chapter 12: financial statement analysis: applications

CHAPTER 12FINANCIAL STATEMENT ANALYSIS:

APPLICATIONSPresenter’s namePresenter’s titledd Month yyyy

Copyright © 2013 CFA Institute 2

EVALUATION OF A COMPANY’S PAST PERFORMANCE

1999200020012002200320042005

2006200720082009201020112012


EVALUATION OF A COMPANY’S PAST PERFORMANCE: APPLE

2007 2008 2009 2010$0

$10,000

$20,000

$30,000

$40,000

$50,000

$60,000

$70,000 SalesGr. ProfitNet income

$ (millions)



Fiscal Year

($ millions) 2010 2009 2008 2007Net sales $65,225 $42,905 $37,491 $24,578

Gross margin 25,684 17,222 13,197 8,152

Net income (NI) 14,013 8,235 6,119 3,495

2010 2009 2008 2007

Gross margin (% sales) 39% 40% 35% 33%



Panel A: Data for Apple Inc. Fiscal Year

($ millions)2010 2009 2008 2007

Cash and marketable securities$51,011 $33,992 $24,490 $15,386

Total current assets41,678 31,555 30,006 21,956

Total assets 75,183 47,501 36,171 24,878

Total current liabilities20,722 11,506 11,361 9,280



2007 2008 2009 20100%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Peripherals and other hardware

Software, service and other sales

Other music related

iPad & related

iPod

Total Mac

iPhone & related


FORECASTING

• Sales Forecast

• Expenses• Gross Profit• Operating Profit

• Assets • Liabilities

• Cash Flow


FORECASTING

• Sales Forecast



• Cash Flow


ITERATIONS IN FORECASTING

Forecast Debt

Forecast Interest

Expense

Forecast Income and

Taxes

Forecast Cash Flow

• Sales Forecast



• Cash Flow


FORECASTING OPERATING PROFIT BASED ON HISTORICAL MARGINS

Johnson & Johnson (NYSE: JNJ)

• U.S. health care conglomerate, founded in 1887.

• 2009 sales of around $61.9 billion from its three main businesses: pharmaceuticals, medical devices and diagnostics, and consumer products.

• For the four years prior to 2009, average operating profit margin was approximately 25.0%.

Baidu (NASDAQ: BIDU)• Chinese language internet

search engine, established in 2000 and went public on NASDAQ in 2005.

• Revenues for 2009 were 4.4 billion renminbi (RMB), an increase of 40% from 2008 and more than 14 times greater than revenues in 2005.

• For the four years prior to 2009, average operating profit margin was approximately 27.1%.


FORECASTING OPERATING PROFIT BASED ON HISTORICAL MARGINS

Johnson & Johnson (NYSE: JNJ)

• 2009 sales were $61.9 billion. • For the four years prior to 2009,

average operating profit margin was approximately 25.0%.

• Actual operating profit for 2009 was $15.6 billion.

• Actual operating profit margin for 2009 was 25.2%.

Baidu (NASDAQ: BIDU)• 2009 revenues were 4.4 billion

renminbi (RMB).• For the four years prior to 2009,

average operating profit margin was approximately 27.1%.

• Actual operating profit for 2009 was RMB1.6 billion.

• Actual operating profit margin for 2009 was 36.4%.


ASSESSING CREDIT QUALITY

• Credit risk: Risk of loss caused by a debtor’s failure to make a promised payment

• Credit analysis: Evaluation of credit risk- Risk in a particular transaction or for a particular security - Obligor’s overall creditworthiness


TECHNIQUES FOR ASSESSING CREDIT QUALITY

• Credit scoring—statistical techniques• Period-by-period cash flow projections• Analysis of business and financial risk factors


ASSESSING CREDIT QUALITY: EXAMPLE

Bombardier Inc.

BAE Systems

plc

EBITDA/Average assets 7.5% 10.1%

Debt/EBITDA 3.9 3.1

Retained cash flow to debt 6.1% 13.7%

Free cash flow to net debt –7.0% 7.7%


STOCK SCREENING

Universe of Stocks

Stocks Meeting Criteria

Selection


EXAMPLE OF STOCK SCREENS

Stocks Meeting Criterion

Criterion Number Percent of Total

P/E <15 1,471 28.36%

Total debt/Assets ≤ 0.5 880 16.97%

NI/Sales > 0 2,907 56.04%

Dividend yield > 0.5% 1,571 30.29%

Meeting all four criteria simultaneously 101 1.95%

Source for data: http://google.com/finance/


SCREENS AND BACK-TESTING

• Valuation metrics + Accounting metrics• Evaluation of screen using “back-testing”• Caveats when back-testing:

- Survivorship bias- Look-ahead bias- Data-snooping bias


TWO HYPOTHETICAL SCREENING STRATEGIES

Strategy A Invest in stocks that are components of a global equity index, have an ROE above the median ROE of all stocks in the index, and have a P/E less than the median P/E.

Strategy BInvest in stocks that are components of a broad-based U.S. equity index, have a ratio of price to operating cash flow in the lowest quartile of companies in the index, and have shown increases in sales for at least the past three years.


TWO HYPOTHETICAL SCREENING STRATEGIES: AVOID UNINTENTIONAL SELECTIONS

Strategy A Invest in stocks that are components of a global equity index, have an ROE above the median ROE of all stocks in the index, and have a P/E less than the median P/E.

What if Net income was < 0 and Equity < 0?

Strategy B

Invest in stocks that are components of a broad-based U.S. equity index, have a ratio of price to operating cash flow in the lowest quartile of companies in the index, and have shown increases in sales for at least the past three years.

What if operating cash flow was < 0?


ANALYST ADJUSTMENTS

• Importance (materiality). Is an adjustment to this item likely to affect the conclusions? In other words, does it matter? In an industry where companies require minimal inventory, does it matter that two companies use different inventory accounting methods?

• Body of standards. Is there a difference in the body of standards being used (U.S. GAAP versus IFRS)? If so, in which areas is the difference likely to affect a comparison?

• Methods. Is there a difference in accounting methods used by the companies being compared?

• Estimates. Is there a difference in important estimates used by the companies being compared?


INVESTMENTS

• Investments- Unrealized gains and losses on the income statement

versus- Unrealized gains and losses not on the income statement

but instead recognized in equity.• If two otherwise comparable companies have significant

differences, it may be useful to adjust.


INVENTORY: EXAMPLE

Company A

(FIFO)Company B

(LIFO)

Current assets (includes inventory) $300,000 $80,000

LIFO reserve NA $20,000

Current liabilities $150,000 $45,000

NA = not applicable


INVENTORY: EXAMPLE

Company A(FIFO)

Company B

Unadjusted(LIFO basis)

Adjusted(FIFO basis)

Current assets (includes inventory) $300,000 $80,000 $100,000

Current liabilities $150,000 $45,000 $45,000

Current ratio 2.00 1.78 2.22


GOODWILL AND INTANGIBLE ASSETS

SCHW AMTD

Market capitalization on January 2010 (market price per share times the number of shares outstanding) $21,871 $11,525

Total shareholders’ equity as of most recent quarter $5,073 $3,551

Goodwill $528 $2,472

Other intangible assets $23 $1,225

The MV/BV for the companies isSCHW $21,871/$5,073 = 4.3AMTD $11,525/$3,551 = 3.2

Note: MV/BV equals the total market value of the stock (the market capitalization) divided by total stockholders’ equity. It is also referred to as the price-to-book ratio because it can also be calculated as price per share divided by stockholders’ equity per share.


GOODWILL AND INTANGIBLE ASSETS

($ millions)SCHW AMTD

Total stockholders’ equity $5,073 $3,551 Less goodwill $528 $2,472 Book value, adjusted $4,545 $1,079

Adjusted MV/BV 4.8 10.7

($ millions)SCHW AMTD

Total stockholders’ equity $5,073 $3,551 Less goodwill $528 $2,472 Less other intangible assets $23 $1,225 Tangible book value $4,522 ($146)

MV/tangible book value 4.8 NM

NM = not meaningful


OFF-BALANCE-SHEET FINANCING

• Use disclosures to assess a company’s financial position as if off-balance-sheet obligations (e.g., operating leases) were included in its total liabilities.

• Steps:- Determine present value of future operating lease payments.- Add present value of future operating lease payments to total debt

and to total assets.- Adjust expenses to

- Include depreciation expense, interest expense.- Exclude rent expense.

• The adjustments for operating leases essentially treat the transaction as if the asset subject to the operating lease had been purchased rather than leased.


SUMMARY

Financial statement analysis applications discussed in this presentation include• Evaluating a company’s past performance.• Projecting a company’s future performance.• Assessing the credit quality of a potential debt investment.• Screening for potential equity investments.• Adjusting a company’s financial statements to facilitate

cross-sectional comparison.

chapter 12: financial statement analysis: applications

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