Decoding Financial

Statements

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Saturday January 4, 2014

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Donald W. Reynolds National Center For Business Journalism At Arizona State University

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n  Gary Trennepohl, Ph.D. n  ONEOK Chair and President’s Council Professor of Finance n  Oklahoma State University n  Trustee, Oklahoma Teachers Retirement System n  Member, OSU Foundation Investment Committee

n  gary.trennepohl@okstate.edu

Topics n  Saturday:

n  8:30 am to 3:00 pm – Decoding Financial Statements and Company Analysis.

n  3:15 pm to 5:00 pm – Investing in a Time of Uncertainty

n  Sunday: n  8:30 am to 11:15 am – Fellows Reports on Story

Projects

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When Studying Finance, Sometimes it may feel like this:

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USING FINANCIAL RATIOS TO ANALYZE A COMPANY

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Part 1: Decoding Financial Statements

1. Financial Ratios – what they tell us 2. Profitability Model – how the firm generates profits

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1. Ratios A. To Measure Financial Health

n  Liquidity current ratio =

quick ratio =

Current assets Current liabilities

Current assets - inventory Current liabilities

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Another View of Liquidity: Net Working Capital

Total Assets = Liab.+Net Worth

Current Assets

Fixed Assets

Current liabilities

Common equity

Long Term Debt +

Net Working Capital

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B. Ratios to Measure Profits net profit margin = return on assets = total asset turnover =

net profit after tax sales

net profit after tax

total assets

sales total assets

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Factors Affecting Profitability:

inventory turnover =

accounts receivable

collection period =

cost of goods sold

inventory

accounts receivable

(sales/365 days)

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C. Debt Ratios

n  How is the firm financed? debt ratio =

debt/equity ratio =

equity multiplier =

total debt total assets

total debt total equity

total assets

common equity

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D. Equity Return Ratios

n  What return is generated for common stockholders?

return on equity = EACS

common equity

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2. Profitability Model – How a Firm Generates Profits

n  The profitability model is useful because it separates return on equity (ROE) into three components - n  financial leverage (equity multiplier), n  operating efficiency (net profit margin) n  asset utilization (total asset turnover).

n  ROE is a function of all three factors

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The Profitability Model is a Function of Three Ratios

n  Return on equity is equal to :

NPM X total asset turnover X equity multiplier

ROE =

net profit

sales X

sales

total assets X

common equity

total assets

INVESTING IN A TIME OF UNCERTAINTY

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Understanding How Markets Work

Who are the Market Participants Things in Percentages Learning from the past: A History of

Return and Risk in the Markets. Concept of Market Efficiency Changing Demographics will drive Investment and Returns in the Future

Four Categories of Market Participants

n  Investors n  Institutional n  Retail

n  Speculators n  Market Makers n  Brokers

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Things in Percentages: Returns and Basis Points

n  Stocks: n  Returns include dividends and capital appreciation

n  Bonds: n  Returns include interest payments and bond price

changes (a function of interest rates) n  A basis point (aka as “bips” for bps)

n  .0001 equals .01% or ONE basis point. So, 1% equals 100 bps.

n  Interest rate changes and Investment Management fees often are stated in basis points.

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C. Perspectives Over Three Generations n  1930’s: A worldwide Depression n  1940’s: A world war that cost 50 million lives n  1950’s: The Korean Conflict; A Cold War and

threatened worldwide nuclear destruction. n  1960-1980’s: Vietnam: Arab Oil Embargo in 1974,

severe inflation, wage and price controls, another oil shock, the dissolution of the Soviet Union.

n  1990’s: The Tech Revolution and the Internet n  2000’s: Two wars in the Middle East and 9/11/2001. n  Last 10 years: a real estate bubble; toxic mortgage

securities; “The Great Recession” and near collapse of the world banking system.

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Demographics Driving Economics from 1950 to 2012 n  U.S. stocks enjoyed a boom in the 1980’s and the

returns in the’90’s averaged 18% yearly. n  2000’s decade returns: S&P returned 1%, Bonds 6%

annually. n  Nov. 2003 to Nov. 2013

n  S&P 500 = 7.69% n  MSCI World = 7.4% n  U.S. Long term Treasury Bonds = 6.27%

n  How has investor perspectives about stocks changed since 1950?

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What this Means for Investors n  Put your fears into perspective:

n  Warren Buffett: “We have usually made our best purchases when apprehensions about some macro event were at a peak.”

n  Is fear warping your perception of risk?

n  Take selective risks: n  If you endured the last 15 years, hang in there. n  Exposure to factors like illiquidity, credit concerns,

natural disasters and insurable events will be better rewarded than in the past century.

n  Invest with a global perspective 22

History of U.S. Stock and Bond Returns Provides a Perspective for the Future

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Bonds as an Investment

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Page 1

Lower Long Term Rates

The secular low in bond yields has yet to be recorded. This assessment for a continuing pattern of lower yields in the quarters ahead is clearly a minority view, as the recent selling of all types of bond products attest. The rise in long term yields over the last several months was accelerated by the recent Federal Reserve announcement that it would be “tapering” its purchases of Treasury and mortgage-backed securities. This has convinced many bond market participants that the low in long rates is in the past. The Treasury bond market’s VKRUW� WHUP�ÀXFWXDWLRQV� DUH� D� IXQFWLRQ� RI�PDQ\�factors, but its primary and most fundamental determinate is attitudes toward current and future LQÀDWLRQ�� �)URP� WKDW�SHUVSHFWLYH�� WKH�RXWORRN� IRU�long term Treasury yields to fall is most favorable LQ� OLJKW� RI�� D�� GLPLQLVKHG� LQÀDWLRQ� SUHVVXUHV�� E��VORZLQJ�*'3� JURZWK�� F��ZHDNHQLQJ� FRQVXPHU�IXQGDPHQWDOV�� DQG� G�� DQWL�JURZWK�PRQHWDU\� DQG�¿VFDO�SROLFLHV�

Quarterly Review and OutlookSecond Quarter 2013

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been, a prerequisite for sustained increases in long WHUP�LQWHUHVW�UDWHV���,QÀDWLRQ¶V�UROH�LQ�GHWHUPLQLQJ�WKH�OHYHO�RI�ORQJ�WHUP�UDWHV�ZDV�TXDQWL¿HG�E\�,UYLQJ�Fisher 83 years ago (Theory of Interest, 1930) with the Fisher equation. It states that long term rates DUH�WKH�VXP�RI�LQÀDWLRQ�H[SHFWDWLRQV�DQG�WKH�UHDO�UDWH�� �7KLV� SURSRVLWLRQ� KDV� EHHQ� UHFRQ¿UPHG� LQ�numerous sophisticated statistical studies and can also be empirically observed by comparing the 7UHDVXU\�ERQG�\LHOG�WR�WKH�LQÀDWLRQ�UDWH��&KDUW������On an annual basis, the Treasury bond yield and the LQÀDWLRQ�UDWH�KDYH�PRYHG�LQ�WKH�VDPH�GLUHFWLRQ�LQ�80% of the years since 1954.

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Long Term U.S. Treasury Rates and Inflation

54 57 60 63 66 69 72 75 78 81 84 87 90 93 96 99 '02 '05 '08 '11 '140%

2%

4%

6%

8%

10%

12%

14%

16%

0%

2%

4%

6%

8%

10%

12%

14%

16%

Inflation

Bond Yield

Bond Yield: Quarterly averages of long-term U.S. Treasury rates. Inflation: annual percent change in GDP deflator, annual percent change in Core PCE deflator from 1996 through 1999, market based Core PCE deflator from 2000. Through 2012.

Chart 1

60 64 68 72 76 80 84 88 92 96 '00 '04 '08 '120

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Core PCE Indexyear-over-year % change, monthly

Source: Bureau of Economic Analysis. Through May 2013.

Year-over-year change for last 2 months at 50 year low

Chart 2

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“The Bond Buyer’s Dilemma” By Burton Malkiel in the WSJ, Dec 7, 2011 n  The yields on long term U.S. Treasuries will likely fall

below inflation for the next several years - Long Term treasuries are likely to be sure losers

n  Investors should consider as alternatives: n  Bonds with moderate credit risk where the spreads over

treasuries are generous. n  Tax exempt municipal bonds are especially attractive n  Foreign bonds in fiscally secure countries, e.g. Australia

n  High quality U.S. stocks with generous dividend yields n  Abbott Labs, ATT, Exxon, J&J, P&G.

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THE VIX – A MEASURE OF EXPECTED MARKET VOLATILITY (RISK).

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You Can Keep Track of Current Market Volatility with the VIX n  The “VIX” is a measure of the market’s perception

about market uncertainty over the next 30 days. n  It’s derived from the Black-Scholes “option pricing

model” of which one input value is expected volatility (ie. future standard deviation) of the S&P 500.

n  You make the calculation by “solving the model backwards” – that is “given the observed price, what volatility is needed to produce that price by the model.”

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Historic Volatility Since 189830-Day Historic Volatility for U.S. Stock Indexes --

(DJIA 1898 - 1956, and S&P 500 for 1957 and later years)

99.84 on Nov. 29, 1929

80.85 on Nov. 14, 2008

87.50 on Nov. 20, 1987

0

20

40

60

80

100

120

1/7/1898 4-Mar-1921 26-Nov-1943 8-Jul-1966 25-Aug-1989 6-Apr-2012

(Jan 7, 1898 - April 27, 2012) Source: Bloomberg

30-d

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Maximum 99.84Minimum 3.21Mean 15.51Median 12.95

“Historic Volatility” is a measure of actual price changes during a specific time period in the past. Mathematically, historic volatility is the annualized standard deviation of daily returns during a specific past period.

Stock and Bond Returns If Markets are “Efficient” ….

Market efficiency refers to how quickly security prices reflect new information. If markets are efficient it isn’t possible

to “beat the market”

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Implications of Market Efficiency for Investors n  Stock experts don’t have an advantage over

amateurs because the competition is so severe n  Investment return will be a function of risk. n  The key factor in market efficiency is information.

Most SEC regulation is designed to promote the flow of information to investors.

n  Technical analysis is valueless because market participants already have incorporated any information contained in past price sequences into stock prices

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Implications (con’t) n  Fundamental analysis and brokerage firm

recommendations will not enable you to identify firms which will outperform the market.

n  Information contained in accounting statements and other public information already is reflected in security prices.

n  It makes no sense to try and time the market. n  If markets can be “beaten” the way is not obvious.

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How Then Should We Invest as Retail Investors?

1.  Buy and hold a well-diversified portfolio through time – and make sure you have exposure to international stocks and bonds – in developed and emerging markets.

2.  Minimize fees, trading costs and expense ratios.

3.  Minimize tax impacts of buying and selling.

4.  Rebalance periodically to your risk/reward target

So, What Does All Of This Data Tell Us?

n  First, remember when people say “this time is different,” it is never different.

n  Markets over and under correct, but they ultimately revert to the mean of their long term values.

n  Periods of over performance will be followed by periods of underperformance, etc.

n  Diversification is a key strategy for investing.

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Diversification in an Institutional Investor Portfolio

1)  Stocks - Large cap, small cap, growth, value, international including emerging markets

2)  Fixed income – Treasuries, high yield, corporate, municipal

3)  Real Estate – REITs, direct investment funds 4)  MLPs – Transportation, E&P, Liquids, Storage 5)  Commodities – Ags, metals, oil and gas, 6)  Precious metals – Gold, silver 7)  Hedge Funds – Various types 8)  Risk management tools – Options, futures

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How Demographics Will Drive International Investing Activity

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The Changing Demographics of Major Countries

1.  Countries with larger numbers of younger workers will enjoy higher growth rates than “older” countries.

2.  Demand for housing, autos, and consumer goods is driven by the 25 to 45 year old age cohort.

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United States

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Italy

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Germany

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China

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Brazil

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India

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