Financial Statement Analysis (and Valuation)

Analysts' recommendations and rigorous valuation models

2010-09-07T13:57:00.003-06:00

In my Financial Statement Analysis and Valuation class we talk about how the "residual income model" is a rigorous approach to valuing a company and possibly spotting mispriced stocks. Specifically, we can compare the valuation model estimate we come up with using our forecasts and compare them to price (see my earlier post on value-to-price here). This would lead us to being able to recommend whether we believed that the stock was currently under- or overvalued... just as sell-side analysts do!

A curious result in the academic literature was presented by Mark Bradshaw who finds that analysts' don't seem to use the residual income model in generating their stock recommendations but instead appear to use their estimates of expected growth. Now this may seem reasonable until we notice that trading on expected growth would have us lose money, while trading on the residual income model would make us a nice return!

In a paper that I coauthored with Andreas Simon, we were interested in whether this finding was true of the very best analysts, so we investigated whether analysts who are good at forecasting appear to use the residual income model in generating their stock recommendations. We find that those analysts who are "putting in the effort" to produce better forecasts are also more likely to be generating their recommendations from a model "like" the residual income model and have more profitable recommendations (note I say "like" because even this group of analysts appear to be aligning their recommendations with their growth expectations than would be suggested by theory). Our paper can be found at ssrn and has been accepted for publication at the Journal of Business Finance and Accounting.

Historical cost and comparability

2010-08-17T13:35:00.006-06:00

Many of my former MAcc and MBA students will (hopefully) remember my discussions in class about how historical cost can potentially distort accounting-based rates of return (like return on assets - ROA) in my mind this lead to a possible comparability concern with accounting.

My coauthor, Melissa Lewis (also an Assistant professor at Utah) and I decided to test whether this is actually the case for a wide sample of firms - and we do indeed find evidence of an inflation in ROA for firms with older assets. More startling, even though we all know about historical cost, we find that investors appear to be unable to correctly estimate the level of this bias, leading to predictable negative future returns - you can read about our paper on SSRN.

Blockbuster's noose?

2010-02-09T13:22:00.003-07:00

After reading the article "Netflix has Blockbuster on the ropes" I'm curious if it is more like Netflix has Blockbuster in a noose...

Can Blockbuster still compete with Netflix? What do we think of Blockbuster's ability to also compete against Red Box? Seems to me like a typical example of "Creative destruction"...

A check of BBI's financial statements and market price yields some interesting questions, what kind of growth rates would be required for BBI to pay "healthy" dividends?

Netflix Q4 results

2010-01-27T14:35:00.003-07:00

Netflix announced their fourth quarter results, disclosing a 36% increase in profits, and a 31% increase in subscriber base (now over 12 Million) and saw a positive market response of a 13.24% increase in their stock price.

Macro-level news

2010-01-27T08:38:00.004-07:00

This week in class we have been talking about "Top-down" analysis (which by the way, we will typically discard in favor of bottom-up analysis). This article mentions that the futures price is indicating an increase in overall market value (for the S& 500), while we didn't discuss these instruments in detail, we have been discussing interest rates (which are expected to be unchanged in the Fed's policy statement due this afternoon), there is also some discussion of additional factors and their expected impact. Note that Apple is set to announce a new product (the tablet) this afternoon, I'll write about this event separately after it occurs. This related article Before the bell: Futures higher amid upbeat earnings also notes some interesting factors and raises some additional points relating to the (expected) turn-around in the housing market.

So given the level of the S&P 500 closed at 1,092.17 yesterday, if we are expecting some possible impact on the market will it be long-term or will it be short-term? What is your estimate of the level of the S&P 500 in the final weeks of class? Moving to our firm level analysis, what tools do we have to incorporate any expected returns on the S&P 500 index into calculating value of the individual companies we are following?

Valuing facebook

2009-03-31T08:49:00.004-06:00

Related to one of our class exercises is the question of how much can these social networking sites be worth?

As a starting point you will notice that all three of the commentators in this article "How much is facebook really worth?" are basing their estimates on multiples of revenue. Of course revenue growth without growth in earnings (and hopefully even residual earnings) tends not to add value in the long-run.

Another point of contention arises between the three authors on the selection of a suitable comparable firm, is it myspace (1st author)? or is it yahoo (last author)? Clearly the assumptions of the value of facebook are widely varied based on the selection of the comparable firm.

Is facebook worth 15 billion?

The hard(ware) and soft(ware) of it

2009-02-11T12:42:00.004-07:00

Apple Inc, is involved in lawsuits relating to the use of its operating system software on computers with PC hardware. According to this article "German Mac clone maker claims immunity from Apple" is selling Intel loaded computers with Mac OS X operating system software pre-installed. An entry-level computer sells for about $643, relative to the entry-level iMac selling at $1199. The issue is that the end user license agreement (EULA) for the operating system 'forbids' the user from installing the software on non-Mac hardware.

But for Apple's valuation, we have a bigger issue in play, what happens if the anti-trust lawsuits prevent Apple from 'forbidding' the installation of their software on non-Mac hardware? Is the EULA an effective barrier to entry?

Clearly, Apple's strategy is likely to remain the same - product differentiation - rather than them trying to compete in low cost alternatives. Does this news, however, change your expectations of future ROE for Apple? How would you expect the profit margin and asset turnover ratios to change in the next few years? How would this affect your forecasts?

Some more banckruptcy predictions

2009-02-11T11:55:00.002-07:00

In this article in Seeking Alpha, Rick Newman highlights 15 companies that he thinks will not survive 2009. Given how much we have analyzed Blockbuster, are we surprised that it makes the list?

In our financial ratio analysis of Blockbuster it may be well worth our time to estimate some of the default probabilities. Perhaps this would be a good time to try out your eVal software and take a closer look at BBI's numbers?

Overstock's overstuffed profits...

2009-02-11T11:32:00.003-07:00

I hadn't looked at Overstocked for a while, but I came across this article recently "Overstock.com and CEO Patrick Byrne Violate Accounting Rules in Q4 2008 Financial Report" interestingly enough it appears that there is no interest by the company to correct, or in accounting terminology, to restate, their financial reports (see here).

What do you think the market response to firms that restate their earnings to be on average? In a paper published in the Journal of Accounting & Economics, Palmrose, Richardson and Scholz find that over a two day window, these firms experience a negative 9% drop in their share price, with the most negative declines being when the restatement is enforced by the SEC.

My guess is that Overstock is headed for a rough time... what kind of change would this make in our valuation world? Obviously the current period earnings are affected, but does this change our opinions of growth too? How important is it for a firm to 'return to GAAP profitability'?

Valuing Netflix earnings and growth

2009-02-09T14:18:00.003-07:00

At the time of this post, the market was valuing Netflix at $37 per share, one year ago the share price was $26.89. The raw return for the stock over the past year was( ($37-26.89)/26.89) = 37.6%

One question to ask was how did Netflix beat the expectations set at the end of last year...?

One interesting article that discusses some of these expectations (at the time) is the article "Netflix looks like a bargain again" written about a year ago, along with expectations about 2008 written in the companion piece "Netflix 2008 Outlook" where the author discusses expected growth rates in subscriptions.

What do you believe the Outlook for 2009 will look like?

The value of 'free'

2009-02-03T21:08:00.004-07:00

A recent promotion by the Denny's restaurant chain - the giving away of breakfast for free, raises some interesting valuation questions: what is the expected future value of a promotions that involve free 'gifts' and how do firms successfully sustain repeat business? Read the article here.

Now obviously the two questions are related. The immediate costs of the free breakfasts are associated with an intangible asset that we can call "customer loyalty". Now we know as accountants that this asset is not capitalized and we would question any attempt to measure this asset due to uncertainty. Clearly it would appear that a gimmick like this could be easily replicated by other restaurant chains, so it is less likely to give rise to any sustainable competitive advantage. Would you return to a restaurant that (willingly) gave you a free meal? does getting something 'free' give you some kind of irrationally happy feeling that makes you want to return to where you got something free? Even though you know that you won't get something free there again?

Another approach may be to look at their ROE generating ability in terms of the DuPont decomposition. In general, I'd imagine most of us would agree that Denny's is going to be profitable as a low margin high turnover company, and based on the google finance numbers for profit margin, this certainly appears to be the case.

Is this promotion consistent with their strategy? How does this strategy have to affect their turnover and/or margins in order to be effective? what do you think the overall affect on value is likely to be?

Netflix profit up 45%

2009-01-26T17:01:00.002-07:00

bricks and mortar

2009-01-21T15:50:00.003-07:00

In his article "Why Blockbuster brick and mortars will be gone in five years" Don Reisinger points out the failings of Blockbuster.

If we applied Altman's Z-score to the last few years of Blockbuster's results, do we see a trend? from the points raised in the above article, what do you think is the most devastating failing of blockbuster in terms of value generation?

Is your company headed for bankruptcy?

2009-01-21T15:38:00.002-07:00

I read an interesting article in Businessweek entitled "Stocks:Bracing for more bankruptcies" where the author noted that in 2009 he expects the bankruptcy rate will increase. In the article, the author cites that Edward Altman (NYU) was predicting a double-digit bankruptcy rate for 2009.

Altman was the author of "Financial Ratios, Discriminant Analysis and the prediction of Corporate Bankruptcy" published in the Journal of Finance in 1968, from which the "Altman Z-Score" became the standard in assessing a firm's probability of going bankrupt. If you are interested in calculating the Altman Z-Score for your company, the formular is relatively simple, and this website makes it even easier... just plug in the required financial statement variables and take a look at your resulting score. Perhaps before you make your stock recommendation it'd be worth checking if your company is expected to be around for the rest of the year.

Netflix Conference Call

2009-01-20T15:31:00.002-07:00

The conference call will be held on Monday the 26th at 3pm Mountain Time, more information at PRNewswire.

Instant Netflix II

2009-01-19T14:45:00.004-07:00

So I signed up for Netflix and bought the fancy new LG BD300 Blu-ray player that allows for Netflix streaming content to be played... similar to the feelings of the author of this article, I was a little underwhelmed by the quality of the picture and sound delived by my fancy little network DVD player...

Regardless, an interesting point is raised by the author, he feels that streaming content was meant to see the demise and eventual end of the DVD. In our case, we focus our comparisons between Netflix and Blockbuster, with Blockbuster a clear second in the agility stakes. In the instant market, though, there are some more players, Vudu, Playstation 3 and Apple TV all have a hand in the market.

What are Netflix's advantages in the instant market? Their disadvantages?

Are smaller cars coming to the US?

2009-01-19T14:28:00.003-07:00

I noticed a few reports floating around about a potential partnership deal between Euro auto manufacturer Fiat and the US auto manufacturer Chrysler. A discussion of the possible partnership is discussed in this article.

So who benefits from this deal? According to the article, and my own views, it looks likely that both companies would benefit. Fiat is likely to gain access to US markets and will hold an equity stake in Chrysler, while Chrysler will have access to a small car line-up with little capital invested.

Consider the top-down analysis approach (macro and industry). What is happening in the economy that potentially effects the auto-industry? If we think back to last summer, the media was somewhat fixated on the price of gasoline...

So are smaller cars likely to be in greater demand? If so, who is already in this market?

As a side note, the Treasury is loaning Chrysler $1.5B to support it's financing arm. In this article, the author notes that Chrysler "plans to offer zero-percent financing on several models and expand lending to car buyers with less than ideal credit" what does this tell you about Chrysler's customer acquisition policy? Is this consistent with the current economic climate?

Is Apple ripe?

2009-01-15T15:57:00.004-07:00

I couldn't help partially stealing the title of this article: "BUY OR SELL - Are Apple shares ripe for buying?" the article is essentially discussing whether the market is too heavily discounting Apple shares following the news of Steve Jobs (Apple's CEO) taking leave for health reasons.

As I have mentioned in class a few times now, market prices in the current market suggest to me that we are currently in a buyer's market.

Let's consider Apple's price at around $83 per share (at the time of writing). That's about a PE (price to earnings) ratio of under 16.5, the lowest PE ratio for Apple in the last 5 years is about 15.9 (note that the forward PE ratio, that is when the earnings are the expected earnings for this year and not last year's, the ratio drops to around 11). With an ROE (return on equity) of about 27 and sales growth in excess of 20% how can we reconcile the apparent strength of the company's financials with their PE ratio?

If we think about our model of value, what does this suggest that the market "feels" about the earnings of Apple? For example, does it seem like the pricing is reflecting a low sustainability (or persistence) of this past performance?

Does it appear that the sustainability of their earnings is low?

Does one individual make that much of a difference to the strategy of the company?

Or maybe, it's being undervalued due to speculation...?

Getting more information

2009-01-14T14:37:00.002-07:00

I wanted to quickly outline how to get files from EDGAR (Electronic Data Gathering, Analysis and Retrieval System). The first step is to look-up your firm's CIK (Central Index Key) which is used by the SEC to index the filings of each individual firm. Go here and type in your company's name, such as "Netflix" the search engine will come back with potential matches, in Netflix's case there where two possible choices (but both had the same CIK suggesting it was the same company).

Now after you click on your company, EDGAR will provide you with a list of forms that have been lodged with the SEC, they are dated and the form type is also displayed. If we go to the section "Form-type" we can tell EDGAR to limit the forms by a certain type. For example, I want to find Netflix's churn metric in their most recent 10-Q, so I tell EDGAR to only to return Form type "10-Q" and then I click on the first filing.

After getting the filing (in html format), I scoll down to the management discussion and analysis section and find the churn metric at 4.2%. Note the management define churn:
Churn: Churn is a monthly measure defined as customer cancellations in the quarter divided by the sum of beginning subscribers and gross subscriber additions, then divided by three months. Management reviews this metric to evaluate whether we are retaining our existing subscribers in accordance with our business plans.

Value-to-price

2009-01-13T16:26:00.003-07:00

I will post some results from relevant accounting studies over the course of the semester. The first I'd like to highlight relates to today's discussion of the residual income model. The paper I want to highlight examines the predictive ability of the residual income value to price ratio over future stock returns. The paper is by Rich Frankel and Charles Lee, who published "Accounting valuation, market expectation, and cross-sectional stock returns" in the Journal of Accounting Research in 1998.

In their paper they find that over holding periods of 36 months, a strategy based on buying high value to price stocks (i.e., stocks the market undervalues relative to the model of fundamental value) and selling stocks low value to price stocks (i.e., stocks the market overvalues relative to the model of fundamental value) earns over a 45% return.

Do you think that these results are likely to hold in our current economy?

some advice...

2009-01-13T13:42:00.002-07:00

Now I know this is repetitive.... but:

it is best to find similar firms to your group members as this will make your analysis (significantly) easier.

How can I find a firm in my sector??

Easy: go to http://finance.google.com/finance

You'll notice the list of sectors at the bottom of the page, simply click on your sector and a whole range of companies will be displayed. Easy... so now as a group you may see a company that you know interests you... so what next... click on that company and you'll notice under the graph that Google finance provides a list of "Related Companies." Now you have what you are after, choosing a set of companies in your group couldn't be easier (unless I just assigned them to you)...

remember for the daytime students, you need to report to me the firm you select by next class (i.e., his Thursday).

Overstock's new debt agreements

2009-01-11T20:51:00.005-07:00

This article discusses the debt covenants engaged in by Overstock.com in their loan with Wells Fargo.

A debt covenant is basically an agreement over a loan that restricts some of the actions a borrower may engage in. If the covenant is violated then the lender has the right to repossess their loan. Often these covenants will refer to accounting information, including restrictions on leverage ratios. An academic study by Illa Dichev and Doug Skinner found that debt covenants that are violated by healthy firms are not always repossessed, however, if we were to believe Gary Weiss, if Overstock violates their covenant it might be because they are heading to bankruptcy...

Do you agree with Gary Weiss on Overstock's impending doom?

How might the loan affect your forecasts of overstocks operating performance?

Cyber Monday

2008-12-02T18:00:00.006-07:00

A big day for Internet retail firms, many of the companies posted sales increases over the prior period this time last year. Overstock, however, didn't post an increase in sales.

From an article on internet retailer:

At Overstock.com, sales fell 3% yesterday compared with the same Monday last year. “Last year Cyber Monday was in November. In November we had gunned marketing, which gave us a bigger November than we should have had, and a weaker December,” says CEO Patrick Byrne. “So our expectation has been to have a hard time matching November’s days this year, but then to make up some ground in December.” read the rest of the article here.

How may this affect your forecast?

What other macro-economic factors may affect your forecast?

Instant Netflix

2008-12-02T16:46:00.004-07:00

Apparently it's just like adding water to instant rolled oats, except instead of water you want an X-box360 with a Live membership (and you can avoid the step with the stove). Put simply, this new method of access to media allows for the consumer to watch their Netflix movies on the same screen they enjoy their X-box experience. See the BusinessWeek story here.

Does this line of business potentially increase Netflix's sources of competitive advantage relative to competitors?

What is blockbuster retaliating with, you ask... find out here.

Does this change your evaluation of the sustainability of this potential source of competitive advantage?

As an aside, any thoughts why X-box 360 outsold the Sony PS3 3-to-1 on Black Friday, and X-box was up 25% from last year's sales?

Rock on...

2008-12-01T17:17:00.004-07:00

So here's an interesting question posited by David Edery in Steven Dubner's Freakonomics blog: Can guitar hero help save the music industry?

Some interesting 'statistics' from the article:

Weezer’s “My Name is Jonas,” a song originally released in 1994, saw a tenfold increase in sales when included in Guitar Hero 3.
Songs from The Who’s greatest hits released for Rock Band, experienced a 159 percent increase in SoundScan sales.
A special guitar hero featuring Aerosmith’s music resulted in more revenue for the band than any individual Aerosmith album.

So if this is valuable 'free advertising' for the record industry, why would they still charge the software companies money to include their licensed songs?

Grades, an economist's view...

2008-12-01T16:28:00.004-07:00

As I start to prepare for my upcoming teaching semester in ACCT6620, my mind already thinks about grading...

One of my economics colleagues, Scott Schaefer, here at the U recently discussed grading from both an incentive point of view (i.e., you will work harder if you know you are graded) and a labor economics point of view (i.e., grades help employers and students more efficiently break down information asymmetries) .

It's worth keeping in mind :)

Read the entry in his blog here: http://utah-economist.blogspot.com/2008/11/grades.html

Tech firms cut jobs

2008-11-16T16:14:00.003-07:00

Three large tech firms in Santa Clara, CA, have announced significant job cuts this past week (see here). The most recent is Sun Microsystems, announcing that between 5,000 and 6,000 jobs will be shed. Sun's CEO, Johnathon Schwartz was quoted here as saying “The focus here is to eliminate some of the inefficiencies that have made it hard to do business with Sun,”and the (short-term) result should be a significant cut to expenditures.

Are glitzy motor shows a thing of the past?

2008-11-16T15:50:00.006-07:00

Many companies in the automobile industry announced heavy cutbacks to spending on motor shows. Traditionally these motor shows have been an (expensive) customer courtship activity, but with significant drops in the car market, possibly due to tougher loan criteria, many companies are not going to be engaging in this form of advertising this year. Further details can be found here.

At this time, Congress is currently debating the merits of bailing out the automobile industry, as summary of recent segments of the debate can be found here.

Compensation

2008-11-16T15:32:00.002-07:00

Today it was announced that the seven top executives at Goldman Sachs will forgo any bonus pay for 2008. Given their leadership in the industry, it's possible more banks will follow suit. Read about the story here in the Wall Street Journal or here in Bloomberg.

This follows from heavy criticism of the financial services industry over the potential payment of bonuses in a year where banks are commonly seen as the cause of the sub-prime crisis. This argument can also be debated, given that bonus pay is considered a vital tool to the retention of high quality staff, a good summary of this debate can be found here.

Tough times for retailers 2

2008-11-14T16:00:00.002-07:00

This article provides further discussion of consumer sentiment and it's expected affect on retail sales. There are also forecasts for retail sales in this article. An interesting point I noticed in the article, is the effect of tighter credit on retail in the auto industry.

The consumer sentiment index published by Reuters and the University of Michigan can be found here.

The 2009 outlook... not good

2008-11-14T15:24:00.003-07:00

This week again saw significant declines on the US stock markets. With significant market volatility it is not surprising that bond prices increased. A summary and discussion can be found here.

Tough times for retailers

2008-11-12T14:12:00.004-07:00

Today Best Buy announced an earnings warning, that is they projected that their earnings will be lower for the year, see the story "Worst. Buy. Ever."

The earnings warning is linked by management to changes in consumer sentiment, as fewer consumers appear willing to spend big recently.

In related news, the rival electronics retailer, Circuit City, had previously announced that it was entering into a Chapter 11 reorganization. This is likely to predict the end of the company, based on the statement of Credit Suisse analyst Gary Balter, who was quoted (in this article) as saying: "We have not seen a consumer electronic retailer successfully reorganize in Chapter 11 in our 24 years in this space."

Excess and the bull...

2008-11-12T11:56:00.005-07:00

Micheal Lewis who wrote the book Liar's Poker recently wrote this interesting article: "The end of Wall Street's Boom" based on his experiences at Wall St. Note that there is profanity in it.

As an aside he also wrote the book Moneyball: The art of winning an unfair game that provides an interesting insight into the use of statistical information in baseball recruiting to aid in the selection of undervalued players and avoiding overvalued players (much like what we are seeking to understand in a market setting with quantitative analysis).

Quantitative analysis

2008-11-11T20:33:00.004-07:00

A large part of our course is about how financial statement analysis can be used to help us gain insights into the valuation (and potential misvaluation) of stocks. One of the leading investment firms using quantitative investing strategies is Barclays Global Investors. This BusinessWeek article "Outsmarting the market" provides some insights into how their operations work.

The debate on the appropriateness of fair value accounting continues...

2008-11-11T19:11:00.008-07:00

In today's news, Mark Olson the chairman of the PCAOB discussed the possibility of the PCAOB providing further guidance to auditors on the application of fair value accounting. The article is here.

The financial services industry is the most vocal critic of the application of fair value techniques. It appears that they'd like more choice in how they value certain financial assets (especially those with significant market prices declines?). Apparently, the best option according to some in the industry is a "mixed attributes model" that allows the choice between fair value (as in market price) and historical cost (see for example the amusingly titled "Bankers: Fair value is like throwing gasoline on a fire".)

Note that the SEC and FASB made an announcement on Sept. 30th aimed at clarifying the implementation of fair value accounting (the full press release can be found here):

"When an active market for a security does not exist, the use of management estimates that incorporate current market participant expectations of future cash flows, and include appropriate risk premiums, is acceptable."

Funnily enough, this treatment of estimating fair value is allowed under SFAS 157, specifically under the use of 'mark to model' accounting. At least in theory, it would be very easy to calibrate a present value model that was equal to the historical cost of the asset. Doing so though, of course raises the criticism that instead of marking to model, they are "marking to make believe." Warren Buffet was quoted (the rest of the article can be found here) as saying “The recent meltdown in much of the debt market, moreover, has transformed this [mark-to-model] process into marking to myth…Indeed, for a few institutions, the difference in valuations is the difference between what purports to be robust health and insolvency.”

Welcome

2008-11-11T16:25:00.000-07:00

I have set up this blog in order to provide additional background material that will be useful to students undertaking ACCT6620 at the University of Utah.