Notes chapter 15 Company Analysis

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					Vicentiu Covrig                        FIN352



         Company Analysis
                  (chapter 15 Jones)




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Vicentiu Covrig                                      FIN352
              Fundamental Analysis
 nGoal: estimate share’s intrinsic value
     - One model: Constant growth version of dividend
       discount model




     - Value justified by fundamentals
     - Often it used in conjunction with ratio analysis



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Vicentiu Covrig                                      FIN352
              Fundamental Analysis
 nEarnings multiple could also be used
            P0=estimated EPS  justified P/E ratio
 nStock is under- (over-) valued if intrinsic value
  is larger (smaller) than current market price
 nFocus on earnings and P/E ratio
    - Dividends paid from earnings
    - Close correlation between earnings and stock price
      changes
    - Regardless of detail and complexity, analysts and
      investors seek an estimate of earnings and a justified
      P/E ratio to determine intrinsic value
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Vicentiu Covrig                           FIN352
        Accounting Aspects of Earnings
  nHow is EPS derived and what does EPS
   represent?
  nFinancial statements provide majority of
   financial information about firms
  nAnalysis implies comparison over time or with
   other firms in the same industry




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Vicentiu Covrig                                     FIN352
          Basic Financial Statements
  nBalance Sheet
      - Liabilities
         uFixed claims against the firm
      - Equity
         uResidual
         uAdjusts when the value of assets change
         uLinked to Income Statement
      - Picture at one point in time



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Vicentiu Covrig                                 FIN352
          Basic Financial Statements
  nIncome Statement                   EBT
        Sales or revenues           - Taxes
      - Product costs                 Net Income available
        Gross profit                  to owners
      - Period Costs                - Dividends
                                      Addition to Retained
        EBIT                          Earnings
      - Interest
                                  nEPS and DPS
        EBT


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Vicentiu Covrig                                     FIN352
           The Financial Statements
  nEarnings per share
      - EPS =Net Inc./average number of shares
                        outstanding
      - Net Inc. before adjustments in accounting
        treatment or one-time events
  nCertifying statements
      - Auditors do not guarantee the accuracy of earnings
        but only that statements are fair financial
        representation


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Vicentiu Covrig                                    FIN352
        Problems with Reported Earnings
  nEPS for a company is not a precise figure that
   is readily comparable over time or between
   companies
      - Alternative accounting treatments used to prepare
        statements
      - Difficult to gauge the ‘true’ performance of a
        company with any one method
      - Investors must be aware of these problems



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Vicentiu Covrig                        FIN352
       Analyzing a Company’s Profitability
  nImportant to determine whether a company’s
   profitability is increasing or decreasing and
   why
  nReturn on equity (ROE) emphasized because is
   key component in finding earnings and
   dividend growth
      - EPS =ROE  Book value per share




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Vicentiu Covrig                            FIN352
                  Du Pont Analysis
  nShare prices depend partly on ROE
  nManagement can influence ROE
  nDecomposing ROE into its components allows
   analysts to identify adverse impacts on ROE
   and to predict future trends
  nHighlights expense control, asset utilization,
   and debt utilization



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Vicentiu Covrig                                      FIN352
                  Du Pont Analysis
  n ROE depends on the product of:
     1)   Profit margin on sales: EBIT/Sales
     2)   Total asset turnover: Sales/Total Assets
     3)   Interest burden: Pre-tax Income/EBIT
     4)   Tax burden: Net Income/Pre-tax Income
     5)   Financial leverage: Total Assets/Equity
  n ROE =EBIT profit margin  Asset turnover
     Interest burden  Tax burden  leverage


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Vicentiu Covrig                                  FIN352

                        Ratios
n Leverage = Total Assets/ Equity
n ROE = ROA * Leverage
n Ex: ROA=14.34%; Leverage = 1.98
n ROE= 28.4%
n Pretax Income = EBIT- Interest expense
n Ex: EBIT = $8,788; Interest expense = $1,234
n Pretax Income = 8,788 – 1,234 = $7,554
n Interest burden = 7554/8788 =0.86
n NI = $5,807
n Tax burden = 5807/7554 = 0.768
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Vicentiu Covrig                             FIN352

                     ROA
 nROA= NI/Total Assets
 nROA=NI/Sales x Sales/Total Assets =
 Net Income Margin x Sales Turnover
 Example: NI= $5,807
 Sales = $31,944 ; Total Assets = $40,510
 ROA= 14.34%; NI/Sales=0.182; Sales/TA=
 0.788


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Vicentiu Covrig                                    FIN352
        Obtaining Estimates of Earnings
  nExpected EPS is of the most value
  nStock price is a function of future earnings and
   the P/E ratio
      - Investors estimate expected growth in dividends or
        earnings by using quarterly and annual EPS
        forecasts
  nEstimating internal growth rate
                       EPS1=EPS0(1+g)


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Vicentiu Covrig                          FIN352
        Estimating an Internal Growth Rate

  nFuture expected growth rate matters in
   estimating earnings, dividends
      - g =ROE  (1- Payout ratio)
      - Only reliable if company’s current ROE remains
        stable
      - Estimate is dependent on the data period
  nWhat matters is the future growth rate, not the
   historical growth rate


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Vicentiu Covrig                                     FIN352
                  Forecasts of EPS
  nSecurity analysts’ forecast of earnings
      - Consensus forecast superior to individual
  nTime series forecast
      - Use historical data to make earnings forecasts
  nEvidence favors analysts over statistical
   models in predicting what actual reported
   earnings will be
      - Analysts are still frequently wrong



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Vicentiu Covrig                                     FIN352
                  Earnings Surprises
  nWhat is the role of expectations in selecting
   stocks?
      - Old information will be incorporated into stock
        prices if market is efficient
      - Unexpected information implies revision
  nStock prices affected by
      - Level and growth in earnings
      - Market’s expectation of earnings


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Vicentiu Covrig                                         FIN352
           Using Earnings Estimates
  n The surprise element in earnings reports is what really
    matters
  n There is a lag in adjustment of stock prices to earnings
    surprises
  n One earnings surprise leads to another
      - Watch revisions in analyst estimates
  n Stocks with revisions of 5% or more -up or down - often
    show above or below-average performance




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Vicentiu Covrig                                  FIN352
                   The P/E Ratio
  nMeasures how much investors currently are
   willing to pay per dollar of earnings
      - Summary evaluation of firm’s prospects
      - A relative price measure of a stock
  nA function of expected dividend payout ratio,
   required rate of return, expected growth rate in
   dividends



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Vicentiu Covrig                                    FIN352
              Dividend Payout Ratio
  nDividend levels usually maintained
      - Decreased only if no other alternative
      - Not increased unless can be supported
      - Adjust with a lag to earnings
  nThe higher the expected payout ratio, the
   higher the P/E ratio
      - Growth rate will probably decline, adversely
        affecting the P/E ratio


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Vicentiu Covrig                                  FIN352
            Required Rate of Return
  nA function of riskless rate and risk premium
                    k = RF + Risk premium
  nConstant growth version of dividend discount
   model can be rearranged so that
                        k = (D1/P0) +g
      - Growth forecasts are readily available




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Vicentiu Covrig                                FIN352
            Required Rate of Return
  nRisk premium for a stock a composite of
   business, financial, and other risks
  nIf the risk premium rises (falls), then k will rise
   (fall) and P0 will fall (rise)
  nIf RF rises (falls), then k will rise (fall) and P0
   will fall (rise)
  nDiscount rates and P/E ratios move inversely
   to each other

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Vicentiu Covrig                                      FIN352
              Expected Growth Rate
  nFunction of return on equity and the retention
   rate
                 g = ROE  (1- Payout ratio)
      - The higher the g, the higher the P/E ratio
  nPEG ratio: P/E ratio divided by g
      - Relates confidence that investors have in expected
        growth to recent growth
      - Fair valuation implies PEG ratio = 1
         uPEG ratio < 1 implies stock undervalued

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Vicentiu Covrig                                                         FIN352
                       Learning objectives
Know the Dividend Discount Model
Know the Constant Growth Model
Know the Discounted model with two growth rates
Know the discounted cash flow approach
Know the P/E model

End of chapter questions 15.1 to 10.5, 10.14;All four demonstration problems;
Problems 10.1 to 10.4




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