Archive for September, 2007

Economic Value Added (EVA)

Economic value added, or EVA(R) is a proprietary residual income model developed by Stern Stewart & Company. Like other residual income models, it charges a capital cost to accounting income measures. However, there are several adjustments made to the accounting figures to have them conform more closely to economic cash flows. Some of the major adjustments include:

  • Capitalizing and amortizing research and development rather than expensing it immediately.
  • Deferring capital charges on strategic investments not expected to have an immediate accounting payoff.
  • Ignoring deferred taxes until paid.
  • Adjusting capital and earnings for LIFO inventory accounting.
  • Operating leases are treated as capital leases.
  • Adjustments are made to non-recurring items.

Similar adjustments can be made to generic residual income models, but the outcome of the model will differ based on which adjustments the investor chooses to make.

Posted on 30th September 2007
Under: Financial Statement Analysis, Investing in Stocks, Investment Returns, Valuation | No Comments »

Bottom Up Investing

Bottom up investing describes investors who focus on company-specific fundamentals to build a portfolio rather than on macroeconomic indicators or themes. Bottom-up investors look at a company’s revenue, earnings, cash flow and product development to determine the best opportunities for investment. The focus is on the individual company’s prospects rather than an overall outlook for the stock market or economy.  Typically bottom-up investors will start by screening the investment universe for a desirable trait (such as a low P/E multiple) to identify candidates for further analysis. Finally, the best companies will be chosen from that list.

Many bottom-up investors will combine their research with a top-down approach. For example, they may focus on the best stocks in the sectors most likely to benefit from global trends or conform to certain sector weights to balance risks.

Posted on 24th September 2007
Under: Active Management, Fundamental Analysis, Investing in Stocks, Portfolio Management, Security Selection | No Comments »

Using Pension Disclosures to Understand the Underlying Economic Position

Subsequent to passage of SFAS 158, companies adhering to U.S. GAAP are required to show the net funded status of their pension plans directly on the balance sheet. If fund assets exceed the projected benefit obligation the company will list a net asset. Otherwise, the net amount will be reflected as a liability. Under International Accounting Standards, the net asset or liability might not be reflected on the balance sheet due to permissible smoothing mechanisms.

Although SFAS 158 moves toward full accountability for pensions, the treatment still differs from that of other assets and liabilities. For example, a company borrowing $1 million to buy equipment would record both the asset and the liability, not merely the net amount. Investors can use the pension disclosures to adjust the balance sheet such that it reflects the underlying economic position of the pension plan.

To do so, any net liability or asset would be removed and the plan assets would be added as a separate asset, while the projected benefit obligation would be added to liabilities. A further adjustment would be to treat the actual return on plan assets as a component of income, and the interest on the obligation as an expense.

Posted on 21st September 2007
Under: Accounting, Adjusting Reported Financial Statements, Financial Statement Analysis, Fundamental Analysis | No Comments »

The Weighted Average Cost of Capital (WACC)

When valuing a firm, the appropriate discount rate is the firm’s weighted average cost of capital – the return required by the firm’s “typical” investor.  Since debtholders typically have a greater claim on the firm’s assets they typically require less of a return. Equity holders have a residual claim and require a greater return on the funds they invest.

In addition, firms are typically able to deduct  interest payments from income for tax purposes, but are not generally permitted to deduct payments to equity holders.

The weighted average cost of capital (WACC) can be calculated as: [(percentage of financing that is debt)X(after tax interest rate)] + [(percentage of financing that is equity) X (required return on equity)]

For example, a firm with total capital of $1 million, of which $400,000 is debt paying a 6% coupon. The firm’s tax rate is 40% and its equity holders require a 10% return.

WACC = 0.4(0.06 * (1 – 0.40)) + 0.6(0.10) = 0.4(0.36) + 0.06 = 0.0744 = 7.44%.

Posted on 20th September 2007
Under: Valuation | No Comments »

The 3-Stage DuPont Model

Return on equity is one of the most significant financial ratios. Not only does it describe how well management is making use of the funds it has been entrusted with, but it also sets the limits of sustainable growth. Analysts at DuPont created a system to analyze the components of ROE to better understand how the return is being generated.

The basic formula for ROE is net income divided by shareholders equity. This, in turn, can be recast into two components – the return on assets and the impact of leverage.

(Net income/Shareholders equity) = (Net income)/(Total Assets) X (Total assets)/(Shareholders equity).

ROA can also be expressed as a function of profit margin and asset turnover: (Net income)/(Total assets) = (Net income)/Sales X Sales/(Total assets) and thus ROE = (Net income)/Sales X Sales/(Total assets) X (Total assets)/(Shareholders equity).

Posted on 19th September 2007
Under: Common Size Analysis, Financial Statement Analysis, Fundamental Analysis, Ratio Analysis | No Comments »

Accounting for Foreign Currency Transactions

When companies using different currencies transact business, at least one of the companies will have to translate a foreign currency into its home currency. For sales made in cash, this can be done at the time of sale.

When the sale is made on credit, the company will have to record an account receivable or account payable until the account is settled. During the interim, the relative values of the currencies could change. The accounting treatment for such changes is governed by International Accounting Standard (IAS) 21 and U.S. Financial Accounting Standard (FAS) 52. The treatment is the same under either method.

  • At the time of sale, the sale is recorded at the current exchange rate and an equivalent value asset or liability is created.
  • If balance sheets are prepared prior to collection, the asset or liability must be restated to the then-current exchange rate value. The change is recognized as an unrealized exchange rate gain/loss on the income statement.
  • When the account is collected, the asset or liability is removed and any previously unrecognized gain/loss is recognized on the income statement.

Since the asset and liability are always presented at fair value and changes flow through the income statement, there is seldom need to adjust the financial statements to examine the effect.

Posted on 19th September 2007
Under: Accounting, Adjusting Reported Financial Statements, Financial Statement Analysis, Fundamental Analysis, Ratio Analysis | No Comments »

Balance Sheet Recognition of Pension Liabilities Under U.S. GAAP

SFAS 158, adopted in September 2006, requires companies to include on the balance sheet the full net value of pension assets and obligations, measured as the difference between the fund assets and the projected benefit obligation. The company does not have to show the full value of assets and the full value of liabilities – just the net of the two. If the fund assets are higher than the pension obligation it will show as an asset, and if not it will be a liability.

Prior to adopting SFAS 158, U.S. rules were similar to those still in effect for International Accounting Standards. Certain gains and losses due to changes in the plan or market returns were smoothed over several years rather than recognized at once. As a result, the balance sheet would generally not reflect the full net asset or liability. In some cases, such as after the Internet bubble burst, many plans were being shown on balance sheets as having net assets (due to past market returns being smoothed in) when the actual funded status was a net liability.

Posted on 18th September 2007
Under: Accounting, Financial Statement Analysis, Fundamental Analysis | No Comments »

Accounting for Inventory After Purchase and Before Resale

U.S. GAAP requires that inventory values on the balance sheet be stated at the lower of cost or market value. If inventory declines in value while being held it must be written down to the “current replacement cost,” which can be between the actual realizable value and the realizable value less discounted by a normal profit margin. This value then represents a new cost basis, from which the inventory could still decline but cannot increase in value.

Under International Accounting Standards, the values are to be the lower of cost or “net realizable value,” which is similar in definition to the current replacement cost adjusted for selling costs. A key difference, however, is that this does not represent a new cost basis. Should the inventory subsequently increase in value, the writedown can be reversed up to the original cost basis.

Under both accounting standards, the inventory values for certain commodities are stated at market value even when this is above the original cost basis.

Posted on 16th September 2007
Under: Accounting | No Comments »

Determining Inventory Cost

U.S. GAAP (ARB 43, SFAS 151) and International Accounting Standards (IAS 2) outline similar procedures for allocating costs to inventory.

Included costs:

  • Cost of purchase
  • Cost of conversion
  • Other costs related to bringing the inventories to the present location and condition
  • A portion of fixed production overhead, based on normal capacity levels

Excluded costs:

  • Abnormal waste-related costs
  • Labor and variable overhead costs
  • Post-production storage costs
  • Administrative and selling costs

The costs that are included in inventory are capitalized as balance sheet inventory until sold, thus matching the related expenses to the revenue generated. Any excluded costs are expensed as incurred.

Posted on 14th September 2007
Under: Accounting | No Comments »

A Two Stage Dividend Discount Model With Constant First-Stage Growth

Some investors will assume that dividends will grow at one constant rate (for example, the consensus growth rate) during the first stage and then grow at a lower rate (for example, the sustainable growth rate or the average growth rate of the S&P 500) afterward.

Consider Rockwell Automation (ROK). According to Yahoo! Finance it pays a $1.16 annual dividend and is expected to grow 14% annually for the next five years. If an investor with a required return of 10% expects the growth rate in the long-term to be more like the S&P average of 7%, she could use a two-stage model terminating with a Gordon growth model to estimate Rockwell’s value.

2-stage Dividend Discount Model for Rockwell Automation

The present value of $45.11 is well below Rockwell’s current $70 share price. This could indicate one of several things:

  • Rockwell is overvalued
  • The 14% growth estimate is too low
  • The 7% terminal growth estimate is too low
  • The 10% required return is too high
  • The terminal dividend estimate is too low
  • The market expects the high growth stage to last longer than five years

This particular model would be expected to produce a conservative valuation, as Rockwell’s earnings have grown much faster than 14% for the last five years and are expected to grow 18% next year. These suggest the 14% rate may be too low. Furthermore, the 12% payout ratio would likely increase once the maturity stage is reached, so the terminal dividend estimate is also probably too low. However, by running this simple first past valuation, the investor can pinpoint the areas where her forecast may differ from the consensus view and further analyze those areas.

Posted on 13th September 2007
Under: Investing in Stocks, Valuation | No Comments »