Lecture 1 - Introduction Flashcards
What is financial statement analysis?
The method by which users extract information to answer their questions about the firm
Who uses financial statement analysis?
- Investors (equity and debt)
- Banks
- Firms
- Governments
Balance Sheet
Lists the firm’s assets, liabilities, and shareholder’s equity
Income Statement
- Reports on changes in shareholders’ equity as a result of business activities
- Net income/earnings/profit is the measure of the value added to shareholders’ equity
Fundamental Investor
An investor who relies on fundamental analysis
P/E Ratio
Market price per share / earnings per share
The P/E ratio indicates how the market evaluates a company with respect to its current earning power.
Roughly interpreted as how many years the company can earn back its current price
The 72 Rule
At a 10% compounding rate, money doubles in about 7.2 years
72/ Growth Rate % = Years to Double
E.g. 72/12% = 6 years to double
Fed Model
Compares the expected earnings yield with the 10yr treasury yield to assess whether stocks are overpriced
Forward PE
Price / Earnings t+1
Expected earnings yield
1 / Forward PE
Bond and stock market in equilibrium when:
the one year forward looking earnings yield equals the 10 year Treasury note yield
According to fed model, stocks are overpriced when:
Forward PE stocks > forward PE notes
E.g. earnings yield 4.75%, treasury yield 5.6%
Problems with the fed model:
- Stocks are riskier than bonds - require a higher return on stocks to compensate for risk
- Growth is ignored - bonds have no abnormal earnings growth while stocks could have future growth in earnings
Equity premium
= difference between annual rate of return of stocks and risk-free assets (treasury bonds/bills)
Equity premium puzzle
Although stocks should earn premium above risk-free assets, economists cannot fully explain why stocks have yielded so much more than bonds historically
Key arguments of Dimson, Marsh and Staunton (2013)
Bonds have done well since 1980, because declining interest rates have meant that bonds purchases in the past were worth more
But as interest rates have headed toward zero, the gains from bonds seem sure to diminish too
Irrational Exuberance 1 (2000):
“the present stock market displays the classic features of a speculative bubble”
correctly predicted dot-com bubble
Irrational Exuberance 2 (2005):
“the enormous home price boom that many countries have been experiencing since the late 1990s”
correctly predicts the housing bubble
Irrational Exuberance 3 (2015):
“evidence of bubbles has accelerated since the crisis. valuations in the stock and bond markets have reached high levels in the United States and some other countries, and valuations in the housing market have been increasing rapidly in many countries.”
Key research report considerations
- Know the company
- Know the industry
- Know the government
- Know the market
- Know the clients
Knowing the company involves:
- Financial accounts
- Products
- Management
- Marketing strategy
- R&D capacity
- M&A activity
- Relationship with customers and suppliers
- Incentives inside a company (salary, options, promotions, performance payment)
Knowing the industry involves:
- Customers
- Competitors
- Technology trend, products, innovation
- New entrants
- The losers
- Industry organisation and level of competition
- Value chain (potential sources of integration)
- International picture
Knowing the government involves:
- New regulations
- Taxation
- International game of politics
- Development policy
- Regime shift
Knowing the clients involves:
- buy side/sell side
- strategy
- recent successes or failures
- incentives
