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
