Company Analysis

1
Company Analysis

• Timothy R. Mayes, Ph.D.
• FIN 3600 Chapter 12

2
Overview of Company Analysis

• Once weve completed the economic forecast and
  industry analysis, we can focus on choosing the
  best positioned company in our chosen industry
• Selecting a company will involve an analysis of
• The companys management
• The companys financial statements
• Key drivers for future growth
• Obviously, we are looking for companies with the
  best management, strong financials, great
  prospects, and that are undervalued by the market
• Always remember that the past is irrelevant, what
  you are buying is future results

3
Evaluating Management

• Strong management is vital for companies to
  perform in accord with the highest expectations
  of investors
• Unfortunately, evaluating the quality of a
  companys management team is very difficult,
  especially for individual investors
• Professionals have the advantage in that they
  have many contacts within the industry who are
  familiar with the management team, and they can
  visit the company and talk with the team
  personally

4
Evaluating Management (cont.)

• As an individual, there are several things you
  can do
• Read the 10k it has information on the
  background of executives and board members.
  Information includes age, pay, stock ownership,
  etc
• Read the business press There are often stories
  which provide insights into the character and
  abilities of senior management
• Call investor relations They can answer any
  reasonable questions that you may have
• Study the financial statements Good management
  leads to solid financials

5
Evaluating Management (cont.)

• Despite your best efforts at judging managements
  ability, things can go wrong
• History is replete with examples of formerly
  great managers running their new companies into
  the ground
• Here are a few examples that come to mind
• ATT C. Michael Armstrong
• Sunbeam Chainsaw Al Dunlap
• Apple Computer John Scully
• Long-term Capital Management John Meriwether,
  Robert Merton, and Myron Scholes (the latter two
  were Nobel Prize winners in economics)

6
Financial Statement Analysis

• There are three statements to watch
• Income statement
• Balance sheet
• Statement of cash flows
• Two major tools
• Ratios
• Growth rates

7
The Income Statement

• The income statement provides us with information
  about the firms revenues and expenses over some
  previous time period (usually quarterly,
  semiannually, and annually)
• The key variables to watch are revenues, gross
  profit margins, operating profit margins, net
  profit margins
• We especially want to evaluate the quality of the
  firms earnings

8
Quality of Earnings

• Under GAAP, companies are allowed fairly wide
  latitude on how they recognize revenues and
  handle extraordinary income and expenses
• Many companies freely admit to managing or
  smoothing earnings, believing that it adds to
  the stability of the stock price over time
• Analysts need to watch for such shenanigans, as
  it may signal problems
• Here are a couple of recent examples of
  questionable quality of earnings
• Qwest Raised revenue recognition questions when
  analysts discovered that they had counted all of
  the future revenues from a 20-year contract as
  current earnings.
• Waste Management Had trouble recently when it
  tried to claim as extraordinary its expense for
  painting its huge fleet of trucks. This added 3
  cents per share (about 10) and let them beat
  expectations by 2 cents (see Waste Management
  Excludes Some Expenses in Accounting, WSJ
  Online, 23 Aug 2001)
• Priceline.com Was claiming as revenue the
  entire price of an airline ticket when, in fact,
  they only received a commission on its sale and
  never actually took ownership of the ticket

9
Quality of Earnings (cont.)

• Another thing to watch for are pro-forma or as
  if earnings. Some analysts have described these
  as all the good stuff and none of the bad.
• Many companies, especially those in the new
  economy, began reporting pro-forma numbers a few
  years ago. The funny part is that the Wall
  Street analysts went along with the game, even
  long after it became clear that there would never
  be any real earnings. (See notes on Reg G below.)
• Also, look for where earnings are coming from.
  Increased sales, or decreased expenses? Sales
  can increase forever, but costs can only be cut
  so far. Generally, when costs are cut to
  increase profits, this must be looked at as a
  temporary boost.
• These types of issues lead to serious questions
  about managements truthfulness and bring into
  question the quality of the firms earnings.
  Typically, when these things are revealed, stock
  prices drop as investor uncertainty rises

10
Earnings Manipulation
11
The Balance Sheet

• The balance sheet describes the assets,
  liabilities, and equity of the firm at a point in
  time
• Key variables to watch on the balance sheet are
  cash, accounts receivable, inventories, and
  long-term debt
• Always remember what Benjamin Graham said in
  Security Analysis, liabilities are real but the
  assets are of questionable value.

12
The Statement of Cash Flows

• Ultimately, cash is king and the statement of
  cash flows tells us exactly why a firms cash
  balance changed
• The statement of cash flows is far more difficult
  to manipulate than the income statement, and can
  help to gauge the quality of earnings
• The Cash Flows from Operations section is the
  most important as it measures the cash provided
  by the day to day operation of the business
• A company could, for example, show steadily
  rising revenues and net income, but negative cash
  flows from operations. How? If accounts
  receivable is rising. This can only go on for so
  long before the company has grown its revenues
  right into bankruptcy because it isnt collecting
  on those sales. Positive earnings must always be
  confirmed by positive cash flows.
• This statement is as important, if not more so,
  than the income statement. Always examine it to
  find out what management is doing with the
  shareholders money

13
Analyzing Financial Ratios

• Financial ratios are the microscope that allows
  us to see behind the raw numbers and find out
  whats really going on
• Financial ratios fall into five categories
• Liquidity
• Efficiency
• Leverage
• Coverage
• Profitability
• When analyzing ratios always remember that no one
  ratio provides the whole story, and that the
  standards for each ratio are different for every
  industry

14
Liquidity Ratios

• The current ratio, quick ratio and cash ratio all
  fall into this category
• They help us to see if the company is able to
  meet its short-term obligations

15
Efficiency Ratios

• The efficiency ratios tell us how effectively
  management is using the firms assets to generate
  sales
• Inventory turnover, accounts receivable turnover,
  days sales outstanding, fixed asset turnover, and
  total asset turnover all fall into this category

16
Leverage Ratios

• How much debt does the firm have? Thats the
  question answered by the leverage ratios
• Examples are the debt ratio and debt to equity
  ratio
• Remember that lots of debt is great as long as
  sales are increasing, but terrible if sales
  decline
• Some debt is, without a doubt, good, but too much
  can be disastrous
• Especially be on the lookout for companies with a
  high proportion of fixed costs (high operating
  leverage) and with lots of debt. Airlines are a
  good example

17
Coverage Ratios

• Coverage ratios are most important to creditors,
  but whatever is important to creditors is
  important to shareholders too
• Examples of coverage ratios include the times
  interest earned ratio and the fixed charge
  coverage ratio

18
Profitability Ratios

• Investors tend to focus the most on profitability
  ratios, but the others are important as well
• Examples include the gross profit margin,
  operating profit margin, net profit margin,
  return on assets and return on equity

19
Using Financial Ratios

• There are two key uses of financial ratios
• Trend Analysis Looking for trends over time in
  ratios. For example, wed like to see that the
  inventory turnover ratio is rising. Normally, at
  least five years of data should be used.
• Comparison to Industry Averages If we assume
  that, on average, the firms competitors are
  doing things right, then it makes sense to make
  these comparisons. This can also help to
  identify areas of relative strength and weakness

20
Growth Rates

• Growth rates of various variables are important
  as well
• Key variables to calculate growth rates of are
  revenues, operating profits, and free cash flow

21
Manipulation of Financial Statements

• Financial statements may be manipulated in a
  number of ways to help identify key trends
• Common-size
• Common base year
• Inflation adjusted
• Each of these techniques can provide insights
  that are not easily seen on the unadjusted
  financial statements