

Investment
Analysis & Portfolio Management
(FIN630)
VU
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
Cocacola's data, we
calculate
EPS for 2002 as
follows:
For
CocaCola =
$
%
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 ROEin
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
107
Investment
Analysis & Portfolio Management
(FIN630)
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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
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 CocaCola 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.
108
Investment
Analysis & Portfolio Management
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Earnings
Estimates:
The
EPS that investor used to
value stocks is the future
(expected) EPS. Current
stock price
is a
function of future earnings
estimates and the P/E ratio,
not the past. If investors
knew
what
the EPS for a particular
company would be next year,
they could achieve good
results
in
the market.
In
doing fundamental security
analysis using EPS, an
investor needs to (1) know
how to
obtain
an earnings estimate; (2)
consider the accuracy of any
earnings estimate obtained;
and
(3) understand the role of
earnings surprises in impacting stock
prices. We consider
each
of these topics in
turn.
A
Forecast of EPS:
Security
Analysts' Estimates of Earnings Among
the most obvious sources of
earnings
estimates
are security analysts, who
make such forecasts as a part of their
job. This type of
earnings
information is widely available.
The value line investment
survey, for example,
forecasts
quarterly earnings for
several quarters ahead for
each company covered.
IBES
international
is a wellknown New York
firm that tracks earnings
estimates by analysts and
makes
them available.
Several
studies suggest that individual
analysts are by and large
undistinguishable in the
ability
to predict EPS. The
Practical implication of these
findings is that the
consensus
forecast
is likely to be superior to the forecasts
of individual analysts.
Mechanical
Estimates of Earnings An alternative
method of obtaining earnings
forecast is
the
use of mechanical procedures such as
time series models. In
deciding what type of
model
to use, some of the evidence
on the behavior of earnings
over time should be
considered.
Time
series analysis involves the
use of historical data to make
earnings forecasts. The
model
used assumes that the
future will be similar to the
past. The series being
forecast,
EPS
is assumed to have trend
elements, an average value,
seasonal factors, and error.
The
moving
average technique is a simple
example of the time series
model for forecasting
EPS.
Exponential
Smoothing, which assigns
differing weights to past to
values, is an example of
a
more sophisticated technique. A regression
equation would represent another
technique
for
making forecasts; the regression
equation could handle
several variables, such as
trend
and
seasonal factors. More sophisticated
models could also be
used.
Studies of
behavior of time path of
earnings have produced mixed
results. Most of the
early
studies
indicated randomness in the growth
rates of earnings. Other studies
found some
evidence
of non randomness. More recent studies,
particularly those of quarterly
earnings,
have
indicated that the time
series behavior of earnings is
not random.
Earnings
Surprises:
We
have established that changes and
earnings and stock prices are
highly correlated. We
have
also discussed the necessity of
estimating EPS and how such
estimates can be
obtained.
What remains is to examine
the role of expectations
about earnings in
selecting
common
stocks.
109
Investment
Analysis & Portfolio Management
(FIN630)
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The
association between earnings and stock
prices is more complicated than
simply
demonstrating
a correlation (association) between
earnings growth and stock
price changes.
Elton,
Gruber, and Gultekin found
that investors could not
earn excess returns by
buying
and
selling stocks on the bases of
the consensus estimate of earnings
growth. (The
consenses
estimate was defined as the average
estimate of security analysts at
major
brokerage houses.)
They also found that
analysts tended to overestimate earnings
for
companies
they expected would perform
well and to underestimate for companies
they
expected
would perform poorly.
Investors
must form expectations about
EPS, and these expectations will be
incorporated
into
stock prices if markets are
efficient. Although these
expectations are often
inaccurate,
they
play an important role in
affecting stock prices. Malkiel and Cragg
concluded that in
making
accurate one year predictions, "It is far
more important to note what
the market will
think
the growth rate of earnings will be
next year rather than to
note the realized
longterm
growth
rate."
As
Latane and Jones pointed
out, new information about
the stock is
unexpected
information.
The important point about
EPS in terms of stock prices is
the difference
between
what the market was
expecting the EPS to be and
what the company
actually
reported.
Unexpected information about
earnings calls for revision
in investor probability
beliefs
about the future and
therefore an adjustment in the
price of the stock.
To
assess the impact of
surprise factor in EPS,
Latane and Jones developed a
mortal to
express
and use the earnings
surprise factor in the
quarterly EPS of companies.
This
standardized
unexpected earnings (SUE) is
discussed as a part of the
market anomalies
associated
with the evidence concerning
market efficiency.
SUE
= Actual quarterly EPS Forecast
quarterly EPS
Standardization
variable
The
SUE concept is designed to
capture the surprise element
in the earnings just
mentioned
in other words, the
difference between what the
markets expects the
company
to earn and
what it actually does earn.
A favorable earnings surprise, in
which the actual
earnings
exceed the market's
expectation, should bring
about an adjustment to the
price of
the
stock as investors revise
their probability believes
about the company's
earnings.
Conversely,
an unfavorable earnings surprise
should lead to a downward adjustment
in
price;
in effect, the market has
been disappointed in its
expectations.
In
conclusion, prices are affected
not only by the level of and
growth in earnings but also
by
the
market's expectations of earnings.
Investors should be concerned
with what the
forecast
for
earnings and the difference
between the actual earnings
and the forecast that is,
the
surprise.
Therefore, fundamental analysis of
earnings should include more
than a forecast,
which
is difficult enough; it should
involve the role of the
market's expectations
about
earnings.
P/E
Ratio:
The
other half of the valuation
framework in fundamental analysis is
the price/earnings
(P/E)
ratio, or multiplier. The P/E
ratio indicates how much per
dollar of earnings
investors
currently
are willing to pay for a
stock; that is, the
price for each dollar of
earnings. In a
sense,
it represents the market's
summary evaluation of a company's
prospects.
110
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Determinants
of the P/E Ratio:
The
expected P/E is conceptually a function of
three factors:
P/E
= D1/E1
kg
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 multiplegrowth 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
kg
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.
111
Investment
Analysis & Portfolio Management
(FIN630)
VU
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.
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