Equity Analysis

Analysts need to evaluate a company's performance in order to value a security. One of their valuation methods is the use of valuation ratios.

Some common valuations ratios are:

• P/E: Price per share / Earnings per share.
  P/E is widely recognized and used by investors. Earning power is a chief driver of investment value, and EPS is perhaps the chief focus of security analysts' attention.

• P/CF: Price per share / Cash flow per share.
  Cash flow is less subject to manipulation by management than earnings. Thus, P/CF ratios can be used to compare companies with different degrees of accounting aggressiveness. Moreover, cash flow is generally more stable than earnings, so P/CF ratios are more stable than P/Es. When EPS is abnormally high, low, or volatile, P/CF ratios are more reliable than P/Es.

• P/S: Price per share / Sales per share.
  • Sales growth is the driving force for the growth of earnings and cash flows.
  • Sales are positive even when EPS is negative.
  • Sales are generally less subject to distortion or manipulation than are other fundamentals.

• P/BV: Price per share / Book value per share.
  Similarly, book value is generally positive even when EPS is negative. Since book value per share is more stable than EPS, P/B may be more meaningful than P/E when EPS is abnormally high or low, or is highly variable.

These price multiples and dividend-related quantities are discussed in more detail in Study Session 12 (Equity Analysis and Valuation).

Credit Analysis

Credit analysis is the evaluation of credit risk.

How does an analyst who has calculated a ratio know whether it represents good, bad, or indifferent credit quality? Somehow, the analyst must relate the ratio to the likelihood that a borrower will satisfy all scheduled interest and principal payments in full and on time. In practice, this is accomplished by testing financial ratios as predictors of the borrower's propensity not to pay (to default). For example, a company with high financial leverage is statistically more likely to default than one with low leverage, all other factors being equal. Similarly, high fixed-charge coverage implies less default risk than low coverage. After identifying the factors that create high default risk, the analyst can use ratios to rank all borrowers on a relative scale of propensity to default.

Many credit analysts conduct their ratio analyses within ranking frameworks established by their employers. In the securities field, bond ratings provide a structure for analysis. Credit rating agencies such as Moody's and Standard & Poor's use financial ratios when assigning a credit rating to a company's debt issues. For example, credit ratios used by Standard & Poor's include EBIT interest coverage, funds from operations to total debt, total debt to EBITDA, and total debt to total debt plus equity.

Much research has been performed on the ability of ratios to assess the credit risk of a company (including the risk of bankruptcy) and predict bond ratings and bond yields.

Segment Analysis

A company may be involved in many different businesses, may do business in many different geographic areas, or may have significant number of customers. It is difficult to analyze a company with multiple business lines because of the inherent differences in financial structures, risk characteristics, etc,. amount the different lines. Aggregation of financial results for all the lines tends to obscure the true picture.

A company must disclose information related to various subdivisions of its business.

• Under IAS 14 (Segment Reporting), disclosures are required for reportable segments.
• U.S. GAAP requirements are similar to IFRS but less detailed.

Based on the limited segment information that companies are required to present, a variety of useful ratios can be computed for business segments to evaluate how units within a business are doing. These ratios include segment margin, segment turnover, segment ROA, and segment debt ratio.

Analysts should pay attention to a segment's relative performance and see how this may fit into the overall business strategy. For example, in January 2000 Motorola's stock price was $139, on its way to a March peak of $180. But Meyer, an analyst for an investment research company, didn't buy the Street's analysis. "The market was valuing each segment at best-in-class multiples," he said. "But Motorola was not best in class in semiconductors, or wireless, or satellites." The margins of each of Motorola's segments compared poorly with top performers (such as Intel), and Meyer issued warnings that accurately foreshadowed the stock's subsequent plunge. "It was the segment information that helped me to really get a grip on the company," he said.

Practice Question 1

To help analyze financial statements for diversified companies, which of the following does FASB require to be reported separately for each segment?

I. Profit or loss
II. Certain revenue and expense items
III. Assets

Correct Answer: I, II and III

To help analyze financial statements for diversified companies, FASB requires that each segment report separately its profit or loss as well as certain revenue and expense items and assets.

Practice Question 2

ABC Co. has the following segment reporting information for 2015:

Widgets have an operating profit margin of ______.

A. 4.6%
B. 10.2%
C. 12.4%

Correct Answer: B

Practice Question 3

A high price/earnings ratio indicates _______.

A. investor confidence in high future earnings
B. that the stock is probably overvalued
C. that the stock is probably undervalued

Correct Answer: A

A high price/earnings ratio indicates optimism about a company's future. That positive outlook may be due to anticipated increases in earnings and growth of the company.

Practice Question 4

What statement(s) is (are) true?

I. Even among similar firms, financial ratios may be misleading, since each firm has latitude in choosing its own accounting methods.
II. Writing off bad debt against the income statement would reduce receivable days.

Correct Answer: I and II

Practice Question 5

ABC Co. has the following segment reporting information for 2015.

Gidgets have a return on assets of ______.

A. 6.0%
B. 10.2%
C. 104.6%

Correct Answer: A

Practice Question 6

In the evaluation of credit ratings, a company will most likely be assigned a higher credit rating if it has a ______.

A. lower EBITDA/Interest ratio
B. lower dividends-to-total-debt ratio
C. higher five-year average of its coefficient of variation of its operating margin

Correct Answer: B

A lower dividend means more retention and increased equity; higher retained cash flow will result in a higher credit rating.