In the Learning Activity “Critical Areas of Financial Analysis” you learned how the opinions of other analysts are a way for managers to make decisions. Examine Table 1.3 (Bond Ratings) carefully and understand the different classifications of bonds by the different analysts. Then, conduct research and find an organization that offers a bond with a “Very High Quality” rating and one that offers bond with a “Very Poor” rating as stated in the table. Provide the link to the financials and examine them. List at least three financial factors for each organization that you feel are the reasons for the analyst ratings. Do you agree with the analyst ratings? Why or not? Would you personally invest in the organization by buying the bonds? Why or why not?
Critical Areas of Financial Analysis Introduction After reading this section, list the various elements of financial analysis and, particularly, the areas (in addition to accounting data) a financial investor/analyst should focus on when examining financial data. Why should analysts look beyond the numbers presented in financial statements? Where should analysts look for additional sources of information about a company? Record your responses in your Learning Journal. Market Data © Robert Churchill/iStock/Thinkstock Another important information source is market data. As the name implies, market data are the data generated in a marketplace. We discuss two types: stock market performance (measured by stock returns) and product market performance (measured by market share). Because it is generated by millions of market participants, market-based data are less subject to manipulation (window dressing) by management than accounting data. Although it has been done, managers have a more difficult time misleading millions of investors in the stock market or millions of consumers in product markets. Stock Returns A corporation’s ultimate objective is to maximize shareholder wealth. This goal leads us directly to the necessity of evaluating share price changes or stock returns, as stock returns measure changes in shareholder wealth. Returns are available in many formats. The Center for Research in Security Prices (CRSP) tapes, developed by the University of Chicago, offer users a data set of daily security returns decades long, covering thousands of publicly traded firms. Returns may also be calculated by gathering share price and dividend information from sources such as Yahoo! and Google. Stock prices and returns are also useful to the analyst because they are forward-looking, and implicitly consider risk. Recall that two shortcomings of accounting statements are their historical nature and the fact that they do not incorporate risk. Stock prices are forward-looking because they include the present value of future expected dividends. Investors’ required return, r, is dependent on the riskiness of the firm’s future cash flows. Therefore, when today’s price changes, it is responding to changes in expected return requirements (which can be caused by a perceived change in risk) and to changes in expected dividends. Using stock returns has a shortcoming as well. We may observe a decline in share price, signaling poor performance, but it is impossible to know why the price declined without more information. Did price decline because the overall market declined? If so, this is outside the firm’s ability to control. Or was the decline a signal of lower expected dividends and/or higher risk? You can see, at this point, that in financial analysis, no single source of information will provide you with all the pieces to the puzzle, yet each makes a contribution toward understanding the larger picture. Market Share The financial balance sheet model of the corporation identifies two markets critical to the success of a business. Financial markets are the source of the external capital the corporation needs in order to fund its investment projects. Stock returns measure the success of the firm in financial markets. Product and service markets are the arenas in which the firm’s products compete, and these markets provide the cash that flows back to claimants. Ultimately, the risks and returns to which claimants are exposed are determined by the success or failure of the firm’s output in the product market. One method of gauging this success is through the calculation of a product’s market share. Here the demand for the product is reflected, and product pricing strategies, product differentiation, quality, reliability, service, delivery, brand-name recognition, and other attributes are collectively judged by consumers in comparison to competing products of other firms. Market share is calculated by dividing the firm’s product sales by the total sales of products perceived to be similar and competing for the same consumer spending. A declining market share indicates that competitors are taking business away from the firm. Lower profits may result if sales decline, if prices are lowered in order to recapture market share, or if marketing expenses increase to promote greater demand. Hand in hand with market share information is the size of the market. If, over time, total industry sales within a market are flat or trending downward, the company must implement a strategy that addresses the problem. Similarly, a growing market calls for a plan to meet potentially high growth. Firms in shrinking markets are challenged to gain a greater share in a smaller market. Such firms may attempt to develop new products that capitalize on company strengths to replace current products that may be headed toward obsolescence. A good example is horse-drawn carriage manufacturers at the turn of the century; when seeing demand for carriages decline, management turned to automobile body manufacturing. IBM, once the most well known of all computer manufacturers, switched strategic direction from manufacturing computer hardware to information services because they saw computers becoming a commodity-like product with wafer-thin product margins. Market size and share information are available from several sources. Government and industry publications are widely available, as well as information services such as Compustat and Standard & Poor’s. The potential size of a market, for example, may be determined using the Census of Manufacturers, published by the U.S. Department of Commerce, or a private source such as the “Survey of Buying Power,” published in Sales and Marketing Management. Opinions of Other Analysts Many large firms are closely followed by securities analysts. In fact, an industry exists whose product is the publication of analysts’ opinions and forecasts of firm performance. The best known of these are Moody’s, Standard & Poor’s, Fitch, Morningstar, and Value Line. Almost any library carries one or more of these companies’ publications. Another source is brokerage firms, which often make their analysts’ reports available to investors. Moody’s, Fitch, and Standard & Poor’s are best known as bond-rating agencies. Ratings are based on the agency’s opinion of the likelihood that a bond will default, and on the protection afforded the claimant by the bond contract in the event that default does occur. Table 1.3 shows the major rating categories used by Moody’s and Standard & Poor’s, along with their meanings. Naturally, the higher the rating, the lower investors’ required return on the bonds will be and the lower the cost of debt for the company. AAA or Aaa bonds, for example, will have lower yields to maturity than BB or Ba bonds. Table 1.3 Bond Ratings Very High Quality High Quality Speculative Very Poor Standard & Poor's AAA AA A BBB BB B CCC D Moody's Aaa Aa A Baa Ba B Caa C Value Line Investment Survey analyzes about 1,700 stocks. Equities are rated for future price appreciation potential (timeliness) and relative riskiness (safety), and Value Line provides explicit estimates of future dividends, dividend growth, sales, and earnings, among other forecasts. Stocks are categorized by industry, and the publication includes some discussion of each firm’s prospects and challenges, as well as a brief industry analysis. Value Line Investment Survey also provides historical data and calculates several ratios. This publication can be found in many libraries, and you can subscribe to Value Line’s publications online, as you can for Morningstar, which provides some of the same types of information as Value Line but is also well known for its analysis of mutual funds. We must keep in mind that if markets are efficient, the information included in reports such as Moody’s or Value Line’s is already included in the market price of the firm’s bonds and stock. Additionally, these ratings and opinions represent those of only one or a small handful of analysts. However, when we analyze the financial performance of a firm, these sources can provide useful data about the company in question and the industry of interest. Moreover, opinions of other analysts serve as a benchmark with which our own conclusions may be compared. To be sure, management of companies whose securities are followed by Moody’s, Standard & Poor’s, or Value Line pay attention to the widely read opinions of their companies. In addition to these major sources of information, other rating agencies specialize in particular industries. For example, A. M. Best ranks the financial safety of insurance companies. Major brokerage houses produce company and industry reports that include analysts’ forecasts and recommendations. Comparative Data Suppose your employer’s sales increased 10% last year. Is this unexpectedly high or disappointing? To answer that question you must compare the result to (1) historical results, (2) your competitors’ results, and (3) your firm’s targeted sales. Historical results are readily available in prior years’ annual reports. In fact, annual reports include data from several years for just this purpose. If, in the last five years, sales had increased by a minimum of 15% per year, then a 10% increase for this year might be disappointing. On the other hand, if 10% were the largest increase in a decade, it might indicate outstanding performance. The historical record provides the analyst with valuable clues to answer this type of question. Look for comparable firms that are competitors in the same product market. Ideally, comparables would be about the same size and have the same product mix as the firm you are analyzing. If comparable firms had increases that averaged 20%, your firm’s 10% increase may look rather dismal. Of course, if comparables showed no sales growth, then your firm might look like a superstar. You may have difficulty locating comparables. Diversified firms may not fit neatly into an industry classification. You may think, for example, that Coca-Cola and PepsiCo are natural comparables, but if you investigate, you will find that PepsiCo owns Frito-Lay and other snack food companies. Surprisingly, it is snack foods that generate most of PepsiCo’s sales and profits. Thus, Coca-Cola and PepsiCo are not as comparable after all. For firms that do fit into an industry classification, there are publications that produce industry average ratios for comparison purposes. Among the most widely available industry averages are those published by Dun & Bradstreet, Robert Morris Associates, and the annual surveys appearing in Forbes and Business Week. Value Line, as previously mentioned, classifies firms by industry and can be another useful source for data on comparables. The Media When you analyze quantitative data like ratios and growth rates, you may be tempted to evaluate performance using numbers alone. This level of analysis does not involve an understanding of the cause of performance. For instance, concluding that share price declined because earnings were lower is not very useful. If we take the quantitative analysis a step further and discover that earnings were lower because sales were down, then we have added to our knowledge but have not really reached the level of understanding that is useful for decision making. What a manager or a claimant needs to know is why sales were down. Did the company lose market share because a competitor introduced a superior product? Did competitors lower their