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Investment Analysis and Portfolio Management

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Investment Analysis & Portfolio Management (FIN630)
Lesson # 16
Fundamental Analysis:
Fundamental analyst at the company level involves analyzing basic financial variables in
order to estimate the company's intrinsic value. These variables include sales, profit mar-
gins, depreciation, the tax rate, sources of financing, asset utilization, and other factors.
Additional analysis could involve the firm's competitive position in its industry, labor re-
lations, technological changes, management, foreign competition, and so on. The end result
of fundamental analysis at the company level is a good understanding of the company's
financial variables and an assessment of the estimated value and potential of the company.
Investors could use the dividend discount model to value common stocks; alternatively, for
a short-run estimate of intrinsic value, the earnings multiplier model could be used. Intrinsic
(estimated) value is the product of the estimated earnings per share (EPS) for next year and
the expected multiplier or P/E ratio,
Stocks estimated value = V0 -/Estimated EPS X expected P/E ratio
Ei = earnings expected for the next year and P/E == the price/earnings ratio expected for the next
year. Many investors use relative valuation techniques, comparing a company's P/E ratio, P/B ratio,
and/or P/S to various benchmarks in order to assess the relative value of the company. Using these
techniques, it is' not necessary to make a. point estimate of intrinsic value. Instead, investors are
simply trying to determine if a stock is reasonably valued, overvalued, or undervalued without
being too precise about the absolute amount. For many investors, this is an effective method of
For purposes of discussion, we concentrate on earnings and P/E ratios for several reasons. First,
this is what investors encounter most frequently when analyzing stocks. Despite all the uproar
recently about accounting scandals, EPS is still the major variable of interest to a majority of
investors. Second, the close correlation between earnings changes and stock-price changes is
well documented. As Siegel states in his book, Stocks for the Long Run, "stock values are based on
corporate earnings."
Alternatively, consider the relationship between earnings growth and price performance. A study
by Elton, Gruber, and Gultekin examined the risk-adjusted excess returns available from buying
stocks on the basis of next year's growth in earnings. They found that those stocks with the
highest future growth in EPS showed the highest risk-adjusted returns. For the 30 percent of
the companies with the highest growth in EPS, the Risk-adjusted excess return was 7.48
percent; for the 30 percent with the lowest growth, the risk-adjusted excess return was 4.93
The Financial Statements:
Investors rely heavily on the financial statements of a corporation, which provide the major
financial data, about companies. To illustrate the use of financial statements in doing
company analysis, we examine the 2002 financial statements for the Coca-Cola Company, a
Investment Analysis & Portfolio Management (FIN630)
famous company with a brand name known worldwide, and a company that epitomizes the
global nature of business in today's world.
The Balance Sheet:
The balance sheet shows the portfolio of assets for a corporation, as well as its liabilities and
owner's equity, at one point in time. The amounts at which items are carried on the balance
sheet are dictated by accounting conventions. Cash is the actual dollar amount, whereas
marketable securities could be at cost or market value. Stockholders equity and the fixed
assets are on a book value basis.
It is important for investors to analyze a company's balance sheet, carefully. Investors wish
to know which companies are undergoing true growth, as opposed to companies that are
pumping up their performance by using a lot of debt they may be unable to service.
Income Statement:
This statement is used more frequently by investors, not only to assess current management
performance but also as a guide to the company's future profitability. The income statement represents
flows for a particular period, usually one year.
The key item for investors on the income statement is the after-tax net Income, which, divided by
the number of common shares outstanding, produces earnings per share. Earnings from continuing
operations typically are used to judge the company's success and are almost always the earnings
reported in the financial press. Nonrecurring earnings, such as net extraordinary items that arise from
unusual and infrequently occurring transactions, ate separated from income from continuing operations.
The Cash-Flow Statement:
The third financial statement of a company is die cash flow statement, which incorporates
elements of the balance sheet and income statement as well as other items. It is designed, to
track the how of cash through the firm. It consists of three parts:
1. Cash from operating activities
2. Cash from investing activities
3. Cash from financing activities
The cash-flow statement can help investors examine the quality of the earnings. For ex-
ample, if inventories are rising more quickly than sales, as happened in late 2000 and early
2001 for several companies, this can be a real sign pf trouble--demand may be softening. If
a company is cutting back on its capital expenditures, this could signal problems down the
road. If accounts receivable are rising at a rate greater than sales are increasing, a company
may be having trouble collecting money owed to it. If accounts payable are rising too
quickly, a company may be conserving cash by delaying payments to suppliers, a potential
sign of trouble for the company.
Certifying the Statements:
The earnings shown on an income statement are derived on the basis of generally accepted
accounting principles (GAAP). The company adheres to a standard set of rules developed by the
accounting profession on the basis of historical costs, which can be measured objectively. An auditor
from an independent accounting firm certifies that the earnings have been derived according to
accounting standards in a statement labeled the "auditor's report."
Investment Analysis & Portfolio Management (FIN630)
Reading the Footnotes:
Regardless of how closely a company adheres to good accounting practices, and how carefully the
auditors do their job, investors still need to examine the. "Notes to the Financial Statements," or
footnotes, if they- are really-to understand the company's financial situation! The footnotes often
provide important information about the accounting methods being used, any ongoing litigation, how
revenue is recognized, and so forth. The footnotes can help, an investor better understand the
quality of the reported earnings. The footnotes are located after the consolidated financial statements, and
can be found in 10-K and 10-Q Reports.
The Problems with EPS:
Reported Earnings:
Earnings derived under GAAP and reported on the income statement are known as reported,
earnings. Although the financial statements are derived on the basis of GAAP and are certified in an
auditor's report, problems exist with reported earnings: The basic problem simply stated; is that-
reported EPS for a company (i.e., accounting EPS) is the product of very complex GAAP principles,
which are subject 10 subjective judgments. EPS is not a precise figure that is readily comparable
over time, and the EPS figures for different companies often are not comparable to each other.
Alternative accountings principles can be, and are, used-to prepare the financial statements."
Many of the items in the balance sheet and income statement can be accounted for in more than
one way. Given the number of items that constitutes the financial statements, the "possible
number of acceptable (i.e., that conform to GAAPs). Combinations that "could be used is large. A
company could produce several legal and permissible EPS figures depending solely on-the
accounting principles used. The question that investors must try to answer is, "Which EPS best
represents the true position of a company?"
Because reported EPS is a function of the many alternative accounting principles in use, it is
extremely difficult, if not impossible, for the true performance of a company to be reflected
consistently in one figure. Since each company is different, is it reasonable to expect one accounting
system to capture the true performance of all companies? With the business world so complex,
one can make a case for the necessity of alternative treatments of the same item or process, such as
inventories or depreciation.
Accountants are caught in the middle between investors, who want a clean, clear-cut EPS figure, and
company, management, which wants to present the financial statements in the most favorable light.
After all, management hires the accounting firm, and, subject to certain guidelines, management
can change accounting firms. As long as the company follows GAAP, the accountant may find it
difficult to resist management pressure to use particular principles. At some point, an accounting firm
may resign as a company's auditor as a result of the problems and pressures that can arise.
The FASB faces conflicting Remands when it formulates or changes accounting principles, because
various interest groups want items accounted for in specific ways. The end result has been that the
"standards" issued by the FASB were often compromises that did not fully resolve the particular
issue; in some cases, they created additional complications.