Decoding Financial

Statements

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Friday January 4, 2013

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Donald W. Reynolds National Center for Business Journalism at Arizona State University

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n  Gary Trennepohl, Ph.D. n  ONEOK Chair and President’s Council Professor of Finance n  Oklahoma State University n  Trustee, Oklahoma Teachers Retirement System n  Member, OSU Foundation Investment Committee

n  gary.trennepohl@okstate.edu

Topics n  Wednesday:

n  8:30 am to 3:00 pm – Decoding Financial Statements and Company Analysis.

n  3:15 pm to 5:00 pm – Investing in a Time of Uncertainty

n  Thursday: n  8:30 am to 11:15 am – Financial Markets in 2012:

Where are the Stories?

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I. Decoding Financial Statements

1. Financial Ratios – what they tell us 2. Profitability Model – how the firm generates profits

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Ratios to Measure Financial Health n  Liquidity

current ratio =

quick ratio =

Current assets Current liabilities

Current assets - inventory Current liabilities

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Another View of Liquidity: Net Working Capital Total Assets = Liab.+Net Worth

Current Assets

Fixed Assets

Current Liabilities

Common equity

Long Term Debt +

Net Working Capital

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Ratios (cont’d.) n  Profitability

net profit margin = return on assets = total asset turnover =

net profit after tax sales

net profit after tax

total assets

sales total assets

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Profitability Ratios (cont’d.) n  Factors affecting profitability

inventory turnover =

accounts receivable collection period =

cost of goods sold

inventory

accounts receivable

(sales/365 days)

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Ratios (cont’d.) n  How is the firm financed?

debt ratio =

debt/equity ratio =

equity multiplier =

total debt total assets

Total debt total equity

total assets common equity

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Ratios (cont’d.) n  What return is generated for common

stockholders?

return on equity = EACS common equity

The Profitability Model

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Evaluating a Company Using The Profitability Model

n  The profitability model is useful because it separates return on equity (ROE) into three components - n  financial leverage (equity multiplier), n  operating efficiency (net profit margin) n  asset utilization (total asset turnover).

n  ROE is a function of all three factors

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The Profitability Model (cont’d.) n  Return on equity =

NPM X total asset turnover X equity multiplier ROE =

net profit sales

X sales total assets

X common equity

total assets

Understanding Basic Principles of Financial Markets and Investing

1.  Drivers of Stock and Bond Prices 2.  The Historical Perspective 3.  Market Efficiency 4.  Diversification Is Critical 5.  Market Risk – the “VIX”

Economics of Stock and Bond Prices

n  Stock Prices over the long term are driven by the earnings they provide to shareholders n  Dividends n  Growth in earnings and dividends n  P/E ratio is a measure of relative value

n  Bond Prices and yield are driven by interest rates and credit quality n  Bond prices move inversely to interest rates. n  Bond investors must predict future interest rates

and economic activity to determine proper price. Strictly Financials 16

History of U.S. Stock and Bond Returns Provides a Perspective

for the Future

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Bonds as an Investment

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“The Bond Buyer’s Dilemma” By Burton Malkiel in the WSJ, Dec 7, 2011 n  The yields on long-term U.S. Treasuries will likely fall

below inflation for the next several years. Long-term Treasuries are likely to be sure losers.

n  Investors should consider as alternatives: n  Bonds with moderate credit risk where the spreads over

Treasuries are generous. n  Tax-exempt municipal bonds are especially attractive. n  Foreign bonds in fiscally secure countries, e.g., Australia

n  High-quality U.S. stocks with generous dividend yields n  Abbott Labs, ATT, Exxon, J&J, P&G.

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If Markets are Efficient ….

Market efficiency refers to how quickly security prices reflect new information. If markets are efficient, it isn’t possible

to “beat the market.”

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Implications of Market Efficiency for Investors n  Stock experts don’t have an advantage over

amateurs because the competition is so severe. n  Investment return will be a function of risk. n  The key factor in market efficiency is information.

Most SEC regulation is designed to promote the flow of information to investors.

n  Technical analysis is valueless because market participants already have incorporated any information contained in past price sequences into stock prices.

A Technician’s Chart1

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November 23, 2012 There is risk of loss in all trading Page 1

Figure 1

THE OPTION STRATEGIST HOTLINE™© McMillan Analysis Corporation

P. O. Box 1323, Morristown, NJ 07962–1323 800-724-1817 Email: info@optionstrategist.com

Thursday, November 22nd, 2012

Note: if you are viewing a text version of this report, click on the following link to see the charts:http://www.optionstrategist.com/weekly-charts

The volatility produced by the oversoldcondition of last week, coupled with theCongressional debate over the fiscal

cliff, has produced some mixed signals forstocks. Some of these are quite powerfulsignals, but the one true indicator is price andso that is the one on which we will moststrongly rely.

The market, as measured by theStandard & Poors 500 Index (SPX) has been ina steady decline since mid-October. From itsearly October highs to its lows last week, ithas lost 125 points – a sizeable decline,although not a particularly “fearful” one. Asa result, SPX is in a downtrend, and that isbearish. There is overhead resistance at1400-1410. The declining 20-day moving average is at 1395, and the trend line (see Figure 1) is atabout 1400. So that general area of 1395 to 1410, which was support on the way down, is nowresistance. It is normal for support to become resistance. Now, the onus is on the bulls to try torecover back above that level, if they can.

Equity-only put-call ratios gave sell signals in early October. At first, they appeared to be

Figure 2 Figure 3

1 From Larry McMillan’s “The Option Strategist’s Hotline” Nov. 22, 2012

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Implications (cont’d.) n  Fundamental analysis and brokerage-firm

recommendations will not enable you to identify firms which will outperform the market.

n  Information contained in accounting statements and other public information already is reflected in security prices.

n  It makes no sense to try and time the market. n  If there’s a way to “beat” the market, it’s not obvious.

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How Then Should We Invest? 1.  Buy and hold a well-diversified portfolio through time

– and make sure you have exposure to international stocks and bonds – in developed and emerging markets.

2.  Minimize fees, trading costs and expense ratios.

3.  Minimize tax impacts of buying and selling.

4.  Rebalance periodically to your risk/reward target.

Diversification in an Institutional Investor Portfolio

1)  Stocks – Large-cap, small-cap, growth, value, international, including emerging markets

2)  Fixed income – Treasuries, high-yield, corporate, municipal

3)  Real estate – REITs, direct-investment funds 4)  MLPs – Transportation, E&P, Liquids, Storage 5)  Commodities – Ags, metals, oil and gas, 6)  Precious metals – Gold, silver 7)  Hedge funds – Various types 8)  Risk-management tools – Options, futures

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So, What Will the Next Decade Bring?

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One Thing that is Really Changing - Demographics of Major Countries

1.  Countries with larger numbers of younger workers will enjoy higher growth rates than “older” countries.

2.  Demand for housing, autos and consumer goods is driven by the 25- to 45-year-old age cohort.

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Italy

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Germany

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United States

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Brazil

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India

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China

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Demographic Changes Are Driving the Way Investments Will Be Made in The Future.

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THE VIX – A MEASURE OF EXPECTED MARKET VOLATILITY (RISK).

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You Can Keep Track of Current Market Volatility with the VIX n  The “VIX” is a measure of the market’s perception

about market uncertainty over the next 30 days. n  It’s derived from the Black-Scholes “option-pricing

model,” of which one input value is expected volatility (i.e., future standard deviation) of the S&P 500.

n  You make the calculation by “solving the model backwards” – that is “given the observed price, what volatility is needed to produce that price by the model.”

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So, What Does All of This Data Tell Us?

n  Remember when people say “this time is different,” it is never different.

n  Markets over and under correct, but they ultimately revert to the mean of their long-term values.

n  Periods of over performance will be followed by periods of under performance, etc.

n  Diversification is a key strategy for investing.

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Story Ideas 1.  What do investors and investment

advisers say about market volatility? 2.  Are investors/advisers investing in

international markets? If so, where and why?

3.  What will happen to bond prices and interest rates in 2012-2014?