Equity Investment Analysis

1
Chapter 13

• Equity Investment Analysis

2
Investment Portfolio

• Importance of Portfolio Diversification
• Based on Investor Goals
• Short-term, liquidity focus
• Mid-term, return but limited risk focus
• Long-term, return focus

3
Gotrocks Funds

• Growth Fund maximize long-term market
  appreciation using large-cap stocks (focus on
  earnings earnings growth potential)
• Income Fund maximize short- intermediate-term
  income using bonds and large-cap stock that pay
  high dividends ( total return as a secondary
  goal)
• Value Fund invest in large-cap stocks that are
  undervaluedrequires evidence of substantial
  restructuring

4
Mutual Funds

• Investment portfolios managed by professionals
  regulated by the SEC
• Advantages diversification, professional
  management, liquidity, small investment
• Disadvantages Fees, average returns less than
  expected, lack of control over investments, taxes

5
Mutual Fund Categories

• Money Market Funds
• Bond
• Stock growth, income, value, asset allocation,
  sector funds, regional funds
• Balanced

6
Six-step Analysis

• Investment purpose
• Corporate overview
• Quantitative financial market analysis
• Detailed accounting analysis
• Comprehensive analysis
• Recommendation or decision

7
Investment Strategies

• Dollar-cost averaging
• Buy hold
• Index funds
• Risk measures, such as Beta analysis

8
Chapter 6

• Quantitative Financial Analysis Techniques
  Incorporating Market Information

9
Quantitative Market Analysis

• Stock prices stock charts
• Earnings per shareactual forecast
• Price earnings ratios (PE)
• Dividend yield
• Market value market-to-book
• Price earnings to growth ratios (PEG)
• Valuation models

10
Stock Prices

• Prices change continuously
• Using daily closing price
• Stock charts, various periods
• Industry market comparisons
• Internet sites

11
Earnings Per Share (EPS)

• Performance measure on per share basis
• Basic vs. diluted
• Forecasted EPS (Zacks Analysts Estimates on
  Quicken)
• Annual vs. quarterly EPS
• 5 year forecasts (relevance vs. reliability)

12
PE Ratios

• Stock price as a market premium for earnings
• Which price? (most current, historic)
• Which EPS? (current year actual, future forecast,
  basic vs. diluted)
• Closing prices
• Alternatives how to evaluate them

13
Market-based Ratios

• Price earnings ratio (PE) Stock price / EPS
• Dividend Yield Dividend per share / Stock price
• Market value stock price x shares outstanding
• Market-to-book market value / stockholders
  equity

14
Market-related Ratios

• Market-to-book market value / stockholders
  equity or measure on a per share basisstock
  price / book value per sharewhy is a market
  premium to book common?
• Sales to market value annual sales to
  outstanding shares x (1) year-end closing market
  price or (2) most recent closing market price

15
Price Earnings to Growth (PEG)

• High PE is usually associated with the
  expectation of high earnings growth, which can be
  evaluated with PEG
• Historic PEG PE based on actual EPS / 5-year
  historic earnings growth
• Forecast PEG PE based on forecast EPS /
  5-year earnings forecast

16
Valuation Models

• Earnings-based growth model (a form of the
  dividend discount model) P kE / (r-g)
• Intrinsic value see Quicken, Evaluator, use last
  year earnings, 5 year earnings forecast SP 500
  long-term growth rate 11)
• Stock screener see Hoovers, Money

17
Earnings-based Growth Model

• P kE / (r g) where P is stock price, k is
  dividend payout rate (actual or predicted), E is
  EPS, r is the discount rate, and g the projected
  earnings growth rate
• This model requires dividends, the discount rate
  is discount rate is arbitrary (it could be the
  actual cost of capitalor based something else),
  and the growth rate is a forecast

18
Stock Screening

• The purpose of stock screening is the determine
  which firms meet specific criteria (such as
  minimum ROE or dividend yield)
• Several internet sites have stock screeners, such
  as Hoovers Yahoo
• The technique is useful to limit the number of
  companies on which to conduct a complete
  financial analysis

19
Chapter 7

• An Accounting Analysis Perspective

20
Financial Reporting Goals User Perspective

• Economic Reality financial position operations
• Complete disclosure
• High earnings quality
• Corporate news reported quickly, especially bad
  news

21
Problems

• Self interest of managers
• Incentives for earnings management
• Incomplete or confusing reporting
• Low earnings quality
• Poor disclosure
• Complexity of economic reality

22
Difficult Accounting Issues

• Recording valuing assets
• Liability recognition
• Revenue recognition
• Expense matching to revenues
• Non-recurring items
• Comprehensive income
• Evaluating cash flows

23
Financial Statement Elements

• Balance Sheet Assets, liabilities, equity
  (including investments distributions to owners)
• Income Statement Revenues, expenses, gains,
  losses, comprehensive income
• Conceptual Framework SFAC No. 6

24
Assets

• Probable future economic benefits (Conceptual
  Framework)
• Recording alternatives Cost (or amortized
  cost), fair value, or no recognition (expense or
  ignore)
• Accounting vs. economic valuation problems

25
Liabilities Equity

• Liabilities probable future economic sacrifices
  (Conceptual Framework)(1) an obligation has been
  incurred (2) amount timing are measurable
• Potential liabilities contingencies
• Off-balance-sheet-obligations
• Equity residual interest in net assets, a
  measure of ownership
• Hybrid issues e.g., convertible bonds

26
Revenue Recognition

• Recognize when (1) realized or realizable (2)
  earnedwhen exchange transactions are
  substantially complete, usually when product is
  delivered or service rendered
• Earnings management potential recognition can be
  conservative or aggressive
• Events for product initial sale, shipment,
  billing, receipt approval by customer, cash
  received

27
Expenses

• Matching principal expenses are matched to
  revenues(1) period costs vs. (product costs)
• Importance of accrual accounting
• Earnings management potential immediate expense
  vs. capitalizing

28
EBIT EBITDA

• Earnings before interest taxes (EBIT) is a
  measure of operating earnings and can be used as
  an indicator or the ability to service debt
• Earnings before interest, taxes, depreciation
  amortization (EBITDA) cam be considered cash
  earnings, since depreciation amortization are
  major non-cash expense items

29
Non-recurring Items

• Gains losses that are unusual infrequent,
  including extraordinary items, discontinued
  operations, accounting changes
• Earnings management potential income from
  continuing operations vs. net income big bath
  write-offs

30
Comprehensive Income

• Specific operating items not considered part of
  net income, including marketable securities
  foreign currency
• Usually recorded as part of statement of
  stockholders equity (SFAS No. 130)
• Dirty surplus (recorded directly to stockholders
  equity)

31
Pro Forma Statements

• Restated financial statements, presented to
  highlight certain elements or features.
• Primary focus is on pro forma earnings, usually
  to show higher earnings than under GAAP.
• Pro forma restatement may be useful, but analysts
  need to consider earnings management potential.

32
Cash Flow Statement

• Cash flows from (1) operating activities, (2)
  investing activities, (3) financing activities
• Importance of operating activities (CFO) usually
  red flag if negative
• Free cash flows CFO CFI
• CFO / Liabilities (ability to cover debt)
• CFO per share compare to EPS share price
• Cash Flow Adequacy Ratio

33
Detailed Accounting Analysis

• Financial accounting overview
• Evaluate reporting completeness
• Evaluate earnings management potential
• Consider possible red flags
• Reevaluate or restate financial information
• Updating annual report informationquarterly
  statements (e.g., 10-Qs), proxy statements,
  public announcements

34
Chapter 8

• Accounting Analysis
• Specific Issues I

35
Marketable Securities

• Marketable securities can include debt (often as
  a use of available cash) equity securities
• Accounting for securities is based on SFAS No.
  115
• Operating performance of the firm must be
  separated from investment performance of
  investments

36
Three Categories of Marketable Securities

• Debt securities held-to-maturity report at
  amortized cost
• Debt equity securities classified as trading
  securities reported at fair value unrealized
  gains losses included in earnings
• Debt equity securities available-for-sale
  reported at fair value with unrealized gains
  losses reported in stockholders equity (dirty
  surplus item)

37
Inventory

• Alternative methods allowed Last-in first-out
  (LIFO, note conformity rule First-in
  first-out (FIFO) Average
• Lower-of-cost-or-market (LCM)
• Tax vs. financial statement effects with
  inflation, LIFO should result in lower taxable
  income (which results in lower taxes lower net
  income)

38
Fixed Assets (Property, Plant Equipment)

• Capitalizing vs. expensing
• Cost allocation
• Depreciation financial accounting vs. taxes
  (deferred taxes if different)
• Straight-line depreciation
• Accelerated (e.g. double-declining-balance

39
Measures of Fixed Asset Age Useful Life

• Average Age Accum. Depr. / Depr. Expense this
  measure approximates age in yearsolder assets
  may be less efficient
• Average Age Accum. Depr. / Ending Gross
  Investment-- fixed assets are depreciated
• Average Depreciable Life Ending Gross
  Investment / Depr. Expense

40
Depreciation

• Fixed assets with 4 year useful life, cost
  5,000, 1,000 salvage value Straight-line
  Double-Declining Balance Year 1
  1,000 2,500 2 1,000
  1,250 3 1,000 625 4
  1,000 312.5

41
Income Tax

• Differences between tax law GAAP
• Permanent differences vs. temporary differences
• Interperiod vs. intraperiod tax allocation
• Deferred taxes associated with temporary
  differencesaccounting based on SFAS No. 109
  the liability method

42
Tax Calculations (using depreciation above, year
1)

• Example SL DDB Income before depr.
  tax 18,000 18,000 Depreciation
  1,000 2,500 Income before tax
  17,000 15,500 Tax (35) 5,950
  5,425 Net income 11,050 10,075

43
Tax Journal Entry

• DDB for tax purposes (tax 5,425) SL for
  financial (tax 5,950) the difference is
  deferred tax (the timing difference)
• Tax Expense 5,950 Taxes Payable 5,425 Def
  erred Tax Liability 525

44
Effective Tax Rates

• Effective tax rate Income tax expense / pretax
  income
• Taxes payable rate Taxes payable / pretax
  income
• Taxes paid rate income taxes paid / pretax
  income
• Note firms subject to state local as well as
  foreign taxes, which can increase tax rates

45
Leases

• Capital leases transfer risks rewards of
  ownership considered equivalent to a purchase
  by the lessee
• Operating leases are off-balance-sheetlease
  payment are expenses
• SFAS No. 13 as cookbook accountingvery
  specific rules, little judgment possible

46
Criteria for Capital Leases

• Based on SFAS No. 13, a lease meeting any one of
  four criteria is a capital lease
• 1. Lease transfers ownership at end of lease term
• 2. Bargain purchase option present
• 3. Lease term equals 75 of estimated economic
  life
• 4. PV of minimum lese payments 90 of fair value

47
Off-balance-sheet Financing

• Financial commitments liabilities may be
  unreported on the balance sheet
• Executory contracts allow the use of inputs
  without ownershipleases are the most common
  example
• Consider earnings management efficient contract
  criteria

48
Advantages of an Operating Lease

• Lower reported liabilitiesthe primary result of
  interest
• Higher profits reported (in the early years)
• Interest expense in lower ( unreported)
• Higher profit ratios (in early years)
• May be useful for avoiding debt covenant
  violations

49
Analyzing Operating Leases

• Given the earnings management potential,
  operating leases should be further analyzed
• Determine the amount of operating leases in the
  leases note
• Estimate the capital lease equivalent add to
  liabilities
• If operating leases are significant (e.g., 10 of
  total assets), re-estimate debt to equity other
  leverage ratios

50
Special Purpose Entities (SPEs)

• SPEs are contractual arrangements for a limited
  purpose, generally designed to be
  off-balance-sheet
• SPEs can be used to acquire operating leases,
  acquisition of long-term assets with debt, fund
  research development, to hold accounts
  receivable, etc.
• The key accounting issue is when an SPE should be
  consolidated into the sponsors financial
  statements

51
Financial Analysis Issues with SPEs

• The major purpose of SPEs seems to be to keep
  assets especially liabilities off-balance-sheet
• From a financial analysis perspective, this means
  earnings management
• The key problem is the lack of information to
  restate financial statements

52
Chapter 9

• Accounting Analysis
• Specific Issues 2

53
Stock Options

• Stock options allow employees the right to
  purchase company stock as a set price over some
  fixed time period. The most common price is
  closing market price at issue date. At this
  price, no compensation expense is recorded.
• SFAS No. 123 requires increased disclosure on
  options, but usually no compensation expense.

54
Stock Option Advantages

• Stock options should match the incentives of the
  agents (managers employees) to those of the
  investors (principals)
• Company usually does not record a compensation
  expense (but potential equity dilution exists)
• Employees benefit from stock appreciation,
  without the risk of decline

55
Stock Options Executive Incentives

• Stock options are supposed to align the
  incentives of managers with those of investors
• Recent scandals suggest that executives have used
  earnings manipulation techniques to maintain
  stock price perhaps use insider trading
• Stock options, dividends Treasury stockare
  they related?
• Restating financial information based on stock
  option disclosures

56
Segment Reporting

• Footnote disclosure on industry geographic
  segments
• Disclosure requirements based on SFAS Nos. 14
  133
• Materiality based on 10 rules for (1)
  revenues, operating profit identifiable assets
  for industry segments (2) sales or identifiable
  assets for geographic segments

57
Segment Disclosures

• Limited information required
• Different disclosures by company
• Segment disclosures normally include sales,
  operating income identifiable assets
• Simple ratios can be used to compare various
  segments

58
Foreign Currency History

• Gold standard
• Bretton Woods Agreement fixed exchange rates
• Floating exchange rates since the early 1970s
• Accounting issues SFAS No. 8 superceded by SFAS
  No. 52

59
Foreign Operations

• How are foreign operations included in US parent
  financial statements when currencies fluctuate?
• Balance sheet effects if foreign currency falls
  relative to the dollar, foreign assets fall in
  value, but liabilities paid back in cheaper
  dollars
• Potential differences for monetary vs.
  non-monetary items current vs. long-term items

60
Foreign Currency Issues

• Foreign currency transactionsgains losses in
  income statement
• Foreign currency translationholding gains
  losses should these be recorded , if so, how?
• Valuation alternatives (1) historical rate (when
  transaction took place) (2) current rate of
  exchange (end of period), (3) weighted average
  for the period
• Reporting alternatives (1) part of current
  operations in income statement (2) report
  directly to balance sheet (dirty surplus)

61
Foreign Currency Translation GAAPSFAS No. 52

• The local currency is usually the functional
  currency (e.g., the British for an English
  subsidiary)
• In most cases the all-current method is used
• Exception in hyperinflation economies (100 over
  3 years), the functional currency is the parent
  currency (dollar) the temporal method is used

62
Foreign Currency TranslationAll-current Method

• Balance sheet all assets liabilities of
  subsidiary are translated at the balance sheet
  date exchange rates
• Income statement revenues, expenses, gains
  losses translated at the weighted-average
  exchange rates
• Translation gains losses reported separately in
  stockholders equity (comprehensive income or
  dirty surplus)

63
Foreign Currency TranslationTemporal Method

• Balance sheet nonmonetary assets (inventory
  fixed assets) translated using the historical
  rate. Other items use the current rate
• Income statement cost of goods sold
  depreciation based on historic rate all others
  use weighted average
• Translation gains losses reported on the income
  statement

64
Analysis of Foreign Currency Translation

• All-current method reduces volatility of reported
  earnings of foreign subsidiaries on the income
  statement (e.g., with all-current method only
  transactions are recorded, not translations)
• Hedging can reduce currency translation risks
• Firms with large liability positions in local
  currency reduce currency translation risk (0 if
  local assets local liabilities)

65
Pensions

• Defined contribution plans employer pays a
  specific amount to employee pensions. Employee
  has the investment risk (that is, employer has no
  more future liability)
• Defined benefit plans employer specifies
  employee benefits to be paid during retirement
  (employer has investment risk future liability)

66
Defined Benefit Plans

• Calculate benefit obligations for employees
• Plan assets are invested to meet retiree
  obligations
• The balance sheet amount is the net difference
  between the twoa prepaid pension cost if
  overfunded
• GAAP is based on SFAS No. 87

67
Other Post-employment Benefits

• Companies may provide benefits to retirees (or
  other terminated/laid-off employees), especially
  health insurance
• Historically, these were reported on a
  pay-as-you-go basis
• SFAS No. 106 requires liability to be recognized,
  accumulated postretirement benefit obligation
  (APBO) particularly important

68
Derivatives

• Derivatives are contracts based on (derived) from
  existing financial instruments
• Derivatives can be used for hedging Interest
  rate swap Foreign exchange (currency)
  swap Commodity futures Market forward
  contracts
• Derivatives can be used for speculation
• Problem for the analysthow to tell the
  difference between hedging speculation

69
Forward Contracts

• A forward contract contract is a sales contract,
  where the amount, maturity date, price at set
  in advance
• A futures contract is a forward contract traded
  on an organized exchange
• Consider a farmer (seller) baker (buyer) in a
  futures wheat contract
• Both have hedged against future price changes

70
Swaps

• A swap is a contract that exchanges one series of
  payments for another
• Interest rate swaps agreement to exchange fixed
  for floating rate interest payments similar to a
  forward contract
• Currency swap requires one party to make
  payments in one currency in exchange for
  obligations in another currency

71
Options

• An options allows a party to buy (call) or sell
  (put) something as a specified amount at a fixed
  price until the maturity date
• The option will be exercised only if the
  transaction is favorable to the buyer. Otherwise,
  the option will lapse
• The option buyer pays a premium to the seller

72
Derivative Accounting

• SFAS No. 133 requires derivatives to be recorded
  on the balance sheet at fair value
• Holding gains losses will normally be recorded
  on the income statement
• Prior to 133, derivatives were off-balance-sheet

73
Chapter 10

• Business Combinations

74
Standards Update

• New FASB Standards SFAS Nos. 141 on Business
  Combinations 142 on Goodwill Other Intangible
  Assets
• According to SFAS No. 141 only the purchase
  method will be allowed for acquisitions (
  additional new requirements)for combinations
  after June 30, 2001
• Goodwill will no longer be amortized according to
  SFAS No. 142

75
Business Combinations

• Business acquisitions have always been a major
  part of American Big Business
• Consider Standard Oil Trust, U.S. Steel, General
  Motors, or AOL-Time Warner
• Until APB Opinion 16, accounting was flexible
  (with considerable earnings management potential)

76
Types of Mergers

• Horizontal Acquire firm in the same
  industryincrease market share decrease
  competition
• Vertical Acquire related firmssuppliers, raw
  material producers, distributors, retailers.
  Expand to potentially all aspects of overall
  industry
• Conglomerate acquire suitable firm in any
  industrykey point is diversification

77
Purchase vs. Pooling

• Pooling of interests assume a combination of two
  near-equal firms by exchanging stock.
  Accounting is essentially adding up the combined
  book value
• Purchase One firm acquires another, using cash,
  debt or stock. Acquired firm assets liabilities
  recorded at fair values

78
Acquisition Example
79
Purchase Method Journal Entry

• Assume firm acquired for 30 million
  cash Accounts Receivable 1.0 Inventory
  3.5 Fixed Assets 10.0 Patents (etc.)
  5.6 Goodwill 12.5 Liabilities
  2.0 Cash 30.0
• Goodwill 30.0 17.5 12.5 million

80
Pooling Journal Entries

• Assume firm was acquired for 30 million in
  acquiring company stock Accounts
  Receivable 1.1 Inventory 2.9 Fixed
  Assets 8.0 Liabilities 2.0 Equity 10.
  0 somewhat complicated

81
Likely Acquisition Targets

• High liquidity firms (acquirer can use the cash)
• Firms with salable assets
• Poor performing companies (e.g., large stock
  price drop) potential turnaround by acquirers
  reorganization
• Low PE firms enhance the value of acquiring
  company (when acquirer has higher PE ratio)