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Analyzing a Company’s Profitability

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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 Coca-cola's data, we
calculate EPS for 2002 as follows:
For Coca-Cola =
$
% 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 ROE--in 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
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Investment Analysis & Portfolio Management (FIN630)
VU
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 Coca-Cola 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.
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Investment Analysis & Portfolio Management (FIN630)
VU
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 well-known 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.
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Investment Analysis & Portfolio Management (FIN630)
VU
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 long-term
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.
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Investment Analysis & Portfolio Management (FIN630)
VU
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 multiple-growth 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.
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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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