Screening for Potential Equity Investments. The idea here is
straightforward. If you are an equity analyst and you want to identify certain
stocks to buy, you can look at their financial data to identify which stocks
to focus on. Here is an example of screening criteria, you might be
interested in companies that have a price to earnings ratio of less than 15,
the price is the stock price, the earnings refers to EPS which we have
calculated in earlier reading. A low EPS means that you are paying a relatively
low amount per dollar of earnings, so you might put in this criteria and from your
universe of stocks you might identify a hundred which meet this criteria. Then
you might be interested in companies that have relatively low leverage so you
could look at the assets over equity ratio. Less than two means that you want
relatively low leverage. Here you might identify 50 companies that meet this
criteria. You might want companies that pay dividends and here you might
identify 75 companies. And then if you want companies that meet all three
criteria then the search might reveal that there are 25 companies that meet
these three criteria, and then you can spend more time researching these
companies. What I have shown here are simply examples they can be several
other criteria that you could use. This material will be covered in more detail
when we do equity. If you are an analyst and you want to keep your risk low then
what sort of criteria are you likely to use. Again there are several criteria
that could be used, but you might for example say that the earnings have to be
positive over the last five quarters. You might say that the leverage ratio such
as assets over equity need to be relatively low and there are other
numbers or other criteria you can use also, but this just gives you
an idea. If the analyst wants low P/E firms, then obviously he should have this
criteria, maybe less than 10, which are financially strong when we say
financially strong what we generally mean is low level of debt relative to
equity, so we might say that the debt to equity ratio needs to be quite low, we
might give a criteria such as debt to equity must be lower than 0.2. We need to
recognize that there are different kinds of equity investors. We will mention this
briefly over here and then see this in detail when we do equity later. Growth
investors. These are investors who are focused on investing in high earnings
growth companies, so typically companies that might have a growth rate of 20% or
more. When companies have high growth rates typically their price to earnings
ratios tend to be high. Value investors are focused on paying a relatively low
share price in relation to earnings per share
or book value per share. Here the P/E's will tend to be low. In the US context
the P/E might say be less than 10. Book value per share refers to assets minus
liabilities, that's book value, divided by number of
shares outstanding would be book value per share. If you are buying companies
that have low book value per share that means they are relatively inexpensive.
Market investors are intermediate category. You need to understand this
term called backtesting. This is where you evaluate how a portfolio based on a
particular screen would have performed. Historically, let's say, that we go with
the screen that was discussed on the previous slide and you've identified 25
companies. Backtesting means that you go back. say 5 years, and you run that
same screen. You identify companies that that meet
the criteria and then you see how would those companies have performed over the
5-year period. Since you are going back in time, you can actually look at
whether your screen would give you stocks which produce a good return over
the next 5 years. When you do back testing, there are some biases that you
need to be aware of. These biases are mentioned briefly here, and they will be
discussed in detail later. When we do equity, an important bias that keeps
showing up in the level 1 curriculum is the survivorship bias. This exists if
delisted companies or companies that have gone out of business are not
considered. If we only consider companies that have survived till the end then our
returns will tend to be overstated because we are skipping or missing out
the companies that might have gone out of business. Look-ahead bias exists if
the database of companies that we are considering includes financial data
updated for restatements. This means that there would be a mismatch between what
the investor would have actually known at the time of the investment decision
and the information which is being used as part of the back-testing experiment.
And finally, Data-snooping bias might exist if excessive analysis is applied
to the same data set. I will not get into more detail here because we will see
this later. Analyst Adjustments to Reported Financials. When comparing
ratios adjustments might be required and we have seen examples throughout the FRA
material. Different companies might use different accounting standards. With
inventory, for example, one company might use LIFO, another company might use FIFO.
If you are comparing ratios that involve inventory, you have to make an adjustment,
for example both companies need to be presented as
FIFO before you can make a comparison. However, before making
adjustments there might be some items that you should consider; one is the
Importance. Here we consider whether the adjustments that we are considering will
really impact our decisions. If we are evaluating a company where inventory is
a very low percentage of current assets then it might not make much sense to do
the LIFO to FIFO conversion. We should also look at whether the companies we
are comparing are using the same body of standards or different body of standards.
If different standards are being used then it would generally be important to
make conversions methods. When we compare, companies we should look at whether they
are using the same accounting methods or different accounting methods, for example
you might have one company that is using straight-line depreciation, another
company might be using accelerated depreciation. Here adjustments need to be
made. And finally, Estimates. Continuing with the depreciation example, two
companies might be using very similar assets, but one company might be
depreciating over 10 years and the other company might be depreciating over
8 years, so we need to recognize that the two companies are using different
estimates because of which there will be differences in expenses and income.
Coming now to some specific adjustments. A lot of what you will see here is a
recap of material that has been seen earlier. Adjustments related to
investments. Let's say that Company A classifies financial assets as available
for sale and Company B classifies similar financial assets as trading or
held for trading. If you remember the reading on balance sheets, you will
recall that any unrealized gain is shown as other comprehensive income if the
financial asset is classified as AFS. The unrealized gain is shown as income
in the income statement. If the asset is classified as trading, this means that
the net income numbers will be different for the two companies and if we are
comparing the two companies then an adjustment is necessary. Inventory. I have
already mentioned this. If you are comparing two companies where inventory
is significant, one company uses FIFO the other company uses LIFO, then we need to
make an adjustment. When companies report inventory using LIFO and this is only
allowed in US GAAP or we should say it's allowed in US GAAP, it's not allowed in
IFRS. When companies report using LIFO, they are required to also provide a LIFO
Reserve. This is a number that when added to LIFO inventory gives us FIFO
inventory. If a company reports LIFO inventory on 31st December 2010 equal to
100--that's life for inventory. In the footnotes, the company will also disclose
a LIFO reserve, let's say the LIFO reserve is 10. What that means is if the
company had reported using FIFO then the inventory would have been 110. What the
footnote might sometimes say is that if inventory had been reported using FIFO,
instead of LIFO, then the number would be ten more. The point being that the term
LIFO reserve is sometimes used explicitly. Sometimes it's only in the
English that the footnotes explain what's going on. Example 10 shows us how
this adjustment is made and effectively it is this simple calculation. Example 11
talks about adjustments to inventory values before comparing current ratios.
Clearly, if you have two companies and you are comparing the current ratios, it
makes sense to first bring the inventory to the same system before
comparing. Goodwill. If you recall goodwill is put on the balance sheet
when a company acquires another company and pays more than the net fair value of
assets, so consider two companies A and B, both are identical, except that A has
grown through acquisition and B has grown organically--organically means that
it has grown on its own, it's not acquired other companies. What is the
impact on goodwill and total assets? Obviously the company that has grown
through acquisition will have a higher goodwill number which means that it will
have a higher asset number so the equity will seem higher, but does this mean that
company A is better? The answer is, not necessarily. When we compare Company A
and B, it makes sense to look at what's called the tangible book value--this is
the book value of assets minus liabilities, where we have removed the
impact of goodwill. So we remove goodwill and then what we are left with is
tangible book value. At times we might also want to remove intangible
identifiable assets such as copyrights patents and so on, so strictly speaking
tangible book value means that we are only considering the value of tangible
assets. Estimates related to Property, Plant and Equipment. The information on
the slide is fairly self-evident. We can study the balance sheet and income
statement and make estimates about the equipment that a company has. For example,
if we look at the number of years of depreciation expense which have been
recognized, let's say we want to estimate this number, we can simply look at the
total accumulated depreciation so far divided by the depreciation expense. If
we want to see how many years of useful life remain for the company's overall
asset base, then we can look at the net property, plant and equipment divided by
the depreciation expense. The rest of the stable is fairly self-evident. That
brings us to the end of the reading. A summary of the important points. You need
to evaluate a company's past performance and explain how the strategy is
reflected in the financials. The Apple case study that I spoke about briefly is
a good example. You need to know how to project net income and cash flows. The
big item there is you first project sales. For a stable company, you can
project expenses based on ratios, even for a stable company you should
generally project the interest expense separately based on debt and interest
levels, and you should also project the tax expense separately based on revenue
and expenses to assess credit quality. The big thing to consider is cash flows.
If cash flows are stable then the credit quality, generally, will be good. We talked
about data in financial statements to screen equity investments. If you want
relatively safe companies then you will put criteria that says that earnings
need to be positive, dividends need to be positive, maybe you can also say that the
leverage ratios need to be less than a certain number and so on. And finally, we
talked about making adjustments. We need to recognize where and when adjustments
help. Once we have recognized what adjustments need to be made then we need
to know the proper steps for making adjustments. Before comparing ratios, we
need to make sure that we are comparing apples to apples,
that's what adjustments is all about. As always read the summary, review the
learning objectives. I have mentioned several examples, most of the examples
are long-winded. The MCQ example that I referenced, you must do that. If you have
time then you can read the other examples, I think they are useful general
knowledge but not overly testable. Practice problems
are great--extremely testable, do them very carefully, and also try to do
practice problems from other sources. That is it