FINA411: Portfolio Management


Laura Avery, MBA, CFA

Portfolio Theory
Chapters 17
FSA
 Chapter Summary

• Objective: To provide an overview of

financial statement analysis and to
relate it to equity valuation analysis.
• Major financial statements
• Profitability measures
• Ratio analysis
• Economic Value Added
• Comparability problems

2
 Overview

• Purpose
• Tools Used
• Statements
• Ratio
Analysis
• Limitations

3
 Use of Accounting Data

• Financial statement analysis can be used

to discover mispriced securities.
• Financial accounting data are widely
available; however, accounting earnings
and economic earnings are not always the
same thing.

4
 Summary Reminder

• Objective: To provide an overview of

financial statement analysis and to relate
it to equity valuation analysis.
• Major financial statements
• Profitability measures
• Ratio analysis
• Economic Value Added
• Comparability problems

5
 Financial Statements

• Balance Sheet
• Common Sized
• Trend or Indexed
• Income Statement
• Common Sized
• Trend or Indexed
• Statement of Changes in Financial
Position

6
 Financial Statements

Balance Sheet:
• Financial condition at a point in time
• Income Statement:
• Profitability over time
• Statement of Cash Flows:
• Tracks the cash implications of
transactions.

7
Table 17.1 Income Statement for
Weston, 2012

8
Table 17.2 Balance Sheet for Weston,
2012 - Assets

9
Table 17.2 Balance Sheet for Weston,
2012 - Liabilities

10
Table 17.3 Consolidated Statement in Changes
in Financial Position for George Weston 2012

11
Table 17.3 Consolidated Statement in Changes
in Financial Position for Weston, 2012 (cont’d)

12
Table 17.3 Consolidated Statement in Changes
in Financial Position for Weston, 2012 (cont’d)

13
 Summary Reminder

• Objective: To provide an overview of

financial statement analysis and to relate
it to equity valuation analysis.
✓ Major financial statements
• Profitability measures
• Ratio analysis
• Economic Value Added
• Comparability problems

14
 Measuring Firm Performance

• Manager responsibilities:
• 1. Investment decisions
• 2. Financing decisions
• Ratios used to show efficiency and profitability of
these decisions:
• ROA- income earned per dollar deployed
• ROC- income earned per dollar invested (long term)
• ROE net income realized by shareholders per dollar
invested

15
 Profitability Measures

• ROC: measures the profitability for

contributors of long-term capital
• ROA: measures the profitability for all
contributors of capital
• ROE: measures the profitability for
contributors of equity capital
• Leverage has a significant effect on
profitability measures

16
 Return on Equity

• ROE determines growth in earnings

• Leverage and ROE
• Leverage magnifies ROA to ROE and is
more volatile
• ROE responds to the Debt-equity ratio

17
 Financial Leverage and ROE

ROE = (1 − Tax rate) ×

Debt
[ ROA + ( ROA − Interest rate) ]
Equity

• If there is no debt or ROA = r (interest),

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.

18
 ROE and Future Prospects

• Past profitability does not guarantee future

profitability.
• Security values are based on future profits.
• Expectations of future dividends determine
today’s stock value.

19
Table 17.4 Nodett’s Profitability Over
the Business Cycle

20
Table 17.5 Impact of Financial Leverage
on ROE

21
 Summary Reminder

• Objective: To provide an overview of

financial statement analysis and to
relate it to equity valuation analysis.
✓ Major financial statements
✓ Profitability measures
• Ratio analysis
• Economic Value Added
• Comparability problems

22
 Ratio Analysis

• Purpose of Ratio Analysis

• Uses
• Trend analysis
• Comparative analysis
• Combination
• Use by External Analysts
• Important information for investment
community
• Important for credit markets

23
 Decomposition of ROE

Net Profit Pretax Profit EBIT Sales Assets

ROE = × × × ×
Pretax Profit EBIT Sales Assets Equity

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

Tax x Interest x Margin x Turnover x Leverage

Burden Burden

24
 Decomposition of ROE

ROE=Tax burden x ROA x Compound leverage

factor

• Tax burden is not affected by

leverage.
• Compound leverage factor= Interest
burden x Leverage

25
 Decomposition of ROE

• ROE=Tax burden x ROA x Compound

leverage factor
• Tax burden is not affected by leverage.
• Compound leverage factor = Interest
burden x Leverage

26
Table 17.6 Ratio Decomposition
Analysis for Nodett and Somdett

27
Table 17.7 Differences between ROS
and ATO Across Industries

28
 Choosing a Benchmark

• Compare the company’s ratios across

time.
• Compare ratios of firms in the same
industry.
• Cross-industry comparisons can be
misleading.

29
Table 17.8 Growth Industries Financial
Statements, 2010 – 2013 ($ thousands)

30
Effect of ROE and Plowback Ratio on P/B

31
Key Financial Ratios - Leverage

32
Key Financial Ratios – Asset Utilization

33
Key Financial Ratios - Liquidity

34
Key Financial Ratios - Profitability

35
Key Financial Ratios – Market Price

36
Table 17.10 Financial Ratios for Metals
and Mining Industry, 2006 – 2012

37
 Table 17.10 Financial Ratios for Metals
and Mining Industry, 2006 – 2012 (con’t)

38
 Table 17.10 Financial Ratios for Metals
and Mining Industry, 2006 – 2012 (con’t)

39
 Summary Reminder

• Objective: To provide an overview of

financial statement analysis and to relate it
to equity valuation analysis.
✓ Major financial statements
✓ Profitability measures
✓ Ratio analysis
• Economic Value Added
• Comparability problems

40
 Economic Value Added

• Difference between return on assets

(ROA) and the opportunity cost of capital
(k), multiplied by capital invested in the
firm
• EVA also called “residual income”
• EVA can be positive or negative for firms
that have positive earnings
• If ROA > k, value is added to the firm
41
Table 17.11 Economic Value Added,
2012

42
 Example 19.2 Intel

• In 2012, Intel’s cost of capital was 7.8%. Its

ROA was 13.9% and its capital base was
$56.34 billion.

• Intel’s EVA =
(0.139-0.078) x $56.34 billion = $3.44 billion

43
 EVA for Intel 2012

• In 2012, Intel’s cost of capital was 7.8%. Its

ROA was 13.9% and its capital base was
$56.34 billion
• EVA = (0.139-0.078) x $56.34 billion
= $3.44 billion

44
Table 17.12 Key Financial Ratios of
Growth Industries, Inc.

45
Table 17.13 Growth Industries of
Cash Flows ($ thousands)

46
 Summary Reminder

• Objective: To provide an overview of

financial statement analysis and to relate
it to equity valuation analysis.
✓ Major financial statements
✓ Profitability measures
✓ Ratio analysis
✓ Economic Value Added
• Comparability problems

47
 Comparability Problems

• Accounting vs. Economic Earnings

• Accounting Differences
• Inventory Valuation
• Depreciation
• Inflation
• Quality of Earnings
• International Accounting Conventions

48
 Earnings Measurement

• Accounting earnings – Net income

according to accounting conventions
• Economic earnings – sustainable cash
flow available to shareholders without
impairing productive capacity of the
firm
• Earnings surprises (SUE)
• Analysts’ forecasts and revisions
49
 Quality of Earnings

• Concept refers to the extent to which one may

expect reported level of earnings to be
sustained
• Factors influencing quality of earnings:
• Allowance for bad debt
• Nonrecurring items
• Earnings smoothing
• Revenue recognition
• Off-balance sheet items

50
International Accounting Differences

• Reserves – many other countries allow

for more flexibility in use of reserves
• Depreciation – US allows separate tax
and reporting presentations
• Intangibles – treatment varies widely

51
Figure 17.4 Comparative Accounting
Rules

52
 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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