Company Analysis

Timothy R. Mayes, Ph.D.

FIN 3600: Chapter 12

Overview of Company Analysis

Once we’ve completed the economic forecast and industry analysis, we can focus on choosing the best positioned company in our chosen industry

Selecting a company will involve an analysis of: The company’s management The company’s financial statements Key drivers for future growth

Obviously, we are looking for companies with the best management, strong financials, great prospects, and that are undervalued by the market

Always remember that the past is irrelevant, what you are buying is future results

Evaluating Management

Strong management is vital for companies to perform in accord with the highest expectations of investors

Unfortunately, evaluating the quality of a company’s management team is very difficult, especially for individual investors

Professionals have the advantage in that they have many contacts within the industry who are familiar with the management team, and they can visit the company and talk with the team personally

Evaluating Management (cont.)

As an individual, there are several things you can do: Read the 10k – it has information on the background of

executives and board members. Information includes age, pay, stock ownership, etc

Read the business press – There are often stories which provide insights into the character and abilities of senior management

Call investor relations – They can answer any reasonable questions that you may have

Study the financial statements – Good management leads to solid financials

Evaluating Management (cont.)

Despite your best efforts at judging management’s ability, things can go wrong

History is replete with examples of formerly great managers running their new companies into the ground

Here are a few examples that come to mind: AT&T – C. Michael Armstrong Sunbeam – “Chainsaw” Al Dunlap Apple Computer – John Scully Long-term Capital Management – John Meriwether, Robert

Merton, and Myron Scholes (the latter two were Nobel Prize winners in economics)

Financial Statement Analysis

There are three statements to watch: Income statement Balance sheet Statement of cash flows

Two major tools: Ratios Growth rates

The Income Statement

The income statement provides us with information about the firms revenues and expenses over some previous time period (usually quarterly, semiannually, and annually)

The key variables to watch are revenues, gross profit margins, operating profit margins, net profit margins

We especially want to evaluate the quality of the firm’s earnings

Quality of Earnings

Under GAAP, companies are allowed fairly wide latitude on how they recognize revenues and handle “extraordinary” income and expenses

Many companies freely admit to “managing” or “smoothing” earnings, believing that it adds to the stability of the stock price over time

Analysts need to watch for such shenanigans, as it may signal problems Here are a couple of recent examples of questionable quality of earnings:

Qwest – Raised revenue recognition questions when analysts discovered that they had counted all of the future revenues from a 20-year contract as current earnings.

Waste Management – Had trouble recently when it tried to claim as “extraordinary” its expense for painting its huge fleet of trucks. This added 3 cents per share (about 10%) and let them beat expectations by 2 cents (see “Waste Management Excludes Some Expenses in Accounting”, WSJ Online, 23 Aug 2001)

Priceline.com – Was claiming as revenue the entire price of an airline ticket when, in fact, they only received a commission on its sale and never actually took ownership of the ticket

Quality of Earnings (cont.)

Another thing to watch for are “pro-forma” or “as if” earnings. Some analysts have described these as “all the good stuff and none of the bad.”

Many companies, especially those in the “new economy”, began reporting pro-forma numbers a few years ago. The funny part is that the Wall Street analysts went along with the game, even long after it became clear that there would never be any real earnings. (See notes on Reg G below.)

Also, look for where earnings are coming from. Increased sales, or decreased expenses? Sales can increase forever, but costs can only be cut so far. Generally, when costs are cut to increase profits, this must be looked at as a temporary boost.

These types of issues lead to serious questions about management’s truthfulness and bring into question the quality of the firm’s earnings. Typically, when these things are revealed, stock prices drop as investor uncertainty rises

Earnings Manipulation

The Balance Sheet

The balance sheet describes the assets, liabilities, and equity of the firm at a point in time

Key variables to watch on the balance sheet are cash, accounts receivable, inventories, and long-term debt

Always remember what Benjamin Graham said in Security Analysis, “liabilities are real but the assets are of questionable value.”

The Statement of Cash Flows

Ultimately, cash is king and the statement of cash flows tells us exactly why a firm’s cash balance changed

The statement of cash flows is far more difficult to manipulate than the income statement, and can help to gauge the quality of earnings

The Cash Flows from Operations section is the most important as it measures the cash provided by the day to day operation of the business

A company could, for example, show steadily rising revenues and net income, but negative cash flows from operations. How? If accounts receivable is rising. This can only go on for so long before the company has grown its revenues right into bankruptcy because it isn’t collecting on those sales. Positive earnings must always be confirmed by positive cash flows.

This statement is as important, if not more so, than the income statement. Always examine it to find out what management is doing with the shareholder’s money

Analyzing Financial Ratios

Financial ratios are the microscope that allows us to see behind the raw numbers and find out what’s really going on

Financial ratios fall into five categories: Liquidity Efficiency Leverage Coverage Profitability

When analyzing ratios always remember that no one ratio provides the whole story, and that the standards for each ratio are different for every industry

Liquidity Ratios

The current ratio, quick ratio and cash ratio all fall into this category

They help us to see if the company is able to meet its short-term obligations

Efficiency Ratios

The efficiency ratios tell us how effectively management is using the firm’s assets to generate sales

Inventory turnover, accounts receivable turnover, days sales outstanding, fixed asset turnover, and total asset turnover all fall into this category

Leverage Ratios

How much debt does the firm have? That’s the question answered by the leverage ratios

Examples are the debt ratio and debt to equity ratio Remember that lots of debt is great as long as sales are

increasing, but terrible if sales decline Some debt is, without a doubt, good, but too much can

be disastrous Especially be on the lookout for companies with a high

proportion of fixed costs (high operating leverage) and with lots of debt. Airlines are a good example

Coverage Ratios

Coverage ratios are most important to creditors, but whatever is important to creditors is important to shareholder’s too

Examples of coverage ratios include the times interest earned ratio and the fixed charge coverage ratio

Profitability Ratios

Investors tend to focus the most on profitability ratios, but the others are important as well

Examples include the gross profit margin, operating profit margin, net profit margin, return on assets and return on equity

Using Financial Ratios

There are two key uses of financial ratios: Trend Analysis – Looking for trends over time in

ratios. For example, we’d like to see that the inventory turnover ratio is rising. Normally, at least five years of data should be used.

Comparison to Industry Averages – If we assume that, on average, the firm’s competitors are doing things right, then it makes sense to make these comparisons. This can also help to identify areas of relative strength and weakness

Growth Rates

Growth rates of various variables are important as well

Key variables to calculate growth rates of are revenues, operating profits, and free cash flow

Manipulation of Financial Statements

Financial statements may be manipulated in a number of ways to help identify key trends: Common-size Common base year Inflation adjusted

Each of these techniques can provide insights that are not easily seen on the unadjusted financial statements