smartwomansecurities
November 7, 2007
Financial Metrics: Part 2
MORGEN PECK
EQUITY RESEARCH ANALYST
FIDELITY INVESTMENTS
These materials are made for educational
purposes and should not be distributed. All
materials are for SWS members’ use only
Announcements
• Business Overview section of
Investment Project due today!
• Competition section is due next
Wednesday (11/14)
• NO seminar on Wednesday 21st
because of Thanksgiving Break!
• Investment Project Mentors
In This Seminar:
• Recap of last week
• Understand cash flows
• How earnings’ season affect stocks
• Valuation (yes, again)
• Case study
Recap From Last Week
• Financial statements are critical to making
investments
• Income Statement gives us information on
profitability over time
– Revenues – expenses = profit
– Important metrics: revenue growth, EPS growth, operating profit
– We use EPS for valuation (P/E)
• Balance Sheet gives us information about financial
health at point in time
– Assets = Liabilities + Equity
– Important metrics: Return on Equity, Return on Assets, Debt/Equity,
Current Assets/Current Liabilities
Questions From Last Week
• Don’t we want liabilities to go down
over time?
– Liabilities are NOT a bad thing, they are a necessity
for a firm and they should increase as the firm grows
• Firm owing its suppliers money because of strong
demand for the firm’s product is a good thing
– We only worry when liabilities growing faster than
assets. That is a bad thing
Questions From Last Week
• Revenues – cost of goods sold – selling,
general & administrative expenses (SG&A)
= operating profit
• Another way to think of operating margin is:
– For every $1 the firm makes in revenues, operating margin is
the % of that $1 that the firm keeps after operating expenses
• If firm has operating margin of 30%, for every dollar of
revenue, it “costs” firm 70c to produce that dollar & they can
keep 30c as profit
Mistake from last week
• In bread example, your company does
not “borrow” money from mutual
funds like Fidelity
– Fidelity gives money to the firm in exchange for
shares and the firm does not have to ever pay back
Fidelity
– Firm does have to pay back money borrowed from
banks
SWY example: P/E & EPS growth
drive stock price
SAFEWAY INCORPORATED (SWY) Price 32.96
1997
65
1997
1998
1998
1999 19992000 2000 20012001 2002
2002 2003
2003
2004
2004
StockVal®
2005
2005
2006
2007
2007
2008
2008
HI
LO
ME
CU
GR
50
40
30
25
20
2009
63
17
33
33
1.2%
10-31-1997
11-02-2007
15
PRICE
35
30
HI
LO
ME
CU
25
20
33.7
6.7
15.4
14.9
15
10
10-31-1997
11-02-2007
5
PRICE / YR-FORWARD EPS ESTS
60
40
HI
LO
ME
CU
20
0
-20
41.0
-26.0
13.8
18.4
12-31-1997
09-30-2007
-40
EARNINGS-PER-SHARE YTY % CHANGE
PFE: P/E compression & EPS
growth deceleration hurt stock
price
PFIZER INCORPORATED (PFE) Price 23.67
1997
52
1997
1998
1998
1999 19992000 2000 20012001 2002
2002 2003
2003
StockVal®
2004
2004
2005
2005
2006
2007
2007
2008
2008
HI
LO
ME
CU
GR
44
36
32
28
24
2009
49
21
33
24
0.0%
10-31-1997
11-02-2007
20
PRICE
49
42
HI
LO
ME
CU
35
28
55.9
10.0
17.9
10.2
21
14
10-31-1997
11-02-2007
7
PRICE / YR-FORWARD EPS ESTS
52
39
HI
LO
ME
CU
26
13
56.9
-23.3
16.6
-23.3
0
-13
12-31-1997
09-30-2007
-26
EARNINGS-PER-SHARE YTY % CHANGE
My contact info if you ever have
questions
• morgen.peck@fmr.com
• 617-563-0042
Statement of Cash Flows
Cash Flows
• Statement of cash flows provides relevant
information about a company’s cash inflows
and outflows
• Net Income ≠ Cash generated!!
– Net income is a function of accrual accounting which smoothes
cash flow
– Cash can’t be manipulated
• Cash flows help investors (and creditors)
assess
– Future funding needs
– Liquidity (cash to run daily/annual operations)
– Long-term solvency (ability to pay bills and service debt)
Sources: Intermediate Accounting; Spiceland., Sepe, Tomassini; 3rd edition; Irwin/McGraw-Hill Publishing Company, 2001
Income Statement vs. Cash Flow
Statement
• Income statement uses accrual accounting to
smooth cash flow, which tends to be lumpy.
– Revenue recognition
• Does a company recognize revenue when end product has been
produced, when it’s shipped, when customer receives it? Orders
often placed at end of the quarter.
– Cost recognition
• Does a company recognize cost when the end product has been
produced, when it receives payment for the product?
– There is a LOT of discretion by the CFO in terms of how s/he can
account for items in the income statement
• Cash flow is literally the cash being generated and
used by the company over a certain period of time
Cash Flows
• 3 sections of the cash flow statements
– Operating Activities
• How much cash do the firm’s core operations generate?
– Investing Activities
• How much cash firm is spending on long term assets to grow (capex)
or on acquisitions
– Financing Activities
• How much cash firm is spending to finance its growth (debt
borrowed & equity issued)
• How much cash firm is returning to shareholders (dividends, share
repurchases)
Cash Flows from Operating Activities
• Inflows
– Cash received from customers (remember accounts
receivables)
• Outflows
– Buying inventory (remember accounts payables)
– Paying salaries and wages
– Paying suppliers (also accounts payable)
Sources: Intermediate Accounting; Spiceland., Sepe, Tomassini; 3rd edition; Irwin/McGraw-Hill Publishing Company, 2001
Reconciling Net Income and
Operating Cash Flow
Operating
cash flow
statement
takes Net
Income and
makes
adjustments
so investors
can see how
much cash
the
business
generated
INCOME STATEMENT
Revenues
- CGS (includes Depreciation & Amortization)
Gross Profit
- Selling, General & Administrative Costs
- Research & Development
- Other Operating Expenses
Operating Income
- Interest Expense
-Taxes
Net Income
Earnings Per Share
Diluted Shares Outstanding
CASH FLOW STATEMENT
Operating Cash Flows:
Net Income
+ Depreciation & Amortization
+ Amortization on Research & Development
+ Changes in A/R, Inventory, A/P
Operating Cash Flow
Cash Flows from Investing Activities
• Inflows
– Cash received from sales of PP&E (selling an plant the
firm doesn’t need anymore). Pretty infrequent.
• Outflows
– Purchasing long-term assets (PP&E) = capital
expenditures (aka capex) (building a new plant)
– Acquisitions of other companies
Sources: Intermediate Accounting; Spiceland., Sepe, Tomassini; 3rd edition; Irwin/McGraw-Hill Publishing Company, 2001
Cash Flows from Financing Activities
• Inflows
– Cash received from borrowing (i.e. firms borrow cash
from banks to make acquisitions)
– Cash received from issuing stock (i.e. firm issues shares
to raise money)
• Outflows
– Repaying debt (i.e. firms eventually have to pay back
what they borrowed from the bank)
– Paying dividends to shareholders
– Repurchasing stock
Sources: Intermediate Accounting; Spiceland., Sepe, Tomassini; 3rd edition; Irwin/McGraw-Hill Publishing Company, 2001
How To Read Cash Flow Statements
• Its usefulness
– You can actually see where cash is going and how the company
spends it
– Changes in the B/S can be explained by looking at CF statement
– Get a better understanding of a company’s investing and
financing activities because these aren’t obvious in the I/S
• Its limitations
– When companies make acquisitions, it is often difficult to fully
reconcile all of the cash inflows and outflows w/ the B/S
Source: ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton
Most Important Metric from CF
statement: Free Cash Flow
• Free Cash Flow = Operating Cash Flow
– Capital Expenditures: Represents the cash that a
company has left over after paying money required to
maintain/expand its asset base
INCOME STATEMENT
Revenues
- CGS (includes Depreciation & Amortization)
Gross Profit
- Selling, General & Administrative Costs
- Research & Development
- Other Operating Expenses
Operating Income
- Interest Expense
-Taxes
Net Income
Earnings Per Share
Diluted Shares Outstanding
Sources: Vince Hanks, Motley Fool, fool.com; Investopedia
CASH FLOW STATEMENT
Operating Cash Flows:
Net Income
+ Depreciation & Amortization
+ Amortization on Research & Development
+ Changes in A/R, Inventory, A/P
Operating Cash Flow
- Capital Expenditures
FREE CASH FLOW
Other Helpful FCF Metrics
– FCF/Net Income = quality of earnings (the
higher the better)
– YoY growth in FCF
• Negative free cash flow is not bad in itself. If free
cash flow is negative, it could be a sign that a
company is making large investments. If these
investments earn a high return, free cash flow
should turn positive some day
Cash Flows (AEOS)
In Millions of USD (except for per share items)
2Q06
1Q06
4Q05
Net Income/Starting Line
Depreciation/Depletion
Amortization
Deferred Taxes
72.10
21.71
-10.68
64.16
19.23
3.12
107.54
19.15
-5.13
Non-Cash Items
Changes in Working Capital
Cash from Operating Activities
10.04
180.15
273.31
11.49
-43.75
54.26
5.20
142.01
268.77
Capital Expenditures
Other Investing Cash Flow Items, Total
-71.44
-27.61
-31.71
22.93
-21.79
-247.15
Cash from Investing Activities
-99.05
-8.78
-268.94
Financing Cash Flow Items
Total Cash Dividends Paid
Issuance (Retirement) of Stock, Net
2.62
-16.88
4.35
3.24
-11.21
-1.71
-11.14
-19.94
Issuance (Retirement) of Debt, Net
-0.30
-0.17
-0.19
Cash from Financing Activities
-10.20
-9.86
-31.27
Foreign Exchange Effects
Net Change in Cash
Cash Interest Paid, Supplemental
Cash Taxes Paid, Supplemental
-1.27
162.79
56.46
2.42
38.04
43.16
1.62
-29.83
46.09
From Google Finance
Lynch’s Views on Cash
• In 1988, Lynch owned 5 million shares of
Ford which was at $38 a share
• He saw in Ford’s B/S statement that it
had $16.30 in net cash/share
– Net cash/share = (cash – debt)/diluted shares
outstanding
• So he saw it as buying a company not for
$38, but for $21.70
– This made its PE ratio something like 3.1
– (Current stock price – net cash/share)/EPS
• Ford went up 40% after he decided to
hold his shares of Ford
valuation
Valuation
• From looking at financials, we get
information that we use in valuation
• We use either EPS or FCF in valuation
– EPS >> use P/E
– FCF >> use discounted cash flow (DCF)
• Because FCF can be lumpy, this is
often why many investors use P/E
analysis for valuation
Discounted cash flow (DCF)
• Discount the profits (dividends, earnings,
or cash flows) that the firm will generate
over time
– Estimate yearly cash flows
– Estimate the discount factor based on the risk (10% is a
safe assumption, but use a higher rate for riskier cash flow)
• Determine the “intrinsic value” of the
business
– Expect a business to make $1000 at the end of each year
and then fold after 3 years, estimating a discount rate of
10%
• DCF = $1000/(1.1)+$1000/(1.12)+ $1000/(1.13) = $2,487
• You should only pay $2,487 for this business. So if there are 100
shares outstanding, a fair price for the stock would be $24.87
DCF & Comparables = 2 Good
Valuation Techniques
• Research analysts typically create
models and perform DCF valuation
– Compare estimated value with actual stock price (if
value > stock price, stock is a good buy)
• Comparable analysis:
– To determine if company is under or overvalued
compared to peers or to the company’s EPS growth
rate
• P/E Ratio
how earnings
affect stocks
Earnings
• Quarterly earnings
– How much profit a company made or lost during the past quarter
– Given in EPS
• Usually company also holds an earnings call where they discuss their
earnings and company financial performance
• Earnings seasons
– Differ by company, but typically they come in the month after the
end of the quarter
• Earnings vs. consensus
– Consensus from Wall Street analysts on what EPS will be
– If the company beats estimates, the stock tends to go up
– If the company falls short, the stock tends to go down
• However, other aspects may also cause stock to move (management
earnings call, announcement about part of the business, etc.)
Implications for Investors
• More volatility in the markets during
earnings season
• Earnings can paint a picture of an
industry or a market as a whole
– For example, 3Q07: all financials stocks are missing
estimates right now
• Even if companies beat estimates, still
depends on investors’ opinions
– For example, earnings may beat estimates but futurelooking guidance may be below analyst expectations
3Q Earnings Disasters
• ALGN guided 4Q07 revenues 4% below
expectations: stock down 35% in one day
AMMD: Another earnings
disaster
• AMMD lowered 4Q guidance because
of operational problems: stock off 35%
WCG: Another disaster
(fraud, not earnings)
• FBI raids company HQ: stock down 70% in
one day
ABAX: Good 3Q EPS
• 3Q EPS came in slightly ahead of
estimates, stock +20% in one day
Looking at Financial Statements
Income Statement I Like
MERIDIAN BIOSCIENCE
VIVO
•
•
•
•
•
Relatively
consistent high
teens revenue
growth
High GM that are
improving over
last 3 years
High &
improving
operating profit
margins
Always
profitable
Very fast EPS
growth
2000
Sep-00
FY
2001
Sep-01
FY
2002
Sep-02
FY
2003
Sep-03
FY
2004
Sep-04
FY
2005
Sep-05
FY
2006
Sep-06
FY
INCOME STATEMENT
Net Sales
Cost of Sales
Gross Profit
R&D
Selling & Marketing
General & Admin.
EBITDA
EBIT
Interest Income
Pretax Income
Provision for Income Taxes
Tax Rate
Net Income
EPS
CY EPS
Mgmt Guidance
First Call Estimates
Diluted Weighted Average Shares
$
57.1
21.7
35.4
2.3
12.3
10.8
15.0
10.2
0.4
7.7
(0.2)
-2%
7.9
0.24 $
$
33.0
56.5
25.8
30.7
3.4
11.0
11.5
9.6
4.9
0.2
2.5
(4.6)
-187%
7.1
0.22 $
0.07 $
59.1
24.5
34.6
2.9
9.7
10.8
14.9
11.2
0.0
9.5
3.2
34%
6.2
0.19 $
0.19 $
65.9
27.6
38.3
3.9
10.6
11.0
16.6
12.8
0.0
11.6
4.6
39%
7.0
0.21 $
0.22 $
79.6
33.9
45.7
4.4
12.5
14.1
18.7
14.7
0.0
13.2
4.0
30%
9.2
0.27 $
0.28 $
93.0
38.2
54.8
3.9
15.0
15.7
24.5
20.2
0.0
19.6
7.0
36%
12.6
0.35 $
0.38 $
108.4
43.7
64.7
4.8
16.5
16.5
32.2
26.9
1.1
28.1
9.7
35%
18.3
0.46
0.50
32.8
33.2
33.6
34.3
36.3
40.2
-1%
-36%
-52%
-10%
5%
55%
130%
-13%
11%
11%
14%
11%
21%
13%
15%
28%
17%
31%
38%
30%
17%
31%
33%
32%
54.3%
5.9%
19.4%
20.3%
17.0%
8.6%
927.4%
12.6%
58.5%
4.9%
16.5%
18.2%
25.3%
19.0%
245.6%
10.6%
58.1%
5.9%
16.1%
16.7%
25.2%
19.4%
23.4%
10.7%
57.4%
5.5%
15.7%
17.7%
23.5%
18.4%
13.6%
11.5%
58.9%
4.2%
16.1%
16.9%
26.3%
21.7%
41.6%
13.5%
59.7%
4.4%
15.2%
15.2%
29.7%
24.8%
43.1%
16.9%
GROWTH & MARGINS
GROWTH (YoY)
Revenues
EBITDA
EBIT
EPS
MARGINS
Gross
R&D
S&M
G&A
EBITDA
EBIT
Incremental EBIT
Net
62.1%
4.0%
21.5%
18.9%
26.2%
17.8%
13.9%
Income Statement I Don’t Like
TYSON FOODS
TSN
•
•
•
Totally
inconsistent
revenue growth
that has been bad
recently
Look how low their
gross & operating
margins are!!!
Pathetic!
They are not
always profitable
(negative EPS in
FY06)
2000
FY
Sep-00
2002
FY
Sep-02
2003
FY
Sep-03
2004
FY
Sep-04
2005
FY
Sep-05
2006
FY
Sep-06
INCOME STATEMENT
Total Revenue
CGS
Gross Profit
SG&A
EBITDA
Operating Income
Interest Expense
Pre-Tax Income
Income Taxes (benefit)
Tax Rate
Net Income
EPS
CY EPS
YoY EPS growth
Diluted Shares Outstanding
Street Estimates
Mgmt Guidance
7410
23367
24549
26432
26014
6453
21550
22805
24550
24266
957
1817
1744
1882
1748
609
877
831
880
939
348
1354
1295
1463
1310
348
887
837
973
809
116
305
296
275
227
234
593
661
683
564
83
210
235
256
199
35.5%
35.4%
35.5%
37.5%
35.3%
151.0
386.5
281.0
482.1
364.8
$ 0.67 $ 1.09 $ 0.80 $ 1.36 $ 1.02 $
$ 1.08 $ 0.97 $ 1.14 $ 1.02 $
125.5%
224.9
$
354
1.09 $
-26.7%
351
0.74 $
25559
24626
933
935
527
10
229
-211
-73
34.5%
-138.3
(0.40)
(0.35)
69.3%
-24.7%
-138.8%
356
1.30 $
357.3
1.06 $
348.75
(0.04)
1.26-1.33
0.95-1.08
-14c to 1 c
GROWTH & MARGINS
GROWTH (YoY)
Revenues
SG&A
EBITDA
EBIT
EPS
122%
49%
68%
88%
126%
5%
-5%
-4%
-6%
-27%
8%
6%
13%
16%
69%
-2%
7%
-10%
-17%
-25%
-2%
0%
-60%
-99%
-139%
7.8%
3.8%
5.8%
3.8%
1.7%
7.1%
3.4%
5.3%
3.4%
1.1%
7.1%
3.3%
5.5%
3.7%
1.8%
6.7%
3.6%
5.0%
3.1%
1.4%
3.7%
3.7%
2.1%
0.0%
-0.5%
MARGINS
Gross
SG&A as % Sales
EBITDA
EBIT
Net
12.9%
8.2%
4.7%
4.7%
2.0%
Balance Sheet I Like
•
•
MERIDIAN BIOSCIENCE
VIVO
•
2000
Sep-00
FY
Growing cash & equivalents
PP&E not growing too fast >> not capital
intensive business
Very high ROE & ROA
2001
Sep-01
FY
2002
Sep-02
FY
2003
Sep-03
FY
2004
Sep-04
FY
2005
Sep-05
FY
2006
Sep-06
FY
BALANCE SHEET
Cash & Equivalents
A/R, net
Inventories
PP&E, net
TOTAL ASSETS
Current Debt
Accounts Payable
Long Term Debt
TOTAL LIABILITIES & EQUITY
ROIC
ROE
ROA
Debt/Cap
Net cash/share
5
14
16
18
85
8
3
27
85
$
5
13
12
17
66
8
2
24
66
5.7%
23.9%
9.4%
51.5%
(0.84) $
3
13
13
18
65
4
2
24
65
15.0%
26.4%
9.5%
49.2%
(0.74) $
2
15
14
18
66
1
2
22
66
14.7%
27.1%
10.7%
43.9%
(0.62) $
2
18
14
17
69
1
3
17
69
18.6%
30.4%
13.5%
34.2%
(0.46) $
33
17
17
17
111
1
3
3
111
17.5%
21.5%
14.0%
3.1%
0.82 $
40
20
18
18
121
0
4
2
121
17.9%
20.5%
15.8%
1.9%
0.96
Balance Sheet I Don’t Like
TYSON FOODS
TSN
2000
FY
Sep-00
•
•
•
•
Cash is going down
PP&E is HUGE % of total
assets >> capital
intensive business
They have a lot of debt
Terrible ROA & ROE.
They are negative in
FY06 because NI is
negative.
2002
FY
Sep-02
2003
FY
Sep-03
2004
FY
Sep-04
2005
FY
Sep-05
2006
FY
Sep-06
BALANCE SHEET
Cash/Equivalents
Accounts Receivable
Inventories
PP&E
TOTAL ASSETS
Current Debt
Accounts Payable
Total Debt
TTL LIAB + EQUITY
ROA
ROIC
ROE
Debt/Total Capital
43
508
965
2141
4841
185
333
1542
4841
41%
51
1101
1885
4038
10562
254
755
3987
10372
3.6%
7.8%
10.9%
50%
25
1280
1994
4039
10486
490
838
3604
10543
2.7%
7.5%
8.8%
44%
33
1240
2063
3964
10464
338
945
3362
10464
4.6%
8.4%
10.3%
41%
40
1214
2062
4007
10504
126
961
2995
10504
3.5%
7.1%
8.2%
38%
28
1183
2057
3945
11121
992
942
3979
11121
NM
NM
NM
40%
FCF Statement I Like
•
MERIDIAN BIOSCIENCE
VIVO
•
•
•
•
2000
Sep-00
FY
Net change in working capital
(change in A/R, inventories, A/P) is
not big
Capex = D&A
FCF and FCF/share is increasing
FCF as % of NI is >100%
VIVO pays a dividend (and it’s
growing)
2001
Sep-01
FY
2002
Sep-02
FY
2003
Sep-03
FY
2004
Sep-04
FY
2005
Sep-05
FY
2006
Sep-06
FY
FREE CASH FLOW
Net Income
Depreciation
Amortization
Net Change in WC
Capital Expenditures
FREE CASH FLOW
FCF/Share
FCF Yield
FCF as % of NI
Dividend
$
7.9
2.0
2.8
(7.6)
(4.0)
2.0
0.06 $
24.9%
3.4
7.1
2.3
2.5
3.3
(1.9)
24.2
0.74 $
339.9%
3.7
6.2
2.3
1.4
2.3
(3.6)
9.1
0.27 $
145.4%
4.0
7.0
2.4
1.4
(0.4)
(1.8)
10.5
0.31 $
150.2%
5.0
9.2
2.6
1.5
(1.7)
(2.4)
10.3
0.30 $
111.8%
5.8
12.6
2.6
1.7
1.5
(2.6)
15.6
0.43 $
124.1%
7.2
18.3
2.7
2.6
(2.2)
(3.1)
19.0
0.47
103.9%
11.1
FCF Statement I Don’t Like
•
•
TYSON FOODS
TSN
•
•
2000
FY
Sep-00
2002
FY
Sep-02
Net Income is negative some years
Capex>D&A >> capital intensive
business
Change in working capital is very
volatile
FCF is very volatile, sometimes negative
2003
FY
Sep-03
2004
FY
Sep-04
2005
FY
Sep-05
2006
FY
Sep-06
FREE CASH FLOWS
NI
+D&A
-Cap Ex
- Change in WC
FCF
FCF/share
FCF Yield
FCF as % of NI
459
281
482
365
467
458
490
501
(632)
(402)
(486)
(571)
294
51
(158)
186
530
334
279
426
$ 1.50 $ 0.95 $ 0.79 $ 1.19 $
13%
7%
4.9%
7.4%
137%
119%
57.9%
116.7%
(138)
517
(531)
(19)
(226)
(0.65)
-4.0%
NM
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 profitability
– Look at the company’s profitability over time in terms of
gross & operating profit, gross & operating margins
• Use statement of cash flows to follow the
cash
– Look at where cash is going; free cash flow is a key metric!
• Valuation: comparisons to other companies
& for one company across time
Next Seminar
• Synthesis: Putting it all together to
make an investment recommendation
– Putting it all together
– How to make stock pitches
– Case studies
Q&A
appendix
Sarbanes-Oxley
• In 2002, President Bush signed the Sarbanes-Oxley Act into
law to "re-establish investor confidence in the integrity of
corporate disclosures and financial reporting.“
– Financial fraud cases (such as those of Enron, WorldCom, Tyco, Adelphia,
AOL, and others)
– End of the "boom" years for the stock market.
• Requires all public companies to submit both quarterly and
annual assessments of the effectiveness of their internal
financial auditing controls to the Securities and Exchange
Commission (SEC).
– Each company's external auditors must also audit and report on the internal control reports
of management and any other areas that may affect internal controls.
• The details of the Sarbanes-Oxley Act address many of the
tactics companies have used to "cook the books" over the
years.