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 EIC 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
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
Three components of return on equity:
 Net Margin = Net Income / Sales. The higher
a company’s profit margin the better.
 Asset Turnover = Sales / Total Assets. The
higher the number the better.
 Leverage Factor = Total Assets / SEquity. The
higher the number, the more debt the
company has.

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
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)
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
–

Time series forecast
–

Consensus forecast superior to individual
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 is already incorporated into
stock prices (market is efficient)
Unexpected information implies revision
Stock prices affected by
–
–
Level and growth in earnings
Market’s expectation of earnings
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


www.netadvantage.standardpoor.com
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
40100
43600
76800
75300
101300
5300
7500
53200
52600
79000
0
0
36300
53700
73100
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
88900
91500
100100
107700
132800
0
0
0
0
0
88900
91500
100100
107700
132800
Depreciation/Amortization.
..
Interest
Expense............
Research /
Exploration......
Other
Expense...............
Earnings BEFORE Extra.
Items
Extraordinary
Items.........
Income AFTER Extra. Items
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
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
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%
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
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