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Slide 3.14 Using Financial Statements
Ratios cannot be interpreted in isolation, but are rather to be
considered as comparative metrics – either across time or between
firms.
Lecture Tip: What is “EEBS”? Under the heading “A Wire Story We’d Like
to See,” those people at Fortune magazine have proposed a new
earnings metric: EEBS, or “Earnings Excluding Bad Stuff.” The
tongue-in-cheek article implies that, since Wall Street does not like
things that negatively impact earnings, firms should just report
earnings they would have made “if all this bad stuff hadn’t
happened” during the quarter. At first glance it sounds silly; on
the other hand, it may be the next logical step for those firms that
practice “income smoothing” and “earnings management.”
Lecture Tip: Here’s a tip for teaching about the interpretations of the PE
ratio, either in your discussion of ratios, or in your discussion of
stock market history. Consider the table of year-end PE ratios for
the S&P 500 (courtesy of the S&P web site computed as Index / as
reported EPS):
Year PE Year PE
1988 11.69 1996 19.13
1989 15.45 1997 24.43
1990 15.47 1998 32.60
1991 26.12 1999 30.50
1992 22.82 2000 26.41
1993 21.31 2001 46.50
1994 15.01 2002 31.89
1995 18.14 2003 22.81
The average PE ratio over the 16-year period is 23.77. But what is the
average over a subset through time?
Period Average PE
1988 – 92 18.31
1993 – 97 19.60
1998 – 2003 31.79
Is the increase in market PE a secular trend or a fluke? What does this imply
for traditional measures of “overvaluation” such as the market
PE? And if the benchmark market PE is higher than it used to be,
what does that suggest for the interpretation of company PEs?
Obviously, the high PE in the latest period was a cyclical value, as
subsequent years (particularly given the credit crisis of the late
2000s) have seen a drop to lower levels, even below the other time
period averages reported in the table above. In fact, even with the
market recovery following the credit crisis, the S&P500 PE ratio
as of June 2015 was 19.
Lecture Tip: A Wall Street Journal article suggested that accounting methods
and ratio analysis may require some rethinking in the “new era”
in which we seem to be living. Specifically, an article entitled
“Bulls Use Convoluted Measures to Justify View” from the April
20, 1998, issue notes that “By almost any standard measure of
stock value, Friday’s record closes leave large stocks trading at or
beyond history’s most extreme limits of valuation.” [Note to the
cautious reader: when the WSJ article was written, the DJIA was
at 9167.50; it went as high as 11,500 in early 2000, dropped to
about 7900 after the terrorist attacks on September 11, 2001, was
back to almost 10,400 following the election in early November
2004, and closed around 8,000 at the end of 2008. ]
In any event, the article notes that the bull market of the 1990s
was attributable in large part to nearly divine macroeconomic
conditions – low inflation, low interest rates, and increasing
productivity. Put another way, the traditional valuation
benchmarks – historical price-earnings ratios, market-to-book
ratios, and dividend yields, as well as the underlying accounting
data - require careful consideration.
Lecture Tip: There are the “official” earnings estimates, compiled by First
Call, and then there are the “unofficial” estimates or “whisper
numbers.” Money Daily, in November 1998 called whisper
numbers “unofficial, unsubstantiated and unattributed forecast[s]
derived from rumors, hints and often, innuendo.” Academic
studies suggest that whisper numbers (which are often
disseminated via the Internet) “are a better proxy for market
expectations and are more accurate than consensus numbers.”
(Purdue University professor Susan Watts, quoted in the same
Money Daily article.) Another common term on Wall Street is
“visibility.” This term refers to the ability of management and
analysts to forecast earnings for future quarters. The more
confident they are about their estimates, the more “visibility” that
exists. Of course, visibility was much better when the economy was
good. When the economy began to slow down, visibility vanished.
It ties back to “EEBS.” In a down economy, companies do not
want to predict bad earnings very far into the future, but they are
more than willing to project good earnings for an extended
number of quarters during a good economy.
Lecture Tip: Ask the students to consider how the market-to-book ratio could
be interpreted if you are considering the purchase of a company’s
stock. Some feel a ratio of less than one would be preferred since
the stock is selling below its book value. You can point out that the
market is evaluating the company’s future earnings power, while
the book value reflects the price at which stock had previously
been issued and the earnings that had been retained in the firm.
Valuation techniques concerning a company’s future earnings will
be explored in later chapters (as will capital market efficiency and
security valuation).
3.3 The DuPont Identity
.A A Closer Look at ROE
The DuPont Identity provides analysts with a way to break down ROE and
investigate what areas of the firm need improvement.
Slide 3.15 The DuPont Identity
ROE = (NI / total equity)
multiply by one (assets / assets) and rearrange
ROE = (NI / assets) (assets / total equity) = ROA*EM
multiply by one (sales / sales) and rearrange
ROE = (NI / sales) (sales / assets) (assets / total equity)
ROE = PM*TAT*EM
Slide 3.16 Using the DuPont Identity
These three ratios indicate that a firm’s return on equity depends
on its operating efficiency (profit margin), asset use efficiency
(total asset turnover) and financial leverage (equity multiplier).
Slide 3.17 Calculating the DuPont Identity
Lecture Tip: The development of financial statement analysis is
rooted in a manufacturing tradition, with the large industrial
corporation at its center. Many notions about financial statement
analysis grew out of a view of business in which specialized plant
and equipment are used to turn raw materials into finished goods
that are then sold on credit. This view was modified by the advent
of the large retail corporation, but the emphasis on balance sheet
assets (receivables, inventories, plant and equipment) and the
measures associated with them remain.
Because of this manufacturer/retailer tradition, much of the
conventional wisdom about statement analysis is inappropriate to
many of today’s business situations. This is even more true when
we consider the advent of the “dot.com’s.” Good examples of firms
that do not fit the traditional mold are the professional
organizations formed by doctors, consultants, attorneys, etc., or
other service companies such as television and radio stations and
colleges and universities. The most important assets for these firms
are the people, and they do not show up on the balance sheet.
Their liquidity does not come from current assets but from the
services provided. Financial statements will eventually evolve, but
it is important to understand where we are starting from.
B. Problems with Financial Statement Analysis
Slide 3.18 Potential Problems
-no underlying financial theory
-finding comparable firms
-what to do with conglomerates, multidivisional firms
-differences in accounting practices
-differences in capital structure
-seasonal variations, one-time events
Lecture Tip: While some investors use PE ratios as if they are universally
comparable, differences in generally accepted accounting
practices used to compute EPS make international comparisons
risky. For example, the conventional wisdom for many years was
that the high PE ratios of Japanese stocks was due in part to the
more conservative nature of Japanese accounting practices which
depressed reported earnings and increased PEs.
An interesting discussion of this issue appeared in the November 14, 1988,
Pensions and Investment Age. Gary Schieneman, Vice President –
International Equity Research with Prudential-Bache applied US
accounting standards to 25 Japanese firms in 17 industries and
found little evidence of a systematic downward bias in reported
earnings. But, Paul Aron, Vice-Chairman emeritus of Daiwa
Securities countered by suggesting that, after adjusting for
methodological problems, 75% of the firms in Mr. Schieneman’s
sample did underreport earnings. Regardless of who is correct, the
most telling aspect of the discussion is Mr. Schieneman’s comment
in summing up: “I don’t think earnings mean a whole lot in
Japan.”
Ethics Note: An interesting example of an additional problem
faced by professional analysts is demonstrated by the Trump-
Roffman case. In 1990, Marvin Roffman, an analyst at Janney
Montgomery Scott, Inc. stated in a Wall Street Journal article that,
on the basis of his examination of the financial data, he had
“severe reservations about the future” of the Trump Taj Mahal in
Atlantic City. In response, Donald Trump threatened to sue Janney
Montgomery Scott. Roffman wrote, and then retracted, a
public apology to Trump and was dismissed. He successfully sued and
received a large settlement. Nonetheless, his case illustrates the
dangers one faces as a practicing analyst. (For further details, see
the New York Times, June 6, 1991.)
Lecture Tip: The explosion of the Internet has placed financial information in
the hands of millions of individuals and has increased the speed
with which information is obtained by professionals. Many
companies now webcast their earnings conference calls. This
information used to only be directly available to analysts, who
then passed selected information on to their clients. There is also
more opportunity for false information to be spread quickly. An
excellent example is the case of Emulex and a phony press release.
On Friday, August 25, 2000, someone issued a press release
indicating that the CEO of Emulex was quitting and that quarterly
earnings would be restated from a profit to a loss. The stock price
immediately plunged 62 percent. Mark Jakob has been arrested for
releasing the phony press release. His motive was apparently to
cover substantial losses from a short position in Emulex. The
Internet and other financial news sources disseminated the
information from the press release much faster than would have
been possible in the past. This is an excellent opportunity to
introduce the subject of efficient markets. If information is more
readily available, it should be incorporated into the price more
quickly, thereby increasing market efficiency. There is a trade-off,
however. False information can also be incorporated very quickly,
so investors need to remember the old adage “you can’t believe
everything you read.”
3.4 Financial Models
Slide 3.19 Financial Models
Financial planning is based on the three areas of corporate finance that were
discussed in chapter one: capital budgeting decisions, capital structure
decisions, and working capital management.
.A A Simple Financial Planning Model
Slide 3.20 Financial Planning Ingredients
Sales Forecast – most other considerations depend upon the sales forecast, so
it is said to “drive” the model
Pro Forma Statements – the output summarizing different projections
Asset Requirements – investment needed to support sales growth
Financial Requirements – debt and dividend policies
The “Plug” – designated source(s) of external financing
Economic Assumptions – state of the economy, anticipated changes in interest
rates, inflation, etc.
.B The Percentage of Sales Approach
Slide 3.21 –
Slide 3.22 Percent of Sales Approach
Sales generate retained earnings (unless all income is paid out in dividends).
Retained earnings, plus external funds raised, support an increase
in assets. More assets lead to more sales, and the cycle starts again.
This simplified approach assumes that certain items are fixed and
other vary proportionally with sales. Once forecasted, you must
select a plug account that will be used to make the balance sheet
balance. This number generally reflects External Financing Needed
(EFN).
Lecture Tip: An interesting discussion can be started by asking the
question, “Does a company’s capacity level affect the percentage
of sales approach?”
Lecture Tip: In the first two chapters of the text, we have described “the
financing decision” in one of two ways: either in broad terms,
referring simply to the means by which funding is acquired to
accomplish our investment objectives, or specific terms, i.e.,
capital structure. At this point, the financing decision is
characterized in another way: as one aspect of the day-to-day
operations of the business. You may wish to take this opportunity
to set the stage for the material on working capital management to
be covered in subsequent chapters. Specifically, it can be helpful to
introduce the concept of “spontaneous” financing (financing that arises in the
normal course of business, requires little face-to-face negotiation
with the lender and is less likely to result in bankruptcy
proceedings in case of default). Students should be reminded that
while long-term financing decisions may have greater potential
impacts on firm value, they are made relatively infrequently. Short-
term investment and financing decisions are made continuously
and affect the daily cash flows of the business.
Slide 3.23 Percent of Sales and EFN
An alternative method for calculating EFN is to use a formula
approach, where we subtract expected increases in (spontaneous)
liabilities and equity from the expected increase in assets.
EFN =
3.6 External Financing and Growth
Slide 3.24 External Financing and Growth
All else equal, more growth means more external financing will be
needed.
Lecture Tip: You might point out that the relationship between firm
growth and external financing needs is of utmost importance to firms in
the early stages of their lives. Typically, these are firms that have
developed a new product or technology, are experiencing rapid sales
growth, have continuing capital needs, and must be extremely careful in
forecasting cash flows. Since many of these firms are relatively small
and/or new, their financing problems are often exacerbated by a lack of
access to the capital markets. As such, the “internal growth rate” and
“sustainable growth rate” concepts are of particular importance to
financial decision-makers.
.A EFN and Growth
Lecture Tip: For new firms, internal financing is often virtually zero,
particularly if the product or service being developed has not yet
been marketed to the public. External financing is, therefore, the
only significant source of funds and may come from venture
capitalists, banks, “angels,” or family and friends. Should you
)1(Sales) Projected(ΔSales
Sales
LiabSpon
Sales
Sales
Assets dPM
wish to digress a bit and discuss the concept of “angel investors,” who often
provide capital to start-ups before venture capitalists become
involved, you will find a good hands-on article in the April 1996
issue of Worth magazine. There are also plenty of online resources
that can shed light on this issue.
Assuming no spontaneous sources of funds, EFN equals the increase in total
assets less the addition to retained earnings.
Low growth firms will run a surplus that causes a decline in the debt-to-equity
ratio. As the growth rate increases, the surplus becomes a deficit,
and the firm will need external financing.
.B Financial Policy and Growth
Slide 3.25 The Internal Growth Rate
The Internal Growth Rate (IGR) is the growth rate the firm can maintain with
internal financing only.
IGR = (ROA*b) / [1 – ROA*b]
Slide 3.26 The Sustainable Growth Rate
The Sustainable Growth Rate (SGR) is the maximum growth rate a firm can
achieve without external equity financing, while maintaining a
constant debt-to-equity ratio.
SGR = (ROE*b) / [1 – ROE*b]
Lecture Tip: Some students will wonder why managers would wish to avoid
issuing equity to meet anticipated financing needs. This is a good
opportunity to bring in concepts from previous chapters
(stockholder/bondholder conflicts of interest and agency costs), as
well as to introduce topics to be covered in future chapters
(information asymmetry and signaling, flotation costs, high cost of
equity and corporate governance).
Slide 3.27 Determinants of Growth
Determinants of growth – From the DuPont identity, ROE can be viewed as
the product of profit margin, total asset turnover, and the equity
multiplier. Anything that increases ROE will increase the
sustainable growth rate as well. Therefore, the sustainable growth
rate depends on the following four factors:
Operating efficiency – profit margin
Asset use efficiency – total asset turnover
Financial leverage – equity multiplier
Dividend policy – retention ratio
Lecture Tip: Wanting sales or revenues to grow by X% per year as
a goal of the firm is properly understood as meaning: “All else
equal, we want sales to grow.” Here are some things to consider:
-Cutting margins might make sales grow – but is it good for the firm?
-Using more assets may make sales grow, but is this truly
increasing efficiency?
-Increasing financial leverage might pay for growth – but can
the firm survive?
-Cutting the dividend might pay for growth – but is it what stockholders
want?
.C A Note about Sustainable Growth Rate Calculations
The sustainable growth rate that we commonly see in other texts or
applications is ROE*b – why is it different? The formula that is
used throughout the text is based on an ROE that is computed
using ending balance sheet numbers for equity. The “simpler”
formula is appropriate only when the ROE is computed using
beginning equity balance sheet numbers.
3.7 Some Caveats Regarding Financial Planning Models
Slide 3.28 Some Caveats
The main problem is that the models are really accounting statement
generators rather than determinants of value. As we will see, value is
determined by cash flows, timing and risk; and these financial planning
models do not address any of these issues.
Slide 3.29 –
Slide 3.30 Quick Quiz
Appendix: Useful Financial Ratios
SHORT-TERM SOLVENCY RATIOS
Current ratio = Current assets ÷ Current liabilities
Quick ratio = (Current assets – Inventory) ÷ Current liabilities
Cash ratio = Cash ÷ Current liabilities
FINANCIAL LEVERAGE RATIOS
Total debt ratio = Total debt ÷ Total assets = (Total assets – Total equity) ÷ Total assets
Debt-equity ratio = Total debt ÷ Total equity
Equity multiplier = Total assets ÷ Total equity = 1 + debt-equity ratio
Times interest earned = Earnings before interest and taxes ÷ Interest
Cash coverage = (Earnings before interest and taxes + depreciation + amortization) ÷
Interest
TURNOVER RATIOS
Inventory turnover = Cost of goods sold ÷ Inventory
Days sales in inventory = 365 ÷ Inventory turnover
Receivables turnover = Sales ÷ Receivables
Days’ sales in receivables= 365 ÷ Receivables turnover
Total asset turnover = Sales ÷ Total assets
Days in inventory = Days in period ÷ Inventory turnover
PROFITABILITY MEASURES
Profit margin = Net income ÷ Sales
Return on assets = Net income ÷ Total assets
Return on equity = Net income ÷ Total equity
EBITDA margin = EBITDA ÷ Sales
MARKET VALUE RATIOS
Price-to-earnings ratio = Market price per share ÷ Earnings per share
Market-to-book ratio = Market price per share ÷ Book value per share
Market capitalization = Market price per share x Shares Outstanding
Enterprise Value (EV) = Market capitalization + Market value of interest bearing debt –
cash
EV Multiple = EV ÷ EBITDA
