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Financial Statement Analysis for Value Investing
Investors in the 21st century operate in several different ways, all attempting to outperform each other and the market as a whole. Some investors adopt passive investing strategies by dedicating a set amount of money per month to index funds. Some spend their time analyzing on a micro-level by attempting to buy the lows and sell the highs on a daily or weekly basis, known as day-trading or swing trading. Others prefer to hedge big bets using derivatives when they suspect a certain security is trending one way or another, known as trading options, futures, and the like. Investors like Warren Buffet prefer to buy companies he likes and hold them his entire life. Buffets strategy is called value-investing. He uses basic financial statement analysis to pick out companies that are undervalued by the market, buys the right amount according to his risk tolerance, and enjoys the profits of the company over the following decades (Hayes, Investopedia, 2020). This paper is not advocating that one strategy is better than the rest and should not be used as investment advice. This paper will focus on value investing by investigating the strategies used to interpret the value of common stock for the purpose of profiting over a long period of time.
Financial statements illustrate the pulse of a company and help potential investors learn about a company. An investor needs to know what to look for within the financial statements, the management type of the company, and external factors like industry type and public perception.
Benjamin Graham in The Intelligent Investor (1949) suggests that an intelligent investor does not solely rely on the financial statement to produce their final interpretation of a stock (1949). The idea is to read the statements knowing that the accountants that prepared the statements want the company to look as good as possible and other information is going to be needed for context. Some areas of the statements can be ignored, and more weight should be added to other parts of the statement depending on the industry. The investor should also make sure they look into the company’s legal history and do some research on the company’s executives. Graham also states that too much information can cause the investor to stall and never make a decision at all. Furthermore, the investor could have all the necessary information and make all the right moves but still fall short of making the profits that they expected (1949).
Financial analysis tends to be unfair to those that try the hardest and give good returns to those that apply simple strategies of buying and holding mutual funds that track the stock market as a whole (Graham, 1949). Graham stated, “to achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks” (Graham, p.250, 1949).
There are many different ways to interpret a financial statement and many investors, CPA’s, and banks will come up with different valuations for the same stock on any given day. For example, on Sunday December 4, 2020, Yahoo Finance reported a P/E ratio for Apple Inc. of 37.27 while Google Finance reported a P/E ratio of 37.32 (Google Finance, 2020) (Yahoo Finance, 2020). The difference in examination between these two companies is because they emphasize differing importance to certain parts of the financial statements. This paper will discuss the most commonly used ratios and valuation methods to interpret the value of a stock.
Annual Report and the Form 10k
The SEC requires public companies to share their financials in the form of a Form 10k to help stakeholders view the changes that have happened over the year. The information within this statement will include the traditional financial statements, where all of the ratios and valuation methods can be used, and information less quantitative like industry outlooks, lawsuits, countries of operation, differences in voting rights across share classes, and more (Webb, 2012).
These less quantitative measures are imperative because it is important to know how a company is operating, for example, within ethical standards. If an investor were to find that a company has a lawsuit against them for child labor allegations, in a foreign country, this could cause the market to shy away from investing in them. Or, as climate change becomes a more apparent issue, investors will likely want to see the companies move in a more sustainable direction. All investors operate under their own differing ethical standards and being aware of this can help make sense of market trends (Benson, 2020).
The Form 10k includes more than the financial statements of a company which helps investors put the quantitative information into context. Financial statement analysis, alone, cannot determine which stocks will offer the most growth and dividends. According to Graham, while an investor analyzes a company’s financial statements, the investor needs to remember the general long-term projections of the industry, the potential risks, the company’s management, the financial strength/capital structure, the dividend record, and the current dividend rate (1949). These five topics will be separated between qualitative and quantitative analysis with general long-term projections and risks, and management being qualitative and capital structure, and dividend information being quantitative.
The general long-term projection will come from an investors expectation of how industries will evolve. In 2020, an investor might expect the technology sector to have more potential than the paper industry. Therefore, an investor would look at the financial statements knowing that it only represents one year in the company’s history and more information will likely be needed in order to identify a trend.
The Form 10k will include information relevant to this in part 1 — item 1A ‘Risk Factors’, and part 2 — item 7A ‘Quantitative and Qualitative Disclosures about Market Risk’. The part 1 risk factors should include any risks that pertain to the company in order of importance. In this section, the company cannot mention how they plan to navigate these risks. In the part 2, ‘Quantitative and Qualitative Disclosures about Market Risk’, section, the company will touch on risks like interest rate risk, foreign exchange risk, and commodity price risk, to name a few. Unlike part 1 — item 1A, this section will acknowledge how the company is prepared to manage these risks (Investor.gov, How to Read a 10-k, 2011).
The management quality of a firm should also be taken into account. A good manager will leave a consistent track record and a company’s productivity is often reflected from management. A company that acquires a few good managers that already have a positive reputation could be enough to convince some investors that higher earnings are coming. A management mishap gone public can bring distrust to the stakeholders and prices may drop (Graham, 1949).
Management information in the 10k can be found in part 2 — item 7 ‘Management’s Discussion and Analysis of Financial Condition and Results of Operation’, and the entirety part 3 which includes ‘Directors, Executive Officers, and Corporate Governance’, ‘Executive Compensation’, ‘Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters’, ‘Certain Relationships and Related Transaction, and Director Independence’, and ‘Principal Accountant Fees and Services.’ These sections help an investor understand the experience of a company’s directors, what they pay themselves and their accountants, and what their financial interest is in the company (Investor.gov, 2011). Within this section an investor can identify the strengths and weaknesses of the executives running the company.
The investor will need to apply weight, according to importance, to all of the qualitative information that is relevant to the success of the company. This will help them apply this information in their quantitative analysis where they will be comparing performance data points (Graham, 1949).
The SEC, or The U.S. Securities and Exchange Commission, provides the guidelines as to how these forms need to be prepared by corporations for public use by following generally accepted accounting principles, or GAAP. The SEC also requires companies to issue their annual reports which include the form 10-k for the use of the public. According to Investopedia, the form 10-k is a complete and thorough analysis of the financial statements and describes the companies risks, legal proceedings, industry standards, and more (Zucchi, 2019).
Two factors that create judgement from investors are the financial strength and capital structure of a company. According to Investopedia, capital structure refers to the combination of debt and equity that a company chooses to finance their operations (2020). Graham states, “stock of a company with a lot of surplus cash and nothing ahead of the common is clearly a better purchase than another one with the same per-share earnings but large bank loans and senior securities” (p.132, 1949).
Within the 10k, investors can find information on the company’s capital structure in part 2 — items 7, ‘Management’s Discussion and Analysis of Financial Condition and Results of Operations’, and 8, ‘Financial Statements and Supplementary Data.’ The first of which gives the management to explain the company’s financial situation in their own words and the latter provides the audited financial statements (investor.gov, 2011). While it is good to have the managements perspective, an investor should make their own conclusions by analyzing the financial statements themselves. Investors will typically use the debt-to-equity ratio, provided in detail on page 10 of this text, to evaluate the capital structure of a company (Tuovila, Investopedia, 2020).
The financial statements in these sections will be thoroughly examined including the balance sheet, income statement, statement of changes in stockholder’s equity, and statement of cash flows. The definitions of each of these are as follows: (Edmonds, Olds, McNair, and Tsay, Survey of Accounting, 2015)
1. Balance sheet — Statement that lists the assets of a business and the corresponding claims (liabilities and equity) on those assets.
2. Income statement — statement that measures the difference between the asset increases and the asset decreases associated with running a business.
3. Statement of changes in stockholder’s equity — Statement that summarizes the transactions occurring during the accounting period that affected the owners’ equity.
4. Statement of cash flows — Statement that explains how a business obtained and used cash during an accounting period.
There are several ways that investors can research a company and determine its true value. Horizontal analysis, vertical analysis, and a plethora of performance ratios are among the most common tools an investor will use. The following information will include the quantitative analysis techniques investors use to interpret a financial statement with the goal of looking for undervalued companies.
Horizontal Analysis of Balance Sheet
A common analysis technique used by investors is the horizontal (or trend) analysis of the financial statements. This analysis compares each article of the financial statement with the corresponding statement from the previous year. For example, one could view the difference in gross margin year after year as an absolute dollar amount or a percentage. This allows the reader to identify trends and make judgements on the production history of a given company (Graham, 1949).
Another common technique used is called the vertical analysis. Edmonds states, “Vertical analysis uses percentages to compare individual components of financial statements to a key statement figure. Horizontal analysis compares items over many time periods; vertical analysis compares many items within the same time period,” (Edmonds, p.324, 2015). For example, when analyzing the balance sheet, the investor would typically use the total assets as the denominator to find a common size percentage. Dividing each value within the statement by the total assets allows one to view the percentage of, for example, debt compared to total assets. When analyzing the income statement, the investor will use the same approach but using the total revenue as the common denominator (Webb, Biola University, 2012).
According to Edmonds, “[r]atio analysis involves studying various relationships between different items reported in a set of financial statements” (p.324, 2015). An efficient investor will know which ratios are relevant to their goals. James Webb, of Biola University’s Crowell School of Business, uses certain ratios to measure the particular financial abilities of a company, illustrated in Figures 1–5. If the goal of the analysis is to measure short-term liquidity, as seen in Figure 1., the investor would use the current and quick ratios and compare those figures to previous years and industry standards and benchmarks.
Short-Term Liquidity Ratios
Current ratio =Current assets/Current liabilities
Quick ratio = Current assets — Inventory/Current liabilities
According to Webb, the current ratio of a healthy company will be anywhere between 1.5–3:1, (2012). Edmonds recognized that, in recent years, the average current ratio of the companies withing the Dow was 1.21:1, (2015). This ratio measures the amount of cash on hand and an investor does not want the firm in question to have too little or too much cash on hand. Too little cash could mean the company is slacking in sales, spending too much, etc. Too much cash could mean that the firm is not utilizing its earnings to reinvest (Edmonds, p.326, 2015).
The quick ratio also reflects a company’s liquidity but disregards less-liquid items like inventory and prepaid items in the calculation. According to Webb, a healthy company will have a quick ratio of .5–1:1 (2012).
The current and quick ratios are important for creditors and investors because it helps them understand how the company plans on paying their liabilities and identifies companies that may be on the brink of bankruptcy.
Long-term Solvency Ratios
To solve for a company’s long-term solvency, the investor will use the total debt, debt to equity, and times interest earned ratios as illustrated in Figure 2. The total debt ratio, or debt to asset ratio, measures the percentage amount of a company’s assets that are financed by debt. The debt-to-equity ratio measures a company’s liabilities as it compares to stockholder’s equity. Lastly, the times interest earned compares EBITDA (earnings before interest + taxes, depreciation, and amortization) to the interest expense. This exposes the amount of cash flow being used up by interest expenses. The investor can then use this ratio to compare against successful companies within the relevant industry (Edmonds, p.329, 2015).
It should be noted that using the EBITDA comes with its advantages and disadvantages. EBITDA can show a useful comparison between two companies earning productivity because expenses are stripped away, revealing possible earning potential if said company were able to decrease their expenses. There are multiple possible ratios that can be used to view a company’s expense categories individually. The downside to EBITDA is that it is not an approved accounting technique recognized by GAAP or IFRS. This is because using such techniques can lead companies to accounting fraud when earnings are exaggerated and investors are misinformed (McClure, Investopedia, 2020).
Long-term solvency measures
Total debt ratio = Total liabilities/Total assets
Debt to equity ratio =Total liabilities/Total equity
Times interest earned = EBITDA/Interest expense
Asset Management/Turnover Measures
Figure 3. provides the ratios that relate to asset management and turnover measures. The first of those is inventory turnover. This measures the number of times that inventory is replaced throughout the year. Inventory turnover ratios are used for a wide range of industries and a respectable ratio can look different given the industry (Edmonds, 2015). For example, on average, a retail running shoe store will experience more turnover than an airplane manufacturer, and, therefore, should be judged using different standards.
The average number of days to sell inventory is found by dividing 365 days by the inventory turnover ratio already calculated. This ratio reveals the number of days a company can go until they need to restock their inventory and will vary by industry (Edmonds, p.332, 2015).
The accounts receivable turnover and average collection period ratios are both used to analyze a company’s ability to collect receivables. The A/R turnover ratio compares the relationship between sales and the average accounts receivable and the higher the number is, the quicker a company is proved to collect their receivables. The average collection period ratio divides the 365 days in a year by the A/R ratio already computed to show the number of days it usually takes to collect receivables (Edmonds, p.332, 2015).
Asset management/turnover measures
Inventory turnover =COGS/Avg. inventory
Average number of days to sell inventory =365 days/Inventory turnover
A/R turnover =Sales/Avg. A/R
Average collection period =365 days/ (A/R turnover)
Profitability ratios are important to potential investors because a portion of a company’s earnings are distributed to stockholders in the form of dividends or a potential for the price of the stock to increase. Figure 4. illustrates three equations used to measure a company’s ability to generate earnings. While the profitability ratios offer insight into the performance of the company, an investor should know how one particular company typically chooses to distribute their earnings. If the company chooses to use earnings to focus on distributing dividends, an investor might use this dividend stock in a portfolio meant to provide liquidity. If the company chooses to focus its earnings on its own growth, an investor might use this growth stock in a portfolio meant to grow wealth (cleartax.in, 2020).
Profit margin measures the amount of sales that are coming back as a profit. By dividing net income by sales, an investor can reveal, per dollar earned, how expensive it is for a company to run their business (Edmonds, 2015). An investor would want to see that a company is working efficiently and the standards on which efficiency is judged change when looking at different business sectors. For example, the profit margins of tech companies and restaurants are very different. Tech companies will typically have a much higher margin than restaurants as expenses and consumer patterns are different (Webb, Biola University, 2012).
The return on assets ratio, also known as the return on investments ratio (ROI), measures the income that is generated by the current investments or average total assets. The ROI of a company can then be compared to other companies and the market as a whole. If the ROI is lower than the market average, then it is likely that the company is underperforming (Edmonds, p.332, 2015).
The return on equity ratio measures the stockholder’s profitability. ROE can be used to measure the efficiency of a company’s financial leverage. By borrowing, a company can increase assets more than through the owners financing. Edmonds states, “as long as a company’s ROI exceeds its cost of borrowing (interest expense), the owners will earn a higher return on their investment in the company by using borrowed money” (Edmonds, p.333, 2015).
Profit margin =Net income/Sales
Return on Assets (ROA) =Net income/Avg. total assets
Return on Equity (ROE) =Net income/Avg. total equity
Stock Market Ratios
Investors use a wide range of ratios to help them properly value a company and some of the most important and commonly used ratios are the earnings per share ratio, book value ratio, P/E ratio, and the dividend yield ratio. These equations are illustrated in Figure 5.
Market value measures
Earnings per share (EPS) =Net income — preferred dividend/Avg shares outstanding
Book Value Ratio =Stockholders’ equity — Preferred rights/Outstanding common shares
Price-Earnings (PE) Ratio =Price per share/Earnings per share
Dividend Yield =Dividends per share/Market price per share
Earnings per share is one of the most used ratios and is used to calculate the earnings for one share of common stock. To find the numerator for this equation, an investor needs to subtract the preferred dividend issued from the net income. To find the denominator (average common stock shares outstanding), divide the book value of the common stock by the par value per share for all years in question, add those values together and divide by the number of years (Edmonds, 2015).
Earnings per share values are important for investors to understand because these values can be manipulated through different accounting methods like alternative depreciation methods, inventory cost-flow assumptions, inflated accounts receivables, etc. Therefore, an investor should be aware of these valuation risks when weighing the importance of the EPS of a stock (Edmonds, 2015).
The book-value per share ratio is used to value the worth of a share of stock as it relates to the statement of stockholder’s equity. Book value is calculated by subtracting the preferred rights from the stockholder’s equity and dividing that by outstanding common share. Edmonds warns that “[b]ecause assets are recorded at historical costs and different methods are used to transfer asset costs to expense, the book value of assets after deducting liabilities means little if anything” (Edmonds, p.334, 2015).
The price earnings ratio, commonly referred to as the P/E ratio, is computed dividing the market price per share by the earnings per share. Comparing the earnings per share with the stocks current market valuation can give an investor good insight into how the market, as a whole, is viewing the future potential of a stock. Earnings per share alone does not take into account the price that would be paid to theoretically produce those earnings. If a company has a high P/E ratio, that means the market is expecting growth (Edmonds, 2015). Webb states that the P/E ratio is likely to change hour to hour as stocks are traded and re-valued and that an average P/E ratio is going to be between 15 and 20. Webb also says that a high P/E ratio could mean that the stock is over-valued and to beware of an over-hyped stock (2012).
The dividend yield ratio is computed by dividing the dividends per share by the market price per share. Dividends are a company’s way of distributing earnings to its stockholders. The dividend yield ratio helps investors compare the dividend values of multiple stocks that have different market values (Edmonds, 2015).
According to Graham, it is best to buy stocks that have a long history of paying out dividends (1949). A company that pays dividends even through economic slumps like recessions and depressions is a good sign of financial strength. A good dividend yield could also be the firm’s way of attracting investors even though they’re in financial trouble. Therefore, it is smart to always look deeper than the surface in order to fully understand the capabilities and choices of a company (Graham, 1949).
Combing Quantitative and Qualitative Data
The form 10k is extremely long and does not need to be read cover to cover in order to acquire all of the necessary information. Graham advises that knowing which questions to ask is a good place to start (1949). First, the investor wants to establish their goal by defining the questions they need answered with industry norms and benchmarks in mind. Next, the investor should identify where to find the relevant information within the 10k/other market research. While researching the qualitative elements of a firm, it is useful to assign particular weights to these findings in order to view the quantitative information as it is affected by the findings. For example, two stocks in the financial services industry, Firm A and Firm B have dividend yields of 4% and 5% respectively. Firm A’s fund manager is well known in the finance industry for being consistent and Firm B’s manager is less experienced but has provided great results during his two years as the manager. If the investor values consistency over possibility, Firm A might be selected after applying a ‘consistency multiplier.’ Finally, the investor can gather data, compare that data to benchmarks and goals previously established, and either purchase or pass on the stock.
Effective financial statement analysis is completely subjective and will usually depend on the investors risk tolerance, investment philosophy, time horizon, and goals. It is important for an investor to establish these things early and stick to their plan. Many times, investors make mistakes when they start straying from their plan due to emotional decisions. Investing is emotional when everyone starts jumping on the opportunity to buy the latest and hottest stock without referring to the underlying financial data (Graham, 1949).
Benjamin Graham, Warren Buffet, and other value investors attempt to keep their emotions out of stock trading by implementing sound financial analysis to establish their own perceptions of a company and, after deciding on a stock to buy, trust in the selection for the years to come as the market price ebbs and flows. The qualitative and quantitative methods outlined in this paper are a strong guideline to understanding a stock (Webb, 2012).
Qualitatively, an investor wants to know what the market outlook is for the company’s industry, how the managers have performed historically, the legal standing of the company, and the risks associated with its business model. Quantitatively, an investor wants to know how the company has managed debt, how they finance business operations, how much money they make, and what they plan on doing with those earnings (Graham, 1949). Once the stock is evaluated using these methods, the investor can then compare the stock to the goals they made at the beginning of the process to determine whether to buy or not.
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