… LIQUIDITY RATIOS…

Current ratio = Current assets / Current liabilities= $3,150,400 / $1,130,700= 2.79x

Quick ratio = (CA – Inventories) / CL= ($3,150,400 – $2,148,800) / $1,130,700= 1,001,600/1,130,700= 0.89x

ABC forecasted current ratio and quick ratio for 2008:

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= 0.89x

2008 2007 2006 Industry

Current Ratio 2.79x 1.20x 2.32x 3.98x

Quick Ratio 0.89x 0.39x 0.86x 1.12x

• Measure short-run solvency — the ability of ABC to meet its short-term debt requirements as they come due• For 2008, Co. had $2.79 of CA for $1 of CL; For 2008, Co. has $ .89 of cash & near cash assets for every $1 of

CL• Below industry average; Liquidity position is weak• The higher the liquidity ratios, the better

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… Some practical examples … ASSET MANAGEMENT RATIOS…

Inv. turnover = Sales / Inventories

= $7,000,600/$2,148,800

= 3.26x

The ABC inventory turnover vs. the industry average: (2008)

2008 2007 2006 Industry

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2008 2007 2006 Industry

InventoryTurnover

3.3x 3.5x 4.9x 6.2x

• Indicates the number of times a company sells its average inventory level during the year

• Inventory turnover is below industry average

• The company might have old inventory, or its contro l might be poor

• A higher inventory turnover is usually better

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(Days Sales Outstanding) DSO is the average number of days after making a sale before receiving cash. (2008)

ABC DSO = Accounts Receivable / Avg sales per day

= Accounts Receivable / (Annual sales/365)

= $900,800 / ($7,000,600/365)

= $900,800/19,179.73

= 47.0 days

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= 47.0 days

2008 2007 2006 Industry

DSO 47.0 51.1 36.3 31.2

• Measures the number of days between the sale date and the cash collection date

• The company is below industry average; it collects on sales on account (A/R) too slowly

• It appears to have a poor credit policy

• A lower DSO is usually better

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ABC Fixed assets (FA) and total assets (TA) turnover ratios vs. the industry average (2008)

FA turnover = Sales / Net fixed assets= $7,000,600/$900,600 = 7.8x

TA turnover = Sales / Total assets

= $7,000,600/$4,051,000 = 1.7x

2008 2007 2006 Industry

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2008 2007 2006 Industry

FA TO 7.8x 5.0x 11.0x 8.1x

TA TO 1.7x 1.6x 2.5x 3.7x

• Measure efficiency; Show how many sales $ a co. can generate from each $1 of its assets

• In 2008, FA turnover is below the industry avg

• TA turnover is below the industry average. May be caused by excessive currents assets (A/R-ACCOUNT/RECEIVABLES and Inventory)

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… Some practical examples … DEBT MANAGEMENT RATIOS…

The ABC debt ratio (D/A) and times-interest-earned (TIE) ratios. (2008)

Debt ratio = Total debt / Total assets= ($1,130,700 + $500,000/$4,051,000= 1,630,700/4,051,000 = 40.3%

TIE = EBIT / Interest expense

= $588,710/$80,000 = 7.4x

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= $588,710/$80,000 = 7.4x

2008 2007 2006 Industry

D/A 40.3% 85.3% 54.7% 30.2%

TIE 7.4x 3.1x 4.2x 9.1x

• Debt to Asset Ratio (debt ratio) shows the % of each $1 of assets that is financed with debt

• Times Interest Earned (TIE) ratio measures a company’s ability to pay the interest on its debt. For 2008, the co. has available $7.40 of earnings before interest and taxes for each $1 of interest it must pay to its creditors.

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… Some practical examples … PROFITABILITY RATIOS…

ABC Net Profit margin (NPM 2008) = Net income / Sales= $305,226/$7,000,600 = 4.4%

2008 2007 2006 Industry

NPM 4.4% 3.6% 2.5% 3.8%

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NPM 4.4% 3.6% 2.5% 3.8%

• NPM represents the company’s ability to translate sales dollars into profits; a higher NPM is better

• Net Profit margin was below the industry average in 2006 and 2007, but is exceeded the industry average in 2008

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… Some practical examples … PROFITABILITY RATIOS…

Profitability ratios: ABC Return on assets and Return on equity (2008)

ROA = Net income / Total assets= $305,226/$4,501,000 = 7.5%

ROE = Net income / Total Stkhlders equity

= $305,226 / $2,420,300 = 12.6%

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2008 2007 2006 Industry

ROA 7.5% 5.7% 6.3% 9.3%

ROE 12.6% 38.5% 13.2% 18.4%

• ROA shows how much profit a co. is able to earn from each $1 of its assets. For 2008, the co. is earning 7.5 cents for each $1 of assets

• ROE shows how many cents are earned on each $1 of stockholders’ investment. For 2008, the co. is earning 12.6 cents for each $1 of its owners’ investment (equity)

• Both ratios are below the industry average.

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… Some practical examples … IRRATIONAL RATIOS… (Harrington, 2005; Wells, 2001;Beneish, 1999)

Analysis of Sales Growth Index

2008 2007 2006 Manipulator & Non-Manipulator Means

ABC SGI 1.556 1.611 1.534 1.607/1.134

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Sales Current Year

Sales Growth Index = _____________

Sales Prior Year

7,000,600

2008 Sales Growth Index = ___________ = 1.556

4,500,000

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Analysis of Gross Margin Index

2008 2007 2006 Manipulator & Non-Manipulator Means

ABC GMI 1.297 1.311 1.233 1.193/1.014

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Gross Margin prior year/sales prior year

Gross Margin Index = _____________________________

Gross Margin current year/sales current year

(1,000,000/4,500,000)

2008 Gross Margin Index = ____________________

(1,199,610/7,000,600)

.2222

2008 Gross Margin Index = ____________________ = 1.297

.1714

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Analysis of Days’ Sales in Receivables Index

2008 2007 2006 Manipulator &Non-Manipulator Means

ABC DSRI .919 .998 1.033 1.465/1.031

Receivables Current Year/ Sales Current Year

Days' Sales in Receivables Index =_______________________________

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Days' Sales in Receivables Index =_

Receivables Prior Year/Sales Prior Year

900,800/7,000,600

2008 Days' Sales in Receivables Index =

_________________

630,000/4,500,000

.1287

2008 Days' Sales in Receivables Index =

________ = .9193

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Analysis of Asset Quality Index

2008 2007 2006 Manipulator &Non-Manipulator Means

ABC AQI 1.000 1.344 1.256 1.254/1.039

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Asset Quality Index = (1 – [(CA + Net FA)/Total Assets] Current Year)(1- [(CA + Net FA)/Total Assets] Prior Year)

Asset Quality Index = (1 – [(3,150,400 + 900,600)/4,051,000](1-[(1,938,000 + 900,900/2,838,900]

Asset Quality Index = (1 – [4,051,000/4,051,000] = 1.000(1-[2,838,900/2,838,900]

“Financials statements tell a story …and story should make sense”…the Barry Minkow Co’ (Wells, 2001)

Barry Minkow (born March 17, 1967) is an American religious leader and ex-convict.As a young teenager Minkow was a fraudulent entrepreneur who managed to present

the front of a successful businessman for a number of years during the 1980s. His company, ZZZZ Best (pronounced "Zee Best") appeared to be an immensely

successful carpet-cleaning company but collapsed in 1987, costing investors an estimated $100 million. He was convicted of fraud and several other offenses and sentenced to 25 years in prison, but served only seven years. During his time in

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sentenced to 25 years in prison, but served only seven years. During his time in prison, Minkow became involved in Christian ministry, which continued after his

probationary release from prison in April 1995.Today he is senior pastor of the Community Bible Church in San Diego, California, having renounced his felonious acts. Minkow is recognized as an expert on fraud,

and speaks on the subject to university students and the business community in an effort to prevent fraud.

Minkow and ZZZZ Best are mentioned in Burton G. Malkiel's work A Random Walk Down Wall Street as an example of stock market bubbles. Minkow tells his story in the book, "They Thought for Themselves", by Sid Roth; published by M V Press,

ISBN 0910267022, published 1996.

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Non-manipulators’ mean: 1.134Manipulators’ mean: 1.607 and above

Sales Growth Index = Current Period Sales/Prior Period Sales

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Asset Quality Index = (1 – CA + Net FA/Total Assets Current Year)(1-CA + Net FA/Total Assets Prior Year)

Non-manipulators’ mean: 1.039Manipulators’ mean: 1.254 and above

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… Some practical examples … Inditex, H&M …look at delta ROIC !

Although both companies are broadly comparable in revenue, gross margin andhistorical growth rates of operating profit, they have considerably differentoperating margins.Perhaps more striking is the material difference in return oninvested capital based on reported financial statements, with roughly 100% forHennes & Mauritz compared to a still very

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Hennes & Mauritz compared to a still very respectable 36% for Inditex in 2008.

The reason for focusing on Return on Invested Capital (ROIC) as a crucial driver of value is that we feel it is superior to earnings or profitability. We view it as important to link earnings to the investments needed to generate these earnings. We, therefore, focus on returns as a true measure of performance and driver of valuation.

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… Some practical examples … best metrics in Inditex but H&M has higher ROIC …

On both net working capital metrics, Inditex outperforms Hennes & Mauritz. Its net working capital as a percentage of sales is negative versus a positive number for Hennes & Mauritz. This means Inditex uses non interest bearing current liabilities to finance its new current assets. The cash conversion cycle analysis demonstrates this more pronounced for Inditex, notably when it comes to

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for Inditex, notably when it comes to the trade payables.

The overall capital turnover (invested capital as a percentage of net sales) is much lower at H&M compared to Inditex, despite the fact that Inditex outperforms H&M in net working capital management. This stronger performance on NWC is more than offset by a fixed asset ratio more than triple that of H&M. This makes capitalturnover the key distinguishing factor why H &M has a return on invested capital almost three times that of Inditex

The percentage of fixed assets owned by a company gives an indication of the fixed assets such as property, plant and equipment needed to generate a certain amount of revenue. The different business models explain divergences in capital turnover. Inditex’s largest format, Zara, is almost completely vertically integrated. It operates in-house manufacturing for all 73 markets in which it is active. As a result, the fixed asset ratio at the group level is substantial. H&M has a more simplified, single-format organisational structure, and thus focuses on fewer target markets than its Spanish competitor. Although H&M, too, is involved in the entire development and sales process of its products, it outsources all production through contracts with approximately 700 suppliers worldwide.

… Some practical examples … Inditex, H&M …that’s the reason…

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On calculation of returns on invested capital is based on the assumption that the company’s balance sheets give a fair reflection of assets and liabilities, and hence invested capital. In the case of fashion retailers, this is not necessarily true, as these companies make active use of operating leases. Under currentaccounting, finance leases give rise to on-balance-sheet assets and liabilities. In the case of operating leases, however, only the lease charge is reflected in income, with no corresponding assets or liabilities recognised. We therefore recommend capitalising the operating leases to get a better reflection of invested capital, and enhance comparability of returns at H&M and Inditex.

The In capitalising the operating leases, we have discounted the actual operating lease payments in 2004-08 to create an operating lease asset. This asset is added to the invested capital as per 2004 and subsequently amortised using the straight-line method.

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… Some practical examples … Inditex, H&M …now it’s ok…

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Adjusting for operating leases causes certain key components to change significantly, notably the NOPAT margins and invested capital are heavily impacted by the capitalisation of operating leases. In particular, it causes the returns on invested capital both at Inditex and Hennes & Mauritz to diverge.

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Some practical examples … Inditex, H&M …and the market already knew everything…

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Qualitative Factors in Financial Statement Analysis

Revenues Tied To One Key Customer, Product,

Or Supplier

RegulatoryEnvironment

Competition

Legal Environment

Future Prospects

Qualitative Factors

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Limitations of Financial Statement Ratio Analysis

Industry Trends;

Seasonal

Different Accounting Practices Inappropriate

Industry Comparisons

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Economic Factors

Seasonal

Technological Changes

Limitations of FS Ratio Analysis

Analysts should look beyond the ratios !

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References

Albright, T. L., & Ingram, R. W. (2006). Financial accounting: A bridge to decision-making. 6th Edition. Mason, OH: Thomson South-Western.

ACFE 2008 Report to the Nation on Occupational Fraud and Abuse. (2008)

Beneish, M. D. (1999, September/October). The detection of earnings manipulation. Financial Analyst Journal. 55(5), 24-36.

Brigham, E. F., & Houston, J. F. (2007). Fundamentals of financial management. 5th Edition. Mason, OH: Thomson South-Western.

Fraser L. M. & Ormiston, A. (2010). Understanding Financial Statements, 9th Edition. New York, NY: Prentice Hall

Harrington, C. (2005, March/April). Formulas for detection: Analysis ratios for detecting financial statement fraud. Fraud Magazine. Association of Certified Fraud Examiners. Retreived January 15, 2009, from http://www.acfe.com/resources/view-content.asp?ArticleID=416

Well, Joseph T. (2008). Principles of Fraud Examination. 2nd Edition. Hobken, NJ: John Wiley & Sons, Inc.

Wells, J. T. (2001, August). Irrational Ratios. Journal of Accountancy. 192(2), 80-83.

Williams, J. R., Haka, S. F., Bettner, M. S., & Carcello, J. V. (2008). Financial & managerial accounting: The basis for business decisions. 14th Edition. New York, NY: McGraw-Hill/Irwin.

Wolf D. T. & Hermanson, D. R. (2004, December). The fraud diamond: Considering the four elements of fraud. The CPA Journal. 38-42.

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ASSET MANAGEMENT

Last

Mod

ified

: 7 D

ec 2

006

12:

23 P

M

7 December 2006

LECTURE II – Part II

An introduction to security valuation

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Investment decision and the valuation process

• Two steps of the investment decision process

─ Determine the required rate of return

• Evaluate the investment to determine if its market price is consistent with your required rate of return

• Estimate the value of the security based on its expected cash flows and your required rate of return

─ Compare this intrinsic value to the market price to decide if you want to buy it

• Two approaches to valuation. The difference between the two approaches is the perceived importance of

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• Two approaches to valuation. The difference between the two approaches is the perceived importance of economic and industry influence on individual securities

─ Top-down, three-step approach

─ Bottom-up, stock valuation, stock picking type approach

Reference: BROWN & REILLY, Chapter XI

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The top down, three steps approach

• Top down, three steps approach

─General economic influences. Decide how to allocate investment funds among countries, and within countries to bonds, stocks, and cash

─ Industry influences. Determine which industries will prosper and which industries will suffer on a global basis and within countries

─ Company analysis. Determine which companies in the selected industries will prosper and which stocks are undervalued

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• Studies indicate that most changes in an individual firm’s earnings can be attributed to changes in aggregate corporate earnings and changes in the firm’s industry

• Studies have found a relationship between aggregate stock prices and various economic series such as employment, income, or production

• An analysis of the relationship between rates of return for the aggregate stock market, alternative industries, and individual stocks showed that most of the changes in rates of return for individual stock could be explained by changes in the rates of return for the aggregate stock market and the stock’s industry


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Theory of valuation

• The value of an asset is the present value of its expected returns. You expect an asset to provide a stream of returns while you own it

• To convert this stream of returns to a value for the security, you must discount this stream at your required rate of return. This requires estimates of the stream of expected returns and the required rate of return on the investment

• Form of returns: earnings, cash flows, dividends, interest payments, capital gains (increases in value). The

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• Form of returns: earnings, cash flows, dividends, interest payments, capital gains (increases in value). The time pattern and growth rate of returns are also important

• As you already know, the required rate of return is made up of three components

─ The risk-free rate of return

─ The expected rate of inflation during the holding period

─ The risk premium determined by the uncertainty of returns

• Valuation of bonds is relatively easy because the size and time pattern of cash flows from the bond over its life are known


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Bloomberg bond valuation screen

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Bloomberg Yield Curve

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Approaches to the valuation of common stock

• Two approaches have developed

─ Discounted cash-flow valuation. Present value of some measure of cash flow, including dividends, operating cash flow, and free cash flow

─ Relative valuation technique. Value estimated based on its price relative to significant variables, such as earnings, cash flow, book value, or sales (uses ratios). Provides information about how the market is currently valuing stocks but no guidance as to whether valuations are appropriate

• The discounted cash flow approaches are dependent on some factors

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• The discounted cash flow approaches are dependent on some factors

─ The rate of growth and the duration of growth of the cash flows

─ The estimate of the discount rate

• The discounting factor depends on the measure of cash flow used

─ Dividends → Cost of equity

─Operating cash flow → Weighted average cost of capital (WACC)

─ Free cash flow to equity → Cost of equity


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The dividend discount model (DDM)

• In the dividend discount model (DDM) the value of a share of common stock is the present value of all future dividends. In its most most basic form the model is

where Vj is the value of common stock j, Dt is the dividend during time period t and k is the required rate of return on stock j

∑∞

= +=+

++

++

+=

13

3

2

21

)1(...

)1()1()1( tt

tj k

D

k

D

k

D

k

DV

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• If the stock is not held for an infinite period, the equation is similar. For example, a sale at the end of year 2 would imply

the selling price at the end of year two is the value of all remaining dividend payments, which is simply an extension of the original equation

• The infinite period model assumes a constant growth rate when estimating future dividends


2

2

2

21

)1()1()1( k

SP

k

D

k

DV j

j ++

++

+=

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The dividend discount model (DDM)

• The basic valuation equation including growth is

• The assumptions of the infinite period DDM including growth are then

• Dividends grow at a constant rate

• The constant growth rate will continue for an infinite period

gk

D

k

gD

k

gD

k

gDV

n

n

j −=+

++++

+++

++= 10

2

200 ...

)1(

)1(...

)1(

)1(

)1(

)1(

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• The constant growth rate will continue for an infinite period

• The required rate of return (k) is greater than the infinite growth rate (g)

• Growth companies have opportunities to earn return on investments greater than their required rates of return. To exploit these opportunities, these firms generally retain a high percentage of earnings for reinvestment, and their earnings grow faster than those of a typical firm

• The infinite period DDM assumes constant growth for an infinite period, but abnormally high growth usually cannot be maintained indefinitely. Combine the models to evaluate the years of supernormal growth and then use DDM to compute the remaining years at a sustainable rate


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Bloomberg DDM screen

Please input a ticker in cell A7 and press enter. For further information about how the model has been constructed, please cllick the Help button for further assistance

3-stage DDM model

Enter Ticker:enel im equity Period contribution to value

ENEL SPA High growth period

Utilities 11,25%Current Transition Period Transition period

Current EPS 0,75 Transition Period length (yrs) 8 32,66%Override values Override values

BloombergHelp

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Current EPS 0,75 Transition Period length (yrs) 8 32,66%Current DPS 0,43 Riskfree Rate 3,30% Stable growth

High growth period Beta 0,77833885 56,09%

Payout ratio 59,99% Expected Market Return 9,00%Riskfree Rate 3,30% Cost of Equity 7,74%Expected Market Return 9,00% Payout ratio 59,99%Beta 0,734007 Stable growth periodHigh growth period length (yrs) 2 EPS Growth Rate 2,00% 2,00%

Cost of Equity 7,48% Cost of Equity 7,99%Applied EPS growth rate 2,83% Beta in stable phase 0,8226711

Hist Avg eps growth 13,71% 30,00% Weighting Riskfree Rate 3,30%

Analyst estimated eps growth -1,83% 70,00% for EPS Expected Market Return 9,00%

Revenue growth Y Model Present Value 4,52

This Year Estimate 0,50 Current Price of Security 4,26Next Year Estimate 0,44 Potential misprice 6,19%Growth Rate in revenues 2,83%

Net difference Goalseeker 0,26

For first 2 years use short term broker forecasts? (Y/N)

Bloomberg DCF (FCFF)screen

Please input a ticker in cell A7 and press enter. For further information about how the model has been constructed, please cllick the Help button for further assistance

3-stage FCFE model -

Enter Ticker:enel im equity Period contribution to value

ENEL SPA High growth period

Utilities 9,33%Current Transition Period Transition period

Current EPS 0,75 Transition Period length (yrs) 8 13,90%Current DPS 0,43 Growth rate in CapEx 12,54% Stable growthCapex per share 1,01 Growth rate in Depreciation 12,54% 76,77%Depr per share 0,51 WC as %age of Revenue -0,36%

Override values Override values

BloombergHelp

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Depr per share 0,51 WC as %age of Revenue -0,36%Revenue per share 8,49 Debt to Capital ratio 70,30%Working Capital per share -0,03 Riskfree Rate 3,30%Chg Working Capital per share -0,96 Beta 0,77833885Debt to Capital ratio 70,30% Expected Market Return 9,00%

High growth period Cost of Equity 7,74%Riskfree Rate 3,30%Expected Market Return 9,00% Stable growth periodBeta 0,734007 EPS Growth Rate 2,00% 2,00%WC as %age of Revenue -0,36% WC as%age revenue -0,36% Revenue growth High growth period length (yrs) 2 Debt to Capital ratio 70,30%Cost of Equity 7,48% Cost of Equity 7,99%Applied EPS growth rate 2,83% Beta in stable phase 0,8226711

Hist Avg eps growth 13,71% 30,00% Weighting Riskfree Rate 3,30%

Analyst estimated eps growth -1,83% 70,00% for EPS Expected Market Return 9,00%

Y Model Present Value 5,51This Year Estimate 0,50 Current Price of Security 4,26Next Year Estimate 0,44 Potential misprice 29,39%Growth Rate in CapEx 14,81%Growth Rate in Depreciation 12,54% Net difference Goalseeker 1,25Growth Rate in revenues 2,83%

For first 2 years use short term broker forecasts? (Y/N)

Bloomberg DCF (FCFF)screen

enel im Equity ENEL SPA

0 0 1 2 3 4 5 6 7 8 9 10

Discounted Cashflow 2005 2006 2007 2008 2009E 2010E 2011E 2 012E 2013E 2014E 2015E 2016E 2017E 2018E 2019E

Turnover 32.272 37.497 42.734 59.577 73.393 84.984 92.120 93.041 93.972 94.912 95.861 96.819 97.787 98.765 99.753

Growth % 16% 14% 39% 23% 16% 8% 1,0% 1,0% 1,0% 1,0% 1,0% 1,0% 1,0% 1,0%

EBITA 5.538 5.998 7.410 10.134 12.386 4.759 5.159 5.210 5.262 5.315 5.368 5.422 5.476 5.531 5.586

Margin % 17,2% 16,0% 17,3% 17,0% 16,9% 5,6% 5,6% 5,6% 5,6% 5,6% 5,6% 5,6% 5,6% 5,6% 5,6%

Depreciation 1.918 2.154 2.506 3.593 4.327 5.000 5.452 5.519 5.551 5.610 5.672 5.729 5.782 5.841 5.901

% Sales 5,9% 5,7% 5,9% 6,0% 5,9% 5,9% 5,9% 5,9% 5,9% 5,9% 5,9% 5,9% 5,9% 5,9% 5,9%

Chg Working Capital 4.375 867 6.372 6.752 7.727 8.304 10.719 10.064 10.044 10.182 10.513 10.457 10.557 10.689 10.820

% Sales 13,6% 2,3% 14,9% 11,3% 10,5% 9,8% 11,6% 10,8% 10,7% 10,7% 11,0% 10,8% 10,8% 10,8% 10,8%

Capex -3.037 -2.759 -4.882 -7.059 -7.331 -12.001 -11.995 -6.071 -6.107 -6.171 -6.240 -6.302 -6.360 -6.426 -6.491

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Multiple Depreciation 1,6x 1,3x 1,9x 2,0x 1,7x 2,4x 2,2x 1,1x 1,1x 1,1x 1,1x 1,1x 1,1x 1,1x 1,1x

Cash Tax -1.934 -2.067 -1.956 -585 -3.213 -1.285 -1.393 -1.407 -1.421 -1.435 -1.449 -1.464 -1.479 -1.493 -1.508

Rate % PY EBITA -37,3% -32,6% -7,9% -25,9% -27,0% -27,0% -27,0% -27,0% -27,0% -27,0% -27,0% -27,0% -27,0% -27,0%

Free Cashflow 4.193 9.450 12.835 13.896 4.778 7.942 13.316 13.330 13.501 13.865 13.842 13.976 14.143 14.308

Growth % 8% -66% 66% 68% 0% 1% 3% 0% 1% 1% 1%

Discount Factor 1,000 0,925 0,855 0,791 0,732 0,677 0,626 0,579 0,535 0,495 0,458 Term. Value

Discounted Free Cashflow 13896 4419 6794 10534 9753 9136 8677 8012 7482 7002 6552 92887

Enterprise Value 185144

Net Funds / (Debt) -57.124 57.124

Minority Interests 741 741

Equity Value 128761

WACC 8,12% 5,123871 0,05123871 CAGR Sales 5,7% 7%

Terminal Growth 1% CAGR EBITA -6,6%

No. Shares 9403,357

Value Per Share 14

Business cycle and industry performance

• Wide dispersion in rates of return in different industries: performance varies from year to year, company performance varies within industries, risks vary widely by industry but are fairly stable over time

• Economic trends can and do affect industry performance. By identifying and monitoring key assumptions and variables, we can monitor the economy and gauge the implications of new information on our economic outlook and industry analysis

• Cyclical or Structural Changes

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• Cyclical or Structural Changes

─ Cyclical changes in the economy arise from the ups and downs of the business cycle

─ Structural changes occur when the economy undergoes a major change in organization or how it functions (demographics, lifestyles, technology, economic reasoning)

─ Keep in mind that regulations substantially affect international transactions

• Rotation strategy is when one switches from one industry group to another over the course of a business cycle (see exhibit 14.2 of Brown and Reilly)

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Reference: BROWN & REILLY, Chapter XIV

Evaluating the industry life cycle

• Five stage model of the industry life cycle

– Pioneering development

– Rapidly accelerating industry growth

– Mature industry growth

– Stabilization and market maturity

– Deceleration of growth and decline

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• Competition and expected industry returns

– Porter’s concept of competitive strategy is described as the search by a firm for a favorable competitive position in an industry. Remember the five forces: rivalry among existing competitors, threat of new entrants, threat of substitute products, bargaining power of buyers, bargaining power of suppliers

– To create a profitable competitive strategy, a firm must first examine the basic competitive structure of its industry

– The potential profitability of a firm is heavily influenced by the profitability of its industry

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Reference: BROWN & REILLY, Chapter XIV

Growth companies/stocks and defensive companies/stocks

• Growth companies have historically been defined as companies that consistently experience above-average increases in sales and earnings

• Financial theorists define a growth company as one with management and opportunities that yield rates of return greater than the firm’s required rate of return

• Growth stocks are not necessarily shares in growth companies. A growth stock has a higher expected rate of return than other stocks with similar risk

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of return than other stocks with similar risk

• Superior risk-adjusted rate of return occurs because of market undervaluation compared to other stocks

• Defensive companies’ future earnings are more likely to withstand an economic downturn. Peculiar characteristics:

– Low business risk

– Not excessive financial risk

– Stocks with low or negative systematic risk

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Reference: BROWN & REILLY, Chapter XV

Cyclical companies/stocks, speculative companies/stocks, growth vs value

• Cyclical companies are those whose sales and earnings will be heavily influenced by aggregate business activity and that will experience changes in their rates of return greater than changes in overall market rates of return

• Speculative companies are those whose assets involve great risk but those that also have a possibility of great gain. They possess a high probability of low or negative rates of return and a low probability of normal or high rates of return

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• Growth stocks will have positive earnings surprises and above-average risk adjusted rates of return because the stocks are undervalued

• Value stocks appear to be undervalued for reasons besides earnings growth potential. Value stocks usually have low P/E ratio or low ratios of price to book value

• The interested student may study the papers by Fama and French on the growth vs value investment styles (for example: Value Versus Growth: The International Evidence)

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Company analysis: the competive enviroment (Porter)

• Forces determining the competitive enviroment (Porter)

─ Current rivalry

─ Threat of new entrants

─ Potential substitutes

─ Bargaining power of suppliers

─ Bargaining power of buyers

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• Defensive strategy involves positioning firm so that it its capabilities provide the best means to deflect the effect of competitive forces in the industry

• Offensive strategy involves using the company’s strength to affect the competitive industry forces, thus improving the firm’s relative industry position

• Porter suggests two major “extreme” strategies: low-cost leadership and differentiation. The firm seeks to be the low-cost producer, and hence the cost leader in its industry or positions itself as unique in the industry

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Lessons from Peter Lynch (Fidelity Investments) and Warren Buffet (Berkshire Hathaway)

• Peter Lynch is a veteran Wall Street stock investor who managed the legendary Fidelity Magellan fund from 1977 to 1990. Warren Buffett needs no introduction

• Favorable attributes of firms according to Peter Lynch

─ Firm’s product should not be faddish

─ Firm should have some long-run comparative advantage over its rivals

─ Firm’s industry or product has market stability

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─ Firm’s industry or product has market stability

─ Firm can benefit from cost reductions

─ Firms that buy back shares show there are putting money into the firm

• Warren Buffet’s four classes of tenets

─ Business tenets

─Management tenets

─ Financial tenets

─Market tenets

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Warren Buffet’s tenets

• Business tenets

─ Is the business simple and understandable?

─ Does the business have a consistent operating history?

─ Does the business have favorable long-term prospects?

• Management tenets

─ Is management rational?

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─ Is management rational?

─ Is management candid with its shareholders?

─ Does management resist the institutional imperative?

• Financial tenets

─ Focus on return on equity, not earnings per share (importance of owner’s earnings)

─ Look for companies with high profit margins

─ For every dollar retained, make sure the company has created at least one dollar of market value

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Estimating the fundamental intrinsic value

• Market tenets

─What is the value of the business?

─ Can the business be purchased at a significant discount to its fundamental intrinsic value?

• How do you estimate the fundamental intrinsic value of a firm?

─ Present value of cash flows (PVCF)

• Present value of dividends (DDM)

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• Present value of dividends (DDM)

• Present value of free cash flow to equity (FCFE)

• Present value of free cash flow (FCFF)

─ Relative valuation techniques

• Price earnings ratio (P/E)

• Price cash flow ratios (P/CF)

• Price book value ratios (P/BV)

• Price sales ratio (P/S)

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Present value of cash flows techniques

• Simplifying assumptions help in estimating present value of future dividends. For example, the assumption of a constant growth rate yields

( ) withrate growth historical dividend valueIntrinsic gDDgk

D +=−

= 1);( 011

( ) rate retention or rate) growth l(historica ROEg

D

Dg n

n

⋅==−− 1

0

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• The required rate of return (or cost of capital) k may be estimated using a CAPM-type assumption

As you know, the model requires k > g. With g > k, the analyst must use multi-stage model

• You may define the as follows: FCFE = net income + depreciation expense - capital expenditures - ∆ in working capital - principal debt repayments + new debt issues

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( )fmarketstockf r)E(rβrk −+=

Present value of cash flows techniques

• The present value of free cash flows to equity (PVFCFE) under the constant growth assumption is given by

• The present value of free cash flows to the firm (PVFCFF) under the constant growth assumption is given by

firm the forequity toflow cash free of rate growth constant expected the

firm the forequity on return of rate required the

1 period inflow cash free expected the

where,

==

=−

=

FCFE

FCFE

g

k

FCFE

gk

FCFEPVFCFE

1

1

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• The present value of free cash flows to the firm (PVFCFF) under the constant growth assumption is given by

• The free cash flows to the firm are given by FCFF = EBIT (1-tax rate) + depreciation expense - capital spending - ∆ in working capital - ∆ in other assets

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firm the toflow cash free of rate growth constant expected the

firm the for capital of cost average weightedthe

1 period in firm the toflow cash free expected the

where,

===

−=

FCFF

FCFF

g

WACC

FCFF

gWACC

FCFFPVFCFF

1

1

Example: the weighted average cost of capital of Banca Intesa

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Present value of cash flows techniques and relative valuation techniques

• The FCFF can also be replaced by the operating free cash flows to the firm. The growth rate estimate can be obtained as follows

and the weighted average cost of capital is given by (in plain English: the proportion of equity in total capital by the after-tax cost of equity plus the proportion of debt in total capital by the after-tax cost of debt)

( )capital Total

ratetax whererate retention

−=⋅= 1;

EBITROICROICgFCFF

iWkWWACC DE +=

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• By plugging in the constant growth DDM in the price to earnings ratio, we get

and therefore the ratio is affected by two variables: the required rate of return on quity (k) and the expected growth rate of dividends (g)

• The constant growth model is not appropriate for growth companies. Moreover, generating rates of return greater than the firm’s cost of capital is considered to be temporary. We would further discuss these issues in the next lecture

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gk

EDEP

−= 11

1

//

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