No presentation of fundamental security analysis would be complete without a discussion of the ideas of Benjamin Graham, the greatest of the investment “gurus.” Until the evolu- tion of modern portfolio theory in the latter half of the 20th century, Graham was the single most important thinker, writer, and teacher in the field of investment analysis. His influ- ence on investment professionals remains very strong.
Graham’s magnum opus is Security Analysis, written with Columbia Professor David Dodd in 1934. Its message is similar to the ideas presented in this chapter. Graham believed careful analysis of a firm’s financial statements could turn up bargain stocks. Over the years, he developed many different rules for determining the most important financial ratios and the critical values for judging a stock to be undervalued. Through many editions, his book has been so influential and successful that widespread adoption of Graham’s tech- niques has led to elimination of the very bargains they are designed to identify.
In a 1976 seminar Graham said: 6
I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities. This was a rewarding activity, say, forty years ago, when our textbook “Graham and Dodd” was first published; but the situation has changed a good deal since then. In the old days any well-trained security analyst could do a good professional job of selecting undervalued issues through detailed studies; but in the light of the enormous amount of research now being carried on, I doubt whether in most cases such extensive efforts will generate sufficiently superior selections to justify their cost.
To that very limited extent I’m on the side of the “efficient market” school of thought now generally accepted by the professors.
6 As cited by John Train in Money Masters (New York: Harper & Row, 1987).
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Nonetheless, in that same seminar, Graham suggested a simplified approach to identify- ing bargain stocks:
My first, more limited, technique confines itself to the purchase of common stocks at less than their working-capital value, or net current-asset value, giving no weight to the plant and other fixed assets, and deducting all liabilities in full from the current assets.
We used this approach extensively in managing investment funds, and over a 30-odd-year period we must have earned an average of some 20 percent per year from this source. I consider it a foolproof method of systematic investment—once again, not on the basis of individual results but in terms of the expectable group income.
There are two convenient sources of information for those interested in trying out the Graham technique: Both Standard & Poor’s Outlook and The Value Line Investment Survey carry lists of stocks selling below net working capital value.
1. The primary focus of the security analyst should be the firm’s real economic earnings rather than its reported earnings. Accounting earnings as reported in financial statements can be a biased estimate of real economic earnings, although empirical studies reveal that reported earn- ings convey considerable information concerning a firm’s prospects.
2. A firm’s ROE is a key determinant of the growth rate of its earnings. ROE is affected pro- foundly by the firm’s degree of financial leverage. An increase in a firm’s debt-to-equity ratio will raise its ROE and hence its growth rate only if the interest rate on the debt is less than the firm’s return on assets.
3. It is often helpful to the analyst to decompose a firm’s ROE ratio into the product of several accounting ratios and to analyze their separate behavior over time and across companies within an industry. A useful breakdown is
ROE5 Net profits
Pretax profits3Pretax profits
EBIT 3EBIT
Sales3 Sales
Assets3Assets Equity
4. Other accounting ratios that have a bearing on a firm’s profitability and/or risk are fixed-asset turnover, inventory turnover, and the current, quick, and interest coverage ratios.
5. Two ratios that make use of the market price of the firm’s common stock in addition to its finan- cial statements are the ratios of market to book value and price to earnings. Analysts sometimes take low values for these ratios as a margin of safety or a sign that the stock is a bargain.
6. Good firms are not necessarily good investments. Stock market prices of successful firms may be bid up to levels that reflect that success. If so, the price of these firms relative to their earn- ings prospects may not constitute a bargain.
7. A major problem in the use of data obtained from a firm’s financial statements is comparabil- ity. Firms have a great deal of latitude in how they choose to compute various items of revenue and expense. It is, therefore, necessary for the security analyst to adjust accounting earnings and financial ratios to a uniform standard before attempting to compare financial results across firms.
8. Comparability problems can be acute in a period of inflation. Inflation can create distortions in accounting for inventories, depreciation, and interest expense.
9. Fair value or mark-to-market accounting requires that most assets be valued at current market value rather than historical cost. This policy has proven to be controversial because ascertaining true market value in many instances is difficult, and critics contend that financial statements are therefore unduly volatile. Advocates argue that financial statements should reflect the best estimate of current asset values.
10. International financial reporting standards have become progressively accepted throughout the world, including the United States. They differ from traditional U.S. GAAP procedures in that they are “principles based” rather than rules based.
SUMMARY
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1. What is the major difference in approach of international financial reporting standards and U.S.
GAAP accounting? What are the advantages and disadvantages of each?
2. If markets are truly efficient, does it matter whether firms engage in earnings management? On the other hand, if firms manage earnings, what does that say about management’s view on effi- cient markets?
3. What financial ratios would a credit rating agency such as Moody’s or Standard & Poor’s be most interested in? Which ratios would be of most interest to a stock market analyst deciding whether to buy a stock for a diversified portfolio?
4. The Crusty Pie Co., which specializes in apple turnovers, has a return on sales higher than the industry average, yet its ROA is the same as the industry average. How can you explain this?
5. The ABC Corporation has a profit margin on sales below the industry average, yet its ROA is above the industry average. What does this imply about its asset turnover?
6. Firm A and firm B have the same ROA, yet firm A ’s ROE is higher. How can you explain this?
7. Use the DuPont system and the following data to find return on equity.
Leverage ratio (assets/equity) 2.2 Total asset turnover 2.0
Net profit margin 5.5%
Dividend payout ratio 31.8%
8. Recently, Galaxy Corporation lowered its allowance for doubtful accounts by reducing bad debt expense from 2% of sales to 1% of sales. Ignoring taxes, what are the immediate effects on ( a ), operating income and ( b ) operating cash flow?
Use the following case in answering Problems 9–11: Hatfield Industries is a large manufacturing conglomerate based in the United States with annual sales in excess of $300 million. Hatfield is cur- rently under investigation by the Securities and Exchange Commission (SEC) for accounting irregu- larities and possible legal violations in the presentation of the company’s financial statements. A due diligence team from the SEC has been sent to Hatfield’s corporate headquarters in Philadelphia for a complete audit in order to further assess the situation.
Several unique circumstances at Hatfield are discovered by the SEC due diligence team during the course of the investigation:
• Management has been involved in ongoing negotiations with the local labor union, of which
approximately 40% of its full-time labor force are members. Labor officials are seeking increased wages and pension benefits, which Hatfield’s management states is not possible at this time due to decreased profitability and a tight cash flow situation. Labor officials have accused Hatfield’s management of manipulating the company’s financial statements to justify not granting any concessions during the course of negotiations.
PROBLEM SETS
i. Basic
ii. Intermediate
income statement balance sheet
statement of cash flows economic earnings accounting earnings return on equity return on assets DuPont system profit margin return on sales total asset turnover
interest coverage ratio times interest earned leverage ratio
inventory turnover ratio average collection period current ratio
quick ratio acid test ratio cash ratio
market–book-value ratio price–earnings (P/E) ratio
economic value added residual income LIFO
FIFO
fair value accounting mark-to-market accounting quality of earnings international financial
reporting standards
KEY TERMS
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• All new equipment obtained over the past several years has been established on Hatfield’s
books as operating leases, although past acquisitions of similar equipment were nearly always classified as capital leases. Financial statements of industry peers indicate that capital leases for this type of equipment are the norm. The SEC wants Hatfield’s management to provide justification for this apparent deviation from “normal” accounting practices.
• Inventory on Hatfield’s books has been steadily increasing for the past few years in compari-
son to sales growth. Management credits improved operating efficiencies in its production methods that have contributed to boosts in overall production. The SEC is seeking evidence that Hatfield somehow may have manipulated its inventory accounts.
The SEC due diligence team is not necessarily searching for evidence of fraud but of possible manip- ulation of accounting standards for the purpose of misleading shareholders and other interested par- ties. Initial review of Hatfield’s financial statements indicates that at a minimum, certain practices have resulted in low-quality earnings.
9. Labor officials believe that the management of Hatfield is attempting to understate its net income to avoid making any concessions in the labor negotiations. Which of the following actions by management will most likely result in low-quality earnings?
a. Lengthening the life of a depreciable asset in order to lower the depreciation expense.
b. Lowering the discount rate used in the valuation of the company’s pension obligations.
c. The recognition of revenue at the time of delivery rather than when payment is received.
10. Hatfield has begun recording all new equipment leases on its books as operating leases, a change from its consistent past use of capital leases, in which the present value of lease payments is classified as a debt obligation. What is the most likely motivation behind Hatfield’s change in accounting methodology? Hatfield is attempting to:
a. Improve its leverage ratios and reduce its perceived leverage.
b. Reduce its cost of goods sold and increase it profitability.
c. Increase its operating margins relative to industry peers.
11. The SEC due diligence team is searching for the reason behind Hatfield’s inventory build-up relative to its sales growth. One way to identify a deliberate manipulation of financial results by Hatfield is to search for:
a. A decline in inventory turnover.
b. Receivables that are growing faster than sales.
c. A delay in the recognition of expenses.
12. A firm has an ROE of 3%, a debt-to-equity ratio of .5, a tax rate of 35%, and pays an interest rate of 6% on its debt. What is its operating ROA?
13. A firm has a tax burden ratio of .75, a leverage ratio of 1.25, an interest burden of .6, and a return on sales of 10%. The firm generates $2.40 in sales per dollar of assets. What is the firm’s ROE?
14. Use the following cash flow data for Rocket Transport to find Rocket’s a. Net cash provided by or used in investing activities.
b. Net cash provided by or used in financing activities.
c. Net increase or decrease in cash for the year.
Cash dividend $ 80,000
Purchase of bus $ 33,000
Interest paid on debt $ 25,000
Sales of old equipment $ 72,000
Repurchase of stock $ 55,000
Cash payments to suppliers $ 95,000 Cash collections from customers $300,000
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1. The information in the following exhibit comes from the notes to the financial statements of QuickBrush Company and SmileWhite Corporation:
Determine which company has the higher quality of earnings by discussing each of the three notes.
2. Scott Kelly is reviewing MasterToy’s financial statements in order to estimate its sustainable growth rate. Consider the information presented in the following exhibit.
MasterToy, Inc.: Actual 2008 and estimated 2009 financial statements for fiscal year ending December 31 ($ million, except per-share data)
2008 2009 Change (%)
Income Statement
Revenue $4,750 $5,140 7.6%
Cost of goods sold 2,400 2,540
Selling, general, and administrative 1,400 1,550
Depreciation 180 210
Goodwill amortization 10 10
Operating income $ 760 $ 830 8.4
Interest expense 20 25
Income before taxes $ 740 $ 805
Income taxes 265 295
Net income $ 475 $ 510
Earnings per share $ 1.79 $ 1.96 8.6
Averages shares outstanding (millions) 265 260 Balance Sheet
Cash $ 400 $ 400
Accounts receivable 680 700
Inventories 570 600
Net property, plant, and equipment 800 870
Intangibles 500 530
Total assets $2,950 $3,100
Current liabilities 550 600
Long-term debt 300 300
Total liabilities $ 850 $ 900
Stockholders’ equity 2,100 2,200
Total liabilities and equity $2,950 $3,100
Book value per share $ 7.92 $ 8.46
Annual dividend per share $ 0.55 $ 0.60
QuickBrush SmileWhite
Goodwill The company amortizes goodwill over 20 years.
The company amortizes goodwill over 5 years.
Property, plant, and equipment
The company uses a straight-line depreciation method over the economic lives of the assets, which range from 5 to 20 years for buildings.
The company uses an accelerated depreciation method over the economic lives of the assets, which range from 5 to 20 years for buildings.
Accounts receivable
The company uses a bad debt allowance of 2% of accounts receivable.
The company uses a bad debt allowance of 5% of accounts receivable.
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a. Identify and calculate the components of the DuPont formula.
b. Calculate the ROE for 2009 using the components of the DuPont formula.
c. Calculate the sustainable growth rate for 2009 from the firm’s ROE and plowback ratios.
3. This problem should be solved using the following data:
Cash payments for interest $(12)
Retirement of common stock (32)
Cash payments to merchandise suppliers (85)
Purchase of land (8)
Sale of equipment 30
Payments of dividends (37)
Cash payment for salaries (35)
Cash collection from customers 260
Purchase of equipment (40)
a. What are cash flows from operating activities?
b. Using the data above, calculate cash flows from investing activities.
c. Using the data above, calculate cash flows from financing activities.
4. Janet Ludlow is a recently hired analyst. After describing the electric toothbrush industry, her first report focuses on two companies, QuickBrush Company and SmileWhite Corporation, and concludes:
QuickBrush is a more profitable company than SmileWhite, as indicated by the 40% sales growth and substantially higher margins it has produced over the last few years. SmileWhite’s sales and earnings are growing at a 10% rate and pro- duce much lower margins. We do not think SmileWhite is capable of growing faster than its recent growth rate of 10% whereas QuickBrush can sustain a 30%
long-term growth rate.
a. Criticize Ludlow’s analysis and conclusion that QuickBrush is more profitable, as defined by return on equity (ROE), than SmileWhite and that it has a higher sustainable growth rate. Use only the information provided in Tables 19A and 19B . Support your criticism by calculating and analyzing:
• The five components that determine ROE.
• The two ratios that determine sustainable growth: ROE and plowback.
b. Explain how QuickBrush has produced an average annual earnings per share (EPS) growth rate of 40% over the last 2 years with an ROE that has been declining. Use only the informa- tion provided in Table 19A .
Use the following in answering CFA Problems 5–8: Eastover Company (EO) is a large, diversified forest products company. Approximately 75% of its sales are from paper and forest products, with the remainder from financial services and real estate. The company owns 5.6 million acres of timber- land, which is carried at very low historical cost on the balance sheet.
Peggy Mulroney, CFA, is an analyst at the investment counseling firm of Centurion Investments.
She is assigned the task of assessing the outlook for Eastover, which is being considered for pur- chase, and comparing it to another forest products company in Centurion’s portfolios, Southampton Corporation (SHC). SHC is a major producer of lumber products in the United States. Building products, primarily lumber and plywood, account for 89% of SHC’s sales, with pulp accounting for the remainder. SHC owns 1.4 million acres of timberland, which is also carried at historical cost on the balance sheet. In SHC’s case, however, that cost is not as far below current market as Eastover’s.
Mulroney began her examination of Eastover and Southampton by looking at the five compo- nents of return on equity (ROE) for each company. For her analysis, Mulroney elected to define equity as total shareholders’ equity, including preferred stock. She also elected to use year-end data rather than averages for the balance sheet items.
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5. a. On the basis of the data shown in Tables 19C and 19D , calculate each of the five ROE compo- nents for Eastover and Southampton in 2010. Using the five components, calculate ROE for both companies in 2010.
b. Referring to the components calculated in part ( a ), explain the difference in ROE for Eastover and Southampton in 2010.
c. Using 2010 data, calculate the sustainable growth rate for both Eastover and Southampton.
Discuss the appropriateness of using these calculations as a basis for estimating future growth.
Income Statement
December 2008
December 2009
December 2010
Revenue $3,480 $5,400 $7,760
Cost of goods sold 2,700 4,270 6,050
Selling, general, and admin. expense 500 690 1,000
Depreciation and amortization 30 40 50
Operating income (EBIT) $ 250 $ 400 $ 660
Interest expense 0 0 0
Income before taxes $ 250 $ 400 $ 660
Income taxes 60 110 215
Income after taxes $ 190 $ 290 $ 445
Diluted EPS $ 0.60 $ 0.84 $ 1.18
Average shares outstanding (000) 317 346 376
Financial Statistics
December 2008
December 2009
December 2010
3-Year Average
COGS as % of sales 77.59% 79.07% 77.96% 78.24%
General & admin. as % of sales 14.37 12.78 12.89 13.16
Operating margin 7.18 7.41 8.51
Pretax income/EBIT 100.00 100.00 100.00
Tax rate 24.00 27.50 32.58
Balance Sheet
December 2008
December 2009
December 2010
Cash and cash equivalents $ 460 $ 50 $ 480
Accounts receivable 540 720 950
Inventories 300 430 590
Net property, plant, and equipment 760 1,830 3,450
Total assets $2,060 $3,030 $5,470
Current liabilities $ 860 $1,110 $1,750
Total liabilities $ 860 $1,110 $1,750
Stockholders’ equity 1,200 1,920 3,720
Total liabilities and equity $2,060 $3,030 $5,470
Market price per share $21.00 $30.00 $45.00
Book value per share $ 3.79 $ 5.55 $ 9.89
Annual dividend per share $ 0.00 $ 0.00 $ 0.00
Table 19A
QuickBrush Company financial statements: yearly data ($000 except per-share data)
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6. a. Mulroney recalled from her CFA studies that the constant-growth discounted dividend model was one way to arrive at a valuation for a company’s common stock. She collected current dividend and stock price data for Eastover and Southampton, shown in Table 19E . Using 11%
as the required rate of return (i.e., discount rate) and a projected growth rate of 8%, com- pute a constant-growth DDM value for Eastover’s stock and compare the computed value for Eastover to its stock price indicated in Table 19F .
b. Mulroney’s supervisor commented that a two-stage DDM may be more appropriate for companies such as Eastover and Southampton. Mulroney believes that Eastover and Income Statement
December 2008
December 2009
December 2010
Revenue $104,000 $110,400 $119,200
Cost of goods sold 72,800 75,100 79,300
Selling, general, and admin. expense 20,300 22,800 23,900
Depreciation and amortization 4,200 5,600 8,300
Operating income $ 6,700 $ 6,900 $ 7,700
Interest expense 600 350 350
Income before taxes $ 6,100 $ 6,550 $ 7,350
Income taxes 2,100 2,200 2,500
Income after taxes $ 4,000 $ 4,350 $ 4,850
Diluted EPS $ 2.16 $ 2.35 $ 2.62
Average shares outstanding (000) 1,850 1,850 1,850
Financial Statistics
December 2008
December 2009
December 2010
3-Year Average
COGS as % of sales 70.00% 68.00% 66.53% 68.10%
General & admin. as % of sales 19.52 20.64 20.05 20.08
Operating margin 6.44 6.25 6.46
Pretax income/EBIT 91.04 94.93 95.45
Tax rate 34.43 33.59 34.01
Balance Sheet
December 2008
December 2009
December 2010 Cash and cash equivalents $ 7,900 $ 3,300 $ 1,700
Accounts receivable 7,500 8,000 9,000
Inventories 6,300 6,300 5,900
Net property, plant, and equipment 12,000 14,500 17,000
Total assets $ 33,700 $ 32,100 $ 33,600
Current liabilities $ 6,200 $ 7,800 $ 6,600
Long-term debt 9,000 4,300 4,300
Total liabilities $ 15,200 $ 12,100 $ 10,900
Stockholders’ equity 18,500 20,000 22,700
Total liabilities and equity $ 33,700 $ 32,100 $ 33,600 Market price per share $ 23.00 $ 26.00 $ 30.00 Book value per share $ 10.00 $ 10.81 $ 12.27 Annual dividend per share $ 1.42 $ 1.53 $ 1.72
Table 19B
SmileWhite Corporation financial statements: yearly data ($000 except per-share data)