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Financial Statement Analysis and Security Valuation Stephen H. Penman

Financial Statement Analysis and Security Valuation Stephen H. Penman. Prepared by Peter D. Easton and Gregory A. Sommers Fisher College of Business The Ohio State University With contributions by Stephen H. Penman – Columbia University

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Financial Statement Analysis and Security Valuation Stephen H. Penman

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  1. Financial Statement Analysisand Security ValuationStephen H. Penman Prepared by Peter D. Easton and Gregory A. Sommers Fisher College of Business The Ohio State University With contributions by Stephen H. Penman – Columbia University Luis Palencia – University of Navarra, IESE Business School

  2. The Analysis of the Cash Flow Statement Chapter 10

  3. Three Approaches to Calculate Free Cash Flow 1. A first approach to calculate FCF, C - I = OI - NOA that is, operating (comprehensive) income adjusted for the change in net operating assets 2. Also, as FCF equals total financing flows, C - I = NFE - NFO + d that is, comprehensive financial expenses, adjusted for the change in net financial obligations, plus dividends to common shareholders. 3. Finally, FCF can also be obtained from the reformulated Statement of Cash Flows.

  4. Business Activities:All the Stocks & Flows Chapter 7 Page 218 Figure 7.3 Product and Input Markets Capital Markets The Firm OR Customers F Debt Holders or Issuers Net Operating Assets (NOA) Net Financial Assets (NFA) C I OE Suppliers d Share Holders OI - DNOA = C - I C - I = D NFA - NFI + d Operating Activities Financing Activities • OR is operating revenue • OE is operating expense • NFI is net financial income OR - OE = OI • D indicates change • NFA can be negative (NFO)

  5. Business Activities and theFinancial Statements Chapter 7 Summary INCOME STATEMENT NIt = OIt - NFEt BALANCE SHEET Net Operating Assets NetFinancial Obligations NOAt = NOAt-1 + OIt - (Ct - It) NFOt = NFOt-1 - (Ct - It) + NFEt + dt CSEt = CSEt-1 + OIt - NFEt - dt CASH FLOW STATEMENT Ct - It = dt + Ft

  6. Three Approaches to Calculate Free Cash Flow 1. A first approach to calculate FCF, C - I = OI - NOA that is, operating (comprehensive) income adjusted for the change in net operating assets 2. Also, as FCF equals total financing flows, C - I = NFE - NFO + d that is, comprehensive financial expenses, adjusted for the change in net financial obligations, plus dividends to common shareholders. 3. Finally, FCF can also be obtained from the reformulated Statement of Cash Flows.

  7. Genentech, Inc. 1995 Reformulated Income Statement Chapter 9 Page 282 Exhibit 9.8 Operating income: Operating revenues $857,283 Operating expenses 712,632 Special merger charge 25,000 737,632 Operating income before tax 119,651 Tax reported 25,841 Tax on financial income (20,523) 5,318 Operating income after tax 114,333 Financial income: Interest revenue 60,562 Interest expense 7,940 Net interest income before tax 52,622 Tax on net interest income (.39) 20,523 Net interest income after tax 32,099 Unrealized gain on securities 44,681 Net financial income 76,780 Comprehensive income available to common $191,113 ======== Weighted average shares outstanding 121,220 Comprehensive income per share $1.58 Logo used with permission of Genetech, Inc.

  8. Genentech, Inc. 1995 Reformulated Balance Sheet • 19951994 • OPERATING ASSETS • Cash $ 10,000 $ 10,000 • Accounts receivable, less allowances 172,160 146,267 • Inventories 93,648 103,200 • Prepaid expenses and other current assets 39,267 28,475 • Property, plant and equipment 503,654 485,293 • Other assets 105,452 60,989 • Operating assets 924,181 834,224 • OPERATING LIABILITIES • Accounts payable 37,101 30,963 • Accrued compensation 36,945 36,939 • Accrued royalties 23,159 25,864 • Accrued marketing and promotion costs 18,863 27,463 • Accrued clinical and other studies 33,621 36,277 • Income taxes payable 14,329 17,839 • Other accrued liabilities 69,068 44,283 • Other long-term liabilities 25,504 25,483 • Operating liabilities 258,590 245,111 • NET OPERATING ASSETS (NOA) 665,591 589,113 • NET FINANCIAL ASSETS (NFA) • Cash equivalents 127,043 56,713 • Short-term investments 603,296 652,461 • Long-term investments 356,475 201,726 • Current portion of long-term debt (358) (871) • Long-term debt (150,000) (150,358) • 936,456 759,671 • COMMON SHAREHOLDERS’ EQUITY $1,602,047 $1,348,784 • ========== ========== Logo used with permission of Genetech, Inc. Chapter 9 Page 276 Exhibit 9.4

  9. Genentech, Inc. 1995 Calculation of Free Cash Flow: Method 1 Chapter 10 Page 311 Box 10.2 • Method 1: C - I = OI - NOA Operating income, 1995 $114,333 Net operating assets, 1995 $665,591 Net operating assets, 1994 589,113 76,478 Free cash flow, 1995 $ 37,855 Logo used with permission of Genetech, Inc.

  10. Three Approaches to Calculate Free Cash Flow 1. A first approach to calculate FCF, C - I = OI - NOA that is, operating (comprehensive) income adjusted for the change in net operating assets 2. Also, as FCF equals total financing flows, C - I = NFA - NFI + d that is, comprehensive financial expenses, adjusted for the change in net financial obligations, plus dividends to common shareholders. 3. Finally, FCF can also be obtained from the reformulated Statement of Cash Flows.

  11. Genentech, Inc. 1995 Reformulated Balance Sheet • 19951994 • OPERATING ASSETS • Cash $ 10,000 $ 10,000 • Accounts receivable, less allowances 172,160 146,267 • Inventories 93,648 103,200 • Prepaid expenses and other current assets 39,267 28,475 • Property, plant and equipment 503,654 485,293 • Other assets 105,452 60,989 • Operating assets 924,181 834,224 • OPERATING LIABILITIES • Accounts payable 37,101 30,963 • Accrued compensation 36,945 36,939 • Accrued royalties 23,159 25,864 • Accrued marketing and promotion costs 18,863 27,463 • Accrued clinical and other studies 33,621 36,277 • Income taxes payable 14,329 17,839 • Other accrued liabilities 69,068 44,283 • Other long-term liabilities 25,504 25,483 • Operating liabilities 258,590 245,111 • NET OPERATING ASSETS (NOA) 665,591 589,113 • NET FINANCIAL ASSETS (NFA) • Cash equivalents 127,043 56,713 • Short-term investments 603,296 652,461 • Long-term investments 356,475 201,726 • Current portion of long-term debt (358) (871) • Long-term debt (150,000) (150,358) • NFA 936,456 759,671 • COMMON SHAREHOLDERS’ EQUITY $1,602,047 $1,348,784 • ========== ========== Logo used with permission of Genetech, Inc. Chapter 9 Page 276 Exhibit 9.4

  12. Genentech, Inc. 1995 Reformulated Income Statement Chapter 9 Page 282 Exhibit 9.8 Operating income: Operating revenues $857,283 Operating expenses 712,632 Special merger charge 25,000 737,632 Operating income before tax 119,651 Tax reported 25,841 Tax on financial income (20,523) 5,318 Operating income after tax 114,333 Financial income: Interest revenue 60,562 Interest expense 7,940 Net interest income before tax 52,622 Tax on net interest income (.39) 20,523 Net interest income after tax 32,099 Unrealized gain on securities 44,681 Net financial income 76,780 Comprehensive income available to common $191,113 ======== Weighted average shares outstanding 121,220 Comprehensive income per share $1.58 Logo used with permission of Genetech, Inc.

  13. After Restatement:Genentech, Inc. Reformulated Statement of Common Equity: Balance - December 31, 1994: $1,348,784 Transactions with shareholders Stock issues $62,150 Stock repurchases - Common dividends - 62,150 Comprehensive Income Net income 146,432 Other comprehensive income 44,681 Preferred dividends - 191,113 Balance - December 31, 1995: $1,602,047 Logo used with permission of Genetech, Inc. • ROCE1995 = 191,113 / [(1,348,784 + 1,602,047) / 2] = 12.95% • or on a per share basis ROCE1995 = [191,113 / 121,220] / 11.50 = 13.71% Chapter 8 Page 235 Exhibit 8.1

  14. Genentech, Inc. 1995 Calculation of Free Cash Flow: Method 2 Chapter 10 Page 311 Box 10.2 • Method 1: C - I = OI - NOA Operating income, 1995 $114,333 Net operating assets, 1995 $665,591 Net operating assets, 1994 589,113 76,478 Free cash flow, 1995 $ 37,855 Logo used with permission of Genetech, Inc. • Method 2: C - I = NFA - NFI + d Net financial assets, 1995 $936,456 Net financial assets, 1994 759,671 $176,785 Net financial income, 1995 (76,780) Net dividend, 1995 (62,150) Free cash flow, 1995 $ 37,855

  15. Three Approaches to Calculate Free Cash Flow 1. A first approach to calculate FCF, C - I = OI - NOA that is, operating (comprehensive) income adjusted for the change in net operating assets 2. Also, as FCF equals total financing flows, C - I = NFA - NFI + d that is, comprehensive financial expenses, adjusted for the change in net financial obligations, plus dividends to common shareholders. 3. Finally, FCF can also be obtained from the reformulated Statement of Cash Flows.

  16. The Standard Statement of Cash Flows Chapter 10 Page 314 • Standard Statement of Cash Flows “Cash Flow from Operations” - “Cash Used in Investing Activities” + “Cash From Financing Activities” =  in Cash and Cash Equivalents

  17. Direct Method Cash Flow Statements:Northrop Grumman Corp. 1998 • Year ended December 31, $ in millions 19981997 • Operating Activities • Sources of Cash • Cash received from customers • Progress payments $ 1,844 $ 2,264 • Other collections 6,929 7,050 • Interest received 11 17 • Income tax refunds received 26 13 • Other cash receipts 6 7 • Cash provided by operating activities 8,816 9,351 • Uses of Cash • Cash paid to suppliers and employees 8,273 8,280 • Interest paid 219 251 • Income taxes paid 46 64 • Other cash payments 34 26 • Cash used in operating activities 8,572 8,621 • Net cash provided by operating activities 244 730 • Investing Activities • Payment for businesses purchased, net (50) - • Additions to property, plant and equipment (211) (238) • Proceeds from sale of property & equipment 63 106 • Proceeds from sale of affiliates/operations - 19 • Advances to affiliate (30) - • Funding of retiree activities (2) - • Other investing activities (5) - • Net cash used in investing activities (235) (113) Logo courtesy of Northrop Grumman Corporation Chapter 10 Page 313 Box 10.3

  18. Genentech, Inc. 1995 Reported Statement of Cash Flows • Increase in Cash Equivalents • YEAR ENDED DECEMBER 31 19951994 • Cash flows from operating activities: • Net income $ 146,432 $ 124,394 • Adjustments to reconcile net income to net • cash provided by operating activities: • Depreciation & amortization 58,421 53,452 • Writedown of securities available-for-sale 6,609 12,590 • Gain on sales of securities available-for-sale (7,432) - • Deferred income taxes (22,655) (34,193) • Loss on fixed asset dispositions (including merger related in 1995) 1,032 5,510 • Writedown of non-marketable equity securities 469 748 • Gain on sale of a non-marketable equity security (703) - • Changes in assets and liabilities: • Net cash flow from trading securities (50,014) (4,634) • Receivables and other current assets (28,446) (11,937) • Inventories 9,552 (18,475) • Accounts payable, other current liabilities and other long-term • liabilities 20,682 72,901 • Net cash provided by operating activities 133,947 200,356 • Cash flows from investing activities: • Purchases of securities held-to-maturity (682,396) (1,088,737) • Proceeds from maturities of securities held-to-maturity 924,345 877,139 • Purchases of securities available-for-sale (353,118) (22,644) • Proceeds from sales of securities available- for-sale 101,591 - • Purchases of non-marketable equity securities - (4,000) • Proceeds from sale of a non-marketable equity security 703 - • Capital expenditures (70,166) (82,837) • Change in other assets (38,651) (1,198) • Net cash used in investing activities (117,692) (322,277) • Cash flows from financing activities: • Stock issuances 54,946 71,955 • Reduction in long-term debt, including current portion (871) (794) • Net cash provided by financing activities 54,075 71,161 • Increase (decrease) in cash and cash equivalents 70,330 (50,760) • Cash and cash equivalents at beginning of year 66,713 117,473 • Cash and cash equivalents at end of year $ 137,043$ 66,713 • Supplemental cash flow data: • Cash paid during the year for: • Interest, net of portion capitalized $ 7,917 $ 7,058 • Income taxes 44,699 4,099 • Non-cash activity: Income tax benefits of $7,204 in 1995 and $26,038 in 1994 realized from employee stock option exercises were recorded as an increase in stockholders' equity. (C - I)GAAP = 133,947 - 117,692 = 16,255  37,855 Logo used with permission of Genetech, Inc. Chapter 10 Page 316

  19. Problems with the Standard Statement of Cash Flows Chapter 10 Page 314-318 1. Change in operating cash should be included in the investment section, and the change in cash equivalents in the financing section

  20. Genentech, Inc. 1995 Reported Statement of Cash Flows • Increase in Cash Equivalents • YEAR ENDED DECEMBER 31 19951994 • Cash flows from operating activities: • Net income $ 146,432 $ 124,394 • Adjustments to reconcile net income to net • cash provided by operating activities: • Depreciation & amortization 58,421 53,452 • Writedown of securities available-for-sale 6,609 12,590 • Gain on sales of securities available-for-sale (7,432) - • Deferred income taxes (22,655) (34,193) • Loss on fixed asset dispositions (including merger related in 1995) 1,032 5,510 • Writedown of non-marketable equity securities 469 748 • Gain on sale of a non-marketable equity security (703) - • Changes in assets and liabilities: • Net cash flow from trading securities (50,014) (4,634) • Receivables and other current assets (28,446) (11,937) • Inventories 9,552 (18,475) • Accounts payable, other current liabilities and other long-term • liabilities 20,682 72,901 • Net cash provided by operating activities 133,947 200,356 • Cash flows from investing activities: • Purchases of securities held-to-maturity (682,396) (1,088,737) • Proceeds from maturities of securities held-to-maturity 924,345 877,139 • Purchases of securities available-for-sale (353,118) (22,644) • Proceeds from sales of securities available- for-sale 101,591 - • Purchases of non-marketable equity securities - (4,000) • Proceeds from sale of a non-marketable equity security 703 - • Capital expenditures (70,166) (82,837) • Change in other assets (38,651) (1,198) • Net cash used in investing activities (117,692) (322,277) • Cash flows from financing activities: • Stock issuances 54,946 71,955 • Reduction in long-term debt, including current portion (871) (794) • Net cash provided by financing activities 54,075 71,161 • Increase (decrease) in cash and cash equivalents 70,330 (50,760) • Cash and cash equivalents at beginning of year 66,713 117,473 • Cash and cash equivalents at end of year $ 137,043$ 66,713 • Supplemental cash flow data: • Cash paid during the year for: • Interest, net of portion capitalized $ 7,917 $ 7,058 • Income taxes 44,699 4,099 • Non-cash activity: Income tax benefits of $7,204 in 1995 and $26,038 in 1994 realized from employee stock option exercises were recorded as an increase in stockholders' equity. Logo used with permission of Genetech, Inc. Chapter 10 Page 316

  21. Problems with the Standard Statement of Cash Flows Chapter 10 Page 314-318 1. Change in operating cash should be included in the investment section, and the change in cash equivalents in the financing section 2. Investments in financial assets are included in the investments section rather than in the financing section

  22. Genentech, Inc. 1995 Reported Statement of Cash Flows • Increase in Cash Equivalents • YEAR ENDED DECEMBER 31 19951994 • Cash flows from operating activities: • Net income $ 146,432 $ 124,394 • Adjustments to reconcile net income to net • cash provided by operating activities: • Depreciation & amortization 58,421 53,452 • Writedown of securities available-for-sale 6,609 12,590 • Gain on sales of securities available-for-sale (7,432) - • Deferred income taxes (22,655) (34,193) • Loss on fixed asset dispositions (including merger related in 1995) 1,032 5,510 • Writedown of non-marketable equity securities 469 748 • Gain on sale of a non-marketable equity security (703) - • Changes in assets and liabilities: • Net cash flow from trading securities (50,014) (4,634) • Receivables and other current assets (28,446) (11,937) • Inventories 9,552 (18,475) • Accounts payable, other current liabilities and other long-term • liabilities 20,682 72,901 • Net cash provided by operating activities 133,947 200,356 • Cash flows from investing activities: • Purchases of securities held-to-maturity (682,396) (1,088,737) • Proceeds from maturities of securities held-to-maturity 924,345 877,139 • Purchases of securities available-for-sale (353,118) (22,644) • Proceeds from sales of securities available- for-sale 101,591 - • Purchases of non-marketable equity securities - (4,000) • Proceeds from sale of a non-marketable equity security 703 - • Capital expenditures (70,166) (82,837) • Change in other assets (38,651) (1,198) • Net cash used in investing activities (117,692) (322,277) • Cash flows from financing activities: • Stock issuances 54,946 71,955 • Reduction in long-term debt, including current portion (871) (794) • Net cash provided by financing activities 54,075 71,161 • Increase (decrease) in cash and cash equivalents 70,330 (50,760) • Cash and cash equivalents at beginning of year 66,713 117,473 • Cash and cash equivalents at end of year $ 137,043$ 66,713 • Supplemental cash flow data: • Cash paid during the year for: • Interest, net of portion capitalized $ 7,917 $ 7,058 • Income taxes 44,699 4,099 • Non-cash activity: Income tax benefits of $7,204 in 1995 and $26,038 in 1994 realized from employee stock option exercises were recorded as an increase in stockholders' equity. Logo used with permission of Genetech, Inc. Chapter 10 Page 316

  23. Problems with the Standard Statement of Cash Flows Chapter 10 Page 314-318 1. Change in operating cash should be included in the investment section, and the change in cash equivalents in the financing section 2. Investments in financial assets are included in the investments section rather than in the financing section 3. Cash interest is included in the operating rather than in the financing section 4. Tax cash flows are all included in the operating section, and not allocated to operating and financing

  24. Genentech, Inc. 1995 Reported Statement of Cash Flows • Increase in Cash Equivalents • YEAR ENDED DECEMBER 31 19951994 • Cash flows from operating activities: • Net income $ 146,432 $ 124,394 • Adjustments to reconcile net income to net • cash provided by operating activities: • Depreciation & amortization 58,421 53,452 • Writedown of securities available-for-sale 6,609 12,590 • Gain on sales of securities available-for-sale (7,432) - • Deferred income taxes (22,655) (34,193) • Loss on fixed asset dispositions (including merger related in 1995) 1,032 5,510 • Writedown of non-marketable equity securities 469 748 • Gain on sale of a non-marketable equity security (703) - • Changes in assets and liabilities: • Net cash flow from trading securities (50,014) (4,634) • Receivables and other current assets (28,446) (11,937) • Inventories 9,552 (18,475) • Accounts payable, other current liabilities and other long-term • liabilities 20,682 72,901 • Net cash provided by operating activities 133,947 200,356 • Cash flows from investing activities: • Purchases of securities held-to-maturity (682,396) (1,088,737) • Proceeds from maturities of securities held-to-maturity 924,345 877,139 • Purchases of securities available-for-sale (353,118) (22,644) • Proceeds from sales of securities available- for-sale 101,591 - • Purchases of non-marketable equity securities - (4,000) • Proceeds from sale of a non-marketable equity security 703 - • Capital expenditures (70,166) (82,837) • Change in other assets (38,651) (1,198) • Net cash used in investing activities (117,692) (322,277) • Cash flows from financing activities: • Stock issuances 54,946 71,955 • Reduction in long-term debt, including current portion (871) (794) • Net cash provided by financing activities 54,075 71,161 • Increase (decrease) in cash and cash equivalents 70,330 (50,760) • Cash and cash equivalents at beginning of year 66,713 117,473 • Cash and cash equivalents at end of year $ 137,043$ 66,713 • Supplemental cash flow data: • Cash paid during the year for: • Interest, net of portion capitalized $ 7,917 $ 7,058 • Income taxes 44,699 4,099 • Non-cash activity: Income tax benefits of $7,204 in 1995 and $26,038 in 1994 realized from employee stock option exercises were recorded as an increase in stockholders' equity. Logo used with permission of Genetech, Inc. Chapter 10 Page 316

  25. Problems with the Standard Statement of Cash Flows Chapter 10 Page 314-318 1. Change in operating cash should be included in the investment section, and the change in cash equivalents in the financing section 2. Investments in financial assets are included in the investments section rather than in the financing section 3. Cash interest is included in the operating rather than in the financing section 4. Tax cash flows are all included in the operating section, and not allocated to operating and financing 5. The statement does not reflect non-cash transactions 6. In the case of installment purchases, only the first installment is classified as investment

  26. The Reformulated Statementof Cash Flows Chapter 10 Page 319 Box 10.4 GAAP Free Cash Flow + Net cash interest outflow (after tax) + Investments in financial assets - Sale of financial assets - Noncash investments - Increase in operating cash - Investment in operating assets on installment basis = Free Cash Flow GAAP Financing Flow + Net cash interest outflow (after tax) - Noncash financing + Purchase of financial assets + Increase in cash equivalents = Financing Cash Flow

  27. The Calculation of Cash Flowfrom Operations Chapter 10 Page 321 • The practical matter of distinguishing cash flow from operations from cash flow from investment activities is not an easy one: the cash flow from operations in the GAAP statement is not a clean measure. • Some cash flows from investment activities are classified as cash flows from operations • Taxes on gains from assets sales are classified as cash flow from operations • Note, however, that if what is needed is just the FCF (C-I), then a misclassification between investment and operating activities has no effect

  28. Cash Flows and Accrual Flows Chapter 10 Page 313 Box 10.3 • Net income has a cash flow component and an accrual component • The statement of cash flows gives the cash component, allowing one to calculate the accrual component by difference with net income • The indirect method provides an explicit reconciliation of these two numbers. If the direct method is used instead, a reconciliation is required in the notes • Measurement of accruals includes a more subjective component than measurement of cash flows: the quality of earnings

  29. A Financial StatementAnalysis Template Chapter 9 Page 292 1. Reformulate the statement of stockholders’ equity on a clean-surplus basis. 2. Calculate the comprehensive rate of return on common equity, ROCE, and the growth in equity from the reformulated statement of common stockholders’ equity. 3. Reformulate the balance sheet to distinguish operating and financial assets and obligations. 4. Reformulate the income statement on a clean-surplus basis and distinguish operating and financing income. 5. Compare reformulated balance sheets and income statements with reformulated statements of comparison firms through a comparative common size analysis and trend analysis. 6. Reformulate the cash flow statement. 7. Carry out the analysis of ROCE. 8. Carry out the analysis of growth.

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