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Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

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Earnings and Cash Flow Analysis

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Earnings and Cash Flow Analysis

• Our goal in this chapter is to show you the financial accounting concepts necessary to:– Understand basic financial statements, and – Perform earnings and cash flow analysis using basic financial

statements.

• Keep in mind: Cash flow is a company’s lifeblood.

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Sources of Financial Information, I.

• An excellent primary source: annual reports – Look for the shamrock (♣) in The Wall Street Journal

• Found in the Journal on the daily stock price report page

• The shamrock indicates that the company will send an annual report to you, if you request it through the Journal.

• Internet– The New York Stock Exchange website provides a directory of

websites for companies listed on the NYSE– http://finance.yahoo.com provides some basic financial

information if you enter the stock symbol

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Sources of Financial Information, II.

• The Securities and Exchange Commission (SEC) requires companies to prepare and submit regular reports– When received by the SEC, these reports are freely made

available through Electronic Data gathering and Retrieval (EDGAR) archives

– 10K: Annual company report filed with the SEC– 10Q: Quarterly updates of 10K reports

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Sources of Financial Information, III.

• Also, the SEC Regulation FD (Fair Disclosure) requires companies making a public disclosure of material nonpublic information to do so fairly without preferential recipients.– Material nonpublic information is important, previously

unknown information that could significantly impact share prices

– Most companies satisfy Regulation FD by distributing important announcements via e-mail alerts to those who register for the service at the company’s website (look in the investor relations section).

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Three Important Financial Statements

• The Balance Sheet:– Provides a snapshot view of a company’s assets and liabilities– The Balance Sheet is as of a particular date.

• The Income Statement:– Provides a summary of a firm’s revenues and expenses– The Income Statement is over a specific accounting period,

usually a quarter or a year.

• The Cash Flow Statement:– Is an analysis of the sources and uses of cash by the firm over

an accounting period– Summarizes operating, investing, and financing cash flows

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The Balance Sheet

• Asset - Anything a company owns that has value.

• Liability - A firm’s financial obligation.

• Equity - An ownership interest in the company.

• The fundamental accounting identity:

Assets = Liabilities + Equity

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Borg Corporation Balance Sheet

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Borg Corporation, Condensed Balance Sheet

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The Income Statement

• Income - The difference between a company’s revenues and expenses, used to pay dividends to stockholders or kept as retained earnings within the company to finance future growth.

Net income = Revenues – Expenses

= Dividends + Retained earnings

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Borg Corporation,Condensed Income Statement

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The Cash Flow Statement

• Net Income does not equal cash flow.– Net income contains non-cash items. – Non-cash items are income and expenses not realized in cash

form.– Depreciation can be a significant non-cash item.

• Cash flow represents all income realized in cash form.– Adjusting net income for non-cash items yields Operating

Cash Flow.– Investment Cash Flow includes any purchases or sales of

fixed assets and investments. – Financing Cash Flow includes funds raised by issuing

securities, or expended by repurchasing outstanding securities.

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Borg Corporation,Condensed Cash Flow Statement

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Performance, or Profitability, Ratios

• Four common performance ratios often reported in 10Ks and 10Qs to help investors interpret financial information are:

• Note that ROA and ROE are calculated using the current year-end values for total assets and stockholder equity.

• Although one could use prior-year values, it is more common to use current year-end values.

Equity rStockholde

Income Net (ROE)Equity on Return

AssetsTotal

Income Net (ROA) Assetson Return

Sales Net

Income Operating Margin Operating

Sales Net

Profit Gross Margin Gross

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Example: Calculating Profitability Ratios

• Using the data provided by the Borg Company in the year 2536, we can calculate the profitability ratios:

7.29%$50,000

$3,644

Equity rStockholde

Income Net (ROE)Equity on Return

3.64%$100,000

$3,644

AssetsTotal

Income Net (ROA) Assetson Return

7.78%$90,000

$7,000

Sales Net

Income Operating Margin Operating

22.22%$90,000

$20.000

Sales Net

Profit Gross Margin Gross

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Price Ratio Inputs

• Annual reports will often report per-share calculations of book value, earning, and operating cash flow.– Per share calculations require the number of shares outstanding.

– Cash flow per share uses operating cash flow!

gOutstandin Shares

Flow Cash Operating (CFPS) Share perFlow Cash

gOutstandin Shares

IncomeNet (EPS) Share per Earnings

gOutstandin Shares

Equity rStockholde (BVPS) Share per ValueBook

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Example: Calculating Price Ratio Inputs

• For the Borg Company in the year 2536:

$3.322,000

$6,644

gOutstandin Shares

Flow Cash Operating (CFPS) Share perFlow Cash

$1.822,000

$3,644

gOutstandin Shares

Income Net (EPS) Share per Earings

$252,000

$50,000

gOutstandin Shares

Equity rStockholde (BVPS) Share per ValueBook

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Price Ratios

• Using the inputs we just calculated, we can calculate three important Price Ratios:

CFPS

Price Stock (P/CF) RatioFlow Cash to Price

EPS

Price Stock (P/E) Ratio Earnings Price

BVPS

Price Stock (P/B) Ratio Book to Price

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Example: Calculating Price Ratios

• For the Borg Company, these three ratios round to:

12$3.32

$40

CFPS

Price Stock (P/CF) RatioFlow Cash to Price

22$1.82

$40

EPS

Price Stock (P/E) Ratio Earnings Price

1.6$25

$40

BVPS

Price Stock (P/B) Ratio Book to Price

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Financial Statement Forecasting, I.

• Suppose you are an analyst employed by Vulcan Ventures, and you are an analyst for the Borg Corp.

– One day, Borg announces the completed acquisition of a 50% interest in Ferengi Traders.

• Half the acquired shares do not carry voting rights.

• Therefore, on the balance sheet, the acquisition is treated as an investment.

• The stated purpose of the acquisition is to expand sales outlets.

• Also, Borg announces an expanded marketing campaign.

– You must examine the potential financial impact on the Borg Corp. How do you proceed?

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Financial Statement Forecasting, II.

• You must get detailed information about this acquisition.

• You must make assumptions about future income, cash flow, and other items. – You might have an optimistic scenario– You might have a pessimistic scenario, or both.

• Then, using your assumptions and scenarios, you build pro forma financial statements.

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The Pro Forma Income Statement

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The Pro Forma Cash Flow Statement

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The Pro Forma Balance Sheet

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Projected Profitability and Price Ratios,The Borg Corporation

Original Optimistic Pessimistic

Gross Margin 22.22% 25.00% 20.00%

Operating Margin 7.78% 10.83% 3.00%

Return on Assets (ROA) 3.64% 7.70% 0.77%

Return on Equity (ROE) 7.29% 14.43% 1.54%

Book Value per share (BVPS) $25.00 $28.63 $24.88

Earnings per share (EPS) $1.82 $4.13 $0.38

Cash Flow per share (CFPS) $3.32 $3.98 $0.48

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Projected Stock Prices,The Borg Corporation

• Current Stock Price: $40.

• Which projected stock price is “right”?– Clearly depends on which sales scenario is realized.– Clearly depends on which price ratio financial markets will use

to price Borg shares.– Your job as an analyst will be to assess the situation and

make an investment recommendation (supported by facts, investigation, and analysis).

Optimistic Pessimistic

BVPS times P/B $45.81 $39.81

EPS times P/E $90.86 $8.36

CFPS times P/CF $47.76 $5.76

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Adolph Coors Company,Case Study

• The purpose of studying the Borg Corporation was to help you gain an understanding of basic financial statements, and how to make financial projections.

• To further illustrate these concepts, let’s perform an analysis using a real company—which provides a challenge!

• We will use the 2002 financial statements for Adolph Coors Company.– Suppose sales increase 10% or decrease 10%?– The numbers that follow are in $thousands (except EPS).

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Adolph Coors,2002 Condensed Balance Sheet

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Adolph Coors,2002 Condensed Income Statement

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Adolph Coors,2002 Cash Flow Statement

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Pro Forma Statements, Notes I.

• The pro forma income statements correspond to a 10 percent increase and a 10 percent decrease in sales and cost of good sold.

• This causes gross margin to increase or decrease by 10 percent, too.

• For convenience, italics indicate when actual 2002 values are used.

• Because operating expenses are assumed to be constant at 2002 levels, operating income varies a lot.

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Pro Forma Statements, Notes II.

• Tax rates are assumed the same as in 2002 (helps us calculate net income).

• Dividends remain at 2002 levels (helps us calculate retained earnings).

• Retained earnings on the balance sheet are adjusted by retained earnings from the income statement.

• Cash on the balance sheet must be adjusted to reflect the net cash increase from the cash flow statement.

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Pro Forma Statements, Notes III.

• Because retained earnings and the net cash increase are not equal, the balance sheet will not balance!

• But, all items making up the difference appear on the cash flow statement.– Must adjust plant, property, and equipment and goodwill to

reflect changes in depreciation and amortization.– Must adjust operating assets and current liabilities, too.

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Adolph Coors,2003 Pro Forma Income Statement

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Adolph Coors,2003 Pro Forma Cash Flow Statements

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Adolph Coors,2003 Pro Forma Balance Sheet

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Projected Profitability and Price Ratios,Adolph Coors Company

Original +10 Percent -10 Percent

Gross Margin 36.06% 36.06% 36.06%

Operating Margin 7.90% 10.46% 4.77%

Return on Assets (ROA) 3.76% 4.81% 1.53%

Return on Equity (ROE) 16.46% 20.62% 7.38%

Book Value per share (BVPS) $27.15 $33.17 $28.43

Earnings per share (EPS) $4.47 $6.84 $2.10

Cash Flow per share (CFPS) $7.15 $11.39 $6.65

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Projected Stock Prices,Adolph Coors Company

• 2002 Year-end Stock Price: $61.25.

• As with the Borg Corporation, these projected stock prices reflect widely varying degrees of sensitivity to the sales scenarios.– EPS and CFPS are especially sensitive to the sales scenario.

+10 Percent -10 percent

BVPS times P/B $74.83 $64.13

EPS times P/E $93.74 $28.74

CFPS times P/CF $97.58 $56.94

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Useful Internet Sites

• www.nyse.com (The website of the New York Stock Exchange provides a directory of websites for companies whose stocks are listed at the NYSE.)

• www.sec.gov (reference for electronic data archives, EDGAR)

• www.street.com (see research/tools for earnings estimates)

• www.uoutperform.com (reference for a summary for valuing stocks)

• www.investorsuniverse.org (see the education center)

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Chapter Review, I.

• Sources of Financial Information

• Financial Statements– The Balance Sheet– The Income Statement– The Cash Flow Statement– Performance Ratios and Price Ratios

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Chapter Review, II.

• Financial Statement Forecasting– The Pro Forma Income Statement– The Pro Forma Cash Flow Statement– The Pro Forma Balance Sheet– Projected Profitability and Price Ratios

• Adolph Coors Company Case Study