Financial Statements and Stock Valuation

Whereas the Balance Sheet was described as a photograph of the company at a point in time, the Income Statement covers a period of time and therefore is more like a movie about the company. In the movie, we are able to see how successful or unsuccessful the company has been over a period of time, usually a quarter or a year. The story is told in terms of revenues and expenses and depending on whether revenues were greater (profit) or expenses were greater (loss) will determine if the movie has a happy ending or is a tragedy. In the common Multiple-step format of the Income Statement, we are able to observe the success or failure of the company at controlling various types of expenses and as a result converting sales into profits.

Gross profit provides us with information about success at controlling the Cost of goods sold and being able to sell the goods above the cost to obtain them. Operating profit provides us with information about the company’s ability to control costs in its core business including COGS and operating expenses. Finally, Net income (or net profit) tells us about the ability of the firm to generate a profit after all expenses have been taken into account. The net profit of the company belongs to the owners of the company and can potentially be paid out as cash dividends to the owners. Alternatively, the net income could be retained by the company and reinvested into new assets and projects that can generate higher profits in the future. The decision of how much of the profit to pay out is referred to as the Dividend Policy.

The Cash Flow Statement provides information about the firm’s ability to generate Cash and groups the cash flows into operating, investing, and financing activities. Never forget that “Cash is King” and you can not pay your liabilities with profits, the payments must be in cash. Furthermore, even if you have other assets, quickly converting these assets into cash may require selling them at a significant discount. The Cash Flow Statement was developed to track cash flows and help spot these types of problems.

The tools of financial statement analysis include common size (vertical and horizontal) statements, Financial ratios, and industry comparisons. One alternative is to convert the financial statements into common-size statements where everything is expressed as percentages. You can have two categories of common size statements: Vertical (at a point in time) and Horizontal (changes over time). Financial ratios bring together financial information from different parts of the statements to help make them more meaningful. Financial ratios are typically grouped under 5 headings. Liquidity ratios: provide information about ability of the firm to pay short-term liabilities. Liquidity ratios focus on the relationship between current liabilities (expected to be paid within 1 year) and current assets (expected to be available as cash within 1 year). Activity ratios: provide information about ability of the firm to generate sales revenue. Activity ratios try to measure asset usage efficiency in generating sales. The higher the turnover ratios the more sales are generated by the investments in these assets. Leverage ratios: provide information about how much of financing comes from debt and ability of the firm to meet interest expenses. Leverage ratios provide information about how much of the financing has come from creditors and how likely that the firm will have sufficient resources to pay the interest payments on the loans. Profitability ratios: provide information about ability of the firm to control expenses and convert sales into profits. Profitability ratios measure the ability of the firm to translate sales into profits at different levels. Profitability is the result of being able to keep costs under control, so we should remember that success at generating profits and success at controlling costs are two sides of the same coin. Market ratios typically combine accounting numbers with numbers from the financial markets and attempt to understand how the markets value the companies. Some of these ratios are also used to make investment decisions.

Common stocks typically have these rights: 1. The right to share proportionally in the dividends of the company, 2. The right to share proportionally in the distribution in case of liquidation of the company, 3. The right to vote on important issues affecting the company and elect members to the board of directors, 4. The pre-emptive right prevents the dilution of existing shareholders’ share of ownership against their wishes.

Stock market transactions may also be primary market (new issues) or secondary market transactions. In the primary market, shares are issued and sold by the companies to investors and any proceeds go to the company. In the secondary market, these are simply transactions where one investor sells to another investor and no funds are flowing to or from the company.

Valuation is the process of determining the underlying value of an asset. This value is also referred to as the intrinsic value and comparing it to the current market price allows investors to evaluate whether the asset is undervalued, overvalued, or correctly valued.

Dividend Discount Model (DDM); Probably the oldest and simplest way of valuing shares is to use dividends and cash flows from selling the shares to value them. Other Valuation Models; In practice, the DDM is not used very frequently in valuations as many firms payout either no dividends, very low dividends, or have very volatile dividends. The more commonly used valuation models are discounting Free Cash Flows of the firm or Relative Valuation based models. Another alternative is the option pricing-based model which may be used when other models fail to do a good job.

Some common multiples used in relative valuation are price-earnings (P/E) ratio, market value-to-book value (MV/BV) ratio, price-to-sales ratio, price-to-cash flows ratio and PEG, defined as the P/E ratio divided by the growth rate of earnings.

Efficient Markets Hypothesis: in an efficient market market prices fully reflect all available information.

Strong form of the EMH states that all privately and publicly available information is fully reflected in prices. If strong form efficiency holds, it should not even be possible for insiders like managers, owners, bankers, politicians, or judges to use private information to obtain consistent excess profits. Even insiders trading on their information (independent of legal and ethical considerations) would be engaging in useless activities.