U U N IT

5
Valuation

Overview

One of the most crucial steps to becoming a portfolio manager is understanding and
interpreting financial statements. Portfolio managers are required to narrow down
thousands of investment options to a select few, conduct research and investment
decisions. Financial statements provide insight into the performance of companies,
this includes profitability, efficiency and risk. This will assist portfolio managers to
project the future performance of companies.

Essentially, this will enable portfolio managers to achieve the ultimate goal of building
investments that will provide the highest rate of return. This unit will first introduce
the major financial statements and discuss their usefulness, then examine commonly
used ratios to be used for analysis. In addition, students will also address the areas of
risk that can be examined using financial statements.

Unit 5 Learning Objectives

By the end of this Unit, students will be able to:

• Translate commonly used ratios for the purpose of examining the performance of
a firm.

This Unit is divided into three sessions as follows:

Session 5.1: Analysis of Financial Statements

Session 5.2: Analysis of Growth Potential

Session 5.3: Risk Analysis

© 2015 University of the West Indies Open Campus  61

 Readings and Resources

Required Reading
Faure, P. D. (2013). Equity Market: An Introduction. Valuation (pp. 129-147). Quoin
Institue Ltd. http://bookboon.com/en/equity-market-an-introduction-ebook

62  FINA2004 Portfolio Management – UNIT 5

 SSession 5.1

Analysis of Financial Statements

Introduction
Publicly listed companies publish financial statements quarterly in order to provide
information on what was accomplished with shareholders’ resources. There are four
basic financial statements: Balance Sheet, Income Statement, Cash Flow Statement and
Statement of Shareholders’ Equity.

Session Objectives
By the end of this session, you will be able to:

• Discuss the four basic financial statements commonly used in security analysis

• Explain the information needed from financial statements

Types of Financial Statements

Figure 5.1: Types of financial statements

63  FINA2004 Portfolio Management – UNIT 5

 Balance Sheet
The Balance Sheet provides a snapshot of a company’s resources. The balance sheet
shows how the firm’s equity and liabilities were used to finance its assets. It illustrates
the accounting ratio:

Assets = Liabilities + Capital

The assets reported on the balance sheet are either generated or purchased by the firm.

Income Statement
The income statement shows the flow of sales, expenses and revenue during a
specific period. It provides investors with the information to assess management’s
performance.

Cash Flow Statement

The statement of cash flow tells us all the sources of cash for the firm and how the firm
uses this cash for expenses, investment or paying dividends. The statement of cash
flow has three sections:

• Cash flow from operations: Lists the sources and uses of cash derived from the
normal operations of the firm.

• Cash flow from investing activities: Shows the increases and decreases in revenue
from the firm’s investments in noncurrent assets and fixed assets, and the equity
of other firms.

• Cash flow from financing activities: This section lists all cash inflows and outflows
from the purchase and sale of financial assets.

Statement of Shareholders’ Equity

The statement of shareholders’ equity shows the number of issued shares and
important information on the company’s reserves.

Financial statements should not be used in isolation for the purpose of analysing a
company’s earning potential. For us to thoroughly analyse the prospects of a company,
we must consider (among other things) the industry, the nature of the business
operations, the aggregate economy. For a complete overview of a company’s potential,
the firm’s relative performance over time (time-series analysis) must be compared to
performance within its industry.

The commonly used financial ratios fall under five major categories:

1. Common size statements:

a. All balance sheet items as a percentage of total assets

b. All income statement items expressed as a percentage of sales

64  FINA2004 Portfolio Management – UNIT 5

 This normalised the balance sheet, and can be used to quickly compare two firms.

2. Internal Liquidity ratios:

a. Current Ratio: Current Assets ÷ Current Liabilities

b. Quick Ratio: (Cash+Short Term Investments + Receivables) ÷ Current Liabilities

c. Cash Ratio: Cash and Marketable Securities ÷ Current Liabilities

d. Receivables Turnover: Net Annual Sales ÷ Average Receivables

e. Inventory Turnover = Cost of Goods Sold ÷ Average Inventory

f. Cash Conversion Cycle = Receivables Collection Days + Inventory Processing

Days - Payables Payment Period

g. where Payables Payment Period = 365 ÷ (Cost of Goods Sold ÷ Average Trade
Payable)

These ratios indicates the ability of the firm to meet future short-term obligations.

3. Operating Performance:

a. Operating Efficiency Ratios:

i. Total Asset Turnover: Net Sales ÷ Average Total Net Sales

ii. Net Fixed Asset Turnover: Net Sales ÷ Average Net Fixed Assets

iii. Equity Turnover: Net Sales ÷ Average Equity

b. Operating Profitability Ratios:

i. Gross Profit Margin: Gross Profit ÷ Net Sales

ii. Operating Profit Margin: Operating Profit ÷ Net Sales

iii. Net Profit Margin: Net Income ÷ Net Sales

iv. Return on Equity: Net Income ÷ Common Equity

These ratios measure how management uses its assets and capital, measured by dollars
of sales generated.

Readings and Resources

These videos walk through the application of these ratios to financial statements:
https://www.youtube.com/watch?v=Jkse-Wafe9U
https://www.youtube.com/watch?v=qaDFkAh3J4k

65  FINA2004 Portfolio Management – UNIT 5

 Readings and Resources

Required Reading
The following documents explain financial statement analysis in detail, Financial
Statement Analysis: http://people.stern.nyu.edu/adamodar/pdfiles/
invphiloh/finstatement.pdf

How to read Financial Statements: http://www.princeton.edu/jrc/conferences/

financial-markets/Merrill_Lynch_How_to_Read_A_Financial_Report.pdf

ACTIVITY 5.1
Visit the Jamaica Stock Exchange website (http://www.jamstockex.
com) and download the financials of a listed company of your choice.
Examine the financials for at least three years, and try to identify any
trends or changes.
Read the management reports of the company. Were you able to
identify any of the company’s activities from the financials?

Session Summary

This session illustrates the use of financial ratios to analyse financial statements.
This will help the portfolio manager identify trends in the company and evaluate its
performance.

66  FINA2004 Portfolio Management – UNIT 5

 SSession 5.2

Analysis of Growth Potential

Introduction
Apart from analyzing a firm’s financial statements, we also need to assess the growth
potential, which will contribute to the value of an equity investment. In order to
examine this, we apply ratios to indicate how fast the firm should grow. There are two
factors affecting a firm’s growth potential 1) the percentage of net earnings retained
2) the firm’s ROE, i.e. the level of reinvestment (retained earnings) and rate at which
the firm grows.

Session Objectives
By the end of this session, you will be able to:

• Examine the performance of a firm through financial statements

• Engage in financial statement analysis

Growth Calculation
To calculate the potential growth rate of a firm, we use the following equation:

g = RR x ROE

where, g is the potential growth rate

RR = retention rate of earnings

ROE = return on equity

The Retention Rate is calculated as follows:

Dividends declared

Net earnings
1-

Growth Potential ratios are explained in the following investopedia link Growth
Potential Ratios:
http://www.investopedia.com/exam-guide/cfa-level-1/financial-ratios/
growth-potential-ratios.asp

67  FINA2004 Portfolio Management – UNIT 5

 ACTIVITY 5.2
Based on the key indicators tabulated in the table below and the
readings and resources provided for this unit, analyse Firm A and Firm
B thoroughly. Which firm in your opinion is more attractive, and why?

Firm A Firm B
P/E ratio 3 3
EPS growth rate +10 -20
Debt-to-equity ratio 0.30 0.70
Sales ($ million) 100 100
Cash on balance sheet ($ 20 2
million)

Session Summary

Calculating the growth potential of a company is a strong determinat of the value of

an investment in the firm, and the overall value of adding this investment to one’s
portfolio.

68  FINA2004 Portfolio Management – UNIT 5

 SSession 5.3

Risk Analysis

Introduction
Risk assessment makes up an important part of analyzing a company’s financials. This
assessment will determine the stability of the company’s income flows. There are two
components of a firm’s risk, business risk and financial risk. There are quantitative
measures for each type of risk. However, it is more important that students understand
the importance of risk assessment.

Session Objectives
By the end of this session, you will be able to:

• Explain a firm’s suitability for investment

• Discuss a firm’s financial performance

Business Risk
Business risk refers to the uncertainty of operating income caused by products,
customers, and the way production takes place. This risk arises from:

• The volatility of sales over time

• The fire’s operating leverage – the mix of fixed and variable costs
Ultimately, a firm’s operating income faces risk from its sales revenue and its
production costs. Examining the balance of these two factors will indicate the stability
of the firm’s profitability.

An example is illustrated in the following video link:

https://www.youtube.com/watch?v=UK3ClpsFKVA

Financial Analysis
This component refers to the uncertainty of return to equity holders as a result of the
firm’s fixed financial obligations. An increase in fixed financial obligations will result
in an increase in financial risk.

69  FINA2004 Portfolio Management – UNIT 5

 Session Summary

Risk assessment must complement financial analysis. Applying scenarios to the

previously learned financial ratios (as in the video example) will reveal the firm’s
ability to adapt to environmental changes that can impact its operating income and
overall profitability, and thus total risk of investing in a particular firm.

Unit 5 Summary

Unit 5 has provided students with the information needed to assess company accounts
and the value of an investment in a company. The following units will teach students
how to assess the value of bonds and equities.

70  FINA2004 Portfolio Management – UNIT 5

 References
Reilly, F. K., & Brown, K. C. (2012). Investment Analysis and Portfolio Management.
South-Western Cengage Learning.

71  FINA2004 Portfolio Management – UNIT 5