Financial Statement Analysis and Security Valuation

McGraw-Hill/Irwin© The McGraw-Hill Companies, Inc., 2003 All rights reserved.12-1Intro-Accounting AnalysisIntro-Accounting AnalysisMcGraw-Hill/Irwin© The McGraw-Hill Companies, Inc., 2003 All rights reserved.12-3Accounting Quality•Narrow definition: To what extent does the accounting represent underlying business reality?Trying to understand accounting distortionsWhen distortions are large, accounting analysis is very beneficial•Broader Definition: Narrow definition + Sustainability-To what extent do earnings map to future profitability”? Trying to separate core operating (non-operating) earnings from “unusual” earningsMcGraw-Hill/Irwin© The McGraw-Hill Companies, Inc., 2003 All rights reserved.12-4Accounting #s and Economic RealitySources of noise and bias•Accounting rules --rules can prevent management from telling the story they want to tell because of their restrictive nature•Forecast errors arise because of complexity of businesspredictability of firm’s environmentunforeseen economy wide events•Accounting choicesMcGraw-Hill/Irwin© The McGraw-Hill Companies, Inc., 2003 All rights reserved.12-5Doing Accounting Analysis•Identify key accounting policies•Assess Accounting Flexiblity•Evaluate Accounting Strategy•Evaluate the quality of disclosures•Identify Red Flags•Undo Accounting DistortionsMcGraw-Hill/Irwin© The McGraw-Hill Companies, Inc., 2003 All rights reserved.12-6Identifying Key Accounting Policies (Step 1)•Analysis requires the identification of key value-drivers i.e. important in explaining the success of the firm-Volatile and can change quickly-A change is unpredictable-Is significant enough that prompt action is required-Can be measured either directly or by surrogateMcGraw-Hill/Irwin© The McGraw-Hill Companies, Inc., 2003 All rights reserved.12-7Possible Key Variables•Bookings•Back orders•Market share•Key account orders•The analyst has to identify the accounting measures that capture these constructsMcGraw-Hill/Irwin© The McGraw-Hill Companies, Inc., 2003 All rights reserved.12-8Examples of Industry Key Variables•Airline Paid seats/capacity Fuel •Electrical utilityKWH sold•Hospital Beds occupied/available beds•HotelBeds occupied/available beds•MagazineRenewals/subscriptions expired•Railroad Carloadings•Restaurant Labor cost/revenue•Raw food cost/revenue•Retail StoreGross margin by departmentMcGraw-Hill/Irwin© The McGraw-Hill Companies, Inc., 2003 All rights reserved.12-9Assess Accounting Flexiblity (Step 2)•Some firms have little flexibility e.g. utilities•All can make some choicesMcGraw-Hill/Irwin© The McGraw-Hill Companies, Inc., 2003 All rights reserved.12-10Evaluate Accounting Strategies (Step 3)•Compare to the industry•Incentives for reporting in one direction or the other•Have policies changed?•Have the firms policies been realistic in the past?•Does the firm appear willing to expend resources to achieve an accounting objective that is not economic based?McGraw-Hill/Irwin© The McGraw-Hill Companies, Inc., 2003 All rights reserved.12-11Evaluate Quality of Disclosures (Step 4)•Can you identify business strategy from disclosures (Pres Letter)•Do footnotes explain key accounting policies --deviations from industry, accounting changes•Is current performance adequately explained•Does the firm provide you with a means of identifying performance with respect to key indicators•Bad news•Segment disclosures?McGraw-Hill/Irwin© The McGraw-Hill Companies, Inc., 2003 All rights reserved.12-12Identify Potential Red Flags (Step 5) -1•Unexplained accounting changesSwitch from accelerated to st. line dep (Kaplan)Switch to LIFO (Brown)•Unexpected transactions which boost profit (Debt swaps investigated by Hand, for example)McGraw-Hill/Irwin© The McGraw-Hill Companies, Inc., 2003 All rights reserved.12-13Identify Potential Red Flags (Step 5) -2Unusual increases in accounts receivable•Firms having trouble selling products often ease credit terms•Could also suggest earnings manipulationMcGraw-Hill/Irwin© The McGraw-Hill Companies, Inc., 2003 All rights reserved.12-14Identify Potential Red Flags (Step 5) -3Unusual increases in inventories•Suggest difficulties in generating sales•May suggest slow or obselete items that are to be written off later•Increase current earnings at the expense of future earnings (Overhead spread)McGraw-Hill/Irwin© The McGraw-Hill Companies, Inc., 2003 All rights reserved.12-15Identify Potential Red Flags (Step 5) -4•Increasing gap between earnings and cash flow from operationsA companies operating cycle is pretty much from cash to cash bulges may suggest some form of management•Increasing gap between reported inome and tax incomeAn increase may suggests that a firm has become agressive with its accountingMcGraw-Hill/Irwin© The McGraw-Hill Companies, Inc., 2003 All rights reserved.12-16Identify Potential Red Flags (Step 5) -5•A tendency to use financing mechanisms like R&D partnerships, sale of receivables with recourseGives management chance to play with the accounting•Unexpected large asset write-offs•Large Fourth-quarter write-offs•Qualified audit opinions•Related party transactionsMcGraw-Hill/Irwin© The McGraw-Hill Companies, Inc., 2003 All rights reserved.12-17Undo Distortions (Step 6)•Cash flow as an alternative•FootnotesMcGraw-Hill/Irwin© The McGraw-Hill Companies, Inc., 2003 All rights reserved.12-18Accounting Myths:•“Conservative” accounting is “good” accounting•Unusual Accounting is questionable•“Professional Judgement” is questionable. McGraw-Hill/Irwin© The McGraw-Hill Companies, Inc., 2003 All rights reserved.12-19Sustainability•Separating Core and Non-Core Earnings ComponentsMcGraw-Hill/Irwin© The McGraw-Hill Companies, Inc., 2003 All rights reserved.12-20Analyzing Change in ROCE: The Scheme ROCE RNOA in Financing SPREAD FLEV Level 1 NOASales from OI Core NOAItemsOther Core NOAItems Unusual = [RNOANBC] Core Sales PM ATO Level 2 Core Sales PM x ATO ATO x Core Core NBC Unusual Sales PM Financing Items Level 3 in Core Sales in ATO Drivers in Core in Unusual in Core in Unusual in NFO PM Drivers Other Income Item NBC Drivers Components Components Components Components McGraw-Hill/Irwin© The McGraw-Hill Companies, Inc., 2003 All rights reserved.12-21Analysis of Changes in ROCE1.Analyze Changes in Profitability of Operations2.Analyze the Effects of Changes in FinancingSPREAD] x [FLEV RNOA ROCE(1)(2)McGraw-Hill/Irwin© The McGraw-Hill Companies, Inc., 2003 All rights reserved.12-22Explaining the Changes in Operational ProfitabilityExplaining RNOA1.Distinguish coreand transitorycomponentsCore OIis persistent income from core businessUIis unusual items that are non-recurring, sometimes called transitory items.All items are after taxNOAUI OIOther Core Sales from OI Core NOAUI NOAOI Core RNOA NOANOAMcGraw-Hill/Irwin© The McGraw-Hill Companies, Inc., 2003 All rights reserved.12-23Explaining Changes in Operational Profitability (cont’d.)2.Distinguish margin and turnover drivers of core profitswhere,NOAUI NOAOIOther Core ATO x PM Sales Core NOAUI NOAOIOther Core NOASales from OI Core RNOA SalesSales from OI Core PM Sales CoreMcGraw-Hill/Irwin© The McGraw-Hill Companies, Inc., 2003 All rights reserved.12-24Explaining Changes in Operational Profitability (cont’d.)3.Explain changes in profit margins and asset turnoversExplain (i) by looking at profit margin driversGM (by segment)Selling Expenses /SalesAdministrative Expenses /SalesR&D /SalesPay particular attention to GM: per unit sales prices, production costs…Explain (ii) by looking at turnoversAccounts receivables turnoverInventory turnoverPPE turnoverAccounts payable turnoverOperating liability turnoverAlsoLook at operating asset composition ratiosLook at operating liabilities composition ratiosLook at OLLEVMcGraw-Hill/Irwin© The McGraw-Hill Companies, Inc., 2003 All rights reserved.12-25Reformulating Income Statements to Identify Core and Unusual Items Core Operating Income Core sales revenue Core cost of sales = Core gross margin Core operating expenses = Core operating income from sales before tax Tax on core operating income from sales + Tax as reported + Tax benefit from net financial expenses Tax allocated to core other operating income Tax allocated to unusual items = Core operating income from sales + Core other operating income +Equity income in subsidiaries +Earnings on pension assets +Other income not from sales Tax on core other income = Core operating income Reformulated Operating Income Statement: Core and Unusual Items Unusual Items Special charges Special liability accruals Nonrecurring items Asset write-downs Changes in estimates Start-up costs expensed Profits and losses from asset sales Restructuring charges Profits and losses from discontinued operations Extraordinary operating items Accounting changes + Dividends from subsidiaries (with less than 20% ownership) Unrealized gains and losses on equity investments + Gains from share issues in subsidiaries Currency gains and losses Derivative gains and losses (operations) Tax allocated to unusual items = Comprehensive Operating Income McGraw-Hill/Irwin© The McGraw-Hill Companies, Inc., 2003 All rights reserved.12-26To Analyze Sustainable Earnings, Analyze R&D(In millions of dollars) 1998 1997 1996 Net sales 12,478 11,883 11,013 Cost of products sold 5,394 5,045 4,732 Research and development 1,222 1,302 1,205 Selling, general and administrative 2,744 2,685 2,459 Total operating expenses 9,360 9,032 8,396 Operating earnings (before tax) 3,118 2,851 2,617 Sales growth rate 5.0% 7.9% 10.0% R&D/Sales 9.8% 11.0% 10.9% Analysis of R&D: Abbott Laboratories Abbott Laboratories sales growth rates are declining. R&D expenditures are persistent and reasonably flat, but are declining as a percentage of sales. The analyst views R&D expenses as core expenses, but sees the decline in R&D as a percentage of sales as a red flag. Will R&D decline further as a percentage of sales? Is research becoming less successful in producing new products? Is the decline in the sales growth rate due to a failure to increase expenditure on R&D? Did the firm reduce R&D in 1999 to increase earnings that otherwise would be lower because of the slower sales growth? If the answer to the last question is yes, the reduction in R&D may be transitory, but the analyst has to ask whether the decrease in R&D will damage future sales. McGraw-Hill/Irwin© The McGraw-Hill Companies, Inc., 2003 All rights reserved.12-27To Analyze Sustainable Earnings, Analyze Marketing Expenditures (In millions of dollars) 1998 1997 1996 Net operating revenues 18,813 18,868 18,673 Cost of goods sold 5,562 6,015 6,738 Gross profit 13,251 12,853 11,935 Selling, administrative and general 8,284 7,852 8,020 Operating income (before tax) 4,967 5,001 3,915 Advertising expenses 1,597 1,576 1,441 Advertising expenses/Sales 8.5% 8.4% 7.7% The Analysis of Advertising Costs: Coca-Cola Coke's income statement is very aggregated, with only two operating expense items. Advertising expenses are included in selling, administrative and general expenses but are detailed in footnotes. Advertising expenses are a reasonably constant percentage of sales so the analyst might use an advertising-to-sales ratio of 8.5% to forecast future advertising. As with R&D, the analyst must be sensitive to any drop or increase in the advertising-to-sales ratio. Is the change transitory? Is the firm temporarily reducing advertising to increase profits in the short-run at the expense of the long-run? McGraw-Hill/Irwin© The McGraw-Hill Companies, Inc., 2003 All rights reserved.12-28To Analyze Sustainable Earnings, Analyze Pension CostsComponents of Pension Expense:1.Service Cost2.Interest Cost3.Expected Return on Plan Assets4.Amortization of Prior Service Cost5.Amortization of Transaction Asset or Liability (before 2000)6.Changes in Actuarial Estimates (accrual gains and losses)_____________________________________________________________________ International Business Machines (IBM) Components of pension expense, 1999-2001 (In millions of dollars) 2001 2000 1999 Service cost 1,042 1,008 1,041 Interest cost 3,838 3,787 3,686 Expected return on plan assets (6,264) (5,944) (5,400) Amortization of transition asset (150) (151) (151) Authorization of prior service cost 108 55 4 Actuarial losses (gains) (24) 19 21 Net pension expense (1,450) (1,226) (799) McGraw-Hill/Irwin© The McGraw-Hill Companies, Inc., 2003 All rights reserved.12-29Watch for the Expected Rate of Return on Pension Plan Assets•In the 1980s, firms were using expected rates of return of about 7%•In the 1990s, firms were using expected rates of returns of 10-10½%•Applying a high rate of return to bubble asset prices produces bubble earnings•Pricing on the basis of bubble prices perpetuates the bubbleThe Pension Pyramid SchemeMcGraw-Hill/Irwin© The McGraw-Hill Companies, Inc., 2003 All rights reserved.12-30Watch for Gains of Pension Fund Assets•General Electric’s expected return on plan assets was $3,024 million in 1998 (22.4% earnings before tax) against a service cost of $625 million. Its net pension expense was a gain of $1,016 million.•IBM reported an expected return on plan assets of $6,264 million in 2001 (56.0% of operating income before tax).McGraw-Hill/Irwin© The McGraw-Hill Companies, Inc., 2003 All rights reserved.12-31Watch Gains and Losses on Sales of SharesIntelIn its report for its third quarter for 1999, Intel reported net income of $1,458 million, with no indication of unusual items. Its cash flow statement, however, reported $556 million in gains on sales of investments, along with a $161 million loss on retirements of plant, as add backs to net income to calculate cash from operations.Delta Air LinesDelta reported operating income (before tax) of $350 million for its September quarter in 1999. However, notes to the report indicated that these earnings included pre-tax gains of $252 million from selling its interest in Singapore Airlines and Priceline.com.IBMIBM reported before-tax operating income of $4,085 for its June, 1999 quarter. However, footnotes revealed that this income included a $3,430 million gain from the sale of IBM's Global Network to AT&T. This gain reduced selling, general and administrative expenses in the income statement!McGraw-Hill/Irwin© The McGraw-Hill Companies, Inc., 2003 All rights reserved.12-32Watch for Bleed Backs of Restructuring and Merger ChangesIBM: Creating earnings with restructuring chargesYear19911992199319941995199619971998billions of $3.711.68.9(2.8)(2.1)(1.5)(0.5)(0.4)McGraw-Hill/Irwin© The McGraw-Hill Companies, Inc., 2003 All rights reserved.12-33Miscellaneous Check List•Changes in estimatesBad debt allowancesDeferred revenue and cookie jar accountsWarranty allowancesResidual values for leases•Income TaxesOne-time or expiring creditsValuation allowances for deferred tax assets•Investigate “other income”McGraw-Hill/Irwin© The McGraw-Hill Companies, Inc., 2003 All rights reserved.12-34Analyzing Operating LeverageOperating Leverageis the proportion of total costs that are fixed versus variableSalesCosts Fixed -SalesMarginon Contributi SalesCosts Fixed -Cost Variable -Sales PM SalesThe first component here is called the contribution margin ratioSalesMarginon Contributi SalesCosts Variable-1 RatioMargin on ContributiThis ratio measures the change in income from a change in one dollar of salesMcGraw-Hill/Irwin© The McGraw-Hill Companies, Inc., 2003 All rights reserved.12-35Operating Leverage MeasuresOperating Leverage is sometimes calculated as the ratio of fixed costs to variable costsAnother measure is:Applying this measure to core operations:MarginProfit RatioMargin on Contributi Income OperatingMarginon Contributi OLEVSales Corein Change % x OLEV OI Corein Change %McGraw-Hill/Irwin© The McGraw-Hill Companies, Inc., 2003 All rights reserved.12-36Analysis of Effect of Changes in FinancingSPREAD] x [FLEV RNOA ROCEEffect of FinancingChange in ROCE=Change in RNOAChange due to change in financial leverageChange due to change in spread at previous level of financial leverage++11011ΔROCE = ΔRNOA + ΔSPREAD x FLEV + SPREADx ΔFLEV(i)Effect of change in operating profitability(ii)Effect of change in spread(iii)Effect of change in leverageMcGraw-Hill/Irwin© The McGraw-Hill Companies, Inc., 2003 All rights reserved.12-37Explaining Changes in the SPREADSPREAD = RNOA –NBCRNOA has been explainedExplain Change in NBC:Distinguish core and unusual borrowing costCore financing expensesChange in interest rates (risk free and risk premium)Change in tax rates (and shield)Substitution of preferred for debt financingUnusual financing expensesTax effect from unusually high or low taxes (operating losses)Interest income from tax refunds of prior yearsGains and losses on financial itemsNFOexp. financing Unusual NFOexp. financing Core NBCMcGraw-Hill/Irwin© The McGraw-Hill Companies, Inc., 2003 All rights reserved.12-38A Rough Approximation•Some observationsThe change in leverage effect (iii) is generally minorThe change in borrowing costs is generally small (then, Spread is largely determined by RNOA)The RNOA effect (i) is generally the largest•So, if FLEV and NBC are small, a useful approximation isΔROCE = ΔRNOA x 1 + Average FLEV