Company Analysis Lec2-Investment Managment And Portfolio-Lecture Notes, Study notes of Investment Management and Portfolio Theory

Download Company Analysis Lec2-Investment Managment And Portfolio-Lecture Notes and more Study notes Investment Management and Portfolio Theory in PDF only on Docsity! y g ( ) Lesson # 17 COMPANY ANALYSIS Analyzing a Company’s Profitability: On a company level, EPS is the culmination of several important factors going on within the company. Accounting variables can be used to examine these determining factors by analyzing key financial ratios. Analysts examine the components of EPS in order to try to determine whether a company’s profitability is increasing or decreasing and why. We start with the following accounting identity, which establishes the relationship between EPS and ROE: EPS = ROE x Book value per share Where ROE is the return on equity and book value per share is the accounting value of the stockholder’s equity on a per share basis. Book value typically changes rather slowly, making ROE the primary variable on which to concentrate. Using Coca-cola’s data, we calculate EPS for 2002 as follows: For Coca-Cola = $ % Return EPS = Net income after taxes = $3,050,000,000 = $1.23 — Shares Outstanding 2,478,000,000 ROE = Net income after taxes = $3,050,000,000 = — 25.9 Stockholder’s equity $11,800,000,000 Book value per share = Stockholder’s equity = $4.76 — Shares Outstanding ROE is the accounting rate of return that stockholders are in on their portion of the total capital used to finance the company; in other words, the stockholder’s return on equity. Book value per share measures the accounting value of the stockholders’ equity. Primary emphasis is on return on equity (ROE), because it is the key Component determining earnings growth and dividend growth. The return on equity is the end result of several important variables. Analysts and investors seek to decompose the ROE into its critical components in order both to identify adverse impacts on ROE and to help predict future trends in ROE. Different combinations of financial ratios can be used to decompose ROE—in other words; there are several ways to do this analysis. We will use the multiplicative relationship that consists of important financial ratios that easily can be calculated from a company’s financial statements. Analyzing Return on Equity (ROE): ROE = ROA × Leverage A major complement of ROE is Return on Assets (ROA), an important measure of a company’s profitability. ROA measures the return on assets, whereas ROE measures the docsity.com y g ( ) return to the stockholders, who financed only part of the assets (the bondholders finance the other part). To go from ROA to ROE, the effects of leverage must be considered. The leverage ratio measures how the firm finances its assets. Basically, firms can finance with either debt or equity. Debt, and although a cheaper source of financing, is a riskier method, because of the fixed interest payments that must be systematically repaid on time to avoid bankruptcy. Leverage can magnify that returns to the stockholders (favorable leverage) or diminish them (Unfavorable leverage). Thus, any given ROA magnified into a higher ROE by the judicious use of debt financing. The converse, however, applies; injudicious use of debt can lower the ROE below the ROA. To capture more easily the effects of an average, we use an equity multiplier rather than a debt percentage. This measure reflects the amount of assets financed per dollar of stockholders’ equity. For example, a ratio of 2 would indicate that $2 in assets are being financed by $1 in stockholders’ equity. Leverage = Total Assets/Stockholder’s equity Analyzing Return on Assets (ROA): ROA is an important measure of the firm’s profitability. It is a product of two factors, ROA = Net income margin × Turnover Net income margin = Net income/Sales Turnover = Sales/ Total Assets The first ratio affecting ROA, the net income margin, measures the firm’s earning power on its sales (revenues). How much net return is realized from sales given all costs? Obviously, the more the firms earns per dollar of sales, the better. Asset turnover is a measure of efficiency. Given some amount of total assets, how much sales can be generated? The more sales per dollar of assets, where each dollar of assets has to be financed with a source of funds bearing a cost, the better it is for a firm. The firm may have some assets that are unproductive, thereby adversely affecting its efficiency. ROA = Net Income × Sales Sales Total Assets ROA is a fundamental measure of firm profitability, reflecting how effectively and efficiently the firm’s assets are used. Obviously the higher the net income for a given amount of assets, the better is the return. For Coca-Cola and the return on assets is 12.45%. The ROA is improved by increasing the net income more than the assets (in percentage terms) or by using the existing assets even more efficiently. One of the determinants of ROA may be able to offset poor performance in the other. The net income margin may be low, but the company may generate more sales per dollar of assets than compatible companies. Conversely, poor turnover may be partially offset by high net profitability. In either case, analysts and investors are trying to understand how these factors are impacting Coke, and how they are likely to do so in the future. Earnings Estimates: docsity.com y g ( ) Determinants of the P/E Ratio: The expected P/E is conceptually a function of three factors: P/E = D1/E1 k – g Where; D1/E1 = the expected dividend payout ratio k = the required rate of return for the stock g = expected growth rate in dividends Investors attempting to determine the P/E ratio that will prevail for a particular stock should think in terms of these three factors and their likely changes.  The higher the expected payout ratio, other things being equal, the higher the P/E ratio. However, “other things” are seldom equal. If the payout rises, the expected growth rate in earnings and dividends, g, will probably decline, thereby adversely affecting the P/E ratio. This decline occurs because less funds will be available for reinvestment in the business, thereby leading to a decline in the expected growth rate, g.  The relationship between k and the P/E ratio is inverse. Other things being equal, as k rises, the P/E ratio declines; as k declines, the P/E ratio rises. Because the required rate of return is a discount rate, P/E ratios and discount rates move inversely to each other.  P/E and g are directly related; the higher the g, other things being equal, the higher the P/E ratio. Analyzing the P/E Ratio In analyzing a particular P/E ratio, we first ask what model describes the expected growth rate for that company. Recent rapid growth and published estimates of strong expected future growth would lead investors not to use the constant- growth version of the dividend valuation model. Instead, we should evaluate the company using a multiple-growth model. At some point, however, this growth can be expected to slow down to a more normal rate. P = Dn+1/En+1 En+1 k – g Where n is the year that the abnormal growth ends. Relative to the discussion above on the earnings game, investors must be increasingly concerned with the impact of managing earnings expectations on the P/E ratio. If a fast- growing company is being conservative in guiding the estimates of its earnings, and it regularly reports earnings higher than the consensus, then the forward P/E ratio is actually lower than it appears to be based on the current consensus estimate of earnings. In other words, a company may appear to sell for 50 times next year’s earnings, but this is based on an underestimate of next year’s earnings, because the consensus estimate has been guided to be below what actually occurs. For much of the 1990s Dell Computer fit this model, regularly reporting significantly larger earnings than the consensus estimate. docsity.com y g ( ) Fundamental Security Analysis in Practice: We have analyzed several important aspects of fundamental analysis as it is applied to individual companies. Obviously, such a process can be quite detailed, involving an analysis of a company’s sales potential, competition, tax situation, cost projections, accounting practices, and so on. Nevertheless, regardless of detail and complexity, the underlying process is as described. Analysts and investors are seeking to estimate a company’s earnings and P/E ratio and to determine whether the stock is undervalued (a buy) or overvalued (a sell). In doing fundamental security analysis, investors need to use published and computerized data sources both to gather information and to provide calculations and estimates of future variables such as EPS. The Value Line Investment Survey is the largest investment advisory service in the United States and is available in many libraries. This information can be very helpful in terms of estimates for EPS and in terms of a prediction as to the timelines of each stock for the coming year. In modern investment analysis, the risk for a stock is related to its beta coefficient. Beta reflects the relative systematic risk for a stock, or the risk that cannot be diversified away. The higher the beta coefficient, the higher the risk for an individual stock, and the higher the required rate of return. Beta measures the volatility of the stocks returns— its fluctuations in relation to the market. In trying to understand and predict a company’s return and risk, we need to remember that both are a function of two components. The systematic component is related to the return on the overall market. The other complement is the unique part attributable to the company itself and not to the overall market. It is a function of the specific positive or negative factors that affect a company independent of the market. It should come as no surprise that because security analysis always involves the uncertain future, mistakes will be made, and analysts will differ in their outlooks for a particular company. As we might expect, security analysis in the 21st century is often done differently than it was in the past. The reason for this change is not so much that we have a better understanding of the basis of security analysis the cost of mortars we have discussed earlier— value as a function of expected return and risk— remain the basis of security analysis today. Rather the differences now have to do with the increasingly sophisticated use of personal computers to perform any calculations quickly and objectivity. docsity.com