Questions related to financial statement analysis

1. The average stock return for Corporation A was 12% during the three-year period from 2011 to 2013. Here the corporation saw mixed results as the stock price increased 16% in 2011 as compared to just 8.2% in 2012. Here, the stock price may not be a reflection of actual corporate performance during this period. From 2011 to 2012 the company recognized a near doubling of its net income during the period. In addition the company was able to keep expenses associate with interest and salaries down during the period. The lower stock price appreciation may indicate that the market was already anticipating a large increase in Net Income, or the company may have fallen out of favor with investors.

2. The standardbred deviation between each period is roughly 4% with is around 30% of the average return for the stock. This is fair considering the short time horizon being examined. As only three years are being analyzed, it is quite possible that market turbulence may have influenced stock performance irrespective of the overall business performance. This can occur as macro-economic factors heavily overwhelm the decisions making processes of the investing public. Instead of reviewing the underlying business fundamentals, investors during this three-year period may have been overweight on macroeconomic factors. This could have adversely impacted the stock price contributing to much higher standard deviation. If the standard deviation occurred over a longer time horizon of 10 to 20 years, the overall magnitude would have been much lower.

3. The Coefficient of variance is calculated as the population standard deviation divided by the population mean

4. To begin, the figures in the example are not indicative of economic reality. The ten-year treasury for example just crossed 2% after nearly a decade of 1.5 to 1.8% yields. This is extraordinary considering that investors are willing to lend money out for a decade at a rate less than the overall fed mandate for inflation. Here, the fed mandated inflation criteria, which is publicly available is 2%. However investors around the world are lending money to governments for less that the inflation. On real basis, investors are essentially guaranteed to lose money over their investing time horizon. The recent federal reserve minutes have noted a much faster pace of increases, but impacts on the CAPM are still unknown.

When revieing the CAPM equation, most of the variable are known. The risk free, according to the case is 8%, which would be a dream in today’s environment. The beta is 1.5 indicating an above average “risk” as compared to the market. In reality Beta has nothing to do with risk, but instead measures volatility, which are two very distinct elements in investing. On many occasions professors, academicians and institution investors often loss sight of this fact. Beta, although sophisticated is not very useful in measuring the risk of an investment, in my opinion. The real risk of an investment is the propensity for permanent capital loss. This notion is very opaque and therefore doesn’t lend itself to typical corporate finance. Instead, professors result to Beta, which does nothing to measure the overall “risk” for investors.

With that being said, for the purposes of CAPM, the equity risk premium will be defined as the overall equity return of an index above the overall risk-free rate. In this case, the risk-free rate is defined as 8%. The overall market return over this 3-year period is around 15%. As such the equity risk premium will be calculated as roughly 5%. Using these values to populate the CAPM formula of:

Rf + Beta (Equity Risk Premium)

We arrive at a figure of roughly 15.5%. I use the term roughly and approximately as finance is more art than science. As noted in our discussion related to Beta, the entire profession tends to attribute the work of “educated guesses” as “ science.” This is an affront to many of the more useful disciplines such as psychics or chemistry, which unlike the finance industry, have added much more value than they have extracted in the form of salaries and commissions. This topic is beyond the scope of this report, but I believe it is worth mentioning in regards to the Capital Asset Pricing Model.

Earnings per share 

$6.71 

Dividend Payout Percentage

18%

Dividends

$1.21

5. The dollar amount of dividend declared in 2013 was $1.21. Here, the earning per share of the business was $6.71 in 2013. Likewise the dividend payout ration in 2013 was 18%. Thus the overall dollar amount of dividends per share as $1.21.

6. The dividend discount model, unlike CAPM is very useful for investors in the real world. Thanks in part to John Burr Williams and his classic text, “The Theory of Investment Value,” investors now have a concreate foundation in which to value businesses. However, this technique, just like CAPM is not without it weaknesses. First the positives. The idea of the Gordon Growth Model is based on the fundamental premise that any asset is worth the discounted cash flows the investor can expect to receive form now until judgment day. This is a very sound and rationale method to value a business, a stock, an apartment house, or any productive asset. Unfortunately this method is not without it drawbacks. For one, a large amount of the value within the model occurs in the cash flow far out into the future. This ultimately makes the formula somewhat flimsy as it relies on predictions far into the future which are inherently unknown. Likewise, the model is too simplistic as it often assumes a constant dividend growth rate and a constant discount rate. This is extremely unrealistic as businesses and industry change. In recent years there have been numerous adaptions to the Gordon Growth Formula which include the H model or the dividend discount model in separate stages. All else being equal, this is a great introductory point into business valuation. Using the figures presented in the case, the assumptions for the calculation are below

Assumptions

G(0) = $1.20 – This is the most recent fiscal year dividend. As the dividend payout ratio is so low, I anticipate the company maintaining its payouts long into the future

Growth Rate – 4% - This is a conservative figure. The company is growing rapidly which indicates there is substantial demand for Corporations A products. Likewise when reviewing the income statement and the balance sheet, the company earned roughly a 30% return on equity which is very substantial. As a result, the company would elect to not pay a dividend and instead reinvest earnings into the business to grow it at a 30% compounded rate. Due to the high growth rate, substantial market opportunity, and small capital base, I anticipate the business having a very low payout ratio into the near future.

Discount Rate – This was already discussed above but the discount rate will be around 15%

Dividend Growth Model Value:

Dividend

$1.20

Growth Rate (G)

4%

Discount Rate (R)

15%

Dividend Year 1 (G1)

$1.25

Return minus Growth (R - g)

11%

Stock Value

$11.35

7. Here the investors have a much more optimistic view of the business. They are anticipating much higher growth rates than I am. Here the case looks to use a growth rate of 13% as oppose to my growth rate of 4%. Here, it is very possible that I am too conservative given the meteoric rise in growth for the business. However this is the approach that I am taking to minimize, my personal definition of risk, which is permanent capital loss (Not Beta!). Analyst have been more than willing to attribute rosy growth projections and buy recommendations so long as the company can “manufacture” earnings. A simply review of the financial indicate the management has a very large amount of discretion on how they treat certain line items. They can lower reserves to increase earnings. They likewise can increase provisions for debt loses to lower or “smooth” earnings. As a result, I tend to take a more conservative view to account for the chicanery that management will do within the business. The primary difference here is attributable to the values we place on growth. Me, being more conservative on growth will come to lower value as compared to a more optimistic analyst. Only time will determine who was right.

8. The book value of the organization is determined by the accounting equation. Asset – Liability = Owners Equity. Simply put assets, which are supposed to be income producing can only be financed with shareholder money or “other peoples money.” This in term helps to create the book value of the organization as determine by the value of the assets minus the amount of money put into the organization. (This is not fully correct as Stock holders equity also includes derivative elements and a “catch-all line items” such as “Other Comprehensive Income.” This line items are often subject market turbulence and are not reflective of actual business performance in my opinion). Here book value per share is more aligned with my assessments of value

Total Stockholders’ Equity (SE) 

1,310,159 

Shares Outstanding

100,000

Book Value Per Share

$13.10

9. The company purchased treasury stock as it believes the stock in undervalued. Here, management believes that they are receiving more value in purchasing the shares than they could other obtain through their investment opportunities. This leads me to believe that the market opportunities for the business are limited. If they were not, the company would not invest any money into repurchasing shares and instead use that capital to earn a 30% return by redeploying it into the business. As such, it appears that management, as stewards of investor capital, are allocating it to the highest and best