Chapter 7 Analyzing Common Stocks
Outline Learning Goals I.
Security An Analysis
A) Princi Principle pless of Secu Securit rity y Analys Analysis is 1. The Top-Do Top-Down wn Approach Approach to Securit Security y Analysis Analysis B) Who Needs Needs Security Security Analysi Analysiss in an Efficien Efficientt Market? Market? Concepts in Review II.
Econ Econo omic mic Anal nalysis ysis
A) Economic Economic Analysis Analysis and the Business Business Cycle B) Key Key Econ Econom omic ic Fact Factor orss C) Develo Developi ping ng an an Econo Economic mic Outl Outlook ook 1. Assessing Assessing the Potentia Potentiall Impact Impact on Share Prices Prices 2. The Market Market as a Leading Leading Indicator Indicator Concepts in Review III. III. Indu Indust stry ry Anal Analys ysis is
A) Key Issues 1. The Indu Industr stry y Growth Growth Cycl Cyclee B) Develo Developi ping ng an an Indu Industr stry y Outlo Outlook ok Concepts in Review
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IV. IV.
Gitman/Joehnk • Fundamentals of Investing, Ninth Edition
Fund Fundam amen enta tall Anal Analys ysis is
A) The Co Concept B) Fina Financ ncia iall Stat Statem emen ents ts 1. The The Bala Balanc ncee Shee Sheett 2. The Income Income Statem Statement ent 3. Statem Statement ent of Cash Cash Flows Flows C) Fina Financ ncia iall Rat Ratio ioss 1. What What Ratios Ratios Hav Havee to Offer Offer 2. Measur Measurin ing g Liqui Liquidit dity y a. Cu Curr rren entt Rati Ratio o b. Net Workin Working g Capit Capital al
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IV. IV.
Gitman/Joehnk • Fundamentals of Investing, Ninth Edition
Fund Fundam amen enta tall Anal Analys ysis is
A) The Co Concept B) Fina Financ ncia iall Stat Statem emen ents ts 1. The The Bala Balanc ncee Shee Sheett 2. The Income Income Statem Statement ent 3. Statem Statement ent of Cash Cash Flows Flows C) Fina Financ ncia iall Rat Ratio ioss 1. What What Ratios Ratios Hav Havee to Offer Offer 2. Measur Measurin ing g Liqui Liquidit dity y a. Cu Curr rren entt Rati Ratio o b. Net Workin Working g Capit Capital al
Chapte Chapterr 7 Analyz Analyzing ing Common Common Stocks Stocks
3. Acti Activi vity ty Rati Ratios os a. Accoun Accounts ts Receiva Receivable ble Turno Turnover ver b. Invent Inventory ory Turnov Turnover er c. Total Total Asset Asset Turno Turnover ver 4. Leve Leverag ragee Measur Measuree a. Debt Debt-E -Equ quit ity y Ratio Ratio b. Times Times Inte Interes restt Earne Earned d 5. Measur Measurin ing g Profitab Profitabili ility ty a. Net Net Pro Profi fitt Marg Margin in b. Retu Return rn on on Asse Assets ts c. Retu Return rn on Equi Equity ty 6. Breaki Breaking ng Down Down ROA ROA and ROE ROE a. Goin Going g from from ROA ROA to to ROE ROE b. An Expa Expande nded d ROE Equa Equatio tion n 7. Common Common Stock Stock Ratios Ratios a. Price/ Price/Ear Earnin nings gs Ratio Ratio b. Divide Dividends nds per Share Share c. Payo Payout ut Rati Ratio o d. Book Book Valu Valuee per per Shar Sharee D) Inte Interp rpre reti ting ng the the Numbe Numbers rs 1. Using Using Historica Historicall and Indust Industry ry Standards Standards
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2. Looking at the Competition Concepts in Review
Summary Putting Your Investment Know-How to the Test Discussion Questions Problems Case Problems 7.1
Some Financial Ratios Are Real Eye-Openers
7.2
Doris Looks at an Auto Issue
Excel with Spreadsheets Trading Online with OTIS
Key Concepts 1.
An overview of the security analysis process, including its goals and the functions it performs for the individual investor.
2.
The role and importance of economic in the stock valuation process.
3.
The role and importance of industry analysis in the stock valuation process.
4.
The concept of fundamental analysis and how it is used to assess a company’s financial position and operating results.
5.
The various types of accounting statements and financial ratios used in evaluating the historical performance of a company.
6.
An overview of fundamental analysis at work, including the need to evaluate company performance against historical and industry standards, and how such comparisons form the basic input for the valuation process.
Overview This chapter and the next two analyze principles and concepts of sound common stock investing. 1.
The principles of security analysis are first presented, beginning with the three basic ingredients of any viable analysis: (1) gathering relevant information, (2) organizing it into a logical framework, and (3) determining the intrinsic value of the stock. Knowledge of the intrinsic value of a stock is important in investment decision-making. An investor can decide whether a stock is overvalued or undervalued relative to the market price only if he or she has an indication of the intrinsic worth of the stock. Attention should be paid to the need for security analysis in an efficient market.
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The next section looks at the information-gathering process in detail. The instructor might mention that information for security analysis is usually collected and analyzed in a top-down fashion, in this order: economic analysis, industry analysis, and fundamental analysis. (a) Economic analysis usually takes both the economy and the stock market into account. Key factors that affect the economy are: governmental regulations, monetary and fiscal policies, inflation, spending by consumers and businesses, and foreign trade/balance of payments. These key economic indicators should be mentioned in class. Students should realize that only af ter assimilating this information can the investor prepare an economic outlook. Specific reports on the state of the economy (as noted in the text) should be mentioned. (b)The key factors that bear on industry analysis are considered next. Again, the instructor should mention specific sources of published reports on industry outlooks. (c) Fundamental analysis is the analysis of a particular company and is described below.
3.
In order to do company analysis, relevant financial statements are required. The most important of these are the company’s balance sheet and income statement. The usefulness of these financial statements in revealing information about the company under consideration should be emphasized. The components of both the balance sheet and the income statement, and exactly what they measure, should be indicated. Time should also be spent describing the Statement of Cash Flows and how it can be used by investors to assess the firm’s liquidity position. Bringing in financial statements of a popular or local company typically makes this segment of the course more realistic.
4.
Ratio analysis provides insights into the performance of a company. The instructor should point out that the historical ratios of a company reflect past performance. Also, comparing the company’s ratios with industry ratios—and with ratios of some of its major competitors—shows how a particular company performed in contrast to the performance of other companies in similar businesses. The class’s understanding of the procedures for computing and interpreting ratios should be checked, and the example in the text should be reviewed thoroughly.
5.
These additional points might also be mentioned in class: (a) In all three types of analysis, the investor does not come up with a number, but instead a general view or outlook. (b)All analyses of past performance only help in generating estimates for the future. (c) Further development of this chapter’s concepts follows in Chapter 8.
Answers to Concepts in Review 1.
The three major parts of security analysis are economic analysis, industry analysis, and fundamental analysis. Security analysis is important because it enables the investor to establish the expected return and risk for a stock and to evaluate its desirability in a logical, rational manner.
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2.
Intrinsic value, the end product of security analysis, is the measure of the underlying worth of a stock and provides a standard for helping investors to judge whether a particular stock is undervalued, fairly priced, or overvalued. If the intrinsic value of a stock is more than the market price, then the stock might be a good buy under the assumption that the stock will rise up to its intrinsic value. The converse would be true if the intrinsic value is less than the stock price. The stock might be a good sell.
3.
A satisfactory investment vehicle is one which offers an expected return, from the combination of current income and capital gains, that is commensurate with its perceived exposure to risk . The three steps in security analysis should enable investors to identify satisfactory investment vehicles. First, economic analysis assesses the general state of the economy and its potential effects on security returns. Industry analysis examines specific industries and the characteristics and outlook of those industries. Finally, fundamental analysis looks at the financial condition and operating results of a particular company in depth. Together, they enable the investor to develop expectations about a stock’s future course of behavior—what kind of return to expect and what kind of risk is likely to be involved. By examining variables such as future earnings, dividends, and so on, the security analyses process allows investors to develop a feel for the stock and what to expect of it in the future.
4.
If the stock market is efficient in the strongest form, then securities are never substantially mispriced and hence there would be no need for security analysis. But in reality, the financial markets are not perfectly efficient and pricing errors are inevitable. With thorough security analysis, individuals can profit whenever pricing errors occur. Paradoxically, financial market efficiency is achieved only due to the existence of traders who invest time and money in fundamental analysis to root out pricing errors. Security analysis is also useful in assessing an asset’s liquidity, current income, and risk and in verifying that these match investor criteria.
5.
Economic analysis involves studying the underlying nature of the economic environment in which a firm operates. Economic analysis also helps the investor form expectations about the future course of the economy. Such an analysis could be a detailed examination of the economy, sector by sector, or it may be done on a very informal basis. In any event, it deals with such aspects as production and unemployment statistics, inflation, fiscal and monetary policies, and their effects on security returns. This analysis is, indeed, essential to an investor’s decision-making framework. We live in an economy where firms are affected by general economic conditions; therefore, we cannot talk of security analysis without addressing economic analysis. There’s plenty of real world evidence to demonstrate the high correlation between the performance of stocks and general economic activity—i.e., when the economy starts improving, so do stock returns, all of which indicate the importance of economic analysis to the stock selection process.
6.
The behavior and current state of the economy is captured in the business cycle, which measures the change in total economic activity over time. When economic prospects are strong (the business cycle is on an upswing), security returns should do well. If economic prospects are poor (the business cycle is on a downswing), the returns from most stocks will deteriorate as well.
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(a) Gross Domestic Product (GDP): This is the broadest measure of an economy’s performance. GDP is an estimate of the total value of all goods and services produced in a country over the period of a year. (b) Leading Indicators: This is an index that combines the behavior of a dozen key measures, each of which tends to be an indication of things to come in the economy. The index of leading indicators is a single number that is supposed to “predict” the direction of the economy. (c) Money Supply: This is a measure of the amount of money in circulation as reported by the Federal Reserve. Actually, there are three measures of the money supply: M1, M2 (which is the most widely followed and includes currency, demand deposits, NOW accounts, time deposits, money market deposit accounts, and money funds), and M3. (d)Producer Prices: This is a measure of price behavior at the “wholesale” level. It shows the rate of change in prices at various stages of production, and is supposed to be a harbinger of things to come at the consumer price level (i.e., future inflation rates).
8.
The effects of high rates of inflation on common stocks can be devastating. In inflationary times, the quality of earnings declines as profit margins are squeezed and the purchasing power of the dollar deteriorates. An increase in inflation results in an increase in interest rates. Hence the cost of borrowing of firms increases resulting in less investments. Also, as interest rates rise, the return on common stocks becomes less attractive relative to other securities, like bonds and preferred stocks. However, when inflation subsides, common stocks become major beneficiaries, showing substantial price appreciation.
9.
Industry analysis is the part of the security analysis process involving the study of stocks in terms of their industry groupings. Industry analysis is important because stock prices are influenced, at least in part, by industry effects. Industry analysis can be used to establish the competitive position for a particular industry and to assess the nature of the opportunity the industry offers for the future. It also enables the investor to identify promising firms in an industry.
10. Some important aspects of industry analysis include: (a) The nature of the industry: whether it is monopolistic or competitive. (b)The extent of regulation: whether regulation is minimal or intense. (c) The role of big labor: the status of contract talks and general labor regulations. (d)Technological progress: are any technological breakthroughs likely? (e) Financial and operating characteristics: considerations involving labor, material, and capital. Economic forces important to the industry include the demand for the industry’s goods and services and the correlation with key economic variables. To the extent that an industry is influenced by economic forces, we would want to determine the economic variables that are of primary importance to an industry; it might be GDP, or the level of interest rates, or the unemployment rate. Also, the future outlook for these variables would be important since they are likely to set the tone for future industry performance. 11. The four stages of an industry’s growth cycle are: initial development— product introduction
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rapid expansion—everyone wants one mature growth—almost everyone has one stability or decline—there are other things to want The rapid expansion phase offers the biggest payoff to investors. At this stage, the industry’s products have gained acceptance, investors can foresee the industry’s future more clearly, and economic variables have little to do with the industry’s overall performance. The mature growth stage is most influenced by the economic cycle. 12. Fundamental analysis is the study of the financial affairs of a business. It is essential to the valuation process to the extent that the value of a stock is influenced by the performance of the company that issues the stock. An equivalent statement is that the value of a security depends not only on return, but also on risk—both of which are affected to a large extent by the operating characteristics and financial condition of the firm. Fundamental analysis helps to capture insights to these dimensions from financial statements and other information about a company and incorporates them in the valuation process. 13. Historical analysis provides some insight, along with economic and industry figures, for formulating expectations about the future growth prospects and profitability of a company. In particular, historical analysis helps the investor to learn the strengths and weaknesses of a company, identify underlying trends and developments, and evaluate the company’s operating efficiency. 14. Ratio analysis is the study of relationships that exist among and between various financial statement accounts. Ratio analysis provides a different perspective on the operating results and financial condition of the firm by expanding the information content of the financial statements. The most significant contribution of ratio analysis is that it enables the investor to thoroughly assess the firm’s past and present financial condition and operating results. 15. When historical standards are used, the company’s ratios are compared and studied from one period to the next. Industry standards involve a comparison of a company’s ratios to that of other companies in the same line of business. In the first case, the investor is looking for developing trends; in the second case, the investor wants to see how the company stacks up to its competitors.
Suggested Answers to Investing in Action Questions The Ten Commandments of Financial Statement Analysis (p. 304) (a) Which of the “Ten Commandments” is most important? (b) Why is it important to carefully read the footnotes? Answers:
(a) The answer will vary by student. Perhaps the key is to note that all of each “Commandment” is important. Paraphrasing the first “Commandment,” Thou shalt not use any commandment in isolation. Instructors may discuss Point 7 (on the limitations of financial statements) and Point 3 (on the importance of footnotes) in greater detail during class discussions.
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(b) It is very important to read the footnotes carefully while analyzing financial statements. Any change in accounting rules (e.g. change in inventory valuation from FIFO to LIFO etc.) will be disclosed here, which might have important implications on financial performance. Any off-balance sheet items (like leases) or contingent liabilities will also be disclosed in detail here. These disclosures will have important implications for investors. Hence, a substantial amount of time must be spent on analyzing the footnotes.
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Suggested Answers to Ethics in Investing Questions Cooking the Books: What Were They Thinking? (p. 318) Will the requirement that external auditors not be permitted to provide internal audits eliminate the conflict of interest? Answer:
In the wake of current accounting scandals, separation of internal and external audits and auditor independence has been the focus of the Sarbanes-Oxley Act of 2002 and subsequent ruling of the SEC. The role of internal audit is to perform the assessment of internal controls to and review of financial documentation on behalf of the board and executive management to safeguard against fraud and to strengthen corporate governance. The internal auditor ma y also provide advisory services in operational matters, and perform special assignments if so directed. The external audit, on the other hand, should give an independent review that the numbers in the accounts, as reported to the shareholders, are a reasonable picture of how the company is doing and how it is serving the interests of the shareholders. By separating both audits and making them independent it has become easier for both auditors to detect instances of accounting irregularities. The passage of the Sarbanes-Oxley Act of 2002 has expanded the role of external audit to attest of the effectiveness of management control over financial reporting rather than rubberstamping the numbers provided by the management
Suggested Answers to Discussion Questions 1.
(a) Fiscal policy would usually remain fairly strict during a strong economy with automatic stabilizers such as tax rates restraining inflation. (b)Interest rates influenced by the Fed would tend to move higher if inflation threatened. (c) Industrial production would grow at more than 3 to 5% annually. (d)Retail sales would tend to hold or increase. (e) Product prices would tend to rise given pressure to produce more and with the beginnings of the wage-price spiral.
2.
(a) Airline stock: production growth, fuel prices, and employment (b)A Cyclical stock: current business cycle, future predictions of economic activity (c) An electrical utility stock: interest rates, monetary policy (d)A building materials stock: national production growth, real estate sales, interest rates (e) An aerospace firm: government spending and contract size, employment
3.
(a) Profitability: d, e (b)Activity: a, f (c)Liquidity: c (d)Leverage: b, h (e) Common stock: g, i, j
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Analyzing Common Stocks
Solutions to Problems 1.
From abbreviated financial statements (dollars in millions) Liquidity
(1) (2)
Net working capital Current ratio
=
Current assets – Current liabilities
= =
$150 – $100 = $50 Current assets/Current liabilities
=
$150/$100 = 1.50
=
Sales/Total assets
=
$500/$350 = 1.43
=
Long-term debt/Stockholder’s equity
= =
$50/$200 = 0.25 Earnings before interest and taxes/interest
=
$65/$10 = 6.50
=
Net profits after taxes/Sales
=
$35/$500 = 7.0% Net profits after taxes/Total assets
Activity
(3)
Total asset turnover
Leverage
(4) (5)
Debt–equity ratio Times interest earned
Profitability
(6) (7)
Net profit margin Return on total assets
=
=
$35/$350 = 10.0% Net profits after taxes/Stockholders’ equity
=
$35/$200 = 17.5%
=
(Net profits after taxes – Preferred dividends)/
=
(8)
Return on equity
Common Stock Ratios
(9)
Earnings per share
Number of shares of common stock outstanding =
(10) Price/Earnings ratio
= =
(11) Price-to-Sales ratio
= =
(12) Dividends per share
=
=
(13) Dividend yield
= =
(14) Payout ratio
=
$35 – 0/10 = $3.50 per share Share price/EPS $75/$3.50 = 21.43 times Share price/Sales per share $75/($500/10) = 1.50 Total common dividends paid/ Common Shares outstanding $10/10 = $1.00 per share Dividends per share/Share price $1.00/$75 = 1.33% Dividends per share/EPS
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(15) Book value per share
= =
(16) Price-to-book value
=
$1.00/$3.50 = 29% Common equity/Common shares outstanding $200/10 = $20 Share price/Book value per share
=
$75/$20 = $3.75 Assets – Liabilities – Preferred Stock
=
$550,000,000 – 400,000,000 – 0
=
2.
Book Value
=
$150,000,000
Book Value per shares = Book Value/Number of Shares $150M/300M
=
$0.50 per share
=
3.
Price-to-Book Value = $5.50/$0.50 = 11
4.
(a) EPS
=
Net profits after taxes − Preferred dividends Number of common shares outstanding
=
$10,000,000 − $0 2,500,000
For Amherst: EPS
= $4
per share
(Note: Only preferred dividends, zero here, are subtracted from net profits after taxes. Common dividends are part of EPS.) (b) Book value per share
Stockholers equity number of common shares outstanding '
=
For Amherst: Book Value per share Price-to-book value
=
$45,000,000 2,500,000
=
$18.00 per share
=
Market price of common stock book value per share
=
$20.00 $18.00
For Amherst: Price-to-Book value
(c) Price/earnings (P/E) ratio =
= 1.11
Market price of stock EPS
For Amherst: P/E (d) Net profit margin =
=
$20 = 5 times $4
net profit after taxes total revenues
For Amherst: Net profit margin =
$10,000,000 $150,000,000
= 6.7%
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(e) Dividend payout ratio
=
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133
Dividends per share EPS
For Amherst: Dividend payout ratio Dividend yield
=
$1 = 25% $4
=
dividens per share market price of common stock
=
$1.00 $20.00
For Amherst: Dividend yield (f) PEG Ratio 5.
Stocks P/E Ratio 3−5 years growth rate in earnings
=
5 / 7.5 = 0.667
P/E = 15 and P = $25 $25/E = 15
6.
=
= 5%
$25/15 = E = $1.67
PEG = P/E ÷ (Earnings Growth Rate
×
100)
Earnings Growth Rate: Ending Earnings ÷ Beginning Earnings gives you the future value factor for five years; Scanning across the fifth row of the FVIF table gives you can identify the column (return) that results in that calculated amount. $3.22/ $2.00 = 1.61; FVIF10%, 5 periods = 1.611 PEG = 15/10 = 1.5
7.
=
Annual sales Total assets
Total asset turnover
=
$28,000,000 $15,000,000
Net profit margin
=
Net profits after taxes Annual sales
=
$2,000,000 $28,000,000
=
Net profits after taxes Total assets
=
$2,000,000 $15,000,000
(a) Total asset turnover For Highgate Computer:
=
1.87 times
For Highgate Computer: Net profit margin (b) Return on assets (ROA)
=
7.14%
For Highgate Computer: ROA
= 13.33%
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Note: The instructor might want to show that ROA can also be found by multiplying the firm’s total asset turnover by its net profit margin. This approach can be used to demonstrate that ROA is a function of a company’s profitability and its asset productivity. In the case of Highgate Computer, we have: ROA
=
Total asset turnover
=
1.87 × 0.0714 = 13.3%
×
Net profit margin
Net profits after taxes Stockholder's equity
Return on Equity (ROE) = For Highgate Computer: ROE
=
$2,000,000 $6,000,000
Book value per share
=
Stockholders' equity # of shares of common stock outsatnding
=
$6,000,000 500,000
=
33.33%
For Highgate Computer: Book value per share 8.
= $12
per share
TIE2003 = $550/$200 = 2.75 TIE2004 = $600/$250 = 2.40 Interest coverage fell. The company is less able to meet its interest payments in 2004.
9.
(a) (i)
EPS =
Net profits after taxes − Preferred dividends Number of common shares outstanding
For Financial Learning Systems: EPS = (ii) Price/Earning (P/E) ratio
=
$6,850,000 − $500,000 2,500,000
=
$2.54
Market price of stock EPS
For Financial Learning Systems: P/E = (iii) Book value per share
=
$45.00 $2.54
= 17.72
Stockholders' equity number of common shares outstanding
For Financial Learning Systems: Book value per share
$78,000,000 − $32,000,000 − $5m 2,500,000 = $16.40 per share =
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135
(b) If the EPS rises to $3.75: 17.72 =
market price of stock $3.75
Market price of stock = $66.45 If the EPS drops to $1.50: market price of stock $1.50 Market price of stock = $26.58 17.72 =
(c) If the EPS rises to $3.75 and P/E jumps to 25: market price of stock $3.75 Market price of stock = $93.75 25 =
(d) Both the EPS and P/E drop—to $1.50 and 10 times earnings: market price of stock $1.50 Market price of stock = $15.00 10 =
(e) As shown in the case of Financial Learning Systems, higher earnings improve the stock price for a given P/E multiple, and when the P/E multiple rises, for a given level of earnings, the stock price rises. 10. We will use the following three ratios: Return on assets
=
Net profit after taxes/Total assets
Net profit margin
=
Net profit after taxes/Sales
Total asset turnover
=
Sales/Total assets
(a) In this problem, we cannot calculate ROA until we find out what profits are. To do this, we must determine sales and then apply the net profit margin to this sales figure to determine net profits. That is, using the total asset turnover ratio, sales must be $20,000,000: 2.0 = Sales/$10 million Solving for sales: Sales = $10 million × 2.0 = $20 million Using the equation for net profit margin, net profits after taxes must be $3,000,000: 0.15 = net profits after taxes/$20 million Solving for net profits: Net profits
=
$20 million × 0.15 = $3 million
Given this information, we can compute ROA as: $3,000,000/$10,000,000 = 30% (Note: Or this problem can also be solved by simply multiplying the company’s asset turnover by its profit margin; i.e., 2.0 × 0.15 = 30%).
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(b) To solve this part of the problem, first find the firm’s equity. We know it has $10 million in assets and the problem states that 40% of the assets are financed with equity. Therefore: Equity
=
$10,000,000 × 0.40 = $4,000,000
Now, to find ROE: ROE =
Net Profits $3,000,000 = Equity $4, 000, 000
=
75%
(Note: Comparing ROE to ROA, we see that ROE is much larger [75% vs. 30%]. The reason is the firm’s high debt/financial leverage—i.e., 60% of the firm’s assets are financed with debt, which acts to magnify profitability.) Market price of the stock EPS
11. Price/Earnings (P/E) ratio = First, find EPS: EPS = Since: Net profit after taxes
Net profit after taxes Number of shares of stock outstanding =
Sales × net profit margin:
EPS = P/E ratio = Price-to-sales ratio =
$150,000,000 × 0.10 $15,000,000 = 5, 000, 000 5, 000, 000 $25 = 8.3 times $3 Market price of stock Sales per share
=
$3 per share
Find sales per share: Sales Number of shares outstanding
SPS =
= $30
=
$150, 000, 000 5,000,000
per share
Now, the Price-Sales Ratio is: PSR = Dividend Yield
=
$25 = 0.833 $30 Dividends per share Market price of common $3 × 0.35 $25
=
$1.05 $25
=
=
EPS × Dividend payout ratio* Market price of common
4.2%
*Note: Dividends per share
=
EPS × Dividend payout ratio.
PEG Ratio
=
Stock's P/E Ratio 3−5 years growth rate in earnings
This implies: Growth
=
Stocks P/E Ratio PEG Ratio
Growth
=
8.3/2 = 4.15%
Chapter 7
12. ROA = Net Profit Margin × Total Asset Turnover
=
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137
0.08 × 2 = 0.16 or 16%.
13. ROE = ROA × Equity Multiplier ROA = Net Profit Margin × Total Asset Turnover Equity Multiplier
=
Total Assets/Total Equity
ROA 0.08 × 2 = 0.16 Equity Multiplier
=
$1B/$500M = 2
ROE = 0.16 × 2 = 0.32 or 32% 14. Sales: Total Asset Turnover X Assets Total Asset Turnover
=
2 and Total Assets
=
$1B
Sales = 2 × $1B = $2B Net Profit = Net Profit Margin × Sales Net Profit = 0.08 × $2B = $160M 15. There is no set solution to this problem, since the answer will vary with the stock selected by the student. The students should be encouraged (or required) to actually compute the requested ratios from the recent financial statements of the companies they select. They can use annual reports, Mergent , or S&P to obtain needed balance sheet and income statement information. The Internet also has several useful sites. This problem may result in some interesting and possibly confusing responses, because students will get their information from many diverse sources. Frequently the ratio calculations will differ. This presents the instructor with the opportunity to discuss refinements to ratio calculations, the importance of consistency, and the fact that the ratios are only tools to be used in the stock evaluation and selection process. 16. There is no set solution to this problem. In developing an answer, the students can either “pick up” the ratios/information from Value Line or a similar source, or they can be required to actually compute requested ratios from the recent financial statements of the companies they select. Annual reports, Mergent or S&P will provide the needed balance sheet and income statement information. The following information was taken from Part 1 of the Value Line Investment Survey.
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Value Line’s Timeliness Ranking
Beta
P/E Ratio
Dividen
Earnings
d Yield
Per Share
Wal-Mart Target
3 2
1.05 1.20
27.3 19.5
0.7 0.7
0.46 0.33
Sara Lee Campbell Soup
5 3
0.55 0.65
13.5 17.2
3.7 2.4
0.29 0.18
IBM Intel
3 2
1.05 1.35
20.6 41.6
0.7 0.2
1.02 0.25
Tupperware Ball
4 2
0.75 0.95
20.0 14
5.9 1.1
0 1.34
Liz Claiborne Quicksilver
3 3
0.95 1.00
13.8 16.3
0.6 0
0.89 0.21
General Dynamics
3
0.75
16.5
0
0.6
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Boeing
4
1.00
38.7
Analyzing Common Stocks
1.7
0.32
139
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17. (a) All of the following ratios for Otago Bay Marine are based on the 2003 and 2004 financial statements ($ in thousands) and are computed using the formulas in the chapter: (1)Current ratio
=
Current assets/Current liabilities
2003
$133,212/$22,498
=
5.92
2004
$111,914/$50,862
=
2.20
=
2.36
Industry (2)Total asset turnover = Sales/Total assets 2003
$245,424/$224,470
=
1.09
2004
$259,593/$303,940
=
0.85
=
1.27
Industry (3)Debt-equity ratio
=
Long-term debt/Stockholders’ equity
2003
$20,268/$181,704
=
11.15%
2004
$40,735/$212,343
=
19.18%
=
10.0 %
Industry (4)Net profit margin
=
Net profit after taxes/Total Revenues
2003
$32,032/$245,424
=
13.05%
2004
$35,442/$259,593
=
13.65%
=
9.30%
Industry (5)ROA
=
Net profit after taxes/Total assets
2003
$32,032/$224,470
=
14.27%
2004
$35.442/$303,940
=
11.66%
=
15.87%
Industry (6)ROE
=
Net profit after taxes/Stockholders’ Equity
2003
$32,032/$181,704
=
17.63%
2004
$35,442/$212,343
=
16.69%
=
19.21%
Industry (7)EPS
=
Net profit after taxes − Preferred dividends Number of common shares outstanding
2003
$32, 032 − $0 10,848
= $2.95
per share
2004
$35, 442 − $0 10,848
= $3.27
per share
Industry (8)P/E Ratio
=
=
$1.59
shared price/EPS
2003
$80.75/$2.95
=
27.37
2004
$74.25/$3.27
=
22.71
=
19.87
Industry
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(9) Dividend yield
=
Dividends per share/Market price per share
2003
$0.27/$80.75
=
0.33%
2004
$0.35/$74.25
=
0.47%
=
0.44%
Industry (10)Dividend payout ratio
=
Dividends per share/EPS
2003
$0.27/$2.95
=
9.15%
2004
$0.35/$3.27
=
10.70%
=
26.00%
Industry
(11)Price-to-book value ratio = Share price/Book value per share Book value per share
=
stockholder's equity number of common shares outstanding
2003 BV
=
$181,704 10,848
2004 BV
=
= $16.75
$212,343 = $19.57 10,848
Price-to-book-value: 2003
=
$80.75/$16.75
=
4.82
2004
=
$74.25/$19.57
=
3.79
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=
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143
6.65
(b) Based on the comparison to industry average ratios, the financial condition of Otago Bay Marine (OBM) appears to be deteriorating. First, OBM’s current ratio has declined 63%, indicating its ability to meet short-term obligations has weakened substantially. OBM’s current liabilities, which have grown 126% over the past year, are driving this weakened position in liquidity. Also, the activity measure—total asset turnover—which was below the industry average last year, has declined even further, suggesting that corporate resources are being poorly managed. With respect to leverage, OBM’s ratio has grown to nearly twice the industry average, indicating a need to control and reduce the amount of debt in the capital structure. Despite the high leverage ratio, the firm’s ROE, which indicates the extent to which leverage has enhanced the returns to stockholders, has declined even further below the industry’s average. Similarly, OBM’s ROA has declined even further below the industry’s average ROA. The decline in ROA is related to the large increase (115%) in PPE, and the 107% increase in other long-term assets. A complete analysis would necessarily include an analysis of these assets. For example, the increase in PPE could indicate that the company is anticipating future growth, or that the company has updated its PPE and will be much more profitable in the future due to the efficiencies of modern equipment. The market appears to reflect this deterioration in OBM’s financial picture from 2003 to 2004. The stock price has declined 8% and the P/E ratio has declined 17%, and the price-to-book value has decline another 1% to about half of the industry average. In summary, despite the relatively small percentage increases in net profit after taxes, Otago Bay Marine seems poorly managed. Gone unchecked, OBM’s financial condition will deteriorate further and be reflected in profitability measures well below industry averages. Although OBM’s ratios are only one part of their total financial outlook, they seem to indicate that problems exist within the firm.
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18. (a)
FOR 2000 Profit margin
Asset turnover
=
net earnings net sales
=
$20.2 $179.3
=
11.27%
=
= =
net sales total assets $179.3 $136.3 1.32
Using profit margin and asset turnover to calculate ROA: net earnings net sales × net sales total assets ROA = 11.27% × 1.32 ROA =
=
14.88%
ROE = ROA × Equity multiplier Where Equity multiplier
ROE
=
Total assets/stockholder’s equity
=
$136.3/$109.6
=
1.24
=
14.88%
=
18.45%
×
1.24
(b)For 2004: ROA
ROE
=
Profit margin × Total asset turnover
=
13.65%
=
11.60%
= =
×
0.85
ROA
×
Equity multiplier
11.60%
×
($303,940/$212,343)
11.60%
× 1
.43
16.59% (c) Between 2000 and 2004, Otago Bay Marine’s ROA and ROE measures both deteriorated. With respect to ROA, total assets have grown faster than net sales, thereby affecting total asset turnover—and consequently, ROA—adversely: Whereas net sales grew 44%, total assets grew 123%. The second component of ROA, the profit margin, grew slightly. Thus, the decline in ROA is attributable mainly to the dramatic increase in total assets (ROA fell from 14.88% in 2000 to 11.6% in 2004). The growth in total assets is also a main contributor to the decline in ROE, which is composed of ROA, multiplied by the equity multiplier. The higher equity multiplier reflects the fact that total assets also outgrew stockholder’s equity (a large portion of new assets were debt-financed). However, the multiplier was not large enough to reverse the effects of the decline in ROA on ROE. Thus, through the sharp increase in total assets, ROA and ROE declined.
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145
(d)Generally, these changes from 2000 to 2004 do not appear fundamentally healthy for Otago Bay Marine. The higher total assets, a large percentage of which was financed by debt, appears to have reduced OBM’s profitability and its future ability to meet short and long-term obligations. The decline in ROA is related to the large increase (115%) in PPE, and the 107% increase in other long term assets. A complete analysis would necessarily include an analysis of these assets. For example, the increase in PPE could indicate that the company is anticipating future growth, or that the company has updated its PPE and will be much more profitable in the future due to the efficiencies of modern equipment.
Solutions to Case Problems Case 7.1 Some Financial Ratios are Real Eye-Openers The objective of this case is to have students calculate and interpret ratios as part of the fundamental analysis of a firm. 1.
All the ratios below for South Plains Chemical are computed according to the formulas in the chapter. South Plains Chemical (dollars in thousands) Liquidity
(a) Net working capital (b) Current ratio
=
Current assets – Current liabilities
=
$21,250 – $10,000
=
Current assets/Current liabilities
=
$21,250/$10,000 = 2.12
=
Sales/Accounts receivable
=
$50,000/$8,000 = 6.25
=
Sales/Inventory
=
$50,000/$12,000 = 4.17
=
$11,250
Activity
(c) Receivables turnover (d) Inventory turnover
(e) Total asset turnover = Sales/Total assets =
$50,000/$30,000 = 1.67
Leverage
(f) Debt-equity ratio
=
Long-term debt/Stockholder’s equity
=
$8,000/$12,000 = 0.67
(g) Times interest earned = Earnings before interest and taxes/interest =
$10,000/$2,500 = 4.0
=
Net profits after taxes/Sales
=
$5,000/$50,000 = 1 or 10%
=
Net profits after taxes/Total assets
Profitability
(h) Net profit margin (i) Return on total assets
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(j) Return on equity
=
$5,000/$30,000 = 0.166 or 16.67%
=
Net profits after taxes/Stockholder equity
=
$5,000/$12,000 = 0.4167 or 41.67%
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147
Common Stock Ratios
(k) Earnings per share
=
(Net profits after taxes – Preferred dividends) /# of shares of common stock outstanding
(l) Price/Earnings ratio (m) Dividends per share
=
$5,000 – 0/5,000 = $1/share
=
Share price/EPS
=
$25/$1
=
Total common dividends paid/
=
25 times
Common shares outstanding (n) Dividend yield (o) Payout ratio (p) Book value per share (q) Price-to-book value
2.
=
$1,250/5,000 = $0.25/sh.
=
Dividends per share/Share price
=
$0.25/$25.00 = 0.01 or 1%
=
Dividends per share/EPS
=
$ 0.25 / $1.00 = 0.25 or 25%
=
Common equity/Common shares outstanding
=
$12 million/5 million
=
Share price/Book value per share
=
$25/$2.40 = 10.42
=
$2.40
Comparing the ratios computed in question 1 to the latest industry averages, we find: (a) Liquidity: South Plains is more liquid than the average firm in its industry. (b) Activity: Here South Plains is weak; the low ratios suggest poor utilization of assets. Since accounts receivable and inventory are close to the industry figures, the deviation seems to come from excess fixed assets. (c) Leverage: The firm uses more debt than average, and its ability to cover interest is much lower than the average firm. (d)Profitability: The results are mixed here. The firm has higher margins and higher ROE. The lower return on assets reflect the poor activity ratios mentioned above. (The fact that the firm can have low ROA and high ROE is due to its high leverage. Since a smaller percentage of South Plains is financed with equity, the ROE is magnified more than for the typical firm.) (e) Common stock : All the measures relative to dividends are low for this firm, yet its price/earnings ratio is higher than average. This suggests that the market anticipates above-average profitability and returns in the future. That is why, although its current dividend yield is low, investors are willing to pay a high price/earnings ratio. The same goes for price-to-book value; like the P/E ratio, it’s much higher than average and provides further support that the market is anticipating good things from South Plains.
3.
The firm seems to have good prospects for attractive returns but also has high risk. For Jack to continue his evaluation of South Plains Chemical, he must feel the opportunities for the firm are promising and commensurate with the risk involved. Due to South Plains’ strong profitability, he should now proceed with a more in-depth analysis. (Although not discussed in the case, fundamental analysis should not be performed alone; careful economic and industry analyses are also important.)
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Case 7.2 Doris Looks at an Auto Issue This case allows the student to experience the three steps of security analysis. (a) Other economic information that Doris might find helpful includes government fiscal policy (taxes, spending, debt management); monetary policy (money supply growth, interest rates); consumer spending and the investment plans of businesses; energy situation (oil imports, cost and availability of supplies, domestic oil prospects); foreign trade and the balance of payments (especially the value of the dollar); and the inflation rate. Although each is important, the three most important are probably interest rates, foreign trade and the cost of oil. Interest rates are important since most automobiles are purchased on credit. Foreign trade is important because of the impact that auto imports and exports have on auto sales; also foreign trade affects the value of the dollar, which in turn makes U.S. cars more or less expensive relative to imports. Finally, the cost of gas and oil is closely watched by drivers, and can impact the demand for gas guzzlers versus more fuel efficient cars. (b) 1. Auto imports: Trends in auto imports more clearly define potential growth for domestic producers. The recent growth of imports has been at the expense of U.S. producers. Federal restrictions on foreign imports would greatly alter industry conditions for domestic firms. 2. The relationship of the United Auto Workers (UAW) and the auto makers is an important part of the analysis. A better relationship leads to lower costs of production; a poor relationship may mean strikes, slowdowns, higher wage contracts, and so on. One important date here is the expiration date of the existing contract. 3. Interest Rates: As mentioned above, automobiles are usually purchased with borrowed funds. The cost and availability of these funds is quite important in the sale of new cars. 4. The cost of gas: Since most cars need gasoline to run, it is very important to assess the course of gasoline prices in the future. If gasoline prices become extremely high, the auto industry is bound to suffer. ( Note to the instructor : The situation can be more complex. For example, if the gas price is very high, consumers will tend to get rid of their old gas guzzlers and buy small economy cars. Thus, the issue can also revolve around whether or not the company we are considering is planning to produce small cars. If this is so, then increasing gasoline prices can boost the sales of cars, at least in the short run.) (c) 1. Sales can be found from the total asset turnover ratio: Common shares outstanding
=
Sales Total assets
From the case: 1.5 =
Sales $25 billion
Solving for sales, we have: Sales = 1.5
×
$25 billion
=
$37.5 billion.
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Analyzing Common Stocks
2. Profits can be found from the net profit margin: Net profit margin
=
Net profits after taxes Sales
From the case: 0.15 = Net profit after taxes $37.5 billion Solving for net profits, we have: Net profits after taxes
=
0.15 × $37.5 billion
=
$5.625 billion
3. We can find current assets using the figure for current liabilities and the net working capital formula: Net working capital
=
Current assets – Current liabilities.
$3.4 billion
=
Current assets – $5 billion
From the case:
Solving for current assets, we have: Current assets = $3.4 billion
+
$5 billion
=
$8.4 billion
Therefore, the current ratio equals: Current assets Current liabilities
=
$8.4 billion $5 billion
= 1.68
4. The price of the stock can be found from the P/E ratio: Price/Earnings ratio
=
Price per share EPS
From the case: 12.5 =
Price per share $3
Solving for share price, we have: Price per share = 12.5 ×
$3 = $37.50
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