smartwomansecurities
October 31, 2006
Financial Metrics: Part 1
SPEAKER
Company Name
These materials are made for educational
purposes and should not be distributed. All
materials are for SWS members’ use only
Announcements
What Happened in the Market Last Week
Why Financial Metrics are Important
• From last week, you have been able to
formulate a list of stocks you are interested in
– Based on trends, industry position, Porter’s Five Forces, etc.
• How can you tell these companies are
financially stable?
– Can they cover their debts?
– What are their prospects for growth?
– Will their stock price appreciate? Or are they about to crash?
• Financial statement analysis and understanding
ratios is an integral part of doing the research
behind making investments
– Allows us to make comparisons between similar companies
In This Seminar:
• Read financial statements and
understand what they mean
– Balance Sheet
– Income Statement
– Cash Flows (next week)
• Learn important ratios
• Be able to compare similar stocks on the
basis of financial strength
• Pare down your list of stocks even more,
based on financial metrics
intro to financial statements
Financial Accounting
– Translates activities into objective numbers
• Allows comparability across time, firms and industries
– Enables the assessment of:
• Performance
• Problems
• Prospects
– Informs the decisions of:
• Managers of the company
• Internal and external auditors
• Investors and creditors
Every public company
has to disclose
financial statements.
Thus, understanding
financial statements
offer us a good point
of comparison, as
well as an indication
of a company’s
relative financial
strength
©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton
Accessing Financial Statements
• How do investors get access to
financial statements?
– A public company’s financial statements MUST be
available to the public (further requirements as
mandated by Sarbanes-Oxley, an act passed by
Congress in 2002 to fight fraud in corporations)
– Look at your company’s website and find their 10K
(annual report) or 10-Q (quarterly report) – this is
usually found under “SEC Filings” or something
similar
Accessing Financial Statements
• Public Companies: www.sec.gov/edgar
Financial Statements
• Annual Reports (10-K)
–
–
–
–
–
–
Company overview & business description
Accounting policies (GAAP)
Financial statements (and footnotes!)
Management discussion and analysis (MD&A)
Directors and executive officers’ bios
Executive compensation
• Quarterly Reports (10-Q)
– Financial statements
– MD&A
Financial Statements
• What do investors look at?
–
–
–
–
Balance Sheet
Income Statement
Statement of Cash Flows
Footnotes
A Note on Ratios
• Most of the financial metrics investors
use are given in the form of ratios found
in financial statements
– PE Ratio, Price to Book, Quick Ratio, etc.
• This is so that comparisons can be made
across two different stocks
comparing ratios
It is important to note that ratios tell you nothing by themselves; we can only judge
something in comparison to others. Oftentimes we compare companies that are in the same
industry or have similar business models (ie. Pepsi vs. Coke), or we compare a company to its
industry as a whole (ie. Coke to the beverage industry). These are still imperfect
comparisons, but it is important to note that because industries are so different, it does not
make sense to compare a Coke to Microsoft, or compare a single stock to another industry.
Balance Sheet
Balance Sheet
• Financial snapshot at a single point in time
• Assets (what the company owns)
– economic resources that are expected to benefit future
activities of the organization
• Liabilities (what the company owes)
– the entity’s economic obligations to non-owners
• Owners’ equity (whatever is left)
– the excess of the assets over the liabilities (also called
“stockholder’s/shareholder’s equity”)
– Homeowner example
• Assets = Liabilities + Owner’s Equity
©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton
Balance Sheet: Its Components
Assets: A company’s
resources
Liabilities: Claims
against the company’s
resources
Owner’s Equity:
Remaining Claims
accruing to owners
Sources: Intermediate Accounting; Spiceland., Sepe, Tomassini; 3rd edition; Irwin/McGraw-Hill Publishing Company, 2001
Assets
Assets generate probable future economic benefits
(value) for the company
• Examples: Cash, Accounts Receivable, Supplies, Inventory,
Property and Equipment, Furniture, etc.
• Current Assets: Assets that can be converted to cash within
one year or the operating cycle, whichever is longer (ie. cash,
receivables, inventory)
• Non-Current Assets: Assets that are not expected to be
converted to cash within that time period: property, plants,
equipment, investments and funds
Sources: Intermediate Accounting; Spiceland., Sepe, Tomassini; 3rd edition; Irwin/McGraw-Hill Publishing Company, 2001
Liabilities
Liabilities are obligations to deliver something of
value (usually cash or services) in the future
• Examples: Accounts Payable, Salaries Payable, Interest
Payable, Note Payable
• Current Liabilities: Obligations that are expected to be paid
within one year (ie. notes payable, accounts payable, etc)
• Non-Current Liabilities: Obligations that are not expected
to be paid within one year or the operating cycle, whichever is
longer (ie. bonds payable, long-term notes payable, pension
liabilities, capital leases)
Sources: Intermediate Accounting; Spiceland., Sepe, Tomassini; 3rd edition; Irwin/McGraw-Hill Publishing Company, 2001
Shareholder’s Equity
Equity is the residual interest in the
assets of an entity that remains after
its liabilities are deducted
•
•
•
•
Stock and Paid-in Capital
Retained Earnings
Treasury Stock
Other
Sources: Intermediate Accounting; Spiceland., Sepe, Tomassini; 3rd edition; Irwin/McGraw-Hill Publishing Company, 2001
How We Can Read Balance Sheets
• Its usefulness
– Gives information about the liquidity of a company
– Long-term solvency information (the ability of a
corporation to meet its long-term fixed expenses
and to accomplish long-term expansion and growth)
• Its limitations
– Assets are recorded at historical cost rather than at
market value (what you paid, not what it’s “worth”)
– Resources such as employee skills and reputation are
NOT recorded on balance sheet
Sources: Intermediate Accounting; Spiceland., Sepe, Tomassini; 3rd edition; Irwin/McGraw-Hill Publishing Company, 2001; Investopedia.com
An Investor’s Look at Balance Sheets
• Current Ratio: a measure of short-term liquidity risk
= Current Assets/Current Liabilities
• Return on Equity: Measure of the efficiency with which a
company employs its owners’ capital
= Net Income / Owners’ Equity
• Return on Assets: Measure of the efficiency with which a
company employs its assets
= Net Income / Assets
• Debt-to-Equity: This ratio measures the amount of
long-term debt financing relative to equity in a firm’s
capital structure
= Long-term Debt / Owners’ Equity
Sources: What is a “Strong” Balance Sheet, Chris Cather, Motley Fool, fool.com, February 2, 2005
Other Balance Sheet Ratios
• Price to Book
• Price to Sales
Example: Balance Sheet (AEOS)
American Eagle Outfitters
In Millions of USD (except for per share items)
1Q06
4Q05
Cash & Equivalents
331.36
168.57
130.53
Short Term Investments
482.73
602.80
620.99
Cash and Short Term Investments
814.09
771.37
751.52
Accounts Receivable - Trade, Net
13.29
30.64
29.15
Total Receivables, Net
13.29
30.64
29.15
Total Inventory
267.39
195.31
210.74
Prepaid Expenses
33.95
33.35
30.11
Other Current Assets, Total
Total Current Assets
Property/Plant/Equipment, Total - Gross
Goodwill, Net
Long Term Investments
Other Long Term Assets, Total
36.97
34.13
55.27
1,165.69
1,064.81
1,076.78
752.03
689.87
667.02
9.95
9.95
9.95
117.29
153.72
145.77
39.24
32.17
27.63
1,736.57
1,617.26
1,605.65
Accounts Payable
175.93
121.03
139.20
Accrued Expenses
101.87
109.78
143.60
Total Assets
Notes Payable/Short Term Debt
0.00
0.00
0.00
Other Current liabilities, Total
60.83
63.74
68.69
Total Current Liabilities
338.63
294.56
351.49
Total Long Term Debt
0.00
0.00
0.00
Total Debt
0.00
0.00
0.00
Other Liabilities, Total
104.55
99.60
98.61
Total Liabilities
443.18
394.16
450.10
Common Stock, Total
1.70
1.62
1.61
403.75
387.66
370.62
Retained Earnings (Accumulated Deficit)
1,087.01
1,031.80
978.86
Treasury Stock - Common
-224.13
-223.66
-216.51
25.05
25.68
20.99
Total Equity
1,293.39
1,223.10
1,155.55
Total Liabilities & Shareholders' Equity
1,736.57
1,617.26
1,605.65
149.40
148.93
147.93
Additional Paid-In Capital
Other Equity, Total
From Google Finance
2Q06
Total Common Shares Outstanding
Income Statement
Income Statement
• “Flow” in a given period (vs. a given
point in time)
• Basic equation:
Net Income = Revenues – Expenses
– Revenues: sources of income
– Expenses: uses of income
• Net Income = “earnings” to be divided
among the firm’s shareholders (EPS)
Revenues and Expenses
• Revenues are inflows of resources as a
result of providing goods or services to
customers
– Examples: Sales, interest income, gain on sale of plant
assets
• Expenses are outflows of resources
incurred in generating revenues
– Examples: Cost of goods sold, selling expenses, general
and administrative expenditures, depreciation, interest,
income taxes
Source: Intermediate Accounting; Spiceland., Sepe, Tomassini; 3rd edition; Irwin/McGraw-Hill Publishing Company, 2001
How We Can Read Income Statements
• Its usefulness
– Summarizes sales and profits over a period of time
– Lets us look at changes in key line items and ratios across time
to see whether operations have been changing
• Its limitations
– Difficult to compare some ratios for companies in different
industries
– Revenues reported don’t always equal cash collected, and
expenses reported aren’t always equal to cash paid, so income
usually IS NOT EQUAL to the change in cash for the period
– There are many components in income statements; make sure
you read the footnotes so that you’re getting the whole story!
Source: ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton
An Investor’s Look at Income Statements
• Gross Profit = Revenue – Cost of Goods Sold (“COGS”)
• Gross Margin = Gross Profit/Revenue
• Operating Profit = Revenues – COGS – Remaining costs
involved in operations (ie. employee compensation, advertising, expenses, etc.)
• Operating Margin = Operating Profit/Revenue
– Operating margin measures the proportion of a company’s revenue that is left over
after paying for costs of operating, such as labor, raw materials, etc.)
– A healthy gross margin is important for a company to pay its operating costs. The
higher the margin the better!
Note: Margins vary widely by industry. For example, software companies (ie, Microsoft) tend
to have high margins, whereas retailers (ie, Wal-Mart) tend to have low margins
- Why? (Hint: think about the “value-add” each company offers its customers. How
replicable are the goods/services each company is offering?)
Lower-margin companies like Wal-Mart can still be very profitable because they make up for
their margins through selling large volumes of products
Sources: Foolish Fundamentals: The Income Statement, Motley Fool, fool.com, August 25, 2006; Investopedia
Earnings
• From the income statement, we can
determine the company’s earnings
– The company can do two things with earnings: pay it out
in the form of dividends, or re-invest in the company
(known as “retained earnings”)
• Earnings per share (EPS)
– How much a stock earned per share (or, net income
divided by number of shares outstanding)
• During “earnings” season, companies have to report how well
they did in the previous quarter. Oftentimes you might hear
about a company “missing earnings”… this means that the
company did poor compared to the consensus (from research
analysts) from the Street.
PE Ratio
• One of the most important earnings ratios is the PE
ratio: also called PE multiple, price-to-earnings
ratio, the multiple, etc.
• This is often the first means of comparison
between companies.
– Tell whether a company is overvalued or undervalued
– Reflects how much times earnings investors are willing to pay for a
company
– PE ratios are generally low for slow growers, high for fast growers;
but at the same time, you could see it as being low for undervalued
companies, or high for overvalued companies
• Company PE ratios can be compared to other
similar companies, as well as with the market PE
– The current market PE ratio is –EDIT-. Historically it has ranged
from around –EDIT-
Income Statement (AEOS)
In Millions of USD (except for per share items)
2Q06
1Q06
4Q05
Revenue
Other Revenue, Total
Total Revenue
Cost of Revenue, Total
Gross Profit
Selling/General/Admin. Expenses, Total
Research & Development
Depreciation/Amortization
Total Operating Expense
Operating Income
Other, Net
Income Before Tax
Income After Tax
Net Income Before Extra. Items
Net Income
Preferred Dividends
Income Available to Common Excl. Extra Items
Income Available to Common Incl. Extra Items
Basic Weighted Average Shares
Basic EPS Excluding Extraordinary Items
Basic EPS Including Extraordinary Items
Dilution Adjustment
Diluted Weighted Average Shares
Diluted EPS Excluding Extraordinary Items
Diluted EPS Including Extraordinary Items
Dividends per Share - Common Stock Primary Issue
Diluted Normalized EPS
602.33
602.33
327.79
274.53
143.58
21.70
493.07
109.25
8.97
118.22
72.10
72.10
72.10
72.10
72.10
0.48
149.20
0.00
152.81
0.47
0.11
0.47
522.43
522.43
268.61
253.82
135.76
19.23
423.61
98.82
7.54
106.36
64.16
64.16
64.16
64.16
64.16
0.43
148.48
0.00
152.26
0.42
0.07
0.42
764.37
764.37
410.12
354.24
160.87
19.15
590.14
174.23
4.38
178.60
107.14
107.14
107.54
107.14
107.54
0.72
151.60
0.00
151.46
0.71
0.07
0.71
From Google Finance
Key Takeaways
Key Points
• Use balance sheets to assess a company’s
financial position at a point in time
– Look at key ratios to analyze a company’s business
• Income statements measure performance
– Look at the company’s performance over time in terms of
profits, margins, etc.
Key Ratios
• Important ratios vary from industry to industry,
depending on the type of business
– For example, pharmaceutical companies put a big focus on --- vs.
retail companies which care about --?
• Some generally important ratios across the
board:
–
–
–
–
PE Ratio
Price to Book
Return on Equity, Return on Assets
Current Ratio
• Ratios only tell us something about potential
investments when compared to other similar
companies
Next Seminar
• Week 6: More on financial statements
– Cash Flows
– Case study
– Actually applying these ratios and looking more indepth to balance sheet, income statement, etc.
Q&A