Contents - I

1
-
1

Contents
-

I


External Environment


Financial System


Financial sector


The mechanics of moving resources


Economic forces


Industry factors


Internal Environment


Inputs, Operations, Outputs and supporting activities


The various departments


Corporate governance and agency problems


Company risk and return


The Future


Forecasted cash flows


Forecasted growth rates


1
-
2

Contents II


Types of Financial Analysis


Fundamental Analysis


Profit Maximization.


ROE (Du Pont) Analysis


Factors That Affect Stock Value


Fundamental Valuation Models


Technical Analysis


Use of Exotics in Financial Analysis and valuation


Use of Mathematics in Financial Analysis


Forecasting in financial Analysis


PE and PB Rations in Depth Analysis


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3

Review
-
What is Financial
Analysis


Financial analysis:


To evaluate and valuate.


Evaluate determinants of financial
performance


Determine and put a value to
performance parameters


Make a decision

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4

Review of the First Session


Introduction to the financial system including an
explanation of the financial sector, participants in the
financial system and interest and money as the driver
and lubricants of the economy.


Reviewed the external and internal environment and
their effects as determinants of forecasting and
drivers of value.


Reviewed the basics of financial analysis like its
scope and content and some new trends in financial
analysis that are becoming the new tools that are
increasingly used especially in valuation of financial
derivatives and other structured financial
instruments.


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5

Manager
–

Shareholder


Agents
--
managers with a fiduciary duty to act in the best interests of owners


Agency problem
--
managers maximize their own self
-
interests at the expense
of owners


High salaries of CEOs


Emphasis on short
-
term performance at expense of long
-
term performance


Empire building for status


perquisites


The burden is to align the interests of the manager with those of the
shareholders


This puts a
DRAIN

on the performance and value of the firm.


Tactics used to align interest:


Manager part owner


Stock options


Bonuses


Cash dividends


Debt


Monitoring


Corporate control markets



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6

Shareholder
–

Debt holder


The conflict of interest arises here when the firm is
over indebted.


Shareholders will get into high risk
–

high return
investments, if such investments materialize,
shareholders will reap most of the benefit (debt
holders are paid a fixed percentage and the residual
goes to the shareholders), if not most of the loss will
be on the side of the debt holders.


The solution is covenants


The financial analyst needs to assess such situation
in the process of determining a risk premium among
other things.

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7

Shareholder
-

Shareholder


A rises in companies with subsidiaries and
affiliates


The interests of the subsidiary shareholders
are not in line with those of the shareholders
of the parent companies


Appears in capital budgeting decisions
especially when the parent and the subsidiary
are in two different tax and regulatory
regimes

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8

Auditors


Auditors are prone to be lenient in auditing
financial statements and in valuing business
because they are paid by the very same party
they are auditing or do not want to lose
future business opportunities.


Such considerations need to be taken into
account when financially analyzing a firm.

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9

Regulators


The regulators interests may be
different from those of the company
being analyzed


The regulator may enact regulations
that hurt the company for the public
good; levying taxes is an example.


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10

The Market for Corporate Control


Participants in the financial markets are
monitoring each other to capitalize on
opportunities of buying an undervalued firm.


Firms that have corporate governance
problems are prone to incur higher rate of
return due to the risk premium added from
such problems
.


The financial analyst needs to incorporate
such factors in estimating and forecasting
required rates of return and future cash
flows.

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11

Company Risk and Return


The analyst needs to incorporate specific analysis of the
riskness of the company to reflect that on the required rate of
return on investing sums of money in such company.


Many measures of risk, the most important ones are the most
simple ones, because they are the ones used most in industry
practice.


Beta


Sigma


VaR


Many more like: down side risk, coefficient of variation,
regressions, time series, FF two factor model, FF multi factor
models, Merton intertemporal model, stochastic models, stress
tests under various distributions …..

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12

Types of Financial Analysis


Fundamental: use of all relevant information
and to predict value
–

assumes markets
efficiency.


Technical: use of past price, trading volume
and people behavior to predict value
–

assumes market inefficiency.


Naïve: Financial ratios and some calculated
indicators
–

limited usefulness.

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Fundamental Analysis


The value of an asset is equal to the present
value of all of its future net cash flow.


Need to take previous factors into account
when forecasting cash flows, growth rates
and required rates of return.


Depends on all relevant information


Believes in Semi strong form market
efficiency.

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14

Is stock price maximization the same as profit
maximization?


No, despite a generally high correlation
amongst stock price, EPS, and cash flow.


Current stock price relies upon current
earnings, as well as future earnings and
cash flow.


Some actions may cause an increase in
earnings, yet cause the stock price to
decrease (and vice versa).

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15

Profit Maximization


Example:

Equity = 10 million shares @
DHS
1 a share book
value, no RE, no PIC and no reserves.

Profits =
DHS
10 million

CEO and CFO claim that they can maximize
profits by increasing them to
DHS
10.5 million if
they company would issue 1 million new
shares.

In this case profits are maximized however
profitability is lowered


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Profit Maximization





Well, what happened to profitability?

# shares
Value per share
Profits
Case 1
10
10
10
Case 2
11
11
10.5
Profits are maximized (a handsome increase of 0.5 million)
# shares
Value per share
Profits
EPS
Case 1
10
10
10
1
Case 2
11
11
10.5
0.955
Profits are maximized (a handsom increase of 0.5 million)
However, profitability declined!
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Profit and Profitability Maximization


Example:

Equity =
1
million shares @
DHS
1
a share book
value, no RE, no PIC and no reserves.

Profits =
DHS
1
million

CEO and CFO claim that they can maximize
profits by increasing them to
DHS
1.5
million if
they company would retain all of last year’s
earnings, i.e.
DHS
1
million .

In this case profits and profitability are
maximized

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18

Profit and Profitability Maximization

# shares
Value per share
RE
Value of equity
Profits
EPS
ROE
Case 1
1
1
0
1
1
1
100%
Case 2
1
1
1
2
1.5
1.5
75%
Profits are maximized (a handsom increase of 0.5 million)
EPS maximized (from 1 to 1.5 per share)
However, return on equity is lowered from 100% to 75%
# shares
Value per share
RE
Profits
EPS
Case 1
1
1
0
1
1
Case 2
1
1
1
1.5
1.5
Profits are maximized (a handsom increase of 0.5 million)
EPS maximized (from 1 to 1.5 per share)

How would this affect return on equity?

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19

Maximizing Profits, Profitability
and Return on Equity!


Use leverage to increase the return on equity


However this will increase the riskness of the firm


Increasing risk lowers the price.


Furthermore, the return on total assets will decline


1
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20

Maximizing Profits, Profitability
and Return on Equity!


Example

same as last example, but instead of
retaining earnings, finance growth
operations and profits by borrowing
from the bank at
10
%.

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21

What would happen to the Return on total assets?

# shares
Value per share
Value of equity
Debt
Profits
EPS
ROE
Case 1
1
1
1
0
1
1
100%
Case 2
1
1
1
1
1.4
1.4
140%
Cost of debt is 10% (i.e. 0.1 million)
Profits = 1.5 - 0.1 = 1.4)
Profits , EPS and ROE are all maximized
Maximizing Profits, Profitability
and Return on Equity!

# shares
Value per share
Value of equity
Debt
Total Assets
Profits
EPS
ROE
ROA
Case 1
1
1
1
0
1
1
1
100%
100%
Case 2
1
1
1
1
2
1.4
1.4
140%
70%
Cost of debt is 10% (i.e. 0.1 million)
Profits = 1.5 - 0.1 = 1.4)
Profits , EPS and ROE are all maximized
Return on assets is minimized + you have increased the riskness of the firm
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22

ROE Analysis

Assets

Total
Income
Net

ROA

Assets

Total
Sales

Turnover
Asset

Total


Sales
Income
Net
Margin
Profit

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23

ROE Analysis

Turnover
Asset

Total
Margin
Profit
ROA
Assets

Total
Sales
Sales
Income
Net
ROA




1
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24

ROE Analysis

Multiplier
Equity
ROA
Equity
Common
Assets

Total
Assets

Total
Income
Net
ROE




Equity
Common

Total
Income
Net

ROE

1
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25

ROE Analysis

Multiplier
Equity
Turnover
Asset

Total
Margin
Profit


ROE
Equity
Common
Assets

Total
Assets

Total
Sales
Sales
Income
Net
ROE






1
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26

Factors that affect stock price


Projected cash flows to shareholders


Timing of the cash flow stream


Riskiness of the cash flows

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27

Basic Valuation Model


To estimate an asset’s value, one estimates the
cash flow for each period t (CF
t
), the life of the
asset (n), and the appropriate discount rate (k)












n
1
t
t
t
n
n
2
2
1
1
.
k)
(1
CF

k)
(1
CF
k)
(1
CF
k)
(1
CF


Value

1
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28

Dividend Discount Models


Constant growth


Two growth


Multi growth


Stochastic


Additive w and w/o bankruptcy


Geometric w and w/o bankruptcy

1
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29

Residual Income Valuation

g
k
g
ROE
BV




)
(
*

Value
0
1
-
30

Multipliers


PE


PB


V/EBIT


P/S


P/CF

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31

Technical analysis


Depends on past prices and trading
volumes to predict price and
performance


Markets are inefficient


Prices are trendy


Can be very mathematical


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32

Technical Charts


Point and figure


Candlesticks


OHLC


Price lines


Moving averages


……


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33

Technical Indicators


Candlesticks: hammer, bullish engulfing,
morning star, bearish engulfing, hanging
man, harami, Marubozu, three white soldiers,
…. Many more.


Technical indicators: moving averages,
exponential moving averages, Bollinger
bands, slow stochastic, fast stochastic, Trin,
Trix, Money flow index, RSI, Average
directional index, Williams %R, Price rate of
change, Oscillators, …. Many more.

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34

Exotic Financial Analysis


Stochastic models in forecasting items
and future interest rates and discount
rates, and the previously mentioned
stochastic dividend discount models.


Real Options


Abandonment Options

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35

Use of Mathematics


Towards the end of this program and as
an introduction to future programs we
will look into the mathematics of
financial analysis and their numerical
solutions especially for derivatives and
their use in equity and other securities
financial analyses.

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Forecasting Example

Cash & sec.

$
20

Accts. pay. &





accruals

$
100

Accounts rec.


240

Notes payable


100

Inventories


240


Total CL

$
200


Total CA

$
500

L
-
T debt

100




Common stock

500

Net fixed


Retained


assets


500


earnings


200


Total assets

$
1
,
000


Total claims

$
1
,
000

Balance sheet, in millions of dollars

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37

Sales


$2,000.00

Less:

Var. costs (60%)

1,200.00



Fixed costs


700.00


EBIT


$ 100.00

Interest



16.00


EBT


$ 84.00

Taxes (40%)



33.60

Net income

$ 50.40

Dividends (30%)

$15.12

Add’n to RE

$35.28

Income statement, in millions of dollars

Forecasting Example

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38

Key assumptions


Operating at full capacity in
2006
.


Each type of asset grows proportionally with
sales.


Payables and accruals grow proportionally
with sales.


2006
profit margin (
2.52
%) and payout
(
30
%) will be maintained.


Sales are expected to increase by $
500
million. (%GS =
25
%)

1
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39

Determining additional funds needed AFN

AFN

= (A*/S
0
)
Δ
S
–

(L*/S
0
)
Δ
S
–

M(S
1
)(RR)



= ($
1
,
000
/$
2
,
000
)($
500
)




–

($
100
/$
2
,
000
)($
500
)




–

0.0252
($
2
,
500
)(
0.7
)



= $
180.9
million.


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40

How shall AFN be raised?


The payout ratio will remain at
30
percent
(d =
30
%; RR =
70
%).


No new common stock will be issued.


Any external funds needed will be raised as
debt,
50
% notes payable and
50
% L
-
T
debt.

1
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41

Forecasted Income Statement

Sales


$
2
,
000

1.25

$
2
,
500

Less:

VC

1
,
200

0.60

1
,
500


FC


700

0.35


875


EBIT


$
100


$
125

Interest


16



16


EBT


$
84


$
109

Taxes (
40
%)


34



44

Net income

$
50


$
65

Div. (
30
%)

$
15


$
19

Add’n to RE

$
35


$
46

Forecast

Basis

2007

Forecast


2006

1
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42

2007

1
st

Pass

Forecasted Balance Sheet (
2007
)
-

Assets

2006

Forecast

Basis

Cash

$
20

0.01

$
25

Accts. rec.

240

0.12

300

Inventories


240

0.12


300


Total CA

$
500


$
625

Net FA


500

0.25


625


Total assets

$
1
,
000


$
1
,
250

1
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43

2007

1
st

Pass

2006

Forecast

Basis

Forecasted Balance Sheet (
2007
)
-

Liabilities and Equity

AP/accruals

$
100

0.05

$
125

Notes payable


100



100


Total CL

$
200


$
225

L
-
T debt


100


100

Common stk.

500


500

Ret.earnings


200

+
46
*


246


Total claims

$
1
,
000


$
1
,
071

* From income statement.

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44

What is the additional financing needed
(AFN)?


Required increase in assets

= $
250


Spontaneous increase in liab.

= $
25


Increase in retained earnings

=
$
46


Total AFN

= $
179



The company must have the assets to generate
forecasted sales. The balance sheet must balance,
so we must raise $
179
million externally.

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45

How will the AFN be financed?


Additional N/P


0.5
($
179
) = $
89.50


Additional L
-
T debt


0.5
($
179
) = $
89.50



But this financing will add to interest
expense, which will lower NI and retained
earnings. This will lower equity financing and
increase debt financing, and so on. We will
generally ignore financing feedbacks.

1
-
46

2007

2
nd

Pass

2007

1
st

Pass

AFN

Forecasted Balance Sheet (
2007
)
-

Assets

Cash

$
25

-

$
25

Accts. rec.

300

-

300

Inventories


300

-


300


Total CA

$
625


$
625

Net FA


625

-


625


Total assets

$
1
,
250


$
1
,
250

1
-
47

2007

2
nd

Pass

2007

1
st

Pass

AFN

Forecasted Balance Sheet (
2007
)
-

Liabilities
and Equity

AP/accruals

$
125

-

$
125

Notes payable


100

+
89.5


190


Total CL

$
225


$
315

L
-
T debt


100

+
89.5

189

Common stk.

500

-

500

Ret.earnings


246

-


246


Total claims

$
1
,
071


$
1
,
250

1
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48

Advanced Forecasting


Use of regressions for each item


Use of iterations in finding interest
income and expense


Forecasting with stock dividends, stock
repurchase, stock issuance, stock splits,
….


1
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49

Analyzing PE and PB and its Usages

Case I

:
لاح يف ريعستلا
ومن دوجو مدع
=
ومنلا
0%
ةيدقن تاعرزوت لكش ىلع حابرلأا ةفاك عفدت
=
عيزوتلا
100%
)
اهدوجو مدع وأ ةفاضم ةيداصتقا ةميق دوجو
(
همدع وأ ةيدايتعا ريغ حابرا دوجو
=
بولطملا دئاعلا
10%
هنم ربكأ وأ بولطملا دئاعلا يواسي ققحتملا دئاعلا نا يأ
قوس يأ وأ راكتحا وأ ةسفانم قوس
بولطملا دئاعلا لدعم
/
مهسلا ةيحبر
=
رعسلا
1
-
50

Analyzing PE and PB and its Usages

Case I

ةسفانم
راكتحأ
ةيرتفدلا ةميقلا
10
10
10
بولطملا دئاعلا
10%
10%
10%
يلكلا حبرلا
1
2
3
يداعلا حبرلا
1
1
1
يداع ريغلا حبرلا
0
1
2
ققحتملا دئاعلا
10%
20%
30%
عيزوتلا
1
2
3
ةيرتفدلا ةميقلا
10
10
10
يقوسلا رعسلا
10
20
30
ةيرتفدلا ةميقلا فعاضم ةيرتفدلا ةميقلا ىلا ةيقوسلا ةميقلا
1
2
3
)
ةيحبرلا فعاضم
(
ةيحبرلا ىلا ةيقوسلا ةميقلا
10
10
10
لا مأ ةفاضم ةميق دوجو نع رظنلا ضغب اتباث ةيحبرلا فعاضم ىقبيو ةيرتفدلا ةميقلا فعاضم ريغتي
1
-
51

Analyzing PE and PB and its Usages

Case II

:
لاح يف ريعستلا
ومن دوجو
رخلآا اهفصن زجحيو ةيدقن تاعيزوت لكش ىلع حابرلأا فصن عفدي ومنلا ليومتل
=
ومنلا
0.05
)
ةفاضم ةيداصتقا ةميق دوجو مدع
(
ةيدايتعا ريغ حابرا دوجو مدع
=
عيزوتلا
0.5
عقوتم وه امم رثكأ سيلو طقف بولطملا دئاعلا يواسي ققحتملا دئاعلا نا يأ
=
بولطملا دئاعلا
0.1
ةكرشلا مجح ةدايزل رامثتساو ةسفانم قوس
=
ققحتملا دئاعلا
0.1
)
ومنلا لدعم
-
بولطملا دئاعلا لدعم
(/)
ومنلا لدعم
+
1
(*
تاعيزوتلا
=
رعسلا
1
-
52

Analyzing PE and PB and its Usages

Case II

ةنسلا
1
2
3
4
5
ةيرتفدلا ةميقلا
10
10.5
11.03
11.58
12.16
بولطملا دئاعلا
10%
10%
10%
10%
10%
يلكلا حبرلا
1
1.05
1.103
1.158
1.216
يداعلا حبرلا
1
1.05
1.103
1.158
1.216
يداع ريغلا حبرلا
0
0
0
0
0
ققحتملا دئاعلا
10%
10%
10%
10%
10%
عيزوتلا
0.5
0.525
0.551
0.579
0.608
ةيرتفدلا ةميقلا
10.5
11.03
11.58
12.16
12.76
يقوسلا رعسلا
10.5
11.03
11.58
12.16
12.76
ةيرتفدلا ةميقلا فعاضم ةيرتفدلا ةميقلا ىلا ةيقوسلا ةميقلا
1
1
1
1
1
)
ةيحبرلا فعاضم
(
ةيحبرلا ىلا ةيقوسلا ةميقلا
10.5
10.5
10.5
10.5
10.5
اتباث رمتسا هنكلو ومنلا ببسب ةيحبرلا فعاضم داز
عقوتملا نم ربكأ ومن دجوي لا هنلأ اتباث يقب ةيرتفدلا ةميقلا فعاضم نأ لاإ ةكرشلا يف ومنلا نم مغرلاب
عقوتملا نم ربكأ ومن دجوي لا هنلأ اتباث يقب ةيحبرلا فعاضم نأ لاإ ةكرشلا يف ومنلا نم مغرلاب
1
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53

Analyzing PE and PB and its Usages

Case III

:
لاح يف ريعستلا
ومن دوجو
رخلآا اهفصن زجحيو ةيدقن تاعيزوت لكش ىلع حابرلأا فصن عفدي ومنلا ليومتل
=
ومنلا
0.05
)
ةفاضم ةيداصتقا ةميق دوجو
(
ةيدايتعا ريغ حابرا دوجو
=
عيزوتلا
0.5
بولطملا دئاعلا نم ربكأ ققحتملا دئاعلا نا يأ
=
بولطملا دئاعلا
0.1
ةكرشلا مجح ةدايزل رامثتساو ةسفانم قوس
=
ققحتملا دئاعلا
0.2
)
ومنلا لدعم
-
بولطملا دئاعلا لدعم
(/
ةيدايتعلاا ريغ حابرلأا
+
ةيرتفدلا ةميقلا
=
رعسلا
1
-
54

Analyzing PE and PB and its Usages

Case III

ةنسلا
1
2
3
4
5
ةيرتفدلا ةميقلا
10
11
12.1
13.31
14.64
بولطملا دئاعلا
10%
10%
10%
10%
10%
يلكلا حبرلا
2
2.2
2.42
2.662
2.928
يداعلا حبرلا
1
1.1
1.21
1.331
1.464
يداع ريغلا حبرلا
1
1.1
1.21
1.331
1.464
ققحتملا دئاعلا
20%
20%
20%
20%
20%
عيزوتلا
1
1.1
1.21
1.331
1.464
ةزوجحملا حابرلأا
1
1.1
1.21
1.331
1.464
ةيرتفدلا ةميقلا
11
12.1
13.31
14.64
16.11
يقوسلا رعسلا
31
34.1
37.51
41.26
45.39
ةيرتفدلا ةميقلا فعاضم ةيرتفدلا ةميقلا ىلا ةيقوسلا ةميقلا
2.818
2.818
2.818
2.818
2.818
)
ةيحبرلا فعاضم
(
ةيحبرلا ىلا ةيقوسلا ةميقلا
15.5
15.5
15.5
15.5
15.5
اتباث رمتسا هنكلو ومنلا ببسب ةيحبرلا فعاضم داز
اتباث ةيرتفدلا ةميقلا فعاضم ىقبي
اتباث يقب ةيحبرلا فعاضم نأ لاإ ةكرشلا يف ومنلا نم مغرلاب
1
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55

Analyzing PE and PB and its Usages

Case IV

:
لاح يف ريعستلا
ومن دوجو
رخلآا اهفصن زجحيو ةيدقن تاعيزوت لكش ىلع حابرلأا فصن عفدي ومنلا ليومتل
=
ومنلا
0.05
)
ةفاضم ةيداصتقا ةميق دوجو
(
ةيدايتعا ريغ حابرا دوجو
=
عيزوتلا
0.5
بولطملا دئاعلا نم ربكأ ققحتملا دئاعلا نا يأ
=
بولطملا دئاعلا
0.1
ةيدايتعلاا ريغ حابرلأا يف ومن
=
ققحتملا دئاعلا
0.2
ةكرشلا مجح ةدايزل رامثتساو ةسفانم قوس
=
ةيدايتعلا ريغ حابرلأا ومن
0.05
)
ومنلا لدعم
-
بولطملا دئاعلا لدعم
(/
ةيدايتعلاا ريغ حابرلأا
+
ةيرتفدلا ةميقلا
=
رعسلا
1
-
56

Analyzing PE and PB and its Usages

Case IV

ةنسلا
1
2
3
4
5
ةيرتفدلا ةميقلا
10
11
12.16
13.5
15.06
بولطملا دئاعلا
10%
10%
10%
10%
10%
يلكلا حبرلا
2
2.31
2.68
3.124
3.66
يداعلا حبرلا
1
1.1
1.216
1.35
1.506
يداع ريغلا حبرلا
1
1.271
1.538
1.864
2.262
ققحتملا دئاعلا
20%
21%
22%
23%
24%
عيزوتلا
1
1.155
1.34
1.562
1.83
ةزوجحملا حابرلأا
1
1.155
1.34
1.562
1.83
ةيرتفدلا ةميقلا
11
12.16
13.5
15.06
16.89
يقوسلا رعسلا
31
37.68
44.45
52.63
62.57
ةيرتفدلا ةميقلا فعاضم ةيرتفدلا ةميقلا ىلا ةيقوسلا ةميقلا
2.818
3.1
3.294
3.495
3.705
)
ةيحبرلا فعاضم
(
ةيحبرلا ىلا ةيقوسلا ةميقلا
15.5
16.31
16.59
16.85
17.09
ةيدايتعلاا ريغ حابرلأا يف ومنلا عم ةدرطم ةدايزبو ومنلا ببسب ةيحبرلا فعاضم داز
ةيدايتعلاا ريغ حابرلأا يف ومنلا عم ةدرطم ةدايزبو ومنلا ببسب ةيرتفدلا ةميقلا فعاضم داز
ةيدايتعلاا ريغ حابرلاا يف ومنلا عم نيفعاضملا دادزي
1
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57

Analyzing PE and PB and its Usages

Conclusions


Reinvestment of free cash flow at rates of
return in excess of capital costs creates
growth in abnormal earnings, resulting in
valuation multiple expansion.


The PE is a function of the prospective
growth in future abnormal earnings.


Usages of PE in any other case will result in
mispricing and arbitrage opportunities.


This huge limitation should be considered
among many other ones.

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58

Analyzing PE and PB and its Usages

Conclusions


Which PE to use the historical average
of the same firm’s PE’s, OR


The PE of similar firms, OR


The PE of the industry


How are PE’s used for companies that
have more than one division


1
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59

Analyzing PE and PB and its Usages

Conclusions


PE does take risk into account indirectly (i.e. through
the used pricing model’s discount rate)
.


PE gives the dollar amount (Price) the investor is
willing to pay for one dollar of continued earnings. PE
is the reciprocal of the required rate if return.
Empirical studies show that the required rate of
return (calculated using other return models like the
market model or CAPM) is usually different from the
one calculated by PE ratios.


Only sustainable earnings are used, transitory or non
recurring earnings
must

be excluded.

1
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60

Analyzing PE and PB and its Usages

Recommendations


Use PE ratios with maximum caution


Know when it is used and what it
means


PB is also problematic some times, it is
used when there are abnormal returns
regardless whether they grow or not.

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61

Tools of Financial Analysis


See you all in December