decoding financial statements

7/30/2019 Decoding Financial Statements

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Decoding Financial

Statements

Strictly Financials

FridayJanuary 4, 2013


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Strictly Financials 2

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 Presidents Council Professor of Financen Oklahoma State Universityn Trustee, Oklahoma Teachers Retirement Systemn Member, OSU Foundation Investment Committee

n [email protected]


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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 Liquiditycurrent 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 (contd.)

n Profitability

net profit margin =

return on assets =

total asset turnover =

net profit after tax

sales

net profit after tax

total assets

salestotal assets


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Profitability Ratios (contd.)

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 (contd.)

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 (contd.)

n What return is generated for commonstockholders?

return on equity = EACS

common equity


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The Profitability Model


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Evaluating a Company Using

The Profitability Model

n The profitability model is useful because itseparates 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 (contd.)

n Return on equity =

NPM X total asset turnover X equity multiplier

ROE =

net profit

salesX

sales

total assetsX

common equity

total assets


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Understanding BasicPrinciples of Financial

Markets and Investing

1. Drivers of Stock and Bond Prices2. The Historical Perspective3. Market Efficiency4. Diversification Is Critical5. Market Risk the VIX


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Economics of Stock and Bond

Prices

n Stock Prices over the long term are driven bythe earnings they provide to shareholders

n Dividendsn Growth in earnings and dividendsn P/E ratio is a measure of relative value

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

and economic activity to determine proper price.



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History of U.S. Stock and Bond

Returns Provides a Perspectivefor the Future



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Bonds as an Investment



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The Bond Buyers DilemmaBy Burton Malkiel in the WSJ, Dec 7, 2011

n The yields on long-term U.S. Treasuries will likely fallbelow 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 overTreasuries 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 dividendyields

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 isnt possibleto beat the market.

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Implications of Market Efficiency for

Investors

n Stock experts dont have an advantage overamateurs because the competition is so severe.

n Investment return will be a function ofrisk.n The key factor in market efficiency is information.

Most SEC regulation is designed to promote the flow

ofinformation to investors.

n Technical analysis is valueless because marketparticipants already have incorporated any

information contained in past price sequences into

stock prices.


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A Technicians Chart1


Figure 1

1From Larry McMillans The Option Strategists Hotline Nov. 22, 2012


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Implications (contd.)

n Fundamental analysis and brokerage-firmrecommendations 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 theres a way to beat the market, its 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.


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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 funds4) MLPs Transportation, E&P, Liquids, Storage5)

Commodities Ags, metals, oil and gas,6) Precious metals Gold, silver7) Hedge funds Various types8) Risk-management tools Options, futures



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So, What Will the Next

Decade Bring?

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One Thing that is ReallyChanging - Demographics of

Major Countries

1. Countries with larger numbers of youngerworkers 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 markets perceptionabout market uncertainty over the next 30 days.

nIts derived from the Black-Scholes option-pricingmodel, 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 modelbackwards that is given the observed price, what

volatility is needed to produce that price by themodel.



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So, What Does All

of This Data Tell Us?

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

n Markets over and under correct, but theyultimately revert to the mean of their long-

term values.

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

n Diversification is a key strategy for investing.



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Story Ideas

1. What do investors and investmentadvisers say about market volatility?

2. Are investors/advisers investing in

international markets? If so, whereand why?

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

decoding financial statements

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