19-2

Financial Statement Analysis

Financial statement analysis can be used
to discover mispriced securities.
CHAPTER 19 Financial accounting data are widely
available, but
Accounting earnings and economic earnings
Financial Statement Analysis are not always the same thing!

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McGraw-Hill/Irwin Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

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Table 19.1 Consolidated Statement of Income

Financial Statements
for Hewlett-Packard, 2009
Income Statement:

Balance Sheet:

Statement of Cash Flows:

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Table 19.2 Consolidated Balance Sheet for Table 19.3 Statement of Cash Flows for
Hewlett-Packard, 2009 Hewlett-Packard, 2009

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Accounting Versus Economic Earnings Profitability Measures

Economic earnings ROE measures profitability for
Sustainable cash flow that can be paid to contributors of equity capital.
stockholders without impairing productive After-tax profit/book value of equity
capacity of the firm
ROA measures profitability for all
Accounting earnings contributors of capital.
Affected by conventions regarding the
EBIT/total assets
valuation of assets

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Past vs. Future ROE Financial Leverage and ROE

ROE is a key determinant of earnings growth. ROE can differ from ROA because of
Past profitability does not guarantee future leverage.
profitability. Leverage makes ROE more volatile.
Security values are based on future profits. Let t=tax rate and r=interest rate, then:
Expectations of future dividends determine
Debt
todays stock value. ROE 1 t ROA ROA r
Equity

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Table 19.5 Impact of Financial

Financial Leverage and ROE Leverage on ROE
Debt
ROE 1 t ROA ROA r
Equity

If there is no debt or ROA = r, ROE will simply

equal ROA(1 - t).
If ROA > r, the firm earns more than it pays out
to creditors and ROE increases.
If ROA < r, ROE will decline as a function of
the debt-to-equity ratio.

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Decomposition of ROE
Decomposition of ROE
DuPont Method
ROA =EBIT/Sales x Sales/Assets
ROE =
Net Profit
x
Pretax Profit
x
EBIT
x
Sales
x
Assets = margin x turnover
Pretax Profit EBIT Sales Assets Equity
Margin and turnover are unaffected by
(1) x (2) x (3) x (4) x (5) leverage.
ROA reflects soundness of firms operations,
Tax Interest
x x Margin x Turnover x Leverage regardless of how they are financed.
Burden Burden

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Table 19.6 Ratio Decomposition Analysis for

Decomposition of ROE Nodett and Somdett
ROE=Tax burden X ROA X Compound leverage factor

Tax burden is not affected by leverage.

Compound leverage factor= Interest burden X
Leverage

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Table 19.7 Differences between Profit Margin and

Choosing a Benchmark Asset Turnover across Industries
Compare the companys ratios across time.

Compare ratios of firms in the same industry.

Cross-industry comparisons can be

misleading.

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Table 19.9 Summary of Key Financial Ratios Table 19.9 Summary of Key Financial Ratios

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Table 19.9 Summary of Key Financial Ratios Table 19.9 Summary of Key Financial Ratios

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Figure 19.1 DuPont Decomposition for

Table 19.9 Summary of Key Financial Ratios
Hewlett-Packard

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Economic Value Added Example 19.4 Wal-Mart

EVA is the difference between return on
assets (ROA) and the opportunity cost of
capital (k), multiplied by the capital invested
in the firm.
EVA is also called residual income
If ROA > k, value is added to the firm.
In 2009, Wal-Marts cost of capital was 5.9%.
Its ROA was 9.6% and its capital base was
$115 billion.
Wal-Marts EVA =
(0.096-0.059) x $115 billion = $4.25 billion

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Comparability Problems International Accounting Differences

Accounting Differences
Reserves many other countries allow
Inventory Valuation more flexibility in use of reserves
Depreciation Depreciation US allows separate tax and
Inflation and Interest Expense reporting presentations
Fair Value Accounting Intangibles treatment varies widely
Quality of Earnings
International Accounting Conventions

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Figure 19.2 Adjusted Versus Reported Price-

Earnings Ratios The Graham Technique

Rules for stock selection:

Purchase common stocks at less than their
working-capital value.
Give no weight to plant or other fixed
assets.
Deduct all liabilities in full from assets.

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