lecture 05 - financial statements
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Financial StatementsEconomics 98 / 198
Fall 2007Copyright 2007 Jason Lee
Announcements
• Oct 31 versus Nov 31 lecture?
• Simulation Exercise - Money
CURRENT EVENT / NEWS
LECTURE CONTENT
Today’s Lecture
• Trading Psychology• Financial Statements introduction
– Income Statement– Balance Sheet– Cash Flow Statement– Earning Season
• Ratio Analysis
TRADING PSYCHOLOGY
Trading Psychology
Emotions severely impair your judgment in deciding whether to buy or sells tocks
HOPEFEARGREEDPRIDE
Psychology & The Stock Market
•Emotions can wreak havoc on your results and decisions
•Need to take emotion out of investing
•Do this by developing a system with rules to follow with discipline
Trading Psychology
“Your biggest enemy, when trading, is within yourself. Success will only come when you learn to control your emotions”
- Edwin Lefevre
Accounting 101:
Financial Statements
Reporting Financial Statements
•Public co. required to publish 10K and 10Q– 10K = Annual financial reports– 10Q = Quarterly financial reports
Income StatementBalance SheetStatement of Cash Flows
• Why do we care about these reports?
The Income Statement
•Shows how much a company earned or lost during that specific period
•Considered the most analyzed statement for investors
•Divulges into a company’s profitability
IS THE COMPANY MAKING PROFIT?
Income Statements
•Generally, 3 Major Parts– Revenues– Expenses– Net Income
•Earnings Per Share (EPS)= Profits / Shares Outstanding
•Investors pay very close attention to profits (earnings) and revenue (sales)
Income = Revenues - Expenses
Balance Sheet
•Summarizes company’s assets, liabilities, and shareholders’ equities at specific time
Assets = Liabilities + Shareholder’s Equity
•How do we analyze this statement?• We use ratios and changes in trends to analyze
the information
Balance Sheet
Assets– Current Assets: life span of 1 year or less– Non-Current assets
Liabilities– Current Liabilities– Non-current liabilities
Shareholder’s Equity– Common / Preferred Stock– Retained Earnings
Statement of Cash Flows
• Shows how much money coming in (inflows) and going out (outflows)– Cash flow from operations – Cash flow from investing– Cash flow from financing
• Shows if company having trouble with cash– Profitable companies can struggle cash flows. Why?
• Cash is king! Pays for bills and funds
operations!
Earnings Season
• Companies release quarterly reports and annual reports– “Financial Report Cards”
• Stock analysts issue earnings estimate– Consensus earnings estimates
• Earnings surprise is a good thing– Meeting / beating / missing expectations– If below estimates, then stock usually head
downwards fast!
Understanding Earnings
•Actual earnings value is important, but so is the growth of these earnings
•Compare EPS / Revenue?– Do we compare them to last quarter?– Do we compare them to the same quarter
last year?
EPS % Growth: Google Q2 2007Source: MSN Money Stock Quotes
EPS growth calculated comparing Q2 2007 to Q2 2006
Q2 2007EPS Growth
2007 Q2 EPS
2006 Q2 EPS
$2.98 / sh
$2.39 / sh
=25%
Why do Investors Care About Earnings?
•Strong earnings or expectations of strong earnings drive stock prices. Why?
– Potential for greater reinvestment, and greater earnings
– Passing the money to shareholders in various forms (dividends, buybacks, etc.)
•Ultimately, earnings provide a return on the investment for shareholders
Ratio Analysis
Ratio Analysis
• Used to gain idea of valuation and financial performance
• Compared to competitors and historical values to gain understanding about company’s value– Is it undervalued? Overvalued?– How is it performing?
Profit Margins
Profit Margins• = net income / net sales (revenue)
– Measures how much out of every dollar of sales a company actually keeps in earnings
• High profit margins indicates that management efficient at controlling costs– Increased earnings are good, but if costs are increasing
faster than sales, leads to lower profit per sale
• Good sign if company has growing profit margins
Profit Margins: Example
Company has a net income of $10 million from sales of $100 million, giving it a profit margin of 10% ($10 million/$100 million)
If in the next year net income rose to $15 million on sales of $200 million.
Would its profit margins be growing or diminishing? What does this mean?
Price to Earnings Ratio (P/E)
P/E Ratio• = Price per share / Earnings per share
– Look at company’s earnings relative to its price
• Most basic valuation method of company– How do you we use it?
• Ex. If BIG OIL co. has P/E ratio of 15 and has solid fundamentals, and the industry average is 40, then the BIG OIL would be considered undervalued
Price to Earnings Ratio (P/E)
• Use as a guide, not a guarantee in your analysis
• Sometimes, there is a reason for high or low P/E ratios (understanding business and industry is important)
– High P/E ratios: investors may be willing to pay more for less earnings because its expect higher growth rates in the future
– Low P/E ratios: may seem like a bargain, but low ratio may signal questionable future prospects
Return on Equity (ROE)
Return on Equity (ROE)• = Net Income / Shareholder’s Equity
– how much profit a company can generate with the money shareholders have invested
– Is it a profit-making machine or an inefficient clunker?
• Useful for comparing profitability and efficiency of a company to other firms in same industry– can indicate whether a company is growing without pouring
new capital into business
• Growing ROE also shows management making better use of money invested by shareholders
Return on Equity (ROE)PC Industry Example (Dell vs. Gateway vs. HP)
Dell
HP
Gateway
Debt-to-Equity Ratios
Debt / Equity Ratio• = Total Liabilities / Shareholder’s Equity
– Proportion of equity and debt to finance assets
• High ratio: aggressive debt, potential for higher earnings per share but at more risk– More volatile earnings and larger interest expenses
• Compare this similar companies• Warren Buffet preferred to see lower ratio so that
earnings growth is generated by investors rather than borrowed money
Google Example
2004 2005 2006Profit Margin 13% 24% 29%
ROE 14% 16% 18%
Debt / Equity 0.13 0.09 0.08
EPS Growth 344% 198%
Other Relevant Ratios
• Current Ratio• Return on Assets• Inventory Turnover• Interest Coverage
More on Ratio Analysis / Financial Statement Analysis:
http://www.investopedia.com/university/ratios/ratios1.asphttp://www.investopedia.com/university/financialstatements/
UGBA 102A: Introduction to Financial Accounting
Reading
• Motley Fool. “Analyzing Stocks”
• Recommended:Investopedia. “Valuation”
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