Economics 98 / 198
Fall 2007
Copyright 2007 Jason Lee

• Oct 31 versus Nov 31 lecture?
• Simulation Exercise - Money

• Trading Psychology
• Financial Statements introduction
– Income Statement
– Balance Sheet
– Cash Flow Statement
– Earning Season
• Ratio Analysis

Emotions severely impair your judgment in deciding whether to buy or sells tocks
HOPE
FEAR
GREED
PRIDE

• Emotions can wreak havoc on your results and decisions
• Need to take emotion out of investing
• Do this by developing a system with rules to follow with discipline

“Your biggest enemy, when trading, is within yourself. Success will only come when you learn to control your emotions”
- Edwin Lefevre

Accounting 101:
Financial Statements

• Public co. required to publish 10K and 10Q
– 10K = Annual financial reports
– 10Q = Quarterly financial reports
Income Statement
Balance Sheet
Statement of Cash Flows
• Why do we care about these reports?

• Shows how much a company earned or lost during that specific period
• Considered the most analyzed statement for investors
• Divulges into a company’s profitability
IS THE COMPANY MAKING PROFIT?

• Generally, 3 Major Parts
– Revenues
– Expenses
– Net Income
Income = Revenues - Expenses
• Earnings Per Share (EPS)
= Profits / Shares Outstanding
• Investors pay very close attention to profits (earnings) and revenue (sales)

• Summarizes company’s assets, liabilities, and shareholders’ equities at specific time
Assets = Liabilities + Shareholder’s Equity
• How do we analyze this statement?
• We use ratios and changes in trends to analyze the information

Assets
– Current Assets: life span of 1 year or less
– Non-Current assets
Liabilities
– Current Liabilities
– Non-current liabilities
Shareholder’s Equity
– Common / Preferred Stock
– Retained Earnings

• Shows how much money coming in (inflows) and going out (outflows)
– Cash flow from operations
– Cash flow from investing
– Cash flow from financing
• Shows if company having trouble with cash
– Profitable companies can struggle cash flows. Why?
• Cash is king! Pays for bills and funds operations!

• Companies release quarterly reports and annual reports
– “Financial Report Cards”
• Stock analysts issue earnings estimate
– Consensus earnings estimates
• Earnings surprise is a good thing
– Meeting / beating / missing expectations
– If below estimates, then stock usually head downwards fast!

• Actual earnings value is important, but so is the growth of these earnings
• Compare EPS / Revenue?
– Do we compare them to last quarter?
– Do we compare them to the same quarter last year?

EPS % Growth: Google Q2 2007
Source: MSN Money Stock Quotes
EPS growth calculated comparing Q2 2007 to
Q2 2006
Q2 2007EPS Growth
2007 Q2 EPS
2006 Q2 EPS
$2.98 / sh
$2.39 / sh
=25%

• Strong earnings or expectations of strong earnings drive stock prices. Why?
– Potential for greater reinvestment, and greater earnings
– Passing the money to shareholders in various forms (dividends, buybacks, etc.)
• Ultimately, earnings provide a return on the investment for shareholders

Ratio Analysis

• Used to gain idea of valuation and financial performance
• Compared to competitors and historical values to gain understanding about company’s value
– Is it undervalued? Overvalued?
– How is it performing?

Profit Margins
• = net income / net sales (revenue)
– Measures how much out of every dollar of sales a company actually keeps in earnings
• High profit margins indicates that management efficient at controlling costs
– Increased earnings are good, but if costs are increasing faster than sales, leads to lower profit per sale
• Good sign if company has growing profit margins

Company has a net income of $10 million from sales of $100 million, giving it a profit margin of 10%
($10 million/$100 million)
If in the next year net income rose to $15 million on sales of $200 million.
Would its profit margins be growing or diminishing?
What does this mean?

P/E Ratio
• = Price per share / Earnings per share
– Look at company’s earnings relative to its price
• Most basic valuation method of company
– How do you we use it?
• Ex. If BIG OIL co. has P/E ratio of 15 and has solid fundamentals, and the industry average is 40, then the BIG OIL would be considered undervalued

• Use as a guide, not a guarantee in your analysis
• Sometimes, there is a reason for high or low P/E ratios
(understanding business and industry is important)
– High P/E ratios: investors may be willing to pay more for less earnings because its expect higher growth rates in the future
– Low P/E ratios: may seem like a bargain, but low ratio may signal questionable future prospects

Return on Equity (ROE)
• = Net Income / Shareholder’s Equity
– how much profit a company can generate with the money shareholders have invested
– Is it a profit-making machine or an inefficient clunker?
• Useful for comparing profitability and efficiency of a company to other firms in same industry
– can indicate whether a company is growing without pouring new capital into business
• Growing ROE also shows management making better use of money invested by shareholders

PC Industry Example (Dell vs. Gateway vs. HP)
Dell
Gateway
HP

Debt / Equity Ratio
• = Total Liabilities / Shareholder’s Equity
– Proportion of equity and debt to finance assets
• High ratio: aggressive debt, potential for higher earnings per share but at more risk
– More volatile earnings and larger interest expenses
• Compare this similar companies
• Warren Buffet preferred to see lower ratio so that earnings growth is generated by investors rather than borrowed money

Profit Margin
ROE
Debt / Equity
EPS Growth
2004
13%
14%
0.13
2005
24%
16%
0.09
344%
2006
29%
18%
0.08
198%

• Current Ratio
• Return on Assets
• Inventory Turnover
• Interest Coverage
More on Ratio Analysis / Financial Statement Analysis: http://www.investopedia.com/university/ratios/ratios1.asp
http://www.investopedia.com/university/financialstatements/
UGBA 102A: Introduction to Financial Accounting

• Motley Fool. “Analyzing Stocks”
• Recommended:
Investopedia. “Valuation”