EVALUATION OF A COMPANY S PAST PERFORMANCE CHAPTER 8 FINANCIAL STATEMENT ANALYSIS: APPLICATIONS EVALUATION OF A COMPANY S PAST PERFORMANCE: APPLE

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1 CHAPTER 8 FINANCIAL STATEMENT ANALYSIS: APPLICATIONS EVALUATION OF A COMPANY S PAST PERFORMANCE Presenter s name Presenter s title dd Month yyyy Copyright 2013 CFA Institute 2 EVALUATION OF A COMPANY S PAST PERFORMANCE: APPLE EVALUATION OF A COMPANY S PAST PERFORMANCE: APPLE $ (millions) $70,000 $60,000 $50,000 $40,000 $30,000 $20,000 $10,000 $0 Sales Gr. Profit Net income Fiscal Year ($ millions) Net 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, Gross margin (% sales) 39% 40% 35% 33% Copyright 2013 CFA Institute 3 Copyright 2013 CFA Institute 4

2 EVALUATION OF A COMPANY S PAST PERFORMANCE: APPLE EVALUATION OF A COMPANY S PAST PERFORMANCE: APPLE Panel A: Data for Apple Inc. ($ millions) Cash and marketable securities Total current assets Total assets Total current liabilities Fiscal Year $51,011 $33,992 $24,490 $15,386 41,678 31,555 30,006 21,956 75,183 47,501 36,171 24,878 20,722 11,506 11,361 9, % 90% 80% 70% 60% 50% 40% 30% Peripherals and other hardware Software, service and other sales Other music related ipad & related ipod Total Mac iphone & related 20% 10% 0% Copyright 2013 CFA Institute 5 Copyright 2013 CFA Institute 6 FORECASTING FORECASTING Copyright 2013 CFA Institute 7 Copyright 2013 CFA Institute 8

3 FORECASTING FORECASTING Copyright 2013 CFA Institute 9 Copyright 2013 CFA Institute 10 ITERATIONS IN FORECASTING FORECASTING OPERATING PROFIT BASED ON HISTORICAL MARGINS Johnson & Johnson Baidu (NASDAQ: BIDU) Forecast Cash Flow Forecast Debt Forecast Income and Taxes Forecast Interest Expense (NYSE: JNJ) U.S. health care conglomerate, founded in 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%. Chinese language internet search engine, established in 2000 and went public on NASDAQ in Revenues for 2009 were 4.4 billion renminbi (RMB), an increase of 40% from 2008 and more than 14 times greater than revenues in For the four years prior to 2009, average operating profit margin was approximately 27.1%. Example 8-5 Copyright 2013 CFA Institute 11 Copyright 2013 CFA Institute 12

4 FORECASTING OPERATING PROFIT BASED ON HISTORICAL MARGINS ASSESSING CREDIT QUALITY 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%. 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%. 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 Actual operating profit for 2009 was $15.6 billion. Actual operating profit margin for 2009 was 25.2%. Actual operating profit for 2009 was RMB1.6 billion. Actual operating profit margin for 2009 was 36.4%. Copyright 2013 CFA Institute 13 Copyright 2013 CFA Institute 14 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 Retained cash flow to debt 6.1% 13.7% Free cash flow to net debt 7.0% 7.7% Copyright 2013 CFA Institute 15 Copyright 2013 CFA Institute 16

5 STOCK SCREENING EXAMPLE OF STOCK SCREENS Universe of Stocks Stocks Meeting Criterion Criterion Number Percent of Total Stocks Meeting Criteria Selection P/E <15 1, % Total debt/assets % NI/Sales > 0 2, % Dividend yield > 0.5% 1, % Meeting all four criteria simultaneously % Source for data: Copyright 2013 CFA Institute 17 Copyright 2013 CFA Institute 18 SCREENS AND BACK-TESTING TWO HYPOTHETICAL SCREENING STRATEGIES Valuation metrics + Accounting metrics Evaluation of screen using back-testing Caveats when back-testing: - Survivorship bias - Look-ahead bias - Data-snooping bias 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 B Invest in stocks that are components of a broadbased 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. Copyright 2013 CFA Institute 19 Copyright 2013 CFA Institute 20

6 TWO HYPOTHETICAL SCREENING STRATEGIES: AVOID UNINTENTIONAL SELECTIONS ANALYST ADJUSTMENTS 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 broadbased 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? 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? Copyright 2013 CFA Institute 21 Copyright 2013 CFA Institute 22 INVESTMENTS INVENTORY: EXAMPLE 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. 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 Copyright 2013 CFA Institute 23 Copyright 2013 CFA Institute 24

7 INVENTORY: EXAMPLE Company A (FIFO) Unadjusted (LIFO basis) Company B Adjusted (FIFO basis) Current assets (includes inventory) $300,000 $80,000 $100,000 Current liabilities $150,000 $45,000 $45,000 Current ratio Copyright 2013 CFA Institute 25 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 is SCHW $21,871/$5,073 = 4.3 AMTD $11,525/$3,551 = 3.2 Note: MV/BV equals the total market value of the stock (the market capitalization) divided by total stockholders equity. It is also referred to as the price-to-book ratio because it can also be calculated as price per share divided by stockholders equity per share. Copyright 2013 CFA Institute 26 GOODWILL AND INTANGIBLE ASSETS ($ millions) SCHW AMTD Total stockholders equity $5,073 $3,551 Less goodwill $528 $2,472 Book value, adjusted $4,545 $1,079 Adjusted MV/BV ($ 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 Copyright 2013 CFA Institute 27 OFF-BALANCE-SHEET FINANCING Use disclosures to assess a company s financial position as if offbalance-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. Copyright 2013 CFA Institute 28

8 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. Copyright 2013 CFA Institute 29