SECURITY ANALYSIS

LECTURE-05

Instructor:
Ayaz Ali Maitlo
ayazalimaitlo@gmail.com

COMPANY ANALYSIS
Income statement is basic statement for analyzing
the
company performance.
The income statement is perhaps used more than any other
to assess the future of the firm, and most important is
earning per share has became key figure on this statement.
Earning power has direct impact on the price of share of the
company.
This chapter has two aims:
Using financial statement we will examine the chemistry of earnings.
The traditional methods applied by analysts in assessing the outlook
for Revenue, Expenses and Earnings in the firm over a forward
holding period, given the economic and industry outlook.

COMPANY ANALYSIS
The various ingredients in the financial
statement can be related in such a way that the
analyst is able to visualize the critical aspects of
a firms operations that dictate the level, trend,
and stability of earnings.
The methods that will explained are
The return on investment (ROI) approach
The market-share/profit margin approach
An independent, subjective approach to the forecast
of revenues and expenses.

CHEMISTRY OF EARNINGS
One of the most effective ways of getting inside
earnings is to explore the financial statement for all
possible explanations of a change , or lack of
change, in earnings.
Changes can be resulted from
Operations of the business
And/or
In the financing of the business

That is changes in productivity or in the resources

base.

ASSET PRODUCTIVITY AND

EARNINGS
Assets are used by management to
generate revenue and net income.
Funds are acquired from Debt & Equity
modes of financing.
Return on equity will depend upon the
relationship between return on total capital
and the cost of borrowed funds.
Return on Assets
Operating cycle of business

ASSET PRODUCTIVITY AND

EARNINGS
The key to overall return on funds
committed to the company is
On utilization of asset base
Profit on sale

We can say that return on assets is the

product of the
Turn over of assets
Margin of profit

EARNINGS AND THE ROLE OF

FINANCING Cont.
Company acquire from two ways, they are either
borrowed money or equity funds.
Some of borrowed money is free of cost, like
expense accrued, salary/tax payable etc.
Other borrowed money, such as bank loans and
bond issues, has a readily identifiable interest cost.
Equity financing has two types of cost:
Explicit (Dividend)
Implicit (Capital Gain)

DEBT FINANCING AND EARNINGS

Debt financing provide Leverage to
common-stock holders.
If the cost of borrowed funds is less then
the return on investment, you are ahead of
it.
The productivity of funds is called Return
on Assets and the cost of borrowed funds
is called the Effective Interest Rate.

EQUITY FINANCING AND EARNINGS

Companies obtain equity financing from:
Issuance of new shares and/or
Retention of Earnings

Share can be sold on cash or can exchanges

with other company.
The effect of issuing new shares depends
primarily upon the relationship on the sale
price to the asset value of outstanding shares.
Asset Value per Share

EQUITY FINANCING AND EARNINGS Cont.

Share sold on same, over and under Asset value per share.
The return on assets can be increase if share sold over the
asset value per share and vice versa.
Asset value per share can be increase by retiring existing
share.
Earnings retention provides a basic source of earnings
growth.
Corporations in general tend to payout about one-half their
earnings.
Dividend Payout Ratio
Retention Rate

EFFECTS OF TAX
The effects of taxes on income can be
accommodated in our model by making the
following transformation;

EAT=(1-T)[R+(R-I)L/E]E
The notion (1-T) is really indicating what
percentage of each $1of income in available
after satisfying taxing authorities.

EARNINGS AND DIVIDEND PER SHARE

To convert EAT to a per-share basis, we need only
divide it by the number of common shares
outstanding:
EPS =
EPS =

EAT
Numbers of shares outstanding

(1-T)[R+(R-I)L/E]E

Dividend per share can be calculated

Numbers DPS=(1-B)(EPS)
of shares outstanding

FORECASTING VIA THE EARNINGS

MODEL
Our emphasis thus far in the presentation
of the ROI method has been to view it as a
device for analyzing the effects of and
interaction between the return a firm earns
on its assets and the manner in which it is
financed.
However, this analytical device can be
used as a forecasting tool.

FORECASTING VIA THE EARNINGS

MODEL Cont.
For example, assume that a firms tax bracket is
forecast to be 50 percent in 2004, 15 percent
will be earned on its assets, and that it will pay
an effective interest rate of 6 percent.
Further assume that the firm will have $100
million Equity & $100 million of Debt in its
capital structure in 2004. if we substitute these
values into the model :
EAT=(1-T)[R+(R-I)L/E]E

FORECASTING VIA THE EARNINGS

MODEL Cont.
Subtract any forecast proffered dividend and divide
reminder by average outstanding shares to arrive at EPS.
To continue our example, if our firm is expected to have 3
million share outstanding and a P/E ratio of 15 in 2004
(Market Value / Earning per share) the price per share will be $60
This can be translated by subtracting the beginning per-share
price, adding dividends paid in 2004 and dividing by beginning
price per share.
If the price at the end of 2004 is $50 and no dividends are
expected during 2005, then projected return on equity will be 20
percent.

MARKET SHARE/PROFIT MARGIN

APPROACH
The market-share/profit-margin approach
emanated directly from the industry
analysis.
If investor has choice, he will undoubtedly
select a leader rather than a follower. Thus
the next logical step for the analyst is to
determine what share of the industrys total
market the firm under analysis can
reasonably be expected to achieve.

MARKET SHARE/PROFIT MARGIN

APPROACH Cont.
Assume that the analyst is studying and industry that
produces auxiliary swimming-pool equipment.
The industry sales for 2002 are $10 million and your
company has 10 percent share of the total market.
Forecasted increase in total industry sales is 20
percent because of more favorable economic climate.
If your company assume that it will increase its
market share by 12 percent due to aggressive market
campaign, what will be to total Sales in dollar amount.