Investments chapter 14

What does a low P/E do compared to a high P/E, and why might someone still purchase a High P/E stock anyways?

- a low P/E stock will allow you to pay less per dollar of current earnings A high P-E stock may still be a better bargain if its earnings ere expected to grow quickly enough, as P/E often reflects growth opportunities in the sense that high P/E usually means an abundance of growth opportunities. A high ratio typically can best be interpreted as a signal that the market views the firm as enjoying attractive growth opportunities

How does "nonrecurring items" give rise to comparability problems and affect quality of earnings? -what are nonrecurring items?

- some items that affect earnings should not be expected to recur regularly, including asset sales, effects of accounting changes, effects of exchange rate movements, or unusual investment income -these things contribute to a specific year's earnings, but should not be expected to repeat regularly -they would be considered a "low-quality" component of earnings

How does "off-balance-sheet assets and liabilities" give rise to comparability problems and affect quality of earnings?

- they are not necessarily reported in financial statements, but may appear only as footnotes to the financial statements. Such obligations are known as "contingent liabilities" because it may require payments down the road, but since they do not currently require payments, they are listed only as footnotes and are not accrued, and may not be reported as part of the firm's outstanding debt

What are the parts of the statement of cash flows?

-cash provided from: operating activities, investing activities, financing activities, and the net increase in cash

What does the term "comparability problems" mean? Why do such "comparability problems" occur?

-comparing financial results of different companies is not so simple, given the differentiating methods of accounting between different firm's -because of the fact that G.A.A.P. dictates that there is more than one acceptable way to represent various items of revenue and expense - therefor, 2 firm's with exactly the same economic income can have very different accounting incomes

What method of accounting does the statement of cash flows use? what does this mean?

-does not use accrual method of accounting -means that the statement of cash flows will not show an increase in available cash until the bill is paid (revenues are not recognized until cash is exchanged)

What is a common size balance sheet

-each item is expressed as a percentage of total assets -useful when comparing firms of different sizes

What do most profitability measures focus on, and why?

-earnings per dollar employed -because larger firms earn much greater profits than smaller ones

What is the difference between economic income and accounting income?

-economic income measures the reality of money coming into the firm while accounting income measures the money that is coming into the company, as a representation of what is on the income statements. Different methods Accounting and reporting can dictate the value of income generated by the company, however economic income does not change, given different accounting methods. It is the real, hard, tangible money that is coming into the company (not just cash but receivables as well)

What is one way that the statement of cash flows provides for important evidence on the well-being of a firm?

-if a company cannot afford to pay out dividends, it may resort to financing this through borrowing. the statement of cash flows will show that the company cannot meet its demands, as its cash flows from operations are inadequate, which means that the borrowing is used to maintain dividend payments at an unsustainable level, which is a huge warning sign

What does it mean if a firm is earning profits, but is not covering its opportunity cost?

-it means that the firm might be able to redeploy its capital to better uses

What does plowing back funds into the firm do? What is the condition of this

-it should increase the firm's stock price -the condition is that it only increases the stock price IF the funds plowed back into the firm earns a higher rate of return on the reinvested funds than the opportunity cost of capital, that is, the market capitalization rate (k?)

How do "international accounting conventions" give rise to comparability problems and affect quality of earnings?

-occurs due to he interpretation of the financial statements of foreign firms, because such firms do not follow GAAP -other nations use "international financial reporting standards (IFRS)" which are more principle based, why GAAP lays out specific rules with detailed, explicit, and lengthy rules governing almost any circumstance that can be anticipated

What should people look for in a firm to view it as successful?

-only if the Return in its projects is better than the rate investors could expect to earn for themselves in the capital market

What is "earnings smoothing" -How does "earnings smoothjng" give rise to comparability problems and affect quality of earnings?

-taking earnings from precious good quarters, hiding them, and releasing them on financial statements during bad quarters; in order to make the firm seem as though they are able to sustain/ maintain profitability on a regular basis -"such earnings are clearly not sustainable over the long-term and therefor must be considered low quality"

What is "dates sales in receivables", and what does it measure? How should it be interpreted? What is it also called?

-the average level of accounts receivable expressed as a multiple of days sales -this measure of efficiency surrounds the management of accounts receivable -the number of days' worth of sales tied up in accounts receivable OR the average lag between the date of sale and the date payment is received, -it's also called the "average collection period"

What is inventory turnover ratio, and what does it measure

-the ratio of cost of goods sold per dollar of average inventory -it measures the speed with which inventory is turned over

How does "revenue recognition" give rise to comparability problems and affect quality of earnings? -how do analysts combats revenue recognition comparability problems?

-under GAAP, a firm is allowed to recognize a sale before it is paid, which is why firms have accounts receivable, but "sometimes it can be hard to know when to recognize sales" -given the wide latitude firm's have in how they recognize revenue, many analysts choose instead to concentrate in cash flow, which is far harder for a company to manipulate

What method of accounting is used by the income statement and balance sheet? what does this mean?

-uses the accrual method of accounting -means that revenues and expenses are recognized at the time of a sale even if no cash has yet been exchanged

What are the 5 discussed styles of factors that influence quality of earnings?

1) allowance for bad debt 2) nonrecurring items 3) earnings smoothing 4) revenue recognition 5) off-balance sheet assets and liabilities

What are the 2 questions asked, when evaluating a firm's investment activities?

1) how efficiently does the firm deploy its assets? 2) how profitable are its sales?

What are the 6 areas of comparability problems?

1) inventory valuation 2) depreciation 3) inflation and interest expense 4) fair value accounting 5) quality of earnings and accounting practices 6) international accounting conventions

Industries with high turnover usually have what? Industries with low turnover usually have what?

1) low profit margins 2) high profit margins

What are the differentiating areas of international accounting conventions that affect comparability of firms?

1) reserving practices- many countries allow firms considerable more discretion in setting aside reserves for future contingencies than is typical in the U.S. 2) depreciation- we have dual sets of accounting for depreciation in the U.S. (straight line and accelerated depreciation) while most other countries do not allow dual sets of accounts, and most firms use accelerated depreciation to minimize taxes, which makes them seem less profitable than they would seem if they were allowed to use U.S. practices 3) intangibles- the treatment of intangibles such as goodwill can vary widely "are they amortized or expensed"

What does the interest coverage ratio mean? What is it used for, and by who?

A high coverage ratio indicates that the likelihood of bankruptcy is low because the annual earnings are significantly greater than annual interest obligation -it is widely used by both lenders and borrowers in determining the firm's debt capacity and is a major determinant of the firm's bond trading

What is current ratio a measure of

A measure of the ability of the firm to pay off its current liabilities by liquidating its current assrts

What must security analysts do when comparing the financial results across firms over time?

Adjust the earnings and financial ratio figures to a uniform standard

Why do analysts compute a firm's cash ratio?

Because a company's receivables are less liquid than its holdings of cash and marketable securities

What is another complication for when it comes to comparability using depreciation?

Because conventional depreciation is based on historic costs rather than on the current replacement costs of assets, measured depreciation in periods of inflation is understated relative to replacement cost, and REAL economic income (sustained cash flow) is correspondingly overstated

Why is the market-book ratio regarded as the "floor" value that supports the market price?

Because if the market price falls below the book value, the company can liquidate

Why can different accounting choices give rise to comparability problems (other than LIFO and FIFO)

Earnings statements for different companies may be more or less "rosy" presentations of true economic earnings - sustainable cash flow that can be paid to shareholders without impairing the firm's productive capacity

What do turnover ratios in general, represent?

Efficiency-of-utilization

Why and when do firms use accelerated depreciation?

For tax purposes -because early on it will make them look less profitable and thereby decrease taxes on the firm

Why does Benjamin Graham say that it is no longer necessarily useful to utilize elaborate techniques of security analysis in order to find superior value opportunities?

He is on the side of the efficient market in terms of the "efficient market hypothesis" because there is SO many detailed studies occurring by a ****ton of well-trained analysts, meaning that most superior value opportunities are negated by market efficiency.

What does Return on assets tell us?

Income earned per dollar employed by the firm

What does financial leverage increase in terms of risk?

Increase the risk of the equityholder returns -it increases the risk of the firm'a equity as surely as it raises the expected ROE, and the higher discount rate will offset the higher expected earnings

What are the 2 broad activities that the firm's financial managers are responsible for?

Investment decisions and financing decisions

What does inflation most effect in terms of comparability problems?

It effects the calculation of REAL interest expense the most -mismeasurement of real interest means inflation deflated the computation of real income. The effects of inflation on reported values of inventories and depreciation that we have discussed works in the opposite direction

Why do many observers feel that mark-to-market accounting exacerbated the financial meltdown?

It forced banks to excessively write down asset values

What does total asset turnover (ATO) indicate?

It indicates the efficiency of the firm's use of assets in the sense that it measures the annual sales generated by each dollar of assets (the ratio of sales to total assets)

What does price-earnings (P'E) ratio measure?

It places firm's along a growth versus value spectrum, as the ratio of the present value of growth options to the value of assets in place largely determines the P/E multiple

What does "tax-burden ratio" reflect?

It reflects both the government's tax code and the policies pursued by the firm in trying to minimize its tax burden

In terms of the interest-burden ratio, what does it mean, the higher the degree of financial leverage?

It will mean a lower interest burden ratio

What does the quick/ acid test ratio measure?

It's a better measure of liquidity than the current ratio for firms who's inventory is not readily convertible into cash

How is profitability of sales measured?

It's measured with various profit margins

What are the 2 common was to value inventory?

LIFO and FIFO

Which, FIFO or LIFO, is preferred in computing economic earnings, and why?

LIFO is preferred over FIIFO, because it uses up-to-date prices to evaluate the cost of goods sold

What is level 1 of the "3 buckets" of fair value accounting?

Level 1 Assets are traded in active markets and therefor should be valued at their market price

What is level 2 of the "3 buckets" of fair value accounting?

Level 2 assets are not actively traded but their values still may be estimated using observable market data on similar assets. They can be "marked to a matrix" of comparable securities

What is level 3 of the "3 buckets" of fair value accounting?

Level 3 Assets are hardest to value. Here it is difficult to even identify other assets that are similar enough to serve as benchmarks for their market values; one has to resort to pricing models to estimate their intrinsic values. Rather than mark to market, these values are often called "mark to model" although they are also disparagingly known as mark-to-make believe( as the estimates are so prone to manipulation by creative use of model inputs

What are the "3 buckets" of fair value accounting?

Levels 1-3

Concerning low vs. high P/E ratios, what do most analysts say?

Low P/E ratios are generally more attractive than high P/E ratios -in fact, low P/E stocks have generally been positive-alpha investments using the CAPM as a return benchmark. However, CAPM may not always be a good benchmark for returns in this case

What does the presence of debt do?

Makes the ROE of a company more sensitive to the business cycle

What is the problem with many major assets and liabilities, in terms of being comparability problems?

Many do not have easily observable values (Ex: we cannot simply look up the values of employee stock options, healthcare benefits, etc.)

How does "allowance for bad debts" give rise to comparability problems and affect quality of earnings?

Most firms sell goods using trade credit and must make an allowance for bad debt. Unrealistically low/ high allowances reduces the quality of reported earnings

What is a firm's operating profit margin or return on sales (ROS)?

Operating profit per dollar of sales

What is the accounting measurement of depreciation?

The amount of the original acquisition cost of an asset that is allocated to each accounting period over an arbitrary specified life of the asset -it is reported in financial statements

The slope of what lines for what ratios, shoes the tradeoff of profit margin vs. turnover?

ROA and ROE

What do proponents of "fair value accounting" (aka market-to-market accounting) argue?

That financial statements would give a truer picture of the firm if they better reflected the current market values of all assets and liabilities

What does a decline in the liquidity ratios, combined with a decline in coverage ratio suggest?

That the credit rating for the firm is declining as well

What is the result of using LIFO over FIFO

The LIFO firm has both a lower reported profit and a lower balance sheet value of inventories than the FIFO form, and results in an upward bias in ROE because the investment base on which Return is earned is undervalued

What is liquidity? What are the 3 measures for liquidity?

The ability to convert assets into cash at short notice - current ratio, quick ratio, and cash ratio

What is the economic definition of depreciation?

The amount of a firm's operating cash flow that must be reinvested in the firm to sustain its real productive capacity at the current level

What is the DuPont system?

The decomposition of ROE that allowed analysts to focus on the separate factors influencing performance

What will happen to the estimation of depreciation for a machine that works for 20 years, but is depreciated over the first 10 years completely to be taken off the books

The depreciation amount will be overestimated for the first 10 years and underestimated for the last 10 years.

What happens if Return on assets exceeds the borrowing rate?

The firm earns more on its money than it pays out to creditors -the surplus earnings available go to the firm's owners, which increases ROE

What do debt ratios compare?

The firm's indebtness to broad measures of it's assets

What does recur in capital tell us?

The income earned per dollar of long-term capital invested in the firm

What is the market-book value ratio, and what does it mean

The market price of a share of the firm's common stock divided by its book value, that is, shareholders equity per share -a low market-book value is a "safer" investment, seeing the book value as the "floor", supporting the market price - a better interpretation of the ratio is as a measure of growth opportunities. Firm's with greater growth opportunities will tend to exhibit higher multiples of market-price-to-book value

What does return on equity focus on?

The profitability of equity investments -it is one of the 2 basic factors in determined a firm's growth rate of earnings

What is graham's "foolproof" method of systematic investment?

The purchase of common stocks at less than their working-capital value, or net current-asset value, giving no weight to the plant and other fixed assets, deducting all liabilities in full from the current assets

What does leverage measure?

The safety of a firm's debt

What does fixed-asset turnover measure?

The sales per dollar of the firm's money tied up in fixed assets -it is an efficiency of utilization, or turnover, ratio

Define "economic value added"

The spread between ROC and K multiplied by the capital invested in the firm. It therefore measured the dollar value of the firm's return in excess of its opportunity cost. It is another term for "residual income"

What are financing decisions?

They pertain to the firm's sources of capital, and is there enough of a supply of financing to meet the needs of the company

What do investment/ capital budgeting decisions pertain to?

They pertain to the firm's use of capital: the business activities in which it is engaged. Here; the questions we will wish to answer pertain to the profitability of those projects

Why and when do firms use straight-line depreciation?

They use this for the depreciation in published financial statements -this will make them look more profitable than accelerated when it comes to stockholders looking at financial statements

What is "quality of earnings"?

This concept refers to the realism and conservatism of the earnings numbers, in other words, the extent to which we might expect the reported level of earnings to be sustained

What is "channel stuffing"?

This is when a firm sells large quantities of goods to customers, but give them the right to later refuse delivery or return the product. The revenue from the sale is booked now cut likely returns are not recognized until they occur (in a future accounting period) - companies such as autonomy corp. have been able to use channel stuffing to artificially enhance financial performance.

Why do analysts decompose ROE into the product of a series of ratios?

To better understand the factors effecting a firm's ROE, particularly its trend over time and it's performance relative to its competitors

Why/ what are benchmarks used/ used for? What 2 types of benchmarks can a firm use?

To evaluate the performance of a given firm. -the benchmarks using the ratios of the same company in earlier years, and the financial ratios of other firm's in the same industry

How is efficiency assessed?

Using several turnover ratios

What is the relationship between profit margin and turnover ?

Usually, high margins means low turnover and low margins means high turnover -firm's would love to have high values for both, however this is generally not possible, as the way to get high profits is through increased price, which typically decreases demand and therefor decreases the volume of units sold / turnover

What do coverage ratios compare?

Various measures of earning power against the cash flow needed to satisfy debt obligations

When will a firm's pretax profits be greatest? -what ratio reflects this?

When there are no interest payments to be made to debt holders -the interest-burden ratio

How do we account for the opportunity cost of reinvesting funds in a firm (plowback)?

Yo account for this opportunity cost, We measure the success of a firm using the difference between Return on capital (ROC) and the opportunity cost of capital (K)

What is a common size income statement

all items on the income statement are expressed as a fraction of total revenue -makes it easier to compare firms of different sizes

What is EBIT?

earnings before interest and taxes -a measure of profitability of a firm's operations, ignoring any interest burden attributable to debt financing

What is a statement of cash flows used for?

it provides important evidence on the well-being of a firm

What is the difference in assets and liabilities?

the net worth of the firm, called "shareholders' equity"

What is an income statement?

the summary of the profitability of a firm over a period of time -resents revenues generated during the operating period, as well as expenses over the same period, and the net earnings or profits

Describe the balance sheet

this provides a snapshot of the financial condition of a firm at a particular moment -lists all of the firm's assets and liabilities at that moement