Decoding Financial Statements

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Friday
January 4, 2013

Donald W. Reynolds National Center for Business Journalism at Arizona State University

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Gary Trennepohl, Ph.D.

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ONEOK Chair and Presidents Council Professor of Finance Oklahoma State University Trustee, Oklahoma Teachers Retirement System Member, OSU Foundation Investment Committee

gary.trennepohl@okstate.edu

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Topics
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Wednesday:
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8:30 am to 3:00 pm Decoding Financial Statements and Company Analysis. 3:15 pm to 5:00 pm Investing in a Time of Uncertainty 8:30 am to 11:15 am Financial Markets in 2012: Where are the Stories?

Thursday:
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I. Decoding Financial Statements

1. Financial Ratios what they tell us 2. Profitability Model how the firm generates profits

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Ratios to Measure Financial Health

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Liquidity
current ratio =

Current assets Current liabilities Current assets - inventory Current liabilities

quick ratio

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Another View of Liquidity: Net Working Capital

Total Assets
Current Assets

= Liab.+Net Worth
Current Liabilities Net Working Capital Long Term Debt + Common equity

Fixed Assets

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Ratios (contd.)
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Profitability
net profit margin = return on assets = total asset turnover =

net profit after tax sales net profit after tax total assets sales total assets

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Profitability Ratios (contd.)

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Factors affecting profitability inventory turnover = accounts receivable collection period =

cost of goods sold inventory

accounts receivable (sales/365 days)

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Ratios (contd.)
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How is the firm financed? debt ratio debt/equity ratio equity multiplier = = =
total debt total assets Total debt total equity total assets common equity

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Ratios (contd.)
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What return is generated for common stockholders? return on equity =

EACS common equity

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The Profitability Model

Evaluating a Company Using The Profitability Model

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The profitability model is useful because it separates return on equity (ROE) into three components n n n

financial leverage (equity multiplier), operating efficiency (net profit margin) asset utilization (total asset turnover).

ROE is a function of all three factors

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The Profitability Model (contd.)

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Return on equity = NPM X total asset turnover X equity multiplier

ROE =

net profit sales

sales total assets

total assets X common equity

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Understanding Basic Principles of Financial Markets and Investing

1. 2. 3. 4. 5.

Drivers of Stock and Bond Prices The Historical Perspective Market Efficiency Diversification Is Critical Market Risk the VIX

Economics of Stock and Bond Prices

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Stock Prices over the long term are driven by the earnings they provide to shareholders
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Dividends Growth in earnings and dividends P/E ratio is a measure of relative value

Bond Prices and yield are driven by interest rates and credit quality
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Bond prices move inversely to interest rates. Bond investors must predict future interest rates and economic activity to determine proper price.
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History of U.S. Stock and Bond Returns Provides a Perspective for the Future

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Bonds as an Investment

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The Bond Buyers Dilemma

By Burton Malkiel in the WSJ, Dec 7, 2011
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The yields on long-term U.S. Treasuries will likely fall below inflation for the next several years. Long-term Treasuries are likely to be sure losers. Investors should consider as alternatives:
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Bonds with moderate credit risk where the spreads over Treasuries are generous. n Tax-exempt municipal bonds are especially attractive. n Foreign bonds in fiscally secure countries, e.g., Australia

High-quality U.S. stocks with generous dividend yields

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Abbott Labs, ATT, Exxon, J&J, P&G.

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If Markets are Efficient .

Market efficiency refers to how quickly security prices reflect new information. If markets are efficient, it isnt possible to beat the market.
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Implications of Market Efficiency for Investors

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Stock experts dont have an advantage over amateurs because the competition is so severe. Investment return will be a function of risk. The key factor in market efficiency is information. Most SEC regulation is designed to promote the flow of information to investors. Technical analysis is valueless because market participants already have incorporated any information contained in past price sequences into stock prices.
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N STRATEGIST HOTLINE
800-724-1817 Email: info@optionstrategist.com

McMillan Analysis Corporation

J 079621323

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t version of this report, click on the following link to 1 the charts: see om/weekly-charts

A Technicians Chart

by the oversold oupled with the over the fiscal xed signals for quite powerful ator is price and we will most

asured by the PX) has been in tober. From its ws last week, it zeable decline, earful one. As Figure 1 end, and that is 1 From Larry McMillans The Option Strategists Hotline Nov. 22, 2012 d resistance at day moving average is at 1395, and the trend line (see Figure 1) is at Strictly Financials area of 1395 to 1410, which was support on the way down, is now pport to become resistance. Now, the onus is on the bulls to try to

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Implications (contd.)
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Fundamental analysis and brokerage-firm recommendations will not enable you to identify firms which will outperform the market. Information contained in accounting statements and other public information already is reflected in security prices. It makes no sense to try and time the market. If theres a way to beat the market, its not obvious.

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How Then Should We Invest?

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Buy and hold a well-diversified portfolio through time and make sure you have exposure to international stocks and bonds in developed and emerging markets. Minimize fees, trading costs and expense ratios. Minimize tax impacts of buying and selling. Rebalance periodically to your risk/reward target.
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2.

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Diversification in an Institutional Investor Portfolio

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2)

3) 4) 5) 6) 7) 8)

Stocks Large-cap, small-cap, growth, value, international, including emerging markets Fixed income Treasuries, high-yield, corporate, municipal Real estate REITs, direct-investment funds MLPs Transportation, E&P, Liquids, Storage Commodities Ags, metals, oil and gas, Precious metals Gold, silver Hedge funds Various types Risk-management tools Options, futures
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So, What Will the Next Decade Bring?

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One Thing that is Really Changing - Demographics of Major Countries

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Countries with larger numbers of younger workers will enjoy higher growth rates than older countries. Demand for housing, autos and consumer goods is driven by the 25- to 45-year-old age cohort.
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Italy

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Germany

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United States

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Brazil

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India

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China

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Demographic Changes Are Driving the Way Investments Will Be Made in The Future.

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THE VIX A MEASURE OF EXPECTED MARKET VOLATILITY (RISK).

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You Can Keep Track of Current Market Volatility with the VIX
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The VIX is a measure of the markets perception about market uncertainty over the next 30 days. Its derived from the Black-Scholes option-pricing model, of which one input value is expected volatility (i.e., future standard deviation) of the S&P 500. You make the calculation by solving the model backwards that is given the observed price, what volatility is needed to produce that price by the model.

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So, What Does All of This Data Tell Us?

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Remember when people say this time is different, it is never different. Markets over and under correct, but they ultimately revert to the mean of their longterm values. Periods of over performance will be followed by periods of under performance, etc. Diversification is a key strategy for investing.
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Story Ideas
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What do investors and investment advisers say about market volatility? Are investors/advisers investing in international markets? If so, where and why? What will happen to bond prices and interest rates in 2012-2014?