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SESSION 3: Fundamentals of Financial Accounting (continued) 21 October 2009
Duke Investment Club Analyst Training Program
Agenda •
Corporate financial statements: income statement
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Application to fundamental financial analysis
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Overview of weekly market updates
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Disclaimer and general comments We’re students, just like you •
We highly encourage you to challenge what we’re saying – if you see a mistake, tell us, even if it’s in front of the whole class. This is practice for us, too
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We will be the first to acknowledge that we’re full of any four letter word you’d like to substitute in, but the reason we’ve started this class is because we find this stuff really interesting. Hopefully, you do too
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The people to your left and right may one day run the government, an investment bank, a consulting firm, or become the next Warren Buffet (get to know him or her)
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The income statement Corporate financial statements, part II •
www.sec.gov
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“Search for Company Filings”
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“Company or fund name”
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Enter company name or stock ticker
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Find the most recent 10‐K
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Search (ctrl + f) for “statements of operations” and scroll through until you find the income statement
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When analyzing a company it is important to read the notes accompanying the financial statements, as they will provide color to specific (questionable) line items
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The income statement Corporate financial statements, part II •
Measures a company’s financial performance over a specific accounting period (did it make or lose money?)
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A publically traded company will report “earnings” at the close of every quarter to the SEC
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The income statement gives a summary of how the business incurs its revenues and expenses through both operating and non‐operating activities
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Also known as the profit and loss statement (P&L)
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The income statement Sample
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Caveat: the income statement recognizes revenues when they are realized (i.e., when goods are shipped, services rendered, and expenses incurred). With accrual accounting, the flow of accounting events through the income statement doesn't necessarily coincide with the actual receipt and disbursement of cash; the income statement measures profitability, not cash flow.
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Four measures of profitability are revealed at critical junctions in a company's operations ‐ gross, operating, pretax and after tax 6
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The income statement Gross profit
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Net Sales (sales or revenue): value of the company’s sales of goods and services to it’s customers
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Cost of Sales (cost of goods or COGS): expense incurred for raw materials, labor, manufacturing overhead, etc. (includes depreciation, may be a separate line item or can be found in BS)
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Gross Profit (gross income or gross margin): difference between net sales and cost of sales. Provides the resources to cover all of the company’s other expenses. The greater and more stable a company's gross margin, the greater potential there is for positive bottom line results. 7
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The income statement EBITDA •
Earnings Before Interest, Taxes, Depreciation and Amortization: can be used to analyze and compare profitability between companies and industries because it eliminates the effects of accounting and financing decisions. However, this is a non‐GAAP measure that allows a greater amount of discretion as to what is (and is not) included in the calculation.
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EBITDA first came into common use with leveraged buyouts in the 1980s, when it was used to indicate t he ability of a company to service debt.
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EBITDA is a good metric to evaluate profitability, but not cash flow.
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The income statement Operating income
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Operating expenses (selling, general and administrative expenses): comprises a company’s operational expenses. Assumed that management can exercise a great deal of control over this line item. The trend of SG&A expenses, as a percentage of sales, is watched closely to detect signs, both positive and negative, of managerial efficiency.
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Operating income (operating profit, EBIT): represents a company's earnings from its normal operations before any so‐called non‐operating income and/or costs such as interest expense, taxes and special items are taken into account. By excluding both taxes and interest expenses, the figure hones in on the company's ability to profit and thus makes for easier cross‐company comparisons. 9 Duke Investment Club
The income statement Pretax income
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Other Income (Expense): includes interest expenses and thus the costs of the company’s borrowings. Can also include interest income from invested funds (and would thus be a positive number)
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Extraordinary Gain (Loss): a variety of events can occasion charges against income, are identified as: restructuring charges, unusual or nonrecurring items and discontinued operations. These write‐ offs are supposed to be one‐time events.
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Pretax Income: income before taxes are taken into account. Can be a more accurate measurement of corporate profitability since taxes are not a part of a company’s business operations. 10
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The income statement Net income
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Taxes: the income tax amount has not actually been paid ‐ it is an estimate, or an account that has been created to cover what a company expects to pay.
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Net Income (net profit or net earnings): this is the “bottom line”, most commonly used indicator of a company’s profitability. After the payment of dividends, if any, net income becomes part of a company's equity position as retained earnings. Supplemental data is also presented for net income on the basis of shares outstanding (basic) and the potential conversion of stock options, warrants, etc. (diluted) 11
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The income statement Earnings per share •
To calculate EPS you take the earnings left over for shareholders and divide by the number of shares outstanding. You can think of EPS as a per‐capita way of describing earnings.
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The bottom line is that earnings drive stock prices. Strong earnings generally result in the stock price moving up (and vice versa).
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Fate of a stock when earnings are released is largely based on whether or not reported earnings met Wall Street’s expectations
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Financial ratios Ratios derived from income statement data, p. 1 Ratio
P/E ratio
PEG ratio
Profit margin
Return on invested capital
Equation
Explanation [alternative names]
share price P/E = earnings per share
In general, a high P/E suggests that investors are expecting higher earnings growth in the future compared to companies with a lower P/E.
P / E ratio annual eps growth
PEG is a widely used indicator of a stock's potential value. It is favored by many over the P/E ratio because it also accounts for growth. Similar to the P/E ratio, a lower PEG means that the stock is more undervalued.
net income revenue
Profit margin is very useful when comparing companies in similar industries. A higher profit margin indicates a more profitable company that has better control over its costs compared to its competitors.
PEG =
profit m arg in =
net income − dividends ROIC = total capital
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A calculation used to assess a company's efficiency at allocating the capital under its control to profitable investments. The return on invested capital measure gives a sense of how well a company is using its money to generate returns. Total capital includes long‐term debt, and common and preferred shares.
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Financial ratios Ratios derived from income statement data, p. 2 Ratio
Enterprise multiple
Enterprise value
Equation
Enterprise multiple =
P /B =
Explanation
enterprise value EBITDA
Pr ice /share Book value /share
The enterprise multiple looks at a firm as a potential acquirer would, because it takes debt into account ‐ an item which other multiples like the P/E ratio do not include. A low ratio indicates that a company might be undervalued. Calculated as market cap plus debt, minority interest and preferred shares, minus total cash and cash equivalents. Think of enterprise value as the theoretical takeover price. In the event of a buyout, an acquirer would have to take on the company's debt, but would pocket its cash.
N.B.: ratios are most effective when looking at historical patterns for a company or comparing a company against industry or market averages. This list is only a small sampling of the possible ratios that can be derived from the IS, but these are used very commonly by analysts. 14
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Questions, comments, & critiques
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