Valuation Tutor

Visualizing Financial Statements: Column or Pie Charts?

noreply@blogger.com (Financial Trading System) — Tue, 07 Feb 2012 15:32:00 +0000

As you know, Valuation Tutor provides different ways to visualize financial statement related information. Some of these are pie charts, some column charts. The other day, I was asked if a pie chart could also be rendered as a column chart since the user found column charts to be more intuitive. This got me thinking that perhaps I should explain how the different types of charts are intended to be used. Consider the following two charts, both displaying the same data:

In each, have selected six items to plot from the November 2011 10-Q balance sheet of www.1800flowers.com. These items make up current assets (so current assets is the sum of these items).

The column chart shows how these variables have moved over the two reporting periods in the filing. So inventories are up, receivables are up, cash is down. Comparison across time, as in the chart, is sometime called “horizontal analysis.”

The pie chart shows you how the relative proportions have changed in a much more intuitive way. In this particular case, since the items sum up to current assets, you can see that inventories are a much bigger part of current assets in October than in July, as are receivables. Cash is a much smaller proportion, the remaining terms are about the same.

So I hope this makes clear the different type of information revealed by each type of chart. The first shows the time trend in an easy way, and the second makes relative changes quite transparent. Over time, I will provide more examples of how combining the visualizations give you detailed, and immediate, insight into a company, just as in this case. If you were making an inference about this companies balance sheet, you might be concerned about the change in the composition of current assets as reported in the 10-Q.

Accessing and Viewing Financial Reports

noreply@blogger.com (Financial Trading System) — Wed, 01 Feb 2012 20:52:00 +0000

In the advanced version of Valuation Tutor, we have added quite a bit of capability to directly view and plot variables in a companies financial report. For example, consider the following:

I am viewing the income statement in IBM’s 2011 10-K. I can select what fields to plot. Here, I am plotting total revenue, total expenses, net income before taxes, and net income. The raw data is plotted, in this case for the three years reported in the statement. The list of filings we cover is in the dropdown net to “Select Stock.” You can search by ticker or by company name. Our filing database includes interactive filings of major US companies, and you can look at 10-K’s, 10-Q’s, as well as 20-F’s.

These charts provide a quick way to visually look at a company over time. For example, from IBM’s balance sheet, I can look at total assets and total liabilities over the two years reported, and stockholders equity:

You may have noticed the “Data Collector” tab above the chart. This lets you collect

the numerical data and then copy paste it for further analysis, and also has a unique charting capability. To collect data, simply double click on a row, and that row will be transferred to the Data Collector. Here, I have collected data on components of IBM’s revenue for the three years:

Now, check Pie Chart at the top above the data to get:

This tells you at a glance that the three components that make up IBM’s revenue have stayed very stable over the three years, that majority of the revenue comes from services, and financing is a relatively small contributor.

Valuation Tutor Features

noreply@blogger.com (Financial Trading System) — Fri, 27 Jan 2012 03:51:00 +0000

VALUATION TUTOR FEATURES	BASE VERSION	ADVANCED VERSION
Versions	Mac, Windows	Windows
Access to Full Dataset	✓	✓
Access to Online Text	✓	✓
Access to SEC Filings	✓	✓
Common Size Analysis	✓	✓
Cost-Volume Profit Analysis	✓	✓
Business Ratios	✓	✓
Price Ratios	✓	✓
Economic Income and Value Creation	✓	✓
Dividend Discount Model	✓	✓
Free Cash Flow to Equity Model	✓	✓
Residual Income Model	✓	✓
Abnormal Earnings Growth Model	✓	✓
Basic Visualizations	✓	✓
Basic Comparisons	✓	✓
Basic Decile Analysis	✓	✓
Advanced Visualizations		✓
Advanced Decile Analysis		✓
Sector and Industry Fundamentals		✓
Stock Selection Tools		✓
Fundamental Analysis of Portfolios		✓

Top Down: Industry and Sector Fundamentals

noreply@blogger.com (Financial Trading System) — Sat, 21 Jan 2012 15:51:00 +0000

My recent posts have described how you can compare and visualize fundamentals across companies. The advanced version of Valuation Tutor (Windows version only for now), lets you do the same across sectors and industries. In fact, it essentially creates sector and industry financial statements, and then lets you apply all the comparison and visualization power that you have with stocks. You can also compare a subset of stocks to all sectors or all industries and so on.

As an example, after you download the current dataset, on the initial screen look at the top left, where I have checked Industries:

Now, instead of stocks in the dropdown, you can select which industry to analyze. The basic charts now have different initial settings, but you can do all the usual comparisons for any of the topics covered by Valuation Tutor. The numerical values are shown in the middle for the selected industry.

The advanced comparisons work in the same way as with stocks. Let me show you something interesting that I have not described before: you can look at relationships between two fields. For example, consider a top line item like sales and a bottom line item like net income. You could ask: across industries, what is the relationship between net income and sales across industries? The relationships tab in the advanced comparison window shows this to you, for example:

The red line is the regression line. For the current dataset, you can see that the relationship is not a simple one. You can plot any two fields against each other. Note that these relationship can be studies between individual stocks as well.

The advanced visualization works in the same way as stocks. For example, here I am looking at the Aircraft industry against another industry:

The aircraft industry is in purple, the other in green. You can see that purple has more than three times the sales of green, but relatively much greater cost of goods sold. You have to be careful how interpret the charts: each chart shows you the relative proportions of one field only. So the fact that sales are more than three times bigger which COGS is almost thirty times bigger does not mean that the gross margin will be smaller. The numbers behind the charts reveal that purple sales (normalized by assets) are 88, while green sales (normalized by assets) are 17, a ratio of of just over 5. So the green slice in the Sales chart is about one fifth of the pie. Purple COGS are 28 times higher than green COGS (70.5 and 2.5 respectively). So the green slice is 1/28 of the pie. From these numbers, gross margins are 88-70.5=17.5 and 17-2.5=14.5, and so in the gross margin chart, the purple piece is slightly bigger. The last chart shows you that bottom line, purple’s net income is three times that of green’s.

Financial Statement Analysis: Advanced Visualization

noreply@blogger.com (Financial Trading System) — Sun, 08 Jan 2012 01:38:00 +0000

The following video explains some of the advanced visualization capabilities of Valuation Tutor. Below the video is a written example.

Here is the written example. In an earlier post, I described the basic charts produced by Valuation Tutor. For any model (e.g. common size analysis or DuPont Ratios or price ratios) covered by Valuation Tutor, the base visuals let you compare a field calculated by the model (e.g. sales/assets, ROE, P/E ratio) to competitors, sectors, industries, in fact to any subset of companies you want. These visuals look at a single field across multiple companies. The advanced visuals show you multiple fields across multiple companies, though here, you want to keep the number of companies small because the goal is to focus on detailed differences across a few companies. Let me show you how to use these to discover how two companies differ in converting a top line item (like Sales) into a bottom line item (like Net Income). I will compare two companies selected from our dataset. The first is Green and the second is Red. Consider this screenshot taken from Valuation Tutor’s Advanced Visualization window, where the model is Common Size Analysis: Unscaled Values, which means that we are looking at the raw financial statement information:

The first chart shows that Green has more than three times the sales revenue of Red. The Gross Margins are about the same (Red is 87% of Green), so this already tells you that Green must have a proportionately higher higher cost of goods sold. You can see that Red does a much better job of converting the top line (Sales) into the bottom line (Net Income): Green has three times the sales but about 2/3rd the net income. I would have my students go find out what is causing the difference; this has the side benefit of having them become familiar with the statements. Incidentally, the mouse-over tells you the values being plotted and also the numerical proportions.

Also, just as a comparison, you can see the same information in a column chart. I find that the relative differences jump out more easily in the pie charts shown above. Here is the column chart of the same data:

Valuation Tutor lets you choose the type of chart, so if you find the column chart more intuitive, you can use that.

Financial Statement Analysis: The Power of Visualization

noreply@blogger.com (Financial Trading System) — Wed, 14 Dec 2011 21:31:00 +0000

In my previous post, I described how Valuation Tutor let you compare companies along multiple dimensions. These include common size analysis, cost-volume profit analysis, the analysis of business efficiency ratios, as well as price ratios. Each of these contains further classifications. For example, in common size analysis, you can see what happens if you scale by assets, by sales, by invested capital, by the number of employees, etc. You can compare a company to its competitors, sector, industry, companies in major stock indexes, and to any subset of companies in our dataset.

The numerical presentation of the data, which can be copied into a spreadsheet, is important so that students to perform their own analysis. Valuation Tutor also lets you visualize the data, which lets you pick out items of interest. In fact, you can look at different dimensions and quickly discover the dimensions along which a company is outperforming or underperforming. Let me illustrate.

After you launch the software and download the current dataset, you can select a company. For this illustration, I picked Target. If you select Target as the stock to analyze, you see the following screen, explained below.

The top left are the set of dimensions. I am conducting a common size analysis, scaling by total assets. The table in the middle contains the calculations for Target; you can see there are multiple fields, e.g. Sales, Cost of Goods Sold, and so on. The first field (in this case Sales) is plotted for Target vs. its competitors, and also stocks in the same sector and in the same industry. The competitor chart has the sector and industry averages (the horizontal lines) so you can see the relative performance of these companies for this field (Sales divided by Total assets). If you put your mouse over the chart, you can see the corresponding numerical values; right clicking lets you bring up the SEC filing for the company and also gives you the matrix of numbers underlying the chart. You can also copy the chart.

Sales/Assets is only one field. If you want to look at how Target compares on, say, Net Income scaled by Total assets, simply click on Net Income in the table in the middle to get:

These are comparisons of individual fields. You can also look at all fields at once in an interesting way by selecting a different chart. The following is a magnification of the chart that gives information for all the fields in the table:

Each bar shows the proportion of companies (in the same sector) that have a lower value than Target for that field. Note that for some fields, a higher number may not be good, though this can be subject to interpretation.

In future posts, I’ll illustrate other visualizations. For now, let me note some important pedagogical considerations. First, the visualization lets you discover things quickly. An instructor can use this to find interesting stocks to discuss. A student can use this to find an interesting stock to study. Second, you can discover patterns. For example, if you find that your company ranks poorly (or very well) on some dimension, you can dig deeper into the financial statements to see why. Third, the process of experimentation, looking at different companies, looking at different calculations, builds a familiarity with the raw financial statements, calculations based on the reports, and a deeper understanding of how to use the information to come up with a conclusion or make a decision.

Financial Statement Analysis: The Power to Compare

noreply@blogger.com (Financial Trading System) — Tue, 22 Nov 2011 03:26:00 +0000

In a business school curriculum, whether at the undergraduate or graduate level, the analysis of financial statements crops up in many different courses. These include courses dedicated to financial statement analysis but also others, such as corporate finance and investments as well as accounting courses. In these courses, it is important for students to understand what information is available about a company and how to draw conclusions about a companies performance from its financial reports. But ultimately, understanding performance cannot be done for a company in isolation. Students need to be able to compare a company to others, including its competitors, those in its industry, and even to the market as a whole.

Without making comparisons, it is hard to get a feel for what the raw numbers mean. For some types of performance variables, like returns, benchmarking is almost automatic: it is usual to compare returns to a market benchmark like the S&P500, or to historical performance.

One complexity with comparing companies on the basis of financial statement many different numbers that can be calculated. For example, you could do a common size analysis or a cost-volume-profit analysis or you could drill down into the drivers of ROE and ROA. For a student to perform these comparisons, they would need to extract a large amount of data from the statements. For example, if you want to compare the DuPont decomposition of a company to stocks in the S&P 500, you would have to collect data for a large number of companies, import it into Excel, make the calculations, and so on.

Valuation Tutor simplifies this task. The software and textbook show you how to extract data from the statements and analyze a company. But it also comes with a dataset, currently of 1500 companies but to be extended by the end of this year to the companies in the Russell 3000 index (representing over 98% of the US equity market). The dataset give you the power to compare. You can compare a company to those in the same sector, same industry, the same SIC code, to broad market indexes, and in fact to any subset of securities you choose. The software also performs decile analysis so you can see how the company ranks relative to those in your comparison set.

Together with the dataset, we have developed a series of projects that show students how to use the comparisons to make informed judgments about performance. The project are in the online text at http://www.valuationtutor.com/ (click on the textbook contents on the left and you will see the link to the case studies and projects). The screen below shows you the capability. You choose a stock to analyze, select what you want to compare in the tree at the left (we have selected Break-Even Analysis in the example), select whom you want to compare it to, and click the Compare button:

The results will be shown in a new window, and if you click the “Calculate Deciles” button you will see the cutoff for each decile for each column and the decile the company falls into:

Understanding the Business: Financial Statement Analysis, DuPont and SWOT Using Valuation Tutor

noreply@blogger.com (Financial Trading System) — Tue, 27 Sep 2011 20:37:00 +0000

By:

Dr. John O'Brien

Dr. Sanjay Srivastava

In a previous blog we discussed the importance of exploiting processing capacity available today to become acquainted with a stock’s business model and strategy. This reveals how a stock plans to create shareholder value starting with the top line sales revenue. Revenue results from managing the external Opportunities and Threats identified from a SWOT analysis, and bottom line earnings from sales revenues result from managing the Strengths and Weaknesses internal to the organization.

Financial Statement Analysis is a major tool used to identify and manage these Strengths and Weaknesses. It starts by consider the results from the three major firm decisions: Investment, Financing and Dividend as described from the following figure:

Source: Chapter.3 Valuation Tutor.

The top line, Fundamental growth per share (ROE * RR), reflects the results from three major business decisions: Return on Equity (ROE) result from the Investment and Financing decisions and the Retention Ratio (RR)/per Share results from the Dividend decision.

ROE further decomposes via the DuPont analysis into three major components, Profit Margin, Asset Turnover and Financial Leverage. The firm’s profit margin results from how efficiently the firm is converting Sales into Operating Income. Asset Turnover results from sales revenue, working capital management and the firm’s degree of operating leverage. Financial Leverage results from how the firm finances these operations. Traditional DuPont highlights these relationships and is often further refined into a DuPont Burden Analysis, designed to sharpen the decomposition further in terms of it’s sensitivity to major business decisions.

Consider, conducting a burden analysis for IBM in comparison with HPQ:

The refinements sharpen the measures by first measuring profitability relative to operating income to separate out taxes and interest expense. Burden analysis is useless without a comparison and we know from a previous blog that HP is attempting to emulate IBM’s business strategy. That is, by shifting focus away from lower margin commoditized products towards providing higher margin services. By selecting both IBM and HPQ in the above “Select Subset of Stocks” and clicking on Calculate for All automatically performs the DuPont burden analysis on the subset of stocks selected.

Immediately, this reveals that IBM is outperforming HPQ in terms of both ROA and ROE, and the driver of ROA is a superior profitability margin. The only ratio looking better for HPQ is the Asset turnover ratio which we examine further next.

First, Working Capital Management reveals one immediate driver of the better Asset Turnover. The cash conversion cycle for HPQ is shorter than IBM’s 67 days:

Source Valuation Tutor Working Capital Analysis

Looking at the drivers of the Cash Conversion Cycle reveals that an important part of IBM’s current strategy in the current economy is to extend credit to it’s clients so that the days to collect receivables is 103 for IBM versus 62 for HPQ.

Second, we look at the Degree of Operating Leverage for IBM versus HPQ. This is a measure of how sensitive each company’s Operating Income is to Sales. The higher the more sensitive EBIT (Earnings Before Interest and Taxes) is to changes in Sales Revenue. In turn this will drive both operational risk as well as asset turnover numbers in a company. Both IBM and HPQ are similar along this dimension (DOL is just over 2.0 for both companies). However, the big difference arises from the Contribution Margin Ratio being much higher for IBM:

Source Valuation Tutor Activity Analysis.

Again this reinforces the success of IBM’s Business Strategy which is also immediately revealed in the relative importance of the different sales revenue components for IBM and HPQ (Source recent 10-K’s income statements screenshot from Valuation Tutor):

IBM has eliminated it’s lower margin products to focus on Services and Financing whereas HPQ is currently attempting to implement this type of shift.

Impact of Dividend Decision Differences

The other major difference between the two companies that indirectly results in the different asset turnover numbers is the dividend decisions. IBM is very aggressive with respect to paying dividends via Treasury stock purchases. That is, re-purchasing it’s own shares is an important part of IBM’s dividend decision. This enhances the per share values of ratios and in particular both Assets and Sales per share. The increased asset utilization for HPQ’s DuPont relative to IBM largely arises from relatively higher asset per share number for IBM compared to their Sales per share.

This strategy can be an important driver of building shareholder value so long as the share repurchases come from a stock’s Free Cash Flow to Equity. This is where IBM really shines relative to HPQ because IBM can afford to implement a more aggressive Treasury stock strategy than it’s competitor because it generates much larger amounts of Free Cash.

Source Valuation Tutor Price Ratios (Chapter 5)

As a final check for assessing what level of confidence we place on the reported financials from each company, we look at each stock’s Quality of Earnings. The usual measurements of this are relative to the Balance Sheet, Cash Flow and Income Statements. Here both IBM and HPQ appear to be very solid on this front. For the case of IBM this reveals:

Source Valuation Tutor (Chapter 5):

In particular, both IBM and HPQ have negative % Operating Accruals which is a good sign!

So overall, the financial statement analysis for IBM and HPQ reveals that the attraction of IBM’s
business strategy is it’s impact upon Operating Earnings. This in turn generates higher free cash
flows and allows for a more aggressive dividend decision. The bottom line is that IBM has been
much more successful for building shareholder value than HPQ especially during these difficult
economic times.

Understanding a Business; It’s Business Model and Business Strategy

noreply@blogger.com (Financial Trading System) — Wed, 14 Sep 2011 15:33:00 +0000

“The Scarce Resource is not Information; it is Processing Capacity to Attend to Information”

Herb Simon, 1973

In a previous blog, we highlighted how the SEC’s interactive disclosure standards have leveled the investment playing field between professionals and individuals. By sitting on top of the SEC’s interactive data, Valuation Tutor is designed to provide the required processing capacity for understanding a stock’s business model and business strategy.

Source: Chapter 1, Valuation Tutor

In figure 1 understanding the business starts with the business model. The business model is described in Item 1, The Business, in a standard 10-K. You can access Item 1 of a 10-K in Valuation Tutor by entering the stock ticker, selecting the desired form and then clicking on the hyperlink beside the 10-K. For IBM this brings up the following screen.

From the dropdown labeled “Select Statement” you can select the appropriate form for IBM. In IBM’s 10-K, Item 1 “The Business” provides a concise description of the business model immediately followed by a section titled “Strategy.” Similarly, for Wal-Mart:

IBM (2011 10-K): Item 1. Business:

International Business Machines Corporation (IBM or the company) was incorporated in the State of New York on June 16, 1911, as the Computing-Tabulating-Recording Co. (C-T-R), a consolidation of the Computing Scale Co. of America, the Tabulating Machine Co. and The International Time Recording Co. of New York. Since that time, IBM has focused on the intersection of business insight and technological invention, and its operations and aims have been international in nature. This was signaled over 80 years ago, in 1924, when C-T-R changed its name to International Business Machines Corporation. And it continues today: The company creates business value for clients and solves business problems through integrated solutions that leverage information technology and deep knowledge of business processes. IBM solutions typically create value by reducing a client's operational costs or by enabling new capabilities that generate revenue. These solutions draw from an industry leading portfolio of consulting, delivery and implementation services, enterprise software, systems and financing.

WMT (2011 10-K): Item 1: Business

ITEM 1.

BUSINESS

General

Wal-Mart Stores, Inc. (“Walmart,” the “company” or “we”) operates retail stores in various formats around the world and is committed to saving people money so they can live better. We earn the trust of our customers every day by providing a broad assortment of quality merchandise and services at every day low prices (“EDLP”) while fostering a culture that rewards and embraces mutual respect, integrity and diversity. EDLP is our pricing philosophy under which we price items at a low price every day so our customers trust that our prices will not change under frequent promotional activity. Our fiscal year ends on January 31 for our U.S., Canada and Puerto Rico operations. Our fiscal year ends on December 31 for all other operations. During the fiscal year ended January 31, 2010, we had net sales of $405.0 billion.

Now consider how you can translate the above business model descriptions into a useful practical representation that lets you understand the business?

Working with Item 1: Understanding the Business Model

A Business Model describes what a company does to create shareholder value. Our starting point for understanding the business model is to identify exactly how shareholder value is created. This requires that we start by identifying and decomposing the business model into a sequence of value adding activities. This decomposition is referred to as the Value Chain.

In Porter’s original formulation he stressed five primary activities: Inbound logistics, Operations, Outbound Logistics, Sales & Marketing. This original formulation is applicable to Wal-Mart along with some additions.

Step 1: For Wal-Mart Porter’s original representation nearly immediately applies.

For Wal-Mart, management emphasizes stable every-day low prices. This implies that Supply Chain Management (SCM) is critical for Wal-Mart to ensure price stability, starting with Procurement. This was a support activity in Porter’s original formulation but it is a value adding activity for Wal-Mart. The abundance of information also guarantees that this is a chain with information flowing around in virtual real time.

For the case of IBM, Procurement is not a primary activity. Instead Customer Relationship Management (CRM) is critical to ensure that IBM’s chain feeds back repeat business.

Figure 3: A Value Chain for IBM

Source Chapter 1, Valuation Tutor.

Breaking down the business model into a set of value adding activities, that may or may not, be completed by the firm is the first important step required for understanding a business. However, what really matters is the allocation processing capacity to attend to information. In other words, from a business strategy perspective the second important step is to understand the relative weightings:

Step 2: Understanding Business Strategy

Once an analyst has identified the company’s value chain it is feasible to identify the company’s business strategy by assessing which value adding activities the company is currently emphasizing when implementing their business model. Getting business strategy right can add large amounts of shareholder value and similarly getting it wrong will destroy large amounts of shareholder value. As a result, identifying and assessing a stock’s business strategy is of primary importance to an analyst. Again Valuation Tutor is designed to provide the processing capacity that will let you attend to this information.

Porter describes business strategy for a company relative to their competitors in these terms. In particular:

a business performs different activities,

a business performs similar activities in different ways,

or a business chooses not to perform certain activities.

In other words, the business strategy is described by comparing the weights placed on ones own value chain relative to the weights placed on competitors’ value chains.

For example, IBM emphasize the “enabling of new capabilities that generate revenue.” That is, Research and Development including new patents is an important component of IBM’s business model. IBM anticipate the relevance of this to investors’ in their Item 1 as follows which describes how IBM is performing both similar activities in different ways as well as different activities to their competitors in their approach to Research and Development:

“Research, Development and Intellectual Property

IBM's R&D operations differentiate the company from its competitors. IBM annually invests approximately $6 billion for R&D, focusing on high-growth, high-value opportunities. As a result of innovations in these and other areas, IBM was once again awarded more U.S. patents in 2009 than any other company, the 17th consecutive year IBM has been the patent leader. IBM's 4,914 patents in 2009 were the most U.S. patents ever awarded to one company in a single year. Consistent with the shift in the company's business mix, approximately 70 percent of these patents were for software and services. The company will continue to actively seek intellectual property protection for its innovations, while increasing emphasis on other initiatives designed to leverage its intellectual property leadership and promote innovation. “

Similarly, in their Strategy section IBM further describe how they have chosen to not to perform certain activities (Item 1, 10-K):

“The company has shifted its business mix, exiting commoditized segments while increasing its presence in higher-value areas such as services, software and integrated solutions. As part of this shift, the company has acquired over 100 companies this past decade, complementing and scaling its portfolio of products and offerings.”

In other words, IBM shifted away from highly commoditized (low margin) products (e.g., laptops and PC’s) to higher margin team projects. Observe that this strategy exploits IBM’s value chain especially it’s strong positive record for patents and development of cutting edge “know how.” As a result, this strategy has worked well for IBM and shareholders have been duly rewarded with additional shareholder value.

IBM Attracts Imitators of it’s Business Strategy

HP was anticipated to and now has moved towards imitating IBM’s business strategy. Earlier this year the following interview was published in the Financial Times (source FT.COM)

“IBM lays down challenge to rival

By Richard Waters in San Francisco

Published: March 13 2011 21:48

“IBM is years ahead of rival Hewlett-Packard in building the integrated software and services business needed in a modern IT company, according to one of the top lieutenants to Sam Palmisano, IBM chief executive.

Mike Daniels, head of IBM’s services division and a leading contender to succeed Mr Palmisano, threw down the challenge ahead of a key HP strategy session on Monday in which Léo Apotheker, HP’s new chief, is due to lay out his plans for the company. While Mr Apotheker has made it clear that he plans to boost HP’s presence in software, the IBM executive suggested that focusing on building individual divisions would not be enough to put HP level.

It’s not like we have a company that has a software strategy and then a services strategy or a hardware strategy,” Mr Daniels said.

By tying its software and services businesses more closely together, IBM has been able to boost its profit margins ahead of HP and is on track to maintain its lead with further expansion over the next five years, he added.

“’I think it would take a long time for anybody to accumulate the kind of capability that we have,” the IBM executive said.’”

The article went on to observe that Wall Street performance over the past year had IBM stock up by 27% and HP stock down by 20%. It also reported that IBM was working on further tightening their business strategy by spending $14bn on software acquisitions and another $2bn on hiring and training consultants to build business in analytics that are designed to help customers make better use of their data.

That is, the observation that the Nobel prize winning Herb Simon made nearly 40 years ago has become the center stage of business strategy for technology firms today:

“…. The scarce resource is not information; it is processing capacity to attend to information.”

In a future blog we will explore what the implications from understanding a business model and business strategy are for Financial Statement Analysis.

How SEC’s Easy Data Access Helps Investors’ Understand a Business

noreply@blogger.com (Financial Trading System) — Wed, 07 Sep 2011 15:45:00 +0000

“Never invest in a business that you cannot understand” -Warren Buffet

Historically, it was the financial professionals who had the easiest access to corporate data. Today this has all changed, thanks to the SEC. The SEC’s interactive disclosure standards have leveled the investment playing field and brought Buffet’s quote within the reach of every investor. A stated objective of the SEC is:

“As more companies embrace interactive data, sophisticated analysis tools now used by financial professionals could become available to the average investor.” -

Source: http://www.sec.gov/spotlight/xbrl/what-is-idata.shtml

What is really implied by this objective?

Consider the following Valuation Tutor application screen that sits on top of the SEC’s interactive data:

There are four major components to this screen. The top Right Hand Side (RHS) provides the conceptual framework and analytical tools, designed to operate and transform interactive data into information. The top Left Hand Side (LHS) is an online text that provides the concepts and operational steps required for working with the top RHS. The bottom LHS and RHS provide immediate access to the interactive data itself. Simply, enter the stock’s ticker and an amazing amount of data is suddenly available.

For example, consider Amazon.com (AMZN). By entering the stock ticker AMZN, Valuation Tutor immediately pulls in the following list of reports:

Suppose you want the latest 10-K which at the time of this blog was filed on the 28^th January 2011 as illustrated above. By selecting this report the following list is now available to an investor:

The above is only a partial list as you can see from the scroll bar there is a lot more that can be scrolled down to.

Suppose you select the Consolidated Statement of Operations for Amazon. This further provides access to the following:

Or similarly, you may be interested in comparing this with Amazon’s Cash Flow Statement. You can pull these up side-by-side:

By clicking on View Excel Document in either window provides immediate access to this data in Excel for further processing.

Finally, to understand what Amazon’s business model and business strategy actually is you can further give yourself immediate access to the 10-K report itself. This requires a couple of steps, click on the menu item View Filings and select either SEC Filing Viewer on Right or SEC Filing Viewer Popup as illustrated below:

The popup is useful if you have the luxury of two screens but even on a single screen it is very powerful. The Viewer appears as follows (I have entered AMZN as the ticker again):

In the above LHS the two tabs are Financial Report and Complete Filing. The financial report is as described before but the Complete Filing now provides immediate access to the 10-K report by scrolling down as follows:

To read the 10-K, click on the hyperlink under the Document:

Finally, on the RHS of the screen is the tab Data Collector. This can be used to design your own Excel Spreadsheet. Instead of dumping out all fields you can be selective across statements. Click on Financial Report in the LHS of the screen and bring up Amazon’s Consolidated Cash Flow Statement then click on Data Collector on the RHS and the screen appears as follows:

You can now decide what fields you want dumped into Excel by simply double clicking on a row in the LHS. You can work across statements as well so that you are mixing and matching from the Balance Sheet, Income Statement and Cash Flow or other statements. For an example, suppose I double click on Net Income, Net Cash used in Operating Activities, Investing Activities and Financing Activities then the following appears in the RHS:

Finally, click on Copy All and Paste into Excel to provide the following spreadsheet ready for use:

The original architects of the 1933/1934 Securities Acts could never have dreamed about the power they were unleashing with these acts. So this is our interpretation of what the SEC meant in their following quote:

“As more companies embrace interactive data, sophisticated analysis tools now used by financial professionals could become available to the average investor.”

-Source: http://www.sec.gov/spotlight/xbrl/what-is-idata.shtml

In subsequent blogs we will discuss how to transform this data into information.

How Can You Tell When Beta Provides a Useful Estimate of Your Stock’s Cost of Capital?

noreply@blogger.com (Financial Trading System) — Tue, 17 May 2011 04:20:00 +0000

CAPM is the centerpiece of all standard finance textbooks whether Investments or Corporate finance. It provides a standard first pass for assessing the cost of equity capital, by representing the firm with a single number beta. Beta measures how sensitive the stock’s returns are to the returns from the market as a whole, and technically rests upon the statistical measure referred to as covariance. The other major inputs into the CAPM estimate are the current yield to maturity from the long term Treasury bond and the equity premium for the market as a whole. As a result, it is beta that drives the difference among firms for the cost of equity capital under CAPM.

But how can you tell whether this simplistic representation of a firm provides a realistic estimate or not?

One way is to contrast this with a relative market based technique such as MCPM. This is an option based method that exploits two important inputs into the problem at a firm specific level: the yield to maturity on a company’s corporate debt and the volatility of the stock’s return. First, the yield to maturity from debt exploits relative valuation. A stock is riskier than it’s corporate bonds and thus the cost of equity capital should be higher than the cost of debt capital. Second, the volatility of a stock’s returns determines the cost of insuring a stock using a put option, to ensure the returns from a stock are at least as big as the returns from it’s bonds. Combined, MCPM exploits these two properties to establish a realistic estimate for the cost of equity capital.

Thus technically CAPM extracts information from the covariance of the stock’s returns whereas MCPM extracts information from the volatility of a stock’s returns as well as the company’s credit rating.

In this blog we will explore how these ideas currently apply to Ford (F) and Wal-Mart (WMT).

What is F and WMT’s Stock Beta?

Beta provides a measure of the sensitivity of stock returns to the general market returns. Thus, intuitively we would expect Ford (F) to be more sensitive to the general economy than Wal-Mart (WMT). As a result, Ford should have a higher stock beta than Wal-Mart. A quick check of some popular financial sites such as MSN Money and Yahoo provide strong support for this intuition.

Yahoo’s estimated beta (May 12, 2011) for Ford (F) equals 2.4 and for Wal-Mart (WMT) equals 0.36.

MSN’s estimated beta (May 12, 2011) for Ford (F) equals 2.38 and for Wal-Mart (WMT) equals 0.32.

Taking the mean provides F equals 2.39 and WMT equals 0.34.

You can also estimate your own beta and in the “how to” companion blog we show you how to conduct the entire analysis provided in this blog using the Valuation Tutor software combined with data available on the web.

What is the Volatility of Returns?

We can estimate the volatility of a stock’s returns in various ways including implied volatilities from option prices, as well as statistical estimates from past returns. Beta is typically measured from the last 5-years of monthly returns relative to a broad based index such as the S&P500 index. Thus for initial consistency we will first assess the volatility of returns from the current 60-months of monthly returns. We will then re-estimate volatilities using the forward looking estimate implied from current long term option prices.

Again, Yahoo Finance and MSN Money provide the relevant data for this analysis in the form of historical price data that an investor can download and compute the volatility of returns from.

Using the last 5-years of returns our estimate for Ford is 78.3% annualized but the current implied volatility from an at-the-money leap on Ford is 25% (again in a companion blog we will illustrate how to compute the implied volatilities using the Valuation Tutor software). A big difference but the latter estimate is current and more realistic for F today given the historic estimate covered the crisis period.

Conducting the same analysis for WMT results in 16.3% annualized from historical returns and 13.24% resulting from the implied volatility from long term options on WMT.

Question: What is the cost of equity capital for Ford and Wal-Mart when estimated from CAPM?

Intuitively we expect that Ford has a higher cost of equity capital than does Wal-Mart because Ford’s business model results in greater operational and financing risk than Wal-Mart. That is, automobile production is more capital intensive and sales are more sensitive to economic downturns and recovery than is food and general household goods. This difference was dramatically illustrated during the economic crisis. Both the above beta and volatility assessments support that Ford’s cost of equity capital is higher than Wal-Mart. But how much higher and at what level?

There are three inputs into CAPM --- beta, risk free rate and the equity premium e.g., see http://www.ftsmodules.com/public/texts/valuationtutor/VTchp5/topic9/topic9.htm

Input 1 Beta:

As developed above these inputs are: F = 2.39 and WMT = 0.34.

Input 2 Risk Free Rate

The current 30-year Treasury rate is available at: http://www.bondtutor.com/currentYC/currentYC.htm

This site provides the bootstrapped zero Treasury curve under various compounding conventions. We will use the annualized rate which equals 4.88%

Input 3 Equity Premium

Pablo Femandez provides a rich source of information about equity premium estimates for a large number of countries including the US. In his latest survey with Market Risk Premium Used in 56 Countries in 2011: A Survey with 6,014 Answers Pablo Fernandez, University of Navarra - IESE Business School, Javier Aguirreamalloa IESE Business School and Luis Corres Avendaño, IESE, April 25, 2011, they report that the median equity premium estimate for the US is 5.0% based upon a sample of 1503 respondents.

Combined, we can apply CAPM to estimate the cost of equity capital to be the following:

Ford = 0.1683 or 16.83%

Wal-Mart = 0.0658 or 6.58%

Question: How do we know whether this is realistic or not?

For example, if beta is zero then CAPM has the unrealistic implication that a company’s cost of equity capital equals the risk free rate. Corporate controllers would love this but would face a tough battle trying to convince investors in the marketplace! This has led to criticism of CAPM’s prediction for the cost of equity capital and alternative approaches suggested. In particular, a relative market based approach provides a realistic check and balance.

The relative market based approach is an option based approach referred to as the MCPM suggested by James J. McNulty, Tony D. Yeh, William S. Shulze, and Michael H. Lubatkin, Harvard Business Review, October 2002. This option based technique referred to as the Market Derived Pricing Model and it’s implementation is summarized in:

http://www.ftsmodules.com/public/texts/valuationtutor/VTchp5/topic14/topic14.htm

The advantage of this approach is that it assesses the cost of equity capital relative to corporate bond rates. Currently the 30-year AAA corporate rate is around 4.96% and BBB is 5.79% as reported by the Federal Reserve Bank. For the case of Ford, it’s corporate credit rating has been steadily improving since the financial crisis whereas Wal-Mart’s has remained the strongest credit rating among major US retailers (around “AA”). Ford’s corporate Fitch rating is around BB which is just below investment grade and this implies a corporate bond yield that is around 7.6% and for WMT around 5.24%.

Inputs for Applying the MCPM Estimate

There are five basic inputs required to apply MCPM.

· underlying asset price= current market price of the stock

· strike price = forward break-even price (a derived number)

· time to maturity = investment horizon

· volatility = stock’s annualized volatility

· bond yield = corporate debt rate for the time to maturity given the company’s credit rating

· dividend yield= dividend yield on the stock

Briefly the premium over the corporate debt rate is calculated from the cost of insuring the stock with a put option such that it provides at least the same yield to maturity as the corporate bond. This captures the simple idea that the cost of equity capital is bound from below by the cost of debt capital for a particular stock.

Additional Inputs required from MCPM for F and WMT:

YTM: F = 7.6%, WMT = 5.24%

Time to Maturity 30-years

Underlying stock price: F = $15.26, WMT = $55.72

Dividend Yield: F = 0, WMT = 2.4%

Volatility: F = 25%, WMT 13.24% (Historical Volatilities = 78.3% for F, 16.3% for WMT)

Forward B/E Point --- we compute this from the Valuation Tutor calculator

To compute the MCPM’s estimate for F and WMT we will apply the Valuation Tutor calculator as depicted below. This software automatically computes the forward break-even price and the cost of the embedded put option.

First, using historical volatilities:

That the two estimates are similar but the MCPM estimate is a little lower at 0.152 than is CAPM at 0.168. However, if we use current implied volatility estimates from the LEAPS (long term options) on Ford then implied volatility is substantially lower at 0.25. This reduces the MCPM cost of equity capital:

This estimate is significantly lower than the CAPM estimate of 0.168 which suggests that the historical beta is too high. We can compute an implied beta for Ford by equating CAPM to MCPM which implies 1.31 not 2.39.

Implied Beta: In the above we re-estimated beta for F using MCPM which provides a forward looking estimate for beta using implied volatilities from long term option prices. But next consider WMT:

Wal-Mart:

The following screen reveals that using historical volatilities for Wal-Mart the estimated MCPM cost of equity capital is 6.33% compared to CAPM’s estimate of

Further if we use the implied volatility our refined estimate for WMT is:

And our implied beta for WMT is approximately 0.25 even lower than the estimate provided from the historical data but recall the historical data period covered the economic crisis of 2008/2009.

Conclusion:

For Wal-Mart the estimates for cost of equity capital are pretty tight between CAPM and MCPM (6.58% versus 6.137%) and so this range is reasonable. However, for the case of Ford CAPM appears to provide an unrealistically high estimate of 16.83% versus the MCPM estimate of 11.43%. The latter would appear to be more reasonable for F today than 16.83%.

In a companion blog we will step through how to perform this analysis for your own stocks.

Some Current Positive Short Term Inflation Expectations Evidence (5/5/2011)?

noreply@blogger.com (Financial Trading System) — Sat, 07 May 2011 22:06:00 +0000

The US Treasury Yield curve exhibited some interesting behavior this week. In particular, the recent short term increasing inflationary trends reversed. This is good short term news for the economy if these trends can persist over the next few weeks.

By reverse engineering the Treasury Yield curve under the assumptions made by Irving Fisher, we can back out current inflation expectations by maturity on a daily basis. The FTS site: BOND TUTOR provides this information along with the underlying exponential moving average trends.

So what has the current week’s yield curve behavior revealed about inflation expectations?

To answer this we look at the trends for 5-, 7-, 10-, 20- and 30-years and in particular the short (5-years) versus long (30-years). Consider the 5-year first. The two key graphs below are the yellow (daily inflation expectations) and the red graph (exponential moving average). Holding the cursor over the small dot reveals the date and corresponding number. A sharp decline is evident from the yellow spot curve between the dates 5/4/2011 2.42 to 5/5/2011 2.29. This decline broke the exponential moving average (the red curve) from above reversing previous short term increasing trends.

Federal Reserve Bank expectations also influence shorter ends of the yield curve and so the additional
question is whether this behavior was just a trend in the 5-year inflationary expectations? We can answer this question by checking out the other time series:

By clicking on the sub menu items above reveals the behavior for 7-, 10- 20- and 30-years. The
interesting observation is that all maturities exhibited a sharp decline between these days with the 10-
year maturity being the largest.

Finally, an even better sign is provided if this is accompanied by a significant uptick in the real rates?

The FTS web site also provides this information on a daily basis as well at: BONDTUTOR

The trends here are mixed but encouraging. The dots corresponding to 5/4/2011 and 5/5/2011 reveal
an uptick for the 5- and 7-year series and a slowing decline for the remaining series.

The combined real rate and implied inflation rate trends are positive for the economy if they persist.

Inflation Fears and Stock Valuations: Is it All Bad?

noreply@blogger.com (Financial Trading System) — Thu, 17 Feb 2011 05:25:00 +0000

Inflation fears and financial market reactions have recently become a daily event. Headlines such as “Gold rises on inflation fears,” “China’s inflation accelerates …” and “UK Inflation soars 4% in January.” Headlines are designed to grab attention but they leave two legitimate underlying questions for stock market investors.
There may be inflation fears, but what is the trend for inflation expectations?
How do inflation expectations drive stock values?

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Don’t Blindly Follow the NPV Rule: The Business Model and Strategy Matters

noreply@blogger.com (Financial Trading System) — Thu, 17 Feb 2011 05:20:00 +0000

By:
Dr. John O'Brien and Dr. Sanjay Srivastava

Coca-Cola Company (NYSE: Ticker KO) reversed their 24-year old business strategy on February 25, 2010, by confirming its agreement to acquire the North American operations of its largest bottler in a deal valued around $13 billion. A day after the announcement the market slashed KO’s market capitalization by just over $6.8billion by trading down from around $54.39 to $51.46 per share. Almost 1-year later, February 9, 2011 KO announced strong 4th quarter results and net revenue growth that beat the analyst consensus. A major driver being structural changes related to Coca Cola Enterprises (Ticker: CCE). After this announcement KO opened at $64.01 resulting in many more billions of dollars being added since the original announcement.

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When the Book to Price Ratio Matters

noreply@blogger.com (Financial Trading System) — Thu, 17 Feb 2011 05:11:00 +0000

Constellation Energy Group, Inc. (NYSE:CEG) was significantly affected by the financial crisis in October 2008. It is a company whose business ratios are strong but their price ratios are not. This attracted the interest of Berkshire Hathaway plus it signals the presence of a source of risk not captured in traditional models such as CAPM but instead captured by the Book to Price ratio.

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Centralized versus Decentralized Business Strategy: Which is better for growth?

noreply@blogger.com (Financial Trading System) — Tue, 01 Feb 2011 14:56:00 +0000

McDonalds Corporation (MCD) is the world’s largest fast food chain. MCD’s business strategy is “centralized,” resulting in tight controls over both suppliers and franchisees. An immediate competitor to McDonalds is Yum Brands (YUM). Although the business model is similar to MCD, YUM’s business strategy is “decentralized” which carries along very different implications for growth as well as stock price behavior.

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How Business Strategy Drives Stock Price Behavior

noreply@blogger.com (Financial Trading System) — Fri, 28 Jan 2011 14:06:00 +0000

Over the past 5-years the stock price behavior of Wal-Mart (WMT) versus Target (TGT) has been a Tale of Two Stocks. WMT was relatively unaffected by general market movements whereas TGT was not. Both stocks have similar business models but different business strategies. That is, business strategy matters and financial statement analysis will let us understand why.

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