Introduction to Financial
Analysis
Shyam Sunder
Yale School of Management
September 12, 2012
An Overview
• The opportunity sets
• Business model
– Resource flows, technology, and strategy
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How Far to look
Gathering Financial data
Financial manipulations, Shenanigans
Assessing and deciding
What to expect
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Opportunity Set?
• What is the range of investment opportunities you
wish to consider?
– Corporate and government securities (e.g., stocks, bonds,
derivatives)
– Commodities, currencies, their futures and derivatives
– Land, housing, and other real estate (and related
securities)
– Art, antiques, and collectibles
– Other
– Limit discussion today to equities
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Business Model
• Independent of what you choose to analyze,
you always have to identify, understand, and
build the “business model” of the investment
opportunity you wish to analyze
• What do we mean by business model?
– Understand how the investment works
• Let us start with equity investment in a
business firm
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Resource Flows
Capital
Labor
Externalities
Products &
Services
3/18/2016
Sunder, Good Management
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“Production Technology”
• What is the “technology of producing” output from
inputs (include products and services)?
• Plant investment, fixed and variable costs of plant
• How does this “technology” compare with others?
• What have been the changes in past? Prospective
changes? In the firm and in the industry?
• Likely consequences of these changes for the
resource flows?
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For Each Class of Resource Flows
• Identify each significant resource
• Estimate the volume or resource flows
• Identify existing terms of exchange (price, volume,
elasticity)
• Identify market conditions (competition, growth,
new technologies, price sensitivity, etc.)
• Characterize the counterparties (the other side)
• Identify potential changes, disruptions, innovations
• Identify flexibility, substitutability, vulnerability
• New ideas for improving terms of exchange,
reducing vulnerability by restructuring
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Capital Flows
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Common equity
Preferred equity
Bonds
Bank debt
Other borrowing (including private)
What combination of sources of financing?
– Domestic or foreign, currency denomination?
• At what cost and what risk?
• New ideas?
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Labor
• Managerial: skills, quality, work culture, price,
mobility
• White collar: skills, quality, work culture,
price, location
• Blue collar: Education and skills, quality, work
culture, price, location, flexibility
• Fixed and variable components of labor costs
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Product Market
• Demand and growth, potential size
• Price elasticity (demand function)
• Geographical distribution (under exploited
markets)
• Receptivity to innovation
• Product portfolio, overlap, canabalizing,
market shares, profitability and crosssubsidies
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Vendors
• Supply chain (diversification, competition,
vulnerability to disruption)
• Competitive conditions
• Ownership and commitment
• Geographic distribution
• Potential for growth in volume
• Pricing
• New ideas: make-or-buy decisions
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Externalities
• Resource flows which are not priced
• Most difficult part of analysis of business
model
• Difficult to price does not mean not important
• Examples?
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Strategy
• What is firm’s strategy with respect to
– Technology
– Products
– Financiang
– Labor
– Supply chain
– Generating profits and growth
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How Far Do You Look?
• Do you know when you would want to exit
(cash out) your investment?
• If not, how uncertain are you?
• How much flexibility do you have in your time
horizon?
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• 10-K:
Gathering Financial Data
– auditor’s report: absence of opinion, qualified report, reputation of
auditor, audit committee (independent directors act as intermediary
with auditors)
– Footnotes: accounting policies / changes (in policies or estimates),
review inventory valuation, (LIFO vs. FIFO / specific id) (except
technology), revenue recognition (after sale vs. At sale with risk
remaining), depreciation (accelerated vs. Straight line), estimate of
warranty (high vs. Low), estimate of bad debts (high vs. Low),
treatment of advertising (expense vs. Capitalize), loss contingencies
(accrue loss vs. Footnote only), pending or imminent litigation (Item 3,
better than footnote in annual), long term purchase commitments (at
what price?)
– Industry specific notes
– Segment information (showing unhealthy segment)
– Management discussion and analysis
– Specific concise disclosures liquidity, capital expenditures, candor
– consistent with footnotes
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More Financial Data
• Annual Report: president’s letter, forthright vs. Always upbeat
• Proxy (for annual meeting): litigation, executive
compensation
• Turnover of management
• Related party transactions
• 10-Q: unaudited, consistency with 10-K
• 8-K (special events): auditor changes, disagreements over
accounting policies (opinion shopping), change in control of
the company, acquisitions, dispositions, resignation of
directors, bankruptcy
• Prospectus
• Past performance
• Quality of management and directors
• Conference calls, market history, industry reports, personal
experience with products and services of the firm
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Things to Watch for
• Executive incentives which encourage managing financial
statements
• Poor internal controls
• Quarterly financial statements (they are not audited)
• Companies with weak control environment (board of
directors is not independent; auditors not independent)
• Management facing extreme competitive pressure
• Management with questionable character
• Fast growth companies whose real growth is beginning to
slow
• Basket case companies struggling to survive
• Newly public companies
• private companies (especially those which aren’t audited)
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Seven Financial Manipulations
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Recording Revenue Too Soon
Recording Bogus Revenues
Boosting Income With One Time Gains
Shifting Current Expenses to a Later Period
Failing to Record or Disclose All Liabilities
Shifting Current Income to a Later Period
Shifting Future Expenses to the Current Period
accelerating discretionary expenses into the current
period
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Assessing What You Find
• Valuation models: choices, triangulation
• When you find an over or under-valued
security, ask yourself
– Did others miss something that I know?
– Did I miss something that other know?
• Is the market efficient? If so, how efficient?
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Assessing Quality of Management
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Do they manage earnings or provide earnings guidance.
Do they make strategic decisions that maximize expected value, even at the
expense of lowering near-term earnings
Do they make acquisitions that maximize expected value, even at the expense of
lowering near-term earnings.
Do they carry only assets that maximize value.
Do they return cash to shareholders when there are no credible value-creating
opportunities to invest in the business.
Do they reward CEOs and other senior executives for delivering superior long-term
returns.
Do they reward operating-unit executives for adding superior multiyear value.
Do they reward middle managers and frontline employees for delivering superior
performance on the key value drivers that they influence directly.
Do they require senior executives to bear the risks of ownership just as
shareholders do.
Do they provide investors with value-relevant information.
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Deciding on investment
• Have I found something which is mis-priced?
• Do I understand why it is mispriced?
• Does investment in this opportunity fit my
goals, investment horizon, and constraints?
• What is the worst that can happen with this
investment? Can I live with that?
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Was that a good investment or bad?
• Learning from post mortems
• Why did that investment work, or did not
work?
• What did I learn from this experience?
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What should You Expect?
• You are competing with a lot of other smart people
• Most of us cannot expect to be the winners all the
time
• If your winning average is slightly more than 50/50,
you are doing fine
• But it takes a long time to find out
• Markets makes it tough for the wise to make a lot of
money, and for fools to lose a great deal (index funds
will earn you the average anyway)
• So, you better do the hard work of research and
understanding before jumping into the investment
game
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Thank You!