Class Business

Debate Proforma Assignment

Business Cycle– Peak– Trough

Industry relationship to business cycles– Cyclical – Defensive

Business Cycles

Leading Indicators - tend to rise and fall in advance of the economy

– Avg. weekly hours of production workers– Stock Prices – Yield Curve

Coincident Indicators - indicators that tend to change directly with the economy

– Industrial production– Manufacturing and trade sales

Lagging Indicators - indicators that tend to follow the lag economic performance

– Ratio of trade inventories to sales– Ratio of consumer installment credit outstanding to personal

income

NBER Cyclical Indicators:

Sensitivity to business cycles Factors affecting sensitivity of earnings to business

cycles– Sensitivity of sales of the firm’s product to the

business cycles– Operating leverage– Financial leverage

Industry life cycles

Industry Analysis

Financial Statements

Income Statement– Profitability over a given time period

Balance Sheet– “Stock” measure of firm’s financial position

Statement of Cash Flows– Actual Flow of Funds

Old Image of 10-k Links

Example First and SecondLink

New Image of 10-k Links

Example First and SecondLink

Overview of Proforma Analysis

Forecasting Income Statement Accounts

Income Statement Forecast Method

Sales Forecasted by choice

Cost of Sales (GOGS) Calculated: Sales – Gross Profit

Gross Profit Percent of Sales (“Gross Margin”)

Selling, General, and Admin. Expense (SG&A) Percent of Sales

Income before Depreciation and Amortization (EBITDA) Calculated: Gross Profit – SG&A

Depreciation and Amortization Expense (Dep. and Amort.) Percent of Net PP&E

Income after Dep. and Amort. (EBIT) Calculated: EBITDA – Dep. and Amort.

Non-Operating Income (Expense) Forecast driven by expected company policy

Initial Interest ExpensePercent of Prior Year Net Debt (ST Borrowing + LT Debt – Excess

Cash)

Pretax Income Calculated: EBIT + Non-Operating Income – Interest Expense

Income Taxes Percent of Pretax Income (“Tax Rate”)

Net Income Calculated: Pretax Income – Income Taxes

Dividends Percent of Net Income (“Payout Ratio”)

Addition to Retained Earnings Calculated: Net Income – Dividends

   

Forecasting Balance Sheet Accounts

Balance Sheet Forecast Method

Assets  

Excess Cash (Plug item)Zero if operating assets are greater than sources of funds; otherwise,

the amount required to make the sheet balance

Current Assets Percent of Sales

Net Property, Plant, & Equipment Percent of Sales (“Fixed Asset Turnover”)

Intangibles Forecast driven by expected company policy

Other Long Term Assets Percent of Sales

Total Assets Calculated: sum of all asset accounts

   

Liabilities & Owners’ Equity  

Current Liabilities Percent of Sales

Short Term Borrowing (Plug item)Zero if sources of funds are greater than operating assets; otherwise,

the amount required to make the sheet balance

Long Term Debt Forecast driven by expected company policy

Other Liabilities & Preferred Percent of Sales

Shareholders’ Equity Constant based on most recent year’s data

New Retained Earnings Sum of forecasted Additions to Retained Earnings

Total Liabilities & Shareholders’ Equity Calculated: sum of all liability and equity accounts

More on Forecasting

Forecasting– Economic Plausibility

• use ratios

– Accounting Consistency• Plug Figures

– Base much of forecasts on sales forecasts

Ratio Analysis

Purpose of Ratio Analysis Uses

– Trend analysis– Comparative analysis– Forecasting

Use by External Analysts– Important information for investment community

and ratings agencies

Dividend Discount Models:General Model

VD

ko

t

tt

( )11

V0 = Value of Stock Dt = Dividend k = required return

Constant Growth Model

VoD g

k g

o

( )1

g = constant perpetual growth rate

Estimating Dividend Growth Rates

g ROE b

g = growth rate in dividends ROE = Return on Equity for the firm b = plowback or retention percentage rate

= (1- dividend payout percentage rate)

Return on Equity

Equity

DebtRateInterest -ROA ROA rate)Tax -(1 ROE

Financial Leverage and ROE

– ROA = EBIT/Total Assets– ROE = Net Profit/Equity

ROE Example Company A and B have same ROA or same assets in total

of $500 million, but B has financed 30% of their assets while A has no debt. Assume they both pay 40% corporate tax rates, interest on company B’s debt is 7%.

What is A and B’s ROE if their ROA is 12%?– ROEA = .6*[.12 + (.12 - .07)*0] = .072 or 7.2%

– ROEB = .6*[.12 + (.12 - .07)*(150/350)] = .084 or 8.4%

What is A and B’s ROE if their ROA is 6%?– ROEA = .6*[.06 + (.06 - .07)*0] = .036 or 3.6%

– ROEB = .6*[.06 + (.06 - .07)*(150/350)] = .033 or 3.3%

Du Pont Decomposition of ROE

ROE = Net Profit

Pretax Profit

x

Pretax Profit

EBIT

xEBIT

Sales

Sales

Assetsx x

Assets

Equity

(1) x (2) x (3) x (4) x (5)

x Turnover x LeverageInterestBurden

Profit Margin

x

x ROA Compound Leverage Factorx

Walmart versus Neiman-Marcus?

=

=

Tax Burden

Tax Burden

x

Quality of Earnings:Areas of Accounting Choices

Allowance for bad debts Non-securing items Reserves management Stock options Revenue recognition Off-balance sheet assets and liabilities