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during the period. An investor putting equal dollar amounts in the stock of the unexcellent
companies would have earned a portfolio rate of return over the 1981 to 1985 period that was
11.3% higher per year than the rate of return on a comparable portfolio of excellent company

< Concept
3. What were GI™s ROE, P/E, and P/B ratios in the year 2003? How do they compare
to the industry average ratios, which were: CHECK
ROE 8.64%
P/E 8
P/B 0.69
How does GI™s earnings yield in 2003 compare to the industry average?

Choosing a Benchmark
We have discussed how to calculate the principal financial ratios. To evaluate the performance
of a given firm, however, you need a benchmark to which you can compare its ratios. One ob-
vious benchmark is the ratio for the same company in earlier years. For example, Figure 13.1
shows PepsiCo™s return on assets, profit margin, and asset turnover ratio for the last few years.
You can see there that ROA improved dramatically in 1999 and 2000. This was attributable
largely to an improvement in profit margin, as asset turnover was relatively flat.
It is also helpful to compare financial ratios to those of other firms in the same industry.
Financial ratios for industries are published by the U.S. Department of Commerce, Dun &
Bradstreet, the Risk Management Association (formerly Robert Morris Associates), and
others, and many ratios are available on the Web, for example on the Yahoo! site. Table 13.10
Bodie’Kane’Marcus: IV. Security Analysis 13. Financial Statement © The McGraw’Hill
Essentials of Investments, Analysis Companies, 2003
Fifth Edition

466 Part FOUR Security Analysis

F I G U R E 13.1 ROA, Margin Turnover
Pepsi™s financial 20% 2.0
ratios over time. ROA
18% 1.8
improved largely due ROA
to increases in profit 16% 1.6
14% 1.4
12% 1.2

10% 1.0
8% .8
Profit margin
6% .6
4% .4
2% .2

0 0
1995 1996 1997 1998 1999 2000

TA B L E 13.10
Financial ratios for major industry groups

LT Debt Interest Current Quick Asset Profit Return on Return on Payout
Assets Coverage Ratio Ratio Turnover Margin (%) Assets (%) Equity (%) Ratio

All manufacturing 0.22 3.66 1.29 0.86 0.98 8.16 7.98 17.91 0.38
Food products 0.29 4.15 1.08 0.61 1.12 9.70 10.91 24.42 0.43
Clothing 0.27 3.19 1.89 1.01 1.62 6.73 10.91 18.89 0.25
Printing/publishing 0.29 3.70 1.22 1.01 0.90 10.48 9.42 22.48 0.38
Chemicals 0.24 2.94 1.11 0.77 0.71 10.46 7.43 20.86 0.53
Drugs 0.20 4.34 1.18 0.87 0.75 13.37 10.04 28.13 0.66
Machinery 0.17 3.55 1.45 1.03 1.00 5.93 5.94 6.26 0.23
Electrical/electronic 0.15 4.58 1.64 1.18 0.87 8.99 7.81 14.37 0.29
Motor vehicles 0.15 3.79 0.86 0.66 1.15 5.24 6.01 24.58 0.16

Source: U.S. Department of Commerce, Quarterly Financial Report for Manufacturing, Mining and Trade Corporations, first quarter 2000.

contains some of the principal ratios for a wide range of U.S. industries. These can be useful
benchmarks. For example, if PepsiCo™s turnover ratio is less than that of Coca-Cola or other
firms in the soft-drink industry, one would want to know why.

One common use of financial ratios is to evaluate the performance of the firm. While it is
common to use profitability to measure that performance, profitability is really not enough.
A firm should be viewed as successful only if the return on its projects is better than the rate
Bodie’Kane’Marcus: IV. Security Analysis 13. Financial Statement © The McGraw’Hill
Essentials of Investments, Analysis Companies, 2003
Fifth Edition

13 Financial Statement Analysis

TA B L E 13.11 Value Added Capital Return on Cost of
Economic value ($ billions) ($ billions) Capital Capital
added, 1999
A. Some EVA winners
Microsoft $7.85 $20.03 51.8% 12.6%
ExxonMobil $6.32 $180.04 11.7% 8.2%
Intel $5.48 $29.83 30.6% 12.2%
Merck $3.66 $29.55 23.1% 10.7%
General Electric $3.59 $75.83 17.2% 12.5%
B. Some EVA losers
AT&T $8.54 $176.87 4.4% 9.2%
WorldCom $4.92 $94.02 5.6% 10.8%
Lucent $2.55 $65.59 9.8% 13.7%
Loews $2.38 $19.95 2.4% 9.5%
Bank One Corp $1.60 $45.56 8.5% 12.0%

Source: Stern Stewart.

investors could expect to earn for themselves (on a risk-adjusted basis) in the capital market.
Think back to Table 13.9, where we showed that plowing back funds into the firm increases
share value only if the firm earns a higher rate of return on the reinvested funds than the op-
portunity cost of capital, that is, the market capitalization rate. To account for this opportunity
cost, we might measure the success of the firm using the difference between the return on as-
sets, ROA, and the opportunity cost of capital, k. Economic value added (EVA), or residual economic value
income, is the spread between ROA and k multiplied by the capital invested in the firm. It added, or
therefore measures the dollar value of the firm™s return in excess of its opportunity cost. residual income
Table 13.11 shows EVA for a small sample of firms drawn from a larger study of 1,000 A measure of the
firms by Stern Stewart, a consulting firm that has done much to develop and promote the con- dollar value of
cept of EVA. Microsoft had one of the highest returns on capital, at 51.8%. Since the cost of a firm™s return
in excess of its
capital for Microsoft was only 12.6% percent, each dollar invested by Microsoft was earn-
opportunity cost.
ing about 39.2 cents more than the return that investors could have expected by investing in
equivalent-risk stocks. Applying this 39.2% margin of superiority to Microsoft™s capital base
of $20.03 billion, we calculate annual economic value added as $7.85 billion.3 Note that
ExxonMobil™s EVA was larger than Intel™s, despite a far smaller margin between return on
capital and cost of capital. This is because ExxonMobil applied this margin to a larger capital
base. At the other extreme, AT&T earned less than its opportunity cost on a very large capital
base, which resulted in a large negative EVA.
Notice that even the EVA “losers” in this study generally had positive profits. For example,
AT&T™s ROA was 4.4%. The problem is that AT&T™s profits were not high enough to com-
pensate for the opportunity cost of funds. EVA treats the opportunity cost of capital as a real
cost that, like other costs, should be deducted from revenues to arrive at a more meaningful
“bottom line.” A firm that is earning profits but is not covering its opportunity cost might be
able to redeploy its capital to better uses. Therefore, a growing number of firms now calculate
EVA and tie managers™ compensation to it.

Actual EVA estimates reported by Stern Stewart differ somewhat from the values in Table 13.11 because of other
adjustments to the accounting data involving issues such as treatment of research and development expenses, taxes,
advertising expenses, and depreciation. The estimates in Table 13.11 are designed to show the logic behind EVA.
Bodie’Kane’Marcus: IV. Security Analysis 13. Financial Statement © The McGraw’Hill
Essentials of Investments, Analysis Companies, 2003
Fifth Edition

468 Part FOUR Security Analysis

TA B L E 13.12
Key financial ratios of Growth Industries, Inc.

(1) (2) (3) (4) (5) (6) (7)
Net Compound
Profit Pretax EBIT Sales Leverage
Pretax Profit Sales Assets Assets Factor ROA
Year ROE Profit EBIT (ROS) (ATO) Equity (2) (5) (3) (4) P/E P/B

2001 7.51% 0.6 0.650 30% 0.303 2.117 1.376 9.09% 8 0.58
2002 6.08 0.6 0.470 30 0.303 2.375 1.116 9.09 6 0.35
2003 3.03 0.6 0.204 30 0.303 2.723 0.556 9.09 4 0.12
Industry average 8.64 0.6 0.800 30 0.400 1.500 1.200 12.00 8 0.69

In her 2003 annual report to the shareholders of Growth Industries, Inc., the president wrote:
“2003 was another successful year for Growth Industries. As in 2002, sales, assets, and oper-
ating income all continued to grow at a rate of 20%.”
Is she right?
We can evaluate her statement by conducting a full-scale ratio analysis of Growth Indus-
tries. Our purpose is to assess GI™s performance in the recent past, to evaluate its future
prospects, and to determine whether its market price reflects its intrinsic value.
Table 13.12 shows some key financial ratios we can compute from GI™s financial state-
ments. The president is certainly right about the growth in sales, assets, and operating income.
Inspection of GI™s key financial ratios, however, contradicts her first sentence: 2003 was not
another successful year for GI”it appears to have been another miserable one.
ROE has been declining steadily from 7.51% in 2001 to 3.03% in 2003. A comparison of
GI™s 2003 ROE to the 2003 industry average of 8.64% makes the deteriorating time trend
especially alarming. The low and falling market-to-book-value ratio and the falling price“
earnings ratio indicate that investors are less and less optimistic about the firm™s future
The fact that ROA has not been declining, however, tells us that the source of the declining
time trend in GI™s ROE must be due to financial leverage. And we see that, while GI™s lever-
age ratio climbed from 2.117 in 2001 to 2.723 in 2003, its interest-burden ratio fell from 0.650
to 0.204”with the net result that the compound leverage factor fell from 1.376 to 0.556.
The rapid increase in short-term debt from year to year and the concurrent increase in in-
terest expense make it clear that, to finance its 20% growth rate in sales, GI has incurred siz-
able amounts of short-term debt at high interest rates. The firm is paying rates of interest
greater than the ROA it is earning on the investment financed with the new borrowing. As the
firm has expanded, its situation has become ever more precarious.
In 2003, for example, the average interest rate on short-term debt was 20% versus an ROA
of 9.09%. (We compute the average interest rate on short-term debt by taking the total inter-
est expense of $34,391,000, subtracting the $6 million in interest on the long-term bonds, and
dividing by the beginning-of-year short-term debt of $141,957,000.)
GI™s problems become clear when we examine its statement of cash flows in Table 13.13.
The statement is derived from the income statement and balance sheet in Table 13.8. GI™s cash
flow from operations is falling steadily, from $12,700,000 in 2001 to $6,725,000 in 2003. The
Bodie’Kane’Marcus: IV. Security Analysis 13. Financial Statement © The McGraw’Hill
Essentials of Investments, Analysis Companies, 2003
Fifth Edition

13 Financial Statement Analysis

2001 2002 2003
TA B L E 13.13
Cash flow from operating activities
Growth Industries
Net income $ 11,700 $ 10,143 $ 5,285
statement of cash
flows ($thousands) Depreciation 15,000 18,000 21,600
Decrease (increase) in accounts receivable (5,000) (6,000) (7,200)
Decrease (increase) in inventories (15,000) (18,000) (21,600)
Increase in accounts payable 6,000 7,200 8,640
$ 12,700 $ 11,343 $ 6,725
Cash flow from investing activities
Investment in plant and equipment* $(45,000) $(54,000) $(64,800)
Cash flow from financing activities
Dividends paid† $ 0 $ 0 $ 0
Short-term debt issued 42,300 54,657 72,475
Change in cash and marketable securities‡ $ 10,000 $ 12,000 $ 14,400

*Gross investment equals increase in net plant and equipment plus depreciation.

We can conclude that no dividends are paid because stockholders™ equity increases each year by the full amount of net income, implying a
plowback ratio of 1.0.

Equals cash flow from operations plus cash flow from investment activities plus cash flow from financing activities. Note that this equals
the yearly change in cash and marketable securities on the balance sheet.

firm™s investment in plant and equipment, by contrast, has increased greatly. Net plant and
equipment (i.e., net of depreciation) rose from $150,000,000 in 2000 to $259,200,000 in 2003.
This near doubling of the capital assets makes the decrease in cash flow from operations all
the more troubling.
The source of the difficulty is GI™s enormous amount of short-term borrowing. In a sense,
the company is being run as a pyramid scheme. It borrows more and more each year to main-
tain its 20% growth rate in assets and income. However, the new assets are not generating
enough cash flow to support the extra interest burden of the debt, as the falling cash flow from
operations indicates. Eventually, when the firm loses its ability to borrow further, its growth
will be at an end.
At this point, GI stock might be an attractive investment. Its market price is only 12% of its


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