Analyzing a Companyâ€™s Profitability

<< COMPANY ANALYSIS

Objective of Financial Statements >>

Investment Analysis & Portfolio Management (FIN630)

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)

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

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)

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)

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)

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

= the required rate of return for the stock

= 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.

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)

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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