C HAPTER 17

1. CHAPTER7, THIRD EDITION CHAPTER17 Projecting Cash Flow and Earnings Financial Statements and Ratio Analysis, Chapter 7, Third Edition Chapter Sections: Sources of Financial Information Financial Statements Financial Statement Forecasting Starbucks Company Case Study (Adolph Coors, Chapter 7, Third Edition) Chapter 17 of the fourth edition and Chapter 7 of the third edition deal mainly with financial statements and ratio analysis. It is important enough to warrant our attention. We will look at all the ratios but only compute a few. We will skip the forecasting.

2. Financial Statements • Balance Sheet • A financial summary of a firm’s assets, liabilities, and shareholders’ equity at a given point in time • Income Statement • A financial summary of the operating results of firm covering a specified period of time, usually 3 months (quarterly results) and 1 year (annual results) • Cash Flow Statement • A financial summary of a firm’s cash flow and other events that caused changes in the company’s cash position (again, quarterly & annually)

3. Financial Statements (continued) • Balance Sheet • Assets • Anything a company owns that has value • Liabilities • A firm’s financial obligations • Equity • An ownership interest in the company • Assets = Liabilities + Equity • Assets – Liabilities = Equity • Current versus Long-term Balance Sheet Example

4. Financial Statements (continued) • Income Statement • Income • The difference between a company’s revenues and expenses, used to pay dividends to stockholders or kept as retained earnings within the company to finance future growth • Net Income = Revenue – Expenses • But some income and expenses are not always received or paid in cash • That’s why there is the Cash Flow Statement… Income Statement Example

5. Financial Statements (continued) • Cash Flow Statement • a.k.a. Statement of Cash Flows • Cash Flow – Income realized in cash form • Non-cash Item – Income and expense items not realized in cash form • Operating Cash Flow – Cash generated by a firm’s normal business operations • Investment Cash Flow – Cash flow resulting from purchases and sales of fixed assets and investments • Financing Cash Flow – Cash flow originating from the issuance or repurchase of securities and payment of dividends Cash Flow Statement Example

6. Sources of Financial Statements • SEC EDGAR • Annual Report – 10K • Quarterly Update – 10Q • Regulation FD (Fair Disclosure) • Requires companies to make public disclosures of material information fairly • An “Earnings Call” is scheduled for a set date & time • Countless Other Sources I have heard many investors opine that nowadays there is simply too much information. “Wisdom Sold Separately.” – Nick Murray

7. Financial Ratios • Financial Ratios • The relation between two financial quantities expressed as the quotient of one divided by the other • Ratio Analysis • The study of the relationships between financial statement accounts Recall that there is no one ratio that can accurately sum up the overall general state of a company. Each ratio must be considered in the context of all the information gathered. Plus you must consider any ratio in the context of the industry the company exists within. (We will see an example soon.)

8. Financial Ratios – Common Stock • Common Stock Ratios – a.k.a. Market Ratios • Financial ratios that convert key information about a firm to a per-share basis • Price/Earnings Ratio – P/E • Price/Earnings to Growth Ratio – PEG • Dividends per Share • Dividend Yield • Dividend Payout Ratio • Book Value per Share • Price-to-Book-Value, Price-to-Cash Flow, Price-to-Sales These ratios use data from the Balance Sheet or the Income Statement or both.

9. Financial Ratios – Common Stock (continued) • Price / Earnings Ratio – a.k.a. P/E • Market Price divided by Earnings per Share Market Price of Common Stock Price / Earnings Ratio = ––––––––––––––––––––––––––––– Earnings per Share REVIEW: The most popular stock market statistic. Historically, P/E ratios were in the 5 to 12 range for mature companies and 14 to 20 range for growing companies. Greater than 20 was unusual. Today, it is commonplace. The P/E ratio also tells you how long it will take in years (assuming no changes in earnings) for the company to earn back its price. A P/E of 3 will take three years; a P/E of 20 will take twenty years.

10. P/E Ratios and Specific Industries Exxon – 9.74 Google – 22.75 Chevron – 8.72 CononoPhillips – 8.56 BP – 5.38 Yahoo – 18.32 Sohu – 15.55 Baidu – 28.91 ? J.P. Morgan – 9.66 Amgen – 18.97 Citigroup – 10.11 Wells Fargo – 11.83 US Bank – 12.86 Biogen Idec – 27.70 Life Technologies – 20.76 Illumina – 85.39 ?! Bristol Myers – 16.24 General Mills – 15.72 Pfizer – 19.04 Merck – 21.08 Eli Lilly – 13.44 Hormel – 16.38 Kellogg’s – 15.76 Nestle – 19.47 ? As of 4 October 2012

11. P/E Ratios and Specific Industries (continued) • How can we account for the wide P/E disparity between different industries and different companies within industries? • Again, it is the expectation of future earnings and dividend growth by investors “Take a nice little company that has been making shoelaces for 40 years and sells at a respectable six times earning ratio. Change the name from Shoelaces, Inc. to Electronics and Silicon Furth-Burners. In today’s market, the words “electronics” and “silicon” are worth 15 times earnings. However, the real play comes from the word “furth-burners” which no one understands. A word that no one understands entitles you to double your entire score. Therefore, we have six times earnings for the shoelace business and 15 earnings for electronics and silicon, or a total of 21 times earnings. Multiply this by two for furth-burners and we now have a score of 42 times earnings for the new company” – Jack Dreyfus, Founder, Dreyfus Funds A Random Walk Down Wall Street Today, replace furth-burners with nanotechnology and replace electronics and silicon with social networking and China.

12. Financial Ratios – Common Stock (continued) • Price/Earnings to Growth Ratio – a.k.a. PEG • Compares the P/E ratio to the rate of growth Stock’s P/E Ratio PEG Ratio = –––––––––––––––––––––––––––––––––––– 3- or 5-Year Growth Rate in Earnings A PEG Ratio of 1.0 means that P/E Ratio matches its growth rate. Historically, a PEG Ratio of 1.0 was desirable since it meant that the P/E Ratio equaled the growth rate. Anything above 1.0 was considered high. Now, greater than 1.0 is common.

13. Financial Ratios – Common Stock (continued) • Dividends per Share • Measure of how much dividends each share of stock will receive Dividends Annual Dividends Paid to Stockholders per = ––––––––––––––––––––––––––––––––––––––– Share Number of Shares Outstanding REVIEW: As we discussed, dividends became taboo during the 1990’s. Since the 2000-2002 bear market, investors have changed their minds about dividends. Dividends can be discussed in polite company again!

14. Financial Ratios – Common Stock (continued) • Dividend Yield • Measure of how much dividends are as a percentage of the stock price Dividend Dividends per Share = –––––––––––––––––––––––––––– Yield Market Price per Share REVIEW: This important statistic allows an investor to compare a company to other forms of investments that pay income (such as savings accounts or bonds). Traditionally, 4% to 6% was considered good. Currently, the S&P 500 is yielding just over 2% (while 10-year Treasury bonds are yielding less than 2% and savings accounts are yielding far less than 1%.) Some stocks are paying much more while many growth stocks are paying no dividends.

15. Financial Ratios – Common Stock (continued) • Dividend Payout Ratio • Measures of how much of a company earnings are being paid out to shareholders in the form of dividends Dividends per Share Payout Ratio = –––––––––––––––––––––– Earnings per Share REVIEW: More mature companies often pay out almost all their earnings in the form of dividends. Growing companies retain their earnings (called Retained Earnings) to support the growth of the company.

16. Financial Ratios – Common Stock (continued) • Book Value per Share • Measure of the net worth of a company on a per share basis Book Value Common Stockholders’ Equity per = –––––––––––––––––––––––––––––––– Share Number of Shares Outstanding REVIEW: Book Value per Share tells an investor how much assets are behind each share of stock. In other words, if all the assets of the company were liquidated, how much would each shareholder receive? It is common for the actual market price of a share to be above the book value per share since the company is worth more intact than if it were dissolved. Today, it is common for the market price to be far above the book value.

17. Financial Ratios – Common Stock (continued) • Price-to-Book-Value per Share • Ratio of the market price to the book value per share Price-to- Market Price per Share Book-Value = –––––––––––––––––––––––– per Share Book Value per Share REVIEW: Given that the Book Value per Share is often less than the market price, the Price-to-Book-Value Per Share tells an investor how far above the book value the market value is. If the Price-to-Book-Value per Share = 1.0, they are the same. Today, Price-to-Book-Value per Shares of 3 to 4 are not uncommon and some are much higher.

18. Financial Ratios – Common Stock (continued) • Price-to-Cash Flow Ratio • Current price divided by current cash flow per share • Cash flow often differs from earnings per share • For several reasons, but the most common reason is… • Depreciation is not an actual cash expenditure • But there are many reasons cash flow & earnings differ • “Good quality” versus “poor quality” earnings Current Price Price-Cash Flow Ratio = –––––––––––––––––––––––––––– Cash Flow per Share REVIEW: During the Internet mania, many companies were reporting record earnings. At the same time, their cash flow was negative. How could that be?

19. Financial Ratios – Common Stock (continued) • Price-to-Sales Ratio • Current price divided by annual sales per share • Historically, a higher Price-to-Sales Ratio suggested a higher sales growth • And a lower Price-to-Sales Ratio suggested a lower sales growth Current Price Price-to-Sales Ratio = ––––––––––––––––––––––––––––– Annual Sales per Share REVIEW: During the Internet mania, many analysts used Price-to-Sales instead of Price-to-Earnings since most all of the new companies never generated any earnings!

20. Financial Ratios – Profitability • Profitability Ratios • Financial ratios that measure a firm’s returns by relating profits to sales, assets, or equity • Net Profit Margin – a.k.a. After-Tax Profit Margin • Gross Margin • Operating Margin • Return on Assets • Return on Equity – a.k.a. Return on Investment Profitability Ratios allow one to measure the ability of a firm to earn an adequate return on sales, total assets and invested capital.

21. Financial Ratios – Profitability (continued) • Net Profit Margin – a.k.a. After-Tax Profit Margin • The rate of profit being earned from earnings after expenses and taxes Net Income Net Profit Margin = –––––––––––––––––– Total Revenue The higher, the better. It varies greatly from industry to industry.

22. Financial Ratios – Profitability (continued) • Gross Margin • The rate of profit being earned from gross profit Gross Profit Gross Margin = ––––––––––––––––––––– Total Revenue Again, the higher, the better. And again, it varies greatly from industry to industry.

23. Financial Ratios – Profitability (continued) • Operating Margin • The rate of profit being earned from net income adjusting for non-cash items Operating Income Operating Margin = ––––––––––––––––––––––– Total Revenue Yep, you guessed it. The higher, the better. And it varies greatly from industry to industry. So when we are looking at a specific company, we always need to look at its competitors within the industry. When we find a company that is atypical of its competitors in an industry, it is a signal that we have more investigative work to do.

24. Financial Ratios – Profitability (continued) • Return on Assets (ROA) • Measures how profitable a company is relative to its total assets Net Income Return on Assets = –––––––––––––––––––––– Total Assets Return on Assets looks at the amount of resources a company needs to support operations. It reveals how effective the company is in generating profits from the assets it has available. The higher, the better. Very popular ratio.

25. Financial Ratios – Profitability (continued) • Return on Equity (ROE) – a.k.a. Return on Investment • Measure of the overall profitability of a company in relation to the shareholders’ equity Net Income Return on Equity = –––––––––––––––––––––––––––– Total Stockholders’ Equity Because Return on Equity uses Stockholders’ Equity instead of Total Assets for the denominator, Return on Equity is sensitive to the amount of debt a company is carrying. Specifically, if a company carries a great amount of debt, ROE will be much larger than ROA. “You are using other people’s money to make your money.” Some investors think this is good; others are worried about the possible negative consequences of too much debt.

26. Financial Ratios – Liquidity • Liquidity Ratios • Financial ratios concerned with a firm’s ability to meet its day-to-day operating expenses and satisfy its short-term obligations as they come due • Current Ratio • Ratio of current assets to current liabilities • Net Working Capital • Current assets – current liabilities • Acid Test Ratio – a.k.a. Quick Ratio • These ratios use data from the Balance Sheet

27. Financial Ratios – Liquidity (continued) • Current Ratio • One of the more popular financial measures Current Assets Current Ratio = ––––––––––––––––––– Current Liabilities The Current Ratio is a good indicator of how stable a company is. Anything over 1.0 is normally considered acceptable. If your current assets equal or exceed your current liabilities, you should be able to satisfy your short-term obligations without any problems. Obviously, the greater the number is, the better.

28. Financial Ratios – Liquidity (continued) • Net Working Capital • Absolute dollar measure of liquidity Net Working Capital = Current Assets – Current Liabilities Net Working Capital is the Current Ratio in dollar terms. If the Current Ratio is greater than 1.0, then Net Working Capital will be positive. If the Current Ratio is less than 1.0, then Net Working Capital will be negative. The higher the Net Working Capital, the better. (This statistic is less popular than the Current Ratio. It really is not a ratio but is often discussed when discussing the Current Ratio and other liquidity ratios.)

29. Financial Ratios – Liquidity (continued) • Acid Test Ratio – a.k.a. Quick Ratio • A more stringent version of the Current Ratio Acid Cash + Accts recv + Short-term investments + Other current assets Test = –––––––––––––––––––––––––––––––––––––––––– Ratio Current Liabilities Unlike the Current Ratio, the Acid Test Ratio excludes inventory. This ratio measures the ability of the company to meet its short-term obligations even if its current inventory becomes obsolete or undesirable and hence, difficult or impossible to be turned into cash. Anything greater than 1.0 is considered adequate.

30. Financial Ratios – Activity • Activity Ratios • Financial ratios that are used to measure how well a firm is managing its assets • Accounts Receivable Turnover • Inventory Turnover • Total Asset Turnover • These ratios use data from the Balance Sheet and the Income Statement Activity ratios measure a firm’s ability to convert different accounts within their balance sheets into cash or sales. Companies will try to turn their production into cash or sales as fast as possible because this will generally lead to higher revenues.

31. Financial Ratios – Activity (continued) • Accounts Receivable Turnover • Measure of how accounts receivable are managed Total Revenue Accounts Receivable Turnover = ––––––––––––––––––––– Accounts Receivable The higher the number, the better. It indicates the return a company is getting from its investment in accounts receivable. By maintaining accounts receivable, firms are indirectly extending interest free loans to their clients. A high ratio implies that the company operates either on a cash basis, or its extension of credit and collection of accounts receivable is efficient. A low ratio implies that the company should re-assess its credit policies in order to ensure the timely collection of imparted credit not earning interest for the firm.(Or that may just be how that industry operates. Example: Defense.)

32. Financial Ratios – Activity (continued) • Inventory Turnover • Measure of how inventory is managed Total Revenue Inventory Turnover = –––––––––––––––––– Inventory The higher the number, the less time an item spends in inventory and the better the return the company is able to earn from funds tied up in inventory. As with all ratios, this ratio must be compared against industry averages. A low turnover implies poor sales and, therefore, excess inventory. A high ratio implies either strong sales or ineffective inventory buying / maintenance. High inventory levels are unhealthy because they represent an investment with a rate of return of zero. It also opens the company up to trouble in the case of falling prices or obsolete products.

33. Financial Ratios – Activity (continued) • Total Asset Turnover • Measure of how total assets are managed Total Revenue Total Asset Turnover = –––––––––––––––––––– Total Assets The Total Asset Turnover Ratio measures the firm’s efficiency at using assets to support sales and revenue, the higher the number the better. Companies with low profit margins tend to have high asset turnover, those with high profit margins have low asset turnover.

34. Financial Ratios – Leverage • Leverage Ratios • Financial ratios that are used to measure the amount of debt being used to support operations and the ability of the firm to service its debt • Debt-Equity Ratio – a.k.a. Debt-to-Equity Ratio • Times Interest Earned • Total Debt to Total Assets • These ratios use data from the Balance Sheet or the Income Statement Debt is often referred to as leverage. The idea is that you are using other people’s money to make money. You are using the borrowed money as a “lever” to increase your earnings. When one firm buys another firm using borrowed money, it is often referred to as a “leveraged buyout.”

35. Financial Ratios – Leverage (continued) • Debt-Equity Ratio • A measure of a company's financial leverage calculated by dividing long-term debt by shareholders’ equity. It indicates what proportion of equity and debt the company is using to finance its assets Long-term Debt Debt-Equity Ratio = ––––––––––––––––––––––––––– Total Stockholder’s Equity A higher Debt-Equity Ratio generally means that a company has been aggressive in financing its growth with debt. This can result in lower earnings as a result of the additional interest expense. Sometimes investors only use interest bearing long-term debt instead of total liabilities. The lower, the better.

36. Financial Ratios – Leverage (continued) • Times Interest Earned (TIE) • Measures the ability of a company to meet its fixed interest payments Times Earnings before Interest & Taxes Interest = ––––––––––––––––––––––––––––––––– Earned Interest Expense Times Interest Earned is used to determine how frequently interest payments are earned by the company during a year. The higher, the better. Normally, 3 or 4 is considered adequate.

37. Financial Ratios – Leverage (continued) • Total Debt to Total Assets • Measure of how much of the company’s total assets have been financed by debt Total Liabilities Total Debts to Total Assets = ––––––––––––––––––– Total Assets Total Debt to Total Assets includes both short-term and long-term debt and assets. If it varies substantially from the Debt-Equity Ratio, the company may be relying heavily on short-term debt. A heavy reliance on short-term debt can denote more risk.

38. CHAPTER17 – REVIEW Financial Statements and Ratio Analysis Chapter Sections: Sources of Financial Information Financial Statements Financial Statement Forecasting Adolph Coors Company Case Study Next week: Chapter 7, Stock Price Behavior and Market Efficiency