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b. How sensitive are our estimates to your assumptions? Which assumptions are
most critical?
c. Try using a three-stage growth model and comparing the values derived to a
two-stage model. Which estimates seem more reasonable?


Price, Risk and Growth
Go to www.mhhe.com/edumarketinsight to download the Excel reports entitled
“Profitability” that appear in the Valuation section for two major drug firms, Johnson &
Johnson (JNJ) and Merck & Co (MRK). Examine the reports for the last five years of
reported data, then address the following questions:
1. What differences do you find with respect to the firms™ use of financial leverage
over the period? Briefly explain.
2. Which of the firms would you consider to be more expensive in terms of
earnings? Briefly explain.
3. What factors would you examine to explain differences in price“earnings ratios?
Briefly explain your logic.

SOLUTIONS TO 1. a. Dividend yield $2.15/$50 4.3%

Capital gains yield (59.77 50)/50 19.54%

Total return 4.3% 19.54% 23.84%
CHECKS b. k 6% 1.15(14% 6%) 15.2%
c. V0 ($2.15 $59.77)/1.152 $53.75, which exceeds the market price. This would indicate a
“buy” opportunity.
2. a. D1/(k g) $2.15/(0.152 0.112) $53.75
b. P1 P0(1 g) $53.75(1.112) $59.77
c. The expected capital gain equals $59.77 $53.75 $6.02, for a percentage gain of 11.2%.
The dividend yield is D1/P0 2.15/53.75 4%, for a holding-period return of 4% 11.2%
3. a. g ROE b 0.20 .60 0.12
P0 2/(0.125 0.12) 400
Bodie’Kane’Marcus: IV. Security Analysis 12. Equity Valuation © The McGraw’Hill
Essentials of Investments, Companies, 2003
Fifth Edition

12 Equity Valuation

b. When the firm invests in projects with ROE less than k, its stock price falls.
If b 0.60, then g 10% 0.60 6% and P0 $2/(0.125 0.06) $30.77. In contrast, if
b 0, then P0 $5/0.125 $40
4. Because .85, k 5% .85 6% 10.1%
.80 .95 1.10 1.25 P2005
(1.101)2 (1.101)3
1.101 (1.101)4
Now compute the sales price in 2005 using the constant growth dividend discount model.

1.25 (1 g) 1.25 1.071
P2005 $44.62
kg .101 .071
Therefore, V2001 $33.55
5. a. ROE 12%
b $0.50/$2.00 0.25
g ROE b 12% 0.25 3%
P0 D1 /(k g) $1.50/(0.10 0.03) $21.43
P0 /E1 21.43/$2.00 10.71
b. If b 0.4, then 0.4 $2 $0.80 would be reinvested and the remainder of earnings, or $1.20,
would be paid as dividends
g 12% 0.4 4.8%
P0 D1 /(k g) $1.20/(0.10 0.048) $23.08
P0 /E1 $23.08/$2.00 11.54
PEG 11.54/4.8 2.4

Bodie’Kane’Marcus: IV. Security Analysis 13. Financial Statement © The McGraw’Hill
Essentials of Investments, Analysis Companies, 2003
Fifth Edition



Use a firm™s income statement, balance sheet, and
statement of cash flows to calculate standard financial

> Calculate the impact of taxes and leverage on a firm™s
return on equity using ratio decomposition analysis.

> Measure a firm™s operating efficiency by using various asset
utilization ratios.

> Identify likely sources of biases in conventional accounting

Bodie’Kane’Marcus: IV. Security Analysis 13. Financial Statement © The McGraw’Hill
Essentials of Investments, Analysis Companies, 2003
Fifth Edition

Related Websites
This site has articles dealing with financial accounting
issues. http://news.stockmaster.com
http://www.nasdaq.com Financial statement data are available on the websites
listed above.

n the previous chapter, we explored equity valuation techniques. These techniques

I take as inputs the firm™s dividends and earnings prospects. While the valuation
analyst is interested in economic earnings streams, only financial accounting data
are readily available. What can we learn from a company™s accounting data that can
help us estimate the intrinsic value of its common stock?
In this chapter, we show how investors can use financial data as inputs into stock
valuation analysis. We start by reviewing the basic sources of such data: the income
statement, the balance sheet, and the statement of cash flows. We next discuss the
difference between economic and accounting earnings. While economic earnings are
more important for issues of valuation, whatever their shortcomings, accounting data
still are useful in assessing the economic prospects of the firm. We show how analysts
use financial ratios to explore the sources of a firm™s profitability and evaluate the
“quality” of its earnings in a systematic fashion. We also examine the impact of debt
policy on various financial ratios. Finally, we conclude with a discussion of the limita-
tions of financial statement analysis as a tool in uncovering mispriced securities.
Some of these limitations are due to differences in firms™ accounting procedures. Oth-
ers arise from inflation-induced distortions in accounting numbers.
Bodie’Kane’Marcus: IV. Security Analysis 13. Financial Statement © The McGraw’Hill
Essentials of Investments, Analysis Companies, 2003
Fifth Edition

452 Part FOUR Security Analysis

The Income Statement
The income statement is a summary of the profitability of the firm over a period of time, such
income statement
as a year. It presents revenues generated during the operating period, the expenses incurred
A financial statement
during that same period, and the company™s net earnings or profits, which are simply the dif-
showing a firm™s
ference between revenues and expenses.
revenues and
expenses during a It is useful to distinguish four broad classes of expenses: cost of goods sold, which is the
specified period. direct cost attributable to producing the product sold by the firm; general and administrative
expenses, which correspond to overhead expenses, salaries, advertising, and other costs of op-
erating the firm that are not directly attributable to production; interest expense on the firm™s
debt; and taxes on earnings owed to federal and local governments.
Table 13.1 presents a 2000 income statement for PepsiCo, Inc. At the top are revenues from
standard operations. Next come operating expenses, the costs incurred in the course of gener-
ating these revenues, including a depreciation allowance. The difference between operating
revenues and operating costs is called operating income. Income from other, primarily nonre-
curring, sources is then added to obtain earnings before interest and taxes (EBIT), which is
what the firm would have earned if not for obligations to its creditors and the tax authorities.
EBIT is a measure of the profitability of the firm™s operations abstracting from any interest
burden attributable to debt financing. The income statement then goes on to subtract net in-
terest expense from EBIT to arrive at taxable income. Finally, the income tax due the govern-
ment is subtracted to arrive at net income, the “bottom line” of the income statement.

The Balance Sheet
balance sheet
While the income statement provides a measure of profitability over a period of time, the
An accounting
balance sheet provides a “snapshot” of the financial condition of the firm at a particular
statement of a firm™s
time. The balance sheet is a list of the firm™s assets and liabilities at that moment. The differ-
financial position at
ence in assets and liabilities is the net worth of the firm, also called stockholders™ equity or,
a specified time.

Operating revenues
TA B L E 13.1 Net sales $20,438
Consolidated Operating expenses
statement of income
Cost of sales $ 7,943
for PepsiCo, Inc.,
Selling, general, and administrative expenses 8,172
for the year ended
Depreciation and amortization 960
December 31, 2000
Other expenses 138
(figures in millions)
Total operating expenses $17,213
Operating income $ 3,225
Nonoperating income 130
Earnings before interest and income taxes $ 3,355
Net interest expense 145
Earnings before income taxes $ 3,210
Income taxes 1,027
Net income $ 2,183

Note: Column sums subject to rounding error.
Source: PepsiCo Annual Report, 2000.
Bodie’Kane’Marcus: IV. Security Analysis 13. Financial Statement © The McGraw’Hill
Essentials of Investments, Analysis Companies, 2003
Fifth Edition

13 Financial Statement Analysis

equivalently, shareholders™ equity. Like income statements, balance sheets are reasonably
standardized in presentation. Table 13.2 is Pepsi™s balance sheet for year-end 2000.
The first section of the balance sheet gives a listing of the assets of the firm. Current assets
are presented first. These are cash and other items such as accounts receivable or inventories
that will be converted into cash within one year. Next comes a listing of long-term assets,
which generally corresponds to the company™s property, plant, and equipment. The sum of
current and long-term assets is total assets, the last line of the assets section of the balance
The liability and stockholders™ equity section is arranged similarly. First are listed short-
term or “current” liabilities, such as accounts payable, accrued taxes, and debts that are due
within one year. Long-term debt and other liabilities due in more than a year follow. The dif-
ference between total assets and total liabilities is stockholders™ equity. This is the net worth

Dollars Percent of
TA B L E 13.2 (millions) Total Assets
balance sheet for
PepsiCo, Inc., as of Current assets
December 31, 2000 Cash and cash equivalents $ 864 5%
Other short-term investments 466 3
Receivables 1,799 10


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