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Financial Statement Analysis and Security Analysis Concept Questions

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C7.1. The measure of the required return from the CAPM is imprecise. It involves an estimate of a beta and the market risk premium. Betas are estimated with standard errors of about 0.25, so if one estimated a beta of 1.2, say, it could actually be 0.95 or 1.45 with reasonable probability. And the market risk premium is a big guess. See the appendix to Chapter 3. Fundamental investors do not like to put speculation into a valuation, and the CAPM required return is speculative.

C7.2. Inputs into a valuation more can be quite uncertain, particularly the long-term growth rate. One can get any valuation by playing with mirrors: choosing a desired growth rate to support the valuation one is looking for. Investment bankers do it when they use a valuation model to justify a valuation they seek for a stock offering.

C7.3. “Investing is not a game against nature” means that there is not a true intrinsic value to be discovered (as if it existed in nature). So the onus is not on the investor to come up with an intrinsic value. All the investor has to do is assess if the current market price is a reasonable one. That price is set by other investors, based on their analysis, beliefs, fashions, and fads. The question is: Are the forecasts in the market price justified? The game is against other investors who set the price, not against nature.

C7.4. Growth rates (in a continuing value calculation, for example), are highly speculative. Putting speculation about the growth rate into a valuation is dangerous. Always make sure that what goes into a valuation is based on solid analysis: Separate what you know from speculation.

C7.5. Growth refers to outcomes in the long-term, and the long-term is uncertain. Growth can be competed away so that, unless the firm has protection―has build a moat around its castle―it’s expected growth may not materialize. Buying growth is thus risky.

C7.6. In the long run, the growth rate for residual earnings cannot be higher than the required return otherwise the firm would have infinite value. If one thinks of the typical required return of 10%, then a 16% current growth rate must be lower in the future. Basic competitive economics tells us that firms cannot maintain superior growth in the long-term. The best guess at the long-run growth rate is the historical GDP growth rate of about 4%.

C7.7. See the answer to C7.6. Exceptional growth is usually maintained only in the short-term. Eventually growth gets competed away, so that all firms look like the average firm in the economy in the long-run.

C7.8. The degree of competition and the ability of the firm to protect itself from competition―with a brand, with proprietary technology, by adaptive behavior and innovation, for example. The period over which growth reverts to the average is sometimes referred to as the “competitive advantage period” and the speed of reversion to the average as the “fade rate.”

C7.9. Yes, growth is risky, so a high P/E stock with a lot of growth built into its price is risky. And, yes, P/E ratios are positively correlated with beta. Here are the average betas for 10 portfolios formed from a ranking on E/P (the inverse of P/E) for U.S. stocks from 1963-2006. You can see that betas are higher for low E/P (high P/E) stocks. Note also that the returns from buying stocks are lower for the E/P (high P/E) stocks: Buying growth is risky.

| E/P |E/P |Beta |Annual Returns (%) | |Portfolio |(%) | | | | 1 (Low) | -32.5 |1.38 |16.0 | | 2 |-3.3 |1.32 |10.3 | | 3 | 2.0 |1.28 |11.4 | | 4 | 4.5 |1.22 |12.8 | | 5 | 6.1 |1.14 |14.8 | | 6 | 7.4 |1.06 |15.2 | | 7 | 8.6 |1.01 |17.9 | | 8 | 10.0 |0.97 |18.1 | | 9 |11.8 |0.96
|20.8 | | 10 (High) |16.3 |0.99 |25.3 |

C7.10. The market is seeing some growth in this stock. The value the market is given to growth in $16.34 – $12.92 = $3.42 per share.

C7.11. The market sees negative growth in the future.

Chapter 8

C8.1Free cash flow is a cash dividend from the operating activities to the financing activities; that is, it is the net cash payoff from operations that is distributed in the financing activities. The operations generate free cash flow which is then distributed to investors, namely to the shareholders in net dividends with the remainder going to the net debtholders: C – I = d + F. To see the point more clearly, C – I = d in the case where there is no net debt—that is, free cash flow is the dividend to shareholders. With net debt, this dividend is dividend between the shareholders and the debtholders.

C8.2Refer to the cash conservation equation: C – I – d = F. The firm must pass out the excess of free cash flow after dividends to net debtholders, by buying down to its own financial obligations or by buying others’ debt as a financial asset.

C8.3The firm borrows: C – I = d + F. So, if C – I = 0, then the firm borrows to pay the dividend such that d + F = 0.

C8.4An operating asset is used to produce goods or services to sell to customers in operations. A financing asset is used for storing excess cash to be reinvested in operations, pay off debt, or pay dividends.

C8.5An operating liability is an obligation incurred in producing goods and services for customers. A financial liability is an obligation incurred in raising cash to finance operations.

C8.6True. From the reformulated balance sheets and income statement, C-I = OI – (NOA. So, with operating income identified in a reformulated income statement and successive net operating assets identified in a reformulated balance sheet, free cash flow drops out. See Box 8.3.

C8.7Operations drive free cash flow. Specifically, value is added in operations through operating earnings, and free cash flow is the residual after some of this value is added to net operating assets: C – I = OI – (NOA.

C8.8Free cash flow can be paid out as dividends, but dividends are the residual of free cash flow after servicing the interest and principal claims of debt (or investing in net financial assets): d = C – I – NFE + ΔNFO.

C8.9Net operating assets are increased by earnings from operations and reduced by free cash flow: (NOA = OI – (C – I). Expanding, net operating assets are increased by operating income (operating revenues less operating expenses), reduced by cash flow from operations, and increased by cash investment: (NOA = OI – C + I.

C8.10Net financial obligations are increased by the obligation to pay interest, and by dividends, and are reduced by free cash flow: ΔNFO = NFE – (C – I) + d.

C8.11True. Free cash flow is a dividend from the net operating assets to the net financial obligations. So, as (CSE = (NOA – (NFO, free cash flow does not affect CSE. C8.12. Profitable companies have investment opportunities. New investments expenditures can be higher than cash from operations, producing negative free cash flow. Starbucks in Chapter 4 is another example. Chapter 9

C9.1.Because the accounting is not “clean” in reporting additions to “surplus”. “Surplus” is an old-fashioned word meaning shareholder’s equity – the surplus of assets over liabilities. An effect on equity from operations – that creates additional “surplus” — bypasses the income
statement (which is supposed to give the results of operations), and thus is “dirty.” Clean-surplus accounting books all income in the income statement.

C9.2.If a valuation is made on the basis of income that is missing some element (of the value added in operations), the valuation is wrong. For example, if sales or depreciation expense were put in the equity statement rather than the income statement, we would see the income statement as missing something that is value-relevant.

C9.3.Currency translation gains and losses are real. If a U.S. firm holds net assets in another country and the dollar equivalent of those asset falls, the shareholder has lost value.

Many of the net assets behind the Nike’s shareholders’ equity are in countries other than the U.S. If the value of the dollar were to fall against those currencies, the firm would have more dollar value to repatriate to ultimately pay dividends to shareholders. Nike’s 2010 equity statement (in Exhibit 9.1) reports a currency translation loss of $159.2million. This means that the dollar value of net assets in other countries – in which the shareholders are investing – dropped by $159.2 million over 2010. The shareholders lost in dollar terms.

C9.4.Existing shareholders lose when shares are issued to new shareholders at less than the market price. They give up a share worth the market price, but receive in return a cancellation of a liability valued at its book value. The new shareholders buying into the firm through the conversion gain: they receive shares worth more than they paid for the bonds. The accounting treatment (the “market value method”) that records the issue of the shares in the conversion at market value, along with a loss on conversion, reflects the effect on existing shareholders’ wealth.

C9.5.The firm is substituting stock compensation for cash compensation but, while recording the reduced cash compensation (and so increasing reported profits), the firm is not recording the full cost of the stock compensation. One would have to calculate the equivalent cash compensation cost of the stock option compensation to see if the compensation was attractive to shareholders. (One would also have to consider the incentive effects of stock options―the benefits as well as the costs). Watch for a fake increase in profit margins when a firm substitutes stock option compensation for cash compensation.


(a)Yes. Issuing shares at less than the market price dilutes the per-share value of the existing shares. See Chapter 3 and the exercise for Chapter 3 for more.

(b)No. Repurchasing shares at market value has no effect on the per-share value of existing shares. See Chapter 3, text and exercises. The number of shares is reduced and EPS might thus increase (depending on the numerator effect), and this might look like reverse dilution. But the value per share does not change. (Chapter 14 deals with the effect of share repurchases on EPS.)

(c)If Microsoft felt its shares were overvalued in the market it would feel they are too expensive. In this case, repurchasing would dilute the value of each share, as the price is not indicative of value. Buying overpriced shares is never a good idea.

C9.7. No. The tax benefit arises only because the firm pays wages (in the form of options) that the tax authorities allow for as tax deduction. The net benefit (to the shareholder) is the tax benefit less the value given up to employees in stock compensation. This net amount must always be negative, as the tax is the tax rate applied to the difference between the market and issue value of the shares, the value given up by the shareholders.

If there is any benefit to shareholders, it must be from the incentive effects of the stock options. That is, the revenues that employees generated are in excess of the value given to them (net of taxes) for their work.

C9.8.The scheme effectively recognizes the difference between the market price and the exercise price of options exercised as an expense, and so recognizes the compensation expense at exercise date. The net cash paid by the firm is equivalent to paying the compensation as cash wages to employees. But why use cash? The expense could be recognized in the books with accrual accounting without paying out cash.

The only fault with the recognition of the expense is that it is recognized at exercise date rather than matched to revenue over a service period during which the employees worked for the compensation. C9.9.Microsoft might think its own shares are overvalued in the market. So it uses them as “currency” to get a “cheap buy.” Buy when price is less than value.

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