CHAPTER 23 Financial Statement Analysis INVESTMENTS BODIE KANE

Financial Statement Analysis • Financial statement analysis can be used to discover mispriced securities. • Financial accounting data are widely available, but – Accounting earnings and economic earnings are not always the same thing! INVESTMENTS | BODIE, KANE, MARCUS 2

Financial Statements • Income Statement: – Profitability over time • Balance Sheet: – Financial condition at a point in time • Statement of Cash Flows: – Tracks the cash implications of transactions. INVESTMENTS | BODIE, KANE, MARCUS 3

Accounting Versus Economic Earnings • Economic earnings – Sustainable cash flow that can be paid to stockholders without impairing productive capacity of the firm • Accounting earnings – Affected by conventions regarding the valuation of assets INVESTMENTS | BODIE, KANE, MARCUS 4

Profitability Measures • ROE measures profitability for contributors of equity capital. – After-tax profit/book value of equity • ROA measures profitability for all contributors of capital. – EBIT/total assets INVESTMENTS | BODIE, KANE, MARCUS 5

Past vs. Future ROE • ROE is a key determinant of earnings growth. • Past profitability does not guarantee future profitability. • Security values are based on future profits. • Expectations of future dividends determine today’s stock value. INVESTMENTS | BODIE, KANE, MARCUS 6

Financial Leverage and ROE • ROE can differ from ROA because of leverage. • Leverage makes ROE more volatile. • Let t=tax rate and r=interest rate, then: INVESTMENTS | BODIE, KANE, MARCUS 7

Financial Leverage and ROE • 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. INVESTMENTS | BODIE, KANE, MARCUS 8

Decomposition of ROE Du. Pont Method ROE = Net Profit x Pretax Profit (1) Tax Burden x x Pretax Profit EBIT (2) Interest Burden x x EBIT Sales (3) x x Sales Assets (4) x Assets Equity x (5) x Margin x Turnover x Leverage INVESTMENTS | BODIE, KANE, MARCUS 9

Decomposition of ROE ROA=EBIT/Sales X Sales/Assets = margin X turnover • Margin and turnover are unaffected by leverage. • ROA reflects soundness of firm’s operations, regardless of how they are financed. INVESTMENTS | BODIE, KANE, MARCUS 10

Decomposition of ROE=Tax burden X ROA X Compound leverage factor • Tax burden is not affected by leverage. • Compound leverage factor= Interest burden X Leverage INVESTMENTS | BODIE, KANE, MARCUS 11

Table 23. 9 Summary of Key Financial Ratios INVESTMENTS | BODIE, KANE, MARCUS 12

Table 23. 9 Summary of Key Financial Ratios INVESTMENTS | BODIE, KANE, MARCUS 13

Table 23. 9 Summary of Key Financial Ratios INVESTMENTS | BODIE, KANE, MARCUS 14

Table 23. 9 Summary of Key Financial Ratios INVESTMENTS | BODIE, KANE, MARCUS 15

Table 23. 9 Summary of Key Financial Ratios INVESTMENTS | BODIE, KANE, MARCUS 16

Economic Value Added • 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. INVESTMENTS | BODIE, KANE, MARCUS 17