Chapter 17
Company Analysis
Learning Objectives
• Define fundamental analysis at the company
level.
• Explain the accounting aspects of a
company’s earnings.
• Describe the importance of EPS forecasts.
• Estimate the P/E ratio of a company.
• Use the beta coefficient to estimate the risk of
a stock.
Fundamental Analysis
• Last step in top-down approach is individual
company analysis
• Goal: estimate share’s intrinsic value

Constant growth version of dividend discount
model
D1
Intrinsic value  P̂0 
k -g
 Value justified by fundamentals
Multiple Growth Rate
•
•
•
•
•
Y1-2=8%
Y3-4=6%
Y 5 → 3.5% forever
D5 =3.50; RR=12%
P0=?
Fundamental Analysis
• Earnings multiple could also be used
P0 = estimated EPS  justified P/E ratio
• Stock is under- (over-) valued if intrinsic value
is larger (smaller) than current market price
• Focus on earnings and P/E ratio


Dividends paid from earnings
Close correlation between earnings and stock
price changes
Accounting Aspects of Earnings
• How is EPS derived and what does EPS
represent?
• Financial statements provide majority of
financial information about firms
• Analysis implies comparison over time or with
other firms in the same industry
• Focus on how statements used, not made
Basic Financial Statements
• Balance Sheet


Items listed in order of liquidity (assets) or in
order of payment (liabilities)
Assets
•
Cash vs. non-cash assets

•
•
Non-cash assets may be worth more or less than the
amount carried on the books
Depreciation methods for fixed assets
Inventory evaluation choices
Basic Financial Statements
• Balance Sheet

Liabilities
•

Equity
•
•
•

Fixed claims against the firm
Residual claims
Adjusts when the value of assets change
Linked to Income Statement
“Snapshot” at one point in time
Basic Financial Statements
• Income Statement
Sales or revenues
- Product costs
Gross profit
- Period Costs
EBIT
- Interest
EBT
EBT
- Taxes
Net Income available to
owners
- Dividends
Addition to Retained
Earnings
• EPS and DPS
Basic Financial Statements
• Earnings per share
EPS = Net Income/average number of shares
outstanding

Net Income before adjustments in accounting
treatment or one-time events
• Certifying statements

Auditors do not guarantee the accuracy of
earnings, but only that statements are a fair
financial representation
Problems with Reported Earnings
• EPS 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
Analyzing a Company’s
Profitability
• Important to determine whether a company’s
profitability is increasing or decreasing and
why
• Return on equity (ROE) emphasized because
it is a key component in finding earnings and
dividend growth
EPS = ROE  Book value per share
DuPont Analysis
• Share prices depend partly on ROE
• Management can influence ROE
• Decomposing ROE into its components
allows analysts to identify adverse impacts on
ROE and to predict future trends
• Highlights expense control, asset utilization,
and debt utilization
DuPont Analysis
• ROE depends on the product of:





Profit margin on sales: EBIT/Sales
Total asset turnover: Sales/Total Assets
Interest burden: Pre-tax Income/EBIT
Tax burden: Net Income/Pre-tax Income
Financial leverage: Total Assets/Equity
• ROE = EBIT efficiency  Asset turnover 
Interest burden  Tax burden  Leverage
Obtaining Estimates of Earnings
• Expected EPS is of the most value
• Stock 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
• Estimating internal growth rate

EPS1 = EPS0(1+g)
Estimating an Internal Growth Rate
• Future 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
• What matters is the future growth rate, not the
historical growth rate
Forecasts of EPS
• Security analysts’ forecasts of earnings

Consensus forecast superior to individual
• Time series forecast

Use historical data to make earnings forecasts
• Evidence favours analysts over statistical
models in predicting what actual reported
earnings will be

Analysts are still frequently wrong
Earnings Surprises
• What is the role of expectations in selecting
stocks?


Old information will be incorporated into stock
prices if market is efficient
Unexpected information implies revision
• Stock prices affected by


Level and growth in earnings
Market’s expectation of earnings
Earnings Game
• Analysts attempt to guess earnings
• Company provides “guidance” as to what it
thinks earnings will be
• “Guidance number” plays a major role in the
consensus estimate
• Variance of the actual reported earnings has
constituted the earnings surprise
• Earning surprises are guided by companies in
the form of earnings preannouncements
Using Earnings Estimates
• The surprise element in earnings reports is
what really matters
• There is a lag in adjustment of stock prices to
earnings surprises
• One earnings surprise leads to another

Watch revisions in analyst estimates
• Stocks with revisions of 5% or more – up or
down – often show above or below-average
performance
The P/E Ratio
• Measures 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
• A function of expected dividend payout ratio,
required rate of return, expected growth rate
in dividends
P/E  (D1/E1 ) /(k  g)
Dividend Payout Ratio
• Dividend levels usually maintained



Decreased only if no other alternative
Not increased unless it can be supported
Adjust with a lag to earnings
• In theory, the higher the expected payout ratio,
the higher the P/E ratio

However, growth rate will probably decline,
adversely affecting the P/E ratio
Required Rate of Return
• A function of the riskless rate of return and a risk
premium
k = RF + RP
• Constant growth version of dividend discount
model can be rearranged so that

k = (D1/P0) + g
Growth forecasts are readily available
Required Rate of Return
• Risk premium for a stock regarded as a
composite of business, financial, and other
risks
• If the risk premium rises (falls), then k will rise
(fall) and P0 will fall (rise)
• If RF rises (falls), then k will rise (fall) and P0
will fall (rise)
• Discount rates and P/E ratios move inversely
to each other
Expected Growth Rate
• Function of return on equity and the retention
rate

g = ROE  (1 – Payout ratio)
The higher the g, the higher the P/E ratio
• P/E ratio depends on


Confidence that investors have in expected
growth
Reasons for earnings growth
Fundamental Security Analysis in
Practice
• Regardless of detail and complexity, analysts
and investors seek an estimate of earnings
and a justified P/E ratio to determine intrinsic
value
• Security analysis always involves predicting
an uncertain future; mistakes will be made
and outlooks will differ
Appendix 17-A Financial Ratio Analysis
• Used to examine a firm’s financial performance
• A ratio on its own has limited value – to be
useful, one must examine:


Trends
Ratios of comparable firms or industry
benchmarks
Appendix 17-A Financial Ratio Analysis
•
Five types of ratios used to analyze a firm:
1. Liquidity: ability to generate cash and meet
2.
3.
4.
5.
short-term debt
Asset Management: ability to effectively
manage its assets to generate sales and
profits
Debt Management: ability to effectively
handle its debt
Profitability: ability to generate profits
Value: market value versus accounting
values
Example
STATEMENT OF INCOME:
2000
2001
2002
2003
2004
Total Revenue...............
1426000
2143300
2892300
3058600
4448000
Cost of Sales...............
1238700
1931400
2559400
2699200
4005800
Depreciation/Amortization...
40100
43600
76800
75300
101300
Interest Expense............
5300
7500
53200
52600
79000
Research / Exploration......
0
0
36300
53700
73100
Other Expense...............
33100
43600
46100
56400
37900
Unusual Items...............
0
0
0
0
0
Pre-Tax Income..............
108800
117200
120500
121400
150900
Income Tax..................
-19900
-25700
-20400
-13700
-18100
Earnings BEFORE Extra. Items
88900
91500
100100
107700
132800
Extraordinary Items.........
0
0
0
0
0
88900
91500
100100
107700
132800
3500
3800
4000
2900
2600
85400
87700
96100
104800
130200
0.68
0.68
0.706
0.727
0.85
Common Shares - Year End (1000s)
125658
131398
141443
152337
154280
Common Shares - Average (1000s)
125536
128932
136073
144121
153237
14700
22000
28700
27400
32200
6.69
7.63
7.88
17.13
11.63
Income AFTER Extra. Items
Dividends - Preferred Shares
Income Available to Common Shares
Earnings /Share.............
Dividends - Common Shares...
Market Price per Share (Close)
ASSETS:
2000
2001
2002
2003
2004
Cash & Equivalent...........
150000
84000
87500
179200
235100
Accounts Receivable.........
174000
428800
413700
360100
380400
Inventory...................
220200
583500
992700
1215700
1803100
Marketable Securities.......
0
0
0
0
0
Other.......................
0
0
0
0
0
<TOTAL> Current Assets......
544200
1096300
1493900
1755000
2418600
Fixed Assets - Gross
1372700
1650500
1956200
2277600
2914600
less: Accumulated Depreciation
-766200
-809800
-886600
-961900
-1063200
Fixed Assets - Net..........
606500
840700
1069600
1315700
1851400
<TOTAL> Assets..............
1150700
1937000
2563500
3070700
4270000
1997
1998
1999
2000
2001
Bank Loans & Equivalent.....
147800
346800
537400
620800
828500
Accounts Payable............
347200
684400
831800
901400
1380900
Current Portion of L-T Debt.
5400
30000
20800
19300
56400
500400
1061200
1390000
1541500
2265800
Long-Term Debt & Debentures.
83500
211000
425500
586600
963700
Deferred Taxes & Credits....
41600
42000
53800
43300
56400
Equity: Preferred Stock.....
158300
157700
37400
35700
34100
Common Stock........
190600
223100
347400
476800
465200
Retained Earnings...
176300
242000
309400
386800
484800
Total Equity........
525200
622800
694200
899300
984100
<TOTAL> Liabilities + Equity
1150700
1937000
2563500
3070700
4270000
LIABILITIES AND EQUITY:
<TOTAL> Current
Liabilities........
XYZ COMPANY
FINANCIAL RATIOS:
2000
2001
2002
2003
2004
Current Ratio
1.09
1.03
1.07
1.14
1.07
Acid Test (Quick) Ratio
0.65
0.48
0.36
0.35
0.27
44.54
73.02
52.21
42.97
31.22
Inventory Turnover
5.62
3.31
2.58
2.22
2.22
Total Asset Turnover
1.24
1.11
1.13
1.00
1.04
Debt Ratio
0.51
0.66
0.71
0.69
0.76
Debt-to-Equity Ratio
1.11
2.04
2.62
2.37
3.28
Equity Multiplier
2.19
3.11
3.69
3.41
4.34
TIE (or Interest Coverage)
21.53
16.63
3.27
3.31
2.91
Net Income Margin
6.23%
4.27%
3.46%
3.52%
2.99%
Return on Assets (ROA)
7.73%
4.72%
3.90%
3.51%
3.11%
Return on Equity (ROE)
16.93%
14.69%
14.42%
11.98%
13.49%
P/E Ratio
9.84
11.21
11.15
23.56
13.68
M/B Ratio
2.29
2.15
1.70
3.02
1.89
1.75%
2.24%
2.68%
1.11%
1.81%
0.17
0.25
0.30
0.26
0.25
ACP (days)
Dividend Yield
Dividend Payout Ratio
INDUSTRY AVERAGES
FINANCIAL RATIOS:
2000
2001
2002
2003
2004
Current Ratio
2.12
2.85
2.25
2.01
1.69
Acid Test (Quick) Ratio
1.21
1.97
1.36
1.24
1.09
35.20
34.09
44.50
45.90
46.90
Inventory Turnover
7.78
8.20
7.68
8.52
8.16
Total Asset Turnover
1.78
1.43
1.37
1.26
1.23
Debt Ratio
0.23
0.33
0.32
0.29
0.32
Debt-to-Equity Ratio
0.36
0.61
0.56
0.49
0.55
Equity Multiplier
1.57
1.82
1.78
1.70
1.74
TIE (or Interest Coverage)
34.41
42.19
5.95
5.53
8.61
Net Income Margin
8.47%
6.03%
4.34%
4.19%
5.68%
Return on Assets (ROA)
15.08%
8.64%
5.95%
5.27%
7.01%
Return on Equity (ROE)
23.68%
15.72%
10.59%
8.96%
12.20%
P/E Ratio
6.42
9.08
12.13
22.38
15.53
M/B Ratio
1.51
1.42
1.28
2.00
1.88
1.71%
1.73%
2.86%
2.67%
2.08%
0.13
0.24
0.35
0.39
0.26
ACP (days)
Dividend Yield
Dividend Payout Ratio
A. Liquidity
1. Current Ratio
= Current assets / Current liabilities
For XYZ (2004):
= 2,418,600 / 2,265,800 = 1.07
2. Quick Ratio
= [CA – Inventory] / Current liabilities
For XYZ (2004)
= (2,418,600 – 1,803,100) / 2,265,800
= 0.27
B. Asset Management
3. Average Collection Period (ACP)
= Account Receivable / (Sales/365days)
For XYZ (2004):
= 380,400 / (4,448,000/365) = 31.22 days
Note:
A/R Turnover = Sales / Acct Receivable
= 365 / ACP
For XYZ (2004) = 365/31.22 days = 11.69 times
B. Asset Management (Cont’d)
4. Inventory Turnover
= Cost of goods / Inventory
or
= Net Sales / Inventory
For XYZ (2004) (using COGS):
= (4,005,800) /1,803,100
= 2.22 times
Days Inventory = Inventory / Daily COGS (or Sales)
= 365 / Inventory Turnover
For XYZ (2004) = 365/2.22 = 164.4 days
5. Total Asset Turnover
= Sales / TA
= 4,488,000 / 4,270,000
= 1.042
C. Debt Ratios
6. Debt Ratio = Total Debt / TA
= (2,265,800 + 963,700) / 4,270,000
= 0.756
TA = Debt + Equity
7. Debt-to-Equity = Total Debt / Total Equity
= (2,265,800 + 963,700) / 984,100
= 3.282
C. Debt Ratios (Cont’d)
8. Leverage Ratio (or Equity Multiplier)
= TA / Equity
= 4,270,000 / (984,100)
= 4.339
Higher values
More debt
9. TIE (or Interest Coverage)
= EBIT / Interest
= (150,900 + 79,000) / 79,000 = 2.91 times
D. Profitability
10.
ROE = NI / Equity
= 132,800 / 984,100 = 13.49%
11.
ROA = NI / TA
= 132,800 / 4,270,000 = 3.11%
12.
Net Income Margin = NI / Sales
= 132,800 / 4,448,000 = 2.99%
E. Value Ratios
13.
Dividends Payout = DPS / EPS or
= Common Dividends / Earnings Available to
Common Shareholders
= 32,200 / 130,200 = .2473 = 24.73%
14.
P/E = Market Price per Share / EPS
= 11.63 / 0.85 = 13.68
E. Value Ratios (Cont’d)
15.
Market-to-book (M/B) = Market price per share /
Book value per share
= 11.63 / [(984,100 – 34,100) / 154,280]
= 11.63 / 6.16 = 1.89
16.
Dividend Yield = DPS / Market price per share
= (32,200 / 153,237) / 11.63 = .21 / 11.63 =
1.81%
DuPont Analysis
NI
EBT
EBIT Sales
TA





EBT EBIT Sales
TA
Eqty
Tax
Burden
Interest
Burden
EBIT
Efficiency
TA
Turnover
Leverage
Ratio
NI / Sales = Net Income Margin
NI / TA = ROA
TA
 ROA 
Equity
Leverage Ratio = TA / Equity
NI
NI
Sales
TA



Equity
SALES
TA
EQUITY
Net Profit
Margin
Asset
Turnover
Leverage
Ratio
TA
ROE  ROA 
EQUITY
XYZ (2004)
• NI / EBT = 132,800 / 150,900 = .880
• EBT / EBIT = 150,900 / (150,900 + 79,000) =
150,900 / 229,900 = .656
• EBIT / Sales = 229,900 / 4,448,000 = .0517
• Sales / TA = 1.042 (previously calculated)
• TA / Equity = 4.339 (previously calculated)
• ROE = (.8800)(.6564)(.0517)(1.042)(4.339) = .1350
= 13.50%
• This differs from the 13.49% we calculated
previously due to rounding errors
XYZ (2004)
• NI / Sales = 0.0299 (previously calculated)
• Sales /TA = 1.042 (previously calculated)
• Calculate ROA = (.0299)(1.042) = .0311 = 3.11%
(equals the 3.11% previously calculated)
• TA / Equity = 4.339 (previously calculated)
• So, ROE = (.0299)(1.042)(4.339) = 13.52% (differs
from 13.49% previously calculated due to rounding
errors)
Liquidity
• Below average

Current and quick ratios of 1.07 and 0.27 are both
well below industry averages of 1.69 and 1.09
• Bad trend

Current ratio has been steady, but quick ratio has
deteriorated significantly
• Low and deteriorating quick ratio is due to high
levels of inventory
Asset Management
• Collections as measured by ACP is above average
(31 days versus 47 days) and is improving
• Inventory turnover is very low (2.3 versus industry
average of 8.2), and has been continually
deteriorating, and they maintain high inventory
levels
• TA turnover is below average, has been over the
period, and continues to deteriorate
Debt Management
• Debt levels have increased steadily and
coverage has deteriorated



Debt ratio is 0.76 (from 0.51 in 2000)
Debt-to-equity is 3.28 (from 1.11 in 2000)
Coverage is 2.91 (from 21.53 in 2000)
• Debt capacity and coverage are both below
average



Debt ratio is 0.76 versus 0.32 industry average
Debt-to-equity is 3.28 versus 0.55 industry
average
Coverage is 2.91 versus 8.61 industry average
Profitability
• Steady decline in net income margin, ROA, and
ROE over period
• Below industry averages, except for ROE

ROE is above average due to use of greater
leverage (as noted above)
DuPont Analysis
• XYZ (2004)

ROE = (NI/Sales) (Sales/TA) ((TA/Equity)
= (.0299)(1.042)(4.339) = 13.51%
• Industry averages (2004)
ROE = (NI/Sales) (Sales/TA) ((TA/Equity)
= (.0568)(1.23)(1.74) = 12.16%
• This analysis suggests that XYZ displays an above
average ROE due to its higher leverage factor, and
despite the fact it has below average profitability and
asset turnover

Value Ratios
• P/E and M/B ratios are close to average, which
is also the case for their dividend yields (Note: a
lower dividend yield implies a higher price)
• They have been close to, or slightly above
average over the entire period
• This suggests the market views XYZ as an
“average” company despite some of the
problems we have observed
Summary
• Below average and deteriorating in terms of liquidity,
inventory turnover, and debt management
• However, they are profitable, even if they are not up
to industry standards, and their profitability is
dwindling
• The market views XYZ as an “average” company
despite its problems
• XYZ will probably have to deal with its debt,
inventory and liquidity problems in order to maintain
an average valuation in the market
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