COMPANY ANALYSIS

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Investment Analysis & Portfolio Management (FIN630)

Lesson # 16

COMPANY ANALYSIS

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

Where;

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

analysis.

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

percent.

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

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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."

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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.

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