RUBROS COFINANCIABLES

Exhibits 15-1, 15-2 and 15-3 show the balance sheet, income statement, and cash flow statement respectively for Coke to facilitate the discussion of accounting data as it is needed for security analysis. Only a very basic and brief review of accounting terms is included here. These financial statements can easily be replaced by those for other companies or bypassed if it is felt the student does not need this review. Thus, instructors have considerable flexibility in using this material.

Exhibit 15-4 shows a typical company coverage (in this case, Coca-Cola) from The Value

Line Investment Survey. This is useful both to illustrate the analysis of Coke as is done in this

chapter and to show students what is available and widely used when doing security analysis. The use of this figure in Chapter 15 is in keeping with the theme of this text of using material where it is needed, rather that simply presenting it in a separate chapter as a source of

information.

Box Inserts

Box 15-1 is a good example of security analysis, with one person saying to buy Time Warner and one saying don't buy. This is what investing is all about, differences of opinion. This type of exhibit gives instructors a good opportunity to emphasize how investors differ on the future prospects of companies, which in turn makes trading in the markets viable.

ANSWERS TO END-OF-CHAPTER QUESTIONS

15-1. In fundamental analysis, the intrinsic value of a stock is its justified price; that is, it is the

price justified by investors' evaluations of a company's fundamental financial variables. It is also thought of as an estimated value or a formula value.

15-2. A stock’s intrinsic value can be estimated by using the dividend discount model or the

earnings multiplier model.

15-3. Equation 10-2 states that the intrinsic value of a stock is the discounted value o f all

future dividends. The limitations of using the dividend valuation model are:

(a) The model is only applicable if dividends are being paid or can be expected to be paid.

(b) It is necessary to estimate g, the expected growth rate in dividends. Obviously, different users of the model will (legitimately) come up with different estimates of the future growth rate(s), and it is impossible to determine beforehand who is correct. (c) k, the investor’s required rate of return, must be estimated, an imprecise process.

15-4. ―GAAP‖ refers to Generally Accepted Accounting Principles, a standard set of rules

developed by the accounting profession primarily on the basis of historical costs. These principles assure some uniformity in the financ ial statements produced by companies.

15-5. The problem with accounting earnings is that alternative accounting principles can be

used to prepare financial statements. Numerous combinations of these principles are possible. It is probably impossible to estimate the true performance of a company in one accounting figure.

15-6. The auditor’s report signifies only that generally accepted accounting principles were

applied on a consistent basis. It does not guarantee the accuracy or the quality of the earnings in an absolute sense.

15-7. The management of a company hires an auditing firm to prepare the financial statements.

The accounting firm is supposed to conform to accepted accounting standards and act independently. However, management may be able to influence the accounting firm, which wishes to keep the business, because some flexibility in how certain items are treated does exist.

15-8. The concept of earnings quality has to do with the qualitative (and subjective) factors that

contribute to producing the earnings figure and that help to assess the true earning power of the company. There are no absolute elements of earnings quality, but some guidelines for determining quality involve: liberal versus conservative accounting po licies, the

integrity of the reporting period, the use (or misuse) of discretionary costs, the variability of earnings, and balance sheet analysis.

15-9. The determination process for earnings:

• EPS is the product of ROE (return on equity) and book value per share.

• ROE is the product of ROA (return on assets) and leverage (total assets divided by equity).

• ROA, in turn, is the product of the net income margin and turnover.

15-10. A firm has two basic choices in financing, debt and equity. Debt is a cheaper source of

financing, but it is more risky because of the fixed interest payments which must be made. If leverage is favorable, it can magnify the EPS (or diminish them if unfavorable). Given the ROA, leverage determines the ROE, one of the two basic components of EPS.

15-11. Although higher ROE leads to higher EPS, two factors determine stock price, the

ultimate variable of interest to investors. The increasing use of debt financing increases the risk to stockholders, raising their required rate of return. The increase in the required rate of return will, at some point, offset the higher EPS and lower the stock price.

15-12. The earnings growth rate, g, is defined as:

g = br

where r = ROE and b is the retention rate, defined as (1 - dividend payout ratio). This is an important formulation in fundamental analysis.

15-13. Earnings growth rates for individual companies usually do not persist over time.

Investors cannot simply assume that a particular trend will continue. Year-to-year growth rates are often quite variable.

15-14. Investors can obtain the forecasts of security analysts from several sources such as The

Value Line Investment Survey and other investment advisory publications, brokerage

houses, and data banks accessible through a personal computer. Alternatively, model estimates can be made, using procedures such as time series models. The evidence is mixed as to which source is better. Brown and Rozeff found that analysts’ (specifically, Value Line) estimates were superior. However, there is no real consensus on this issue.

15-15. Malkiel and Cragg, among others, have shown how important it is to know what the

market thinks the earnings growth rate will be. Investors form expectations about EPS, and these expectations play a key role in affecting stock prices. In short, earnings expectations are a key variable in selecting stocks.

15-16. The unexpected component of EPS consists of the earnings surprise factor. One way to

use this factor is by calculating a stock’s SUE, the ratio of the unexpected earnings to a standardization value. Having calculated SUEs for a group of stocks, those ranking at the

top (i.e., the highest SUE stocks) are selected for purchase. Those with the lowest SUEs are candidates to be sold if owned, or possibly sold short.

15-17. SUE is closely related to fundamental security analysis. Earnings is one of the primary

variables in fundamental analysis. Earnings surprises should be, and are, closely related to changes in stock prices. Unexpected information about earnings justifies a revision in investor probability beliefs about the future and, therefore, an adjustment in stock prices.

15-18. P/E ratios are often shown on a current basis (current stock price divided by the latest 12

months earnings per share). Alternatively, the P/E could be calculated using the estimated earnings for the next period (typically, a year).

15-19. Any P/E ratios collected will reflect the specific time periods.

The purpose of this exercise is twofold:

(a) To show students the differences in P/E ratios among co mpanies at a given time--in this case, the average annual P/E ratios for a year. For example, investors were willing to pay over 22 times earnings for Apple but only 18 times for Caterpillar in March, 2006. It is easy to generate discussion abo ut the potential return and risk involved in owning these companies, which are quite different types of companies, by comparing numbers such as these. Instructors should point out that certain types of companies--for example, financial institutions, typically have low P/E ratios. (b) To show the differences in P/E ratios across time for all companies, but in particular

high technology and growth companies. Coke’s P/E ratio has varied significantly over the years for a large, blue chip company. Electric utilities can be expected to show low, but relatively stable, P/E ratios.

15-20. As Equation 15-8 shows, the three variables that affect the P/E ratio are:

(a) The dividend payout ratio (direct relation) (b) The required rate of return (inverse relation)

(c) The expected growth rate in dividends (direct relation).

15-21. (a) Earnings and dividends are directly related; therefore, an increase in the expected

growth rate of earnings would equate with an increase in g, which is directly related to the P/E (the typical assumption is that the payout ratio is constant; therefore, g is the expected growth rate in both dividends and earnings).

(b) A decline in the expected payout will lead to a decline in the P/E.

(c) An increase in the risk- free rate of return will result in a rise in k and, therefore, a decline in the P/E.

(d) An increase in the risk premium will result in a rise in k and, therefore, a decline in the P/E.

(e) A decrease in the required rate of return will increase the P/E.

15-22. Beta reflects the relative systematic risk for a stock. Other things being equal, the higher

the beta, the higher the risk, and the higher the required rate of return. Investors will want to know about a stock’s beta in order to estimate the volatility of the stock’s returns. If a rise in the market is expected, investors would prefer, other things being equal, stocks with higher betas. Likewise, with an expected market decline, lower betas would be preferred if stocks are to be held.

15-23. Beta is not the only component of a stock’s return. Return is a function of two

components, the systematic component (which includes the beta) and the unique component (that part attributable to the company itself). This analysis is based on the market model.

ANSWERS TO END-OF-CHAPTER PROBLEMS