Company Analysis

Overview of Company Analysis

weve 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 companys management
The companys financial statements
Key drivers for future growth
we are looking for companies with the best management,
strong financials, great prospects, and that are
undervalued by the market
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 companys
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 can be done:
Read the Annual Report 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 managements
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
firms 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.
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
The disposal of a plant or major piece of equipment, Gains or losses due to
accounting charges, charges to write down the value of goodwill are the
examples of extra ordinary items.
Quality of Earnings (cont.)
Another thing to watch for are foot note or as if earnings. Some
analysts have described these as all the good stuff and none of the
bad.
Some dummy entries are there even long after it became clear that
there would never be any real earnings.
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 managements
truthfulness and bring into question the quality of the firms
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 firms 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 isnt
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 shareholders money
Analyzing Financial Ratios
Financial ratios are the microscope that allows us to see
behind the raw numbers and find out whats 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 firms 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? Thats 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 shareholders too
Examples of coverage ratios include the times
interest earned ratio and the fixed charge
coverage ratio
Interest cover = PBITD/Interest
DSCR= PAT + depreciation +Interest on loan
Interest +EMI
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 capital employed and return on equity
EV/EBITDA ratio
This is a comparison of enterprise value and earnings
before interest, taxes, depreciation and amortization.
It compares the value of a company, inclusive of debt
and other liabilities, to the actual cash earnings
exclusive of the non-cash expenses.
EV/EBITDA Ratio = EV / EBITDA
The EV/EBITDA ratio is a better measure than the P/E
ratio because it is not affected by changes in the
capital structure
The EV/EBITDA ratio is usually appropriate for the
comparison of companies in same industry.

Using Financial Ratios
There are two key uses of financial ratios:
Trend Analysis Looking for trends over time in
ratios. For example, wed 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 firms 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
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
Several Kinds of Value
There are several types of value, of which we are
concerned with four:
Enterprise value- measures the value of the ongoing operations
of a company.
Book Value The carrying value on the balance sheet of the
firms equity (Total Assets less Total Liabilities)
Tangible Book Value Book value minus intangible assets
(goodwill, patents, etc)
Market Value - The price of an asset as determined in a
competitive marketplace
Intrinsic Value - The present value of the expected future cash
flows discounted at the decision makers required rate of return
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
enterprise value (EV)
The enterprise value (EV) measures the value of the
ongoing operations of a company. It measure the value of
a company's business instead of measuring the value of
the company. It can be thought of as a theoretical
takeover price of a companys business.
Enterprise Value = Market Capitalization +Debt
+Preferred Share Capital + Minority Interest - Cash and
cash equivalents
Market Capitalization: Is the market value of common
shares of a company. It is calculated by multiplying the
current market price per share by the total number of
equity shares of the company

Book value
This ration indicate the net worth per share. This
value is the reflection of past profitability and
dividend policy.
= Equity share capital +reserves- P/L A/c debit balance
Total n of equity share
Determinants of Intrinsic Value
There are two primary determinants of the intrinsic value
of an asset to an individual:
The size and timing of the expected future cash flows.
The individuals required rate of return (this is determined by a
number of other factors such as risk/return preferences, returns
on competing investments, expected inflation, etc.).
Note that the intrinsic value of an asset can be, and often
is, different for each individual (thats what makes
markets work).
Stock Valuation
As with any other security, the first step in valuing
common stocks is to determine the expected future cash
flows.
Finding the present values of these cash flows and adding
them together will give us the value:


For a stock, there are two cash flows:
Future dividend payments
The future selling price
( )

=
+
=
1
1
t
t
t
CS
k
CF
V
Some Notes About Stock
In valuing the common stock, we have made two
assumptions:
We know the dividends that will be paid in the future.
We know how much you will be able to sell the stock
for in the future.
Both of these assumptions are unrealistic,
especially knowledge of the future selling price.
Furthermore, suppose that you intend on holding
on to the stock for twenty years, the calculations
would be very tedious!
Stock Valuation: An Example
Assume that you are considering the purchase of a stock
which will pay dividends of $2 (D
1
) next year, and $2.16
(D
2
) the following year. After receiving the second
dividend, you plan on selling the stock for $33.33. What
is the intrinsic value of this stock if your required return
is 15%?
2.00
2.16
33.33
?
Other Valuation Methods
Some companies do not pay dividends, or the
dividends are unpredictable.
In these cases we have several other possible
valuation models:
Earnings Model
Free Cash Flow Model
P/E approach
Price to Sales (P/S)
The Earnings Model
The earnings model separates a companys
earnings (EPS) into two components:
Current earnings, which are assumed to be repeated
forever with no growth and 100% payout.
Growth of earnings which derives from future
investments.
If the current earnings are a perpetuity with
100% payout, then they are worth:
k
EPS
V
CE
1
=
The Earnings Model (cont.)
V
CE
is the value of the stock if the company does not
grow, but if it does grow in the future its value must be
higher than V
CE
so this represents the minimum value
(assuming profitable growth).
If the company grows beyond their current EPS by
reinvesting a portion of their earnings, then the value of
these growth opportunities is the present value of the
additional earnings in future years.
The growth in earnings will be equal to the ROE times
the retention ratio (1 payout ratio):

Where b = retention ratio and r = ROE (return on equity).
br g =
The Earnings Model (cont.)
If the company can maintain this growth rate
forever, then the present value of their growth
opportunities is:

Which, since NPV is growing at a constant rate
can be rewritten as:
( )

=
+
=
1
1
t
t
t
k
NPV
PVGO
g k
k
r
RE
g k
RE
k
r
RE
g k
NPV
PVGO

|
.
|

\
|

=
1
1
1 1
1
The Earnings Model (cont.)
The value of the company today must be the sum
of the value of the company if it doesnt grow
and the value of the future growth:



Where RE
1
is the retained earnings in period 1, r
is the return on equity, k is the required return,
and g is the growth rate



g k
k
r
RE
k
EPS
g k
NPV
k
EPS
V
CS

|
.
|

\
|

+ =

+ =
1
1
1 1 1
The Free Cash Flow Model
Free cash flow is the cash flow thats left over
after making all required investments in
operating assets:

Where NOPAT is net operating profit after tax
Note that the total value of the firm equals the
value of its debt plus preferred plus common:
Cap Op NOPAT FCFA =
CS P D
V V V V + + =
The Free Cash Flow Model (cont.)
We can find the total value of the firms
operations (not including non-operating assets),
by calculating the present value of its future free
cash flows:

Now, add in the value of its non-operating assets
to get the total value of the firm:
( )
g k
g FCF
V
Ops

+
=
1
0
( )
NonOps NonOps Ops
V
g k
g FCF
V V V +

+
= + =
1
0
The Free Cash Flow Model (cont.)
Now, to calculate the value of its equity, we
subtract the value of the firms debt and the
value of its preferred stock:


Since this is the total value of its equity, we
divide by the number of shares outstanding to get
the per share value of the stock.
( )
P D NonOps CS
V V V
g k
g FCF
V +

+
=
1
0
Relative Value Models
Professional analysts often value stocks relative to one another.
For example, an analyst might say that XYZ is undervalued relative
to ABC (which is in the same industry) because it has a lower P/E
ratio, but a higher earnings growth rate.
These models are popular, but they do have problems:
Even within an industry, companies are rarely perfectly comparable.
There is no way to know for sure what the correct price multiple is.
There is no easy, linear relationship between earnings growth and price
multiples (i.e., we cant say that because XYZ is growing 2% faster that
its P/E should be 3 points higher than ABCs there are just too many
additional factors).
A companys (or industrys) historical multiples may not be relevant
today due to changes in earnings growth over time.
The P/E Approach
As a rule of thumb, or simplified model, analysts often
assume that a stock is worth some justified P/E ratio
times the firms expected earnings.
This justified P/E may be based on the industry average
P/E, the companys own historical P/E, or some other P/E
that the analyst feels is justified.
To calculate the value of the stock, we merely multiply
its next years earnings by this justified P/E:
1
EPS
E
P
V
CS
=
The P/S Approach
In some cases, companies arent currently earning any
money and this makes the P/E approach impossible to
use (because there are no earnings).
In these cases, analysts often estimate the value of the
stock as some multiple of sales (Price/Sales ratio).
The justified P/S ratio may be based on historical P/S for
the company, P/S for the industry, or some other
estimate:
1
Sales
S
P
V
CS
=
Con..