Chapter 6 - Analysis of Equity Securities II: Company Analysis and Valuation - 4.75% Flashcards
What is the difference between IFRS and GAAP?
Generally Accepted Accounting Principles (GAAP) had been the standard for over 75 years in the US and Canada, guiding the preparation and presentation of financial information for a publicly traded company.
Canadian publicly accountable enterprises (‘PAEs’) gave up using GAAP and switched to International Financial Reporting Standards (IFRS) for annual reporting periods starting on or after January 1, 2011.
The major ‘philosophical’ difference between the two accounting methodologies is that IFRS is almost entirely principle-based whereas Canadian and U.S. GAAP are primarily rules-based. Rules-based accounting is more rigid, meaning specific procedures are observed when preparing financial statements. This makes for less ambiguity but also increases the complexity of the
process. There is also more difficulty in making rules that fit every situation.
What is company analysis?
Company analysis involves understanding the company’s business, analyzing the company’s financial statements, and forecasting the company’s future financial performance. Equity analysts communicate the results of company analysis and valuation in research reports that can be as short as a single page or as long as several dozen pages. Shorter, more frequently released research reports are often called comments, notes, or flashes. Analysts produce these in response to new information about the company, such as an announcement made by the company or a rumor in the market, or to update investors during a quiet period.
What are the sources of Company Information?
Financial statements are prepared by company management. There are four major parts of a company’s financial statements –
- The statement of financial position (formerly the balance sheet) list a company’s assets, equity and liabilities at a specified point in time. Equity = Assets - Liabilities
- The statement of comprehensive income shows the company’s revenue and expenses over a specified period of time.
- The statement of changes in equity provides a link between the statement of comprehensive income and the statement of financial position at a specified point in time.
- The statement of cash flows outlines the cash inflow and outflow for the company over a specified period of time.
Explain the statement of cash flows.
A statement of comprehensive income matches expenses with revenue to determine the profit of a
company. Although profit is an important indicator of a company’s performance and sustainability, its survival over the long term ultimately depends on its ability to generate cash. Since a statement of comprehensive income does not include a breakdown of cash inflow and outflow and includes some non-cash accounting items, companies are required to prepare a statement of cash flows. The statement of cash flows breaks down a company’s sources and uses of cash in a particular
period according to its operating activities, investing activities, and financing activities.
• Cash flow from operating activities equals cash received from the sale of goods or services minus cash used to generate the revenue.
• Cash flow from investing activities equals cash received from the sale of long-term assets minus cash used to buy long-term assets plus any dividends received from associates.
• Cash flow from financing activities equals cash received from the sale of new shares or the issuance of new debt securities minus cash paid to buy back shares, repay debt securities, or pay dividends.
The sum of the cash flows from the three activities equals the change in the company’s cash (as reported on the statement of financial position) from one period to the next.
What are some of the other regulatory filings?
To maintain a listing on a Canadian stock exchange, a company must file audited annual financial statements through the System for Electronic Document Analysis and Retrieval (SEDAR). These audited annual financial statements must be prepared according to IFRS and be
approved by the company’s board of directors. If a company has securities listed on the Toronto Stock Exchange (TSX), it must file these audited annual financial statements within 90 days of the end of its financial year-end. If a company has securities listed only on the TSX Venture Exchange or CNSX, it must file the statements within 120 days of the end of its fiscal year. Listed companies must also file interim unaudited financial statements. For companies with securities listed on the TSX, the statements must be filed through SEDAR within 45 days of the end of the interim period. If securities are listed only on the TSX Venture Exchange or CNSX,
the filing period is within 60 days of the end of the interim period. In both cases, comparative figures from the previous fiscal year for the applicable time periods are also required.
In the United States, most companies must file a Form 10-K with the Securities and Exchange Commission (SEC) within 90 days of the end of the company’s fiscal year. This annual report provides a comprehensive overview of the company’s business. Most reporting companies in the
United States also file a Form 10-Q quarterly (every three months). This form includes unaudited financial statements and provides a continuing view of the company’s financial position during the year. The report must be filed for each of the first three fiscal quarters of the company’s fiscal year and is due within 45 days of the close of the quarter.
What are the two types of ratio analysis?
Liquidity ratios measure a company’s ability to meet its short-term obligations. Common measures of liquidity include the current ratio and the quick ratio. The current ratio is current assets divided by current liabilities. The quick ratio is current assets minus inventories, then divided by current liabilities.
Risk analysis ratios are used to determine how well the company deals with its debt obligations, including its ability to service required debt payments (coverage) and to assume more debt (capacity). Interest coverage and asset coverage are two common measures of debt coverage. The debt-to-equity ratio is a common measure of debt capacity.
Operating performance ratios help determine a firm’s long-run growth and survival prospects. Profitability measures how well the company has made use of its resources. Common measures include gross profit margin, net profit margin, and return on common equity (ROE).
Value ratios gauge the market’s perception of the value of a company’s shares relative to its dividends, earnings, or other measures such as the equity value (or book value) per common share. Common value ratios include price-to-earnings (P/E) and dividend yield. When valuing a company and making recommendations, analysts often justify their decisions on a value ratio being above or below some benchmark value. The section on valuation later in this chapter discusses these ratios further.
What is the Earnings Per Share Ratio?
At the most basic level, earnings per share (EPS) is calculated as:
EPS = Profit Weighted / Average number of common shares outstanding
What is Return on Equity?
Return on equity (ROE) is more precisely defined as the return on common equity. The common shareholders are the owners of the company. Once the company’s other securities holders (such as debt securities) have been paid from profit, the residual income or loss is added to or subtracted from the retained earnings section of the statement of financial position. The retained earnings shown on the statement of financial position represent the cumulative profit or loss that accrues to the common shareholders.
ROE = (Profit/Revenue) X (Revenue/Total Assets) X (Total Assets/Common Equity)
Explain the Dividend Discount Model (DDM).
Dividend discount models assume that a stock’s intrinsic value is equal to the present value of a stream of future dividends. Inputs to dividend discount models include dividend forecasts and/or dividend growth rates, and discount rates.
Discount rates represent the analyst’s estimate of the market’s required or expected return on the stock. The required return is usually expressed as a risk-free rate based on government bond yields plus a risk premium, which is usually based on an asset pricing model such as the capital asset pricing model (CAPM).
Refer to Page 6.19 for the formula
Explain the Gordon Growth Model.
Constant (Gordon) Growth Model
One way to simply the dividend forecast is to assume that dividends will grow at a constant rate forever. For example, if a stock is paying a $1 dividend this year and the estimated dividend growth rate is 5%, next year it will pay a dividend of $1.05, the year after it will pay $1.1025, and so on. The version of the dividend discount model that uses this assumption is known as the constant or Gordon growth model. Equation 6.6 shows the formula.
What Models can be used to value stocks?
a) Absolute Valuation Models
Absolute valuation models determine a point estimate or precise value for the intrinsic value of a stock based on a set of forecast company fundamentals. If the market value of the stock is less than the model’s intrinsic value, the stock is undervalued; if the market value is greater than the model’s intrinsic value, the stock is overvalued. In the securities industry, the two most widely used absolute valuation models are the dividend discount model and discounted cash flow model.
b) Relative valuation models determine intrinsic value by comparing one or more of the stock’s value ratios or price multiples (such as price-to-earnings, price-to-book value, or price-to-sales ratios) to a benchmark value for the price multiple. If the stock’s current price multiple is less than the benchmark value, the stock is undervalued; if it is greater than the benchmark, the stock is overvalued.
How are Petroleum companies analyzed?
Petroleum reserves are divided into three major classifications. They are defined as follows:
- Proved: Reserves claimed to have a reasonable certainty of recovery (> 90 percent confidence interval) under existing technology. Also known as “P90” or “1P” reserves.
- Probable: Claim of 50 percent recovery confidence interval. Also known as “P50”, “2P” or “proved + probable”.
- Possible: Claim of 10 percent recovery confidence interval. Also known as “P10”, “3P”, or “proved + probable + possible”.
The proved category, being of the highest quality due to its very high statistical threshold, forms the basis for a number of valuation methods. Accordingly, it is divided into a further three sub- classifications as follows:
- Proved developed reserves: Proved developed reserves that can be recovered through existing wells and facilities, and by existing methods. Also known as “PDP”. PDP assets are generally not risked (or discounted by an engineering factor) since they are currently generating cash flow.
- Proved developed not producing: Same as PDP but not currently producing. Also known as “PDNP”. PDNP assets are discounted, or risked by about 25 percent.
- Proved undeveloped reserves: Proved undeveloped reserves are potentially recoverable with existing technology, but not considered commercially recoverable due to greater than one contingency defined to include: economic, legal, environmental, political or regulatory risk. Also known as “PUD”. PUD assets are risked by about 35 percent.
What are Reserve Units?
The global unit measure of reserves for the oil and gas industry is the BOE. BOE stands for barrel of oil equivalent. It is defined as follows:
• The barrels (bbls) of oil used when measuring liquid reserves such as oil and natural gas liquids (NGLs), plus
• The amount of natural gas reserves at a conversion ratio of six thousand standard cubic feet (scf ) of natural gas per BOE. This second factor reflects the fact that six thousand scf of natural gas contains the same amount of heat as one barrel of oil. It is also often referred to as heat or BTU- equivalency. Specifically, one scf of natural gas contains one BTU and one barrel of oil contains 6 thousand BTU of heat.
What is Production Rate?
Economic value (EV) is a standard measure of the economic value of a resource-based company and is calculated as follows: EV = Market value of the company’s equity \+ Book value of the debt outstanding – Amount invested in cash and short term securities
What is Reserve Life Index?
The reserve life index (RLI) represents the number of years it would take to deplete the existing reserves at the current daily production rate. It is calculated by dividing the company’s current reserves by the current annual production rate, or as follows:
RLI = Current Reserves (BOE) /
Current Daily Production Rate (BOED) × 365
