Financial StatementsAnnouncementsCURRENT EVENT / NEWSLECTURE CONTENTToday’s LectureSlide 6Trading PsychologySlide 8Psychology & The Stock MarketSlide 10Accounting 101: Financial StatementsReporting Financial StatementsThe Income StatementIncome StatementsBalance SheetSlide 16Statement of Cash FlowsEarnings SeasonSlide 19Understanding EarningsEPS % Growth: Google Q2 2007 Source: MSN Money Stock QuotesWhy do Investors Care About Earnings?Slide 23Ratio AnalysisProfit MarginsProfit Margins: ExamplePrice to Earnings Ratio (P/E)Slide 28Return on Equity (ROE)Return on Equity (ROE) PC Industry Example (Dell vs. Gateway vs. HP)Debt-to-Equity RatiosGoogle ExampleOther Relevant RatiosReadingFinancial StatementsEconomics 98 / 198Fall 2007Copyright 2007 Jason LeeAnnouncements•Oct 31 versus Nov 31 lecture?•Simulation Exercise - MoneyCURRENT EVENT / NEWSLECTURE CONTENTToday’s Lecture•Trading Psychology•Financial Statements introduction– Income Statement– Balance Sheet– Cash Flow Statement–Earning Season•Ratio AnalysisTRADING PSYCHOLOGYTrading PsychologyEmotions severely impair your judgment in deciding whether to buy or sells tocksHOPEFEARGREEDPRIDEPsychology & The Stock Market•Emotions can wreak havoc on your results and decisions•Need to take emotion out of investing•Do this by developing a system with rules to follow with disciplineTrading Psychology“Your biggest enemy, when trading, is within yourself. Success will only come when you learn to control your emotions” - Edwin LefevreAccounting 101:Financial StatementsReporting Financial Statements•Public co. required to publish 10K and 10Q– 10K = Annual financial reports–10Q = Quarterly financial reportsIncome StatementBalance SheetStatement of Cash Flows•Why do we care about these reports?The Income Statement•Shows how much a company earned or lost during that specific period •Considered the most analyzed statement for investors•Divulges into a company’s profitability IS THE COMPANY MAKING PROFIT?Income Statements•Generally, 3 Major Parts– Revenues–Expenses–Net Income•Earnings Per Share (EPS)= Profits / Shares Outstanding•Investors pay very close attention to profits (earnings) and revenue (sales)Income = Revenues - ExpensesBalance Sheet•Summarizes company’s assets, liabilities, and shareholders’ equities at specific timeAssets = Liabilities + Shareholder’s Equity•How do we analyze this statement?•We use ratios and changes in trends to analyze the informationBalance SheetAssets– Current Assets: life span of 1 year or less–Non-Current assetsLiabilities– Current Liabilities–Non-current liabilitiesShareholder’s Equity– Common / Preferred Stock– Retained EarningsStatement of Cash Flows•Shows how much money coming in (inflows) and going out (outflows)– Cash flow from operations – Cash flow from investing– Cash flow from financing•Shows if company having trouble with cash– Profitable companies can struggle cash flows. Why? •Cash is king! Pays for bills and funds operations!Earnings Season•Companies release quarterly reports and annual reports– “Financial Report Cards”•Stock analysts issue earnings estimate–Consensus earnings estimates•Earnings surprise is a good thing– Meeting / beating / missing expectations– If below estimates, then stock usually head downwards fast!Understanding Earnings•Actual earnings value is important, but so is the growth of these earnings •Compare EPS / Revenue?–Do we compare them to last quarter?–Do we compare them to the same quarter last year?EPS % Growth: Google Q2 2007Source: MSN Money Stock QuotesEPS growth calculated comparing Q2 2007 to Q2 2006Q2 2007EPS Growth2007 Q2 EPS2006 Q2 EPS$2.98 / sh$2.39 / sh=25%Why do Investors Care About Earnings?•Strong earnings or expectations of strong earnings drive stock prices. Why?– Potential for greater reinvestment, and greater earnings– Passing the money to shareholders in various forms (dividends, buybacks, etc.)•Ultimately, earnings provide a return on the investment for shareholdersRatio AnalysisRatio Analysis•Used to gain idea of valuation and financial performance•Compared to competitors and historical values to gain understanding about company’s value– Is it undervalued? Overvalued?– How is it performing?Profit MarginsProfit Margins•= net income / net sales (revenue)– Measures how much out of every dollar of sales a company actually keeps in earnings•High profit margins indicates that management efficient at controlling costs– Increased earnings are good, but if costs are increasing faster than sales, leads to lower profit per sale•Good sign if company has growing profit marginsProfit Margins: ExampleCompany has a net income of $10 millionNfrom sales of $100 million, givingNit a profit margin of 10% ($10 million/$100 million)If in the next year net income roseNto $15 millionNon sales of $200 million.Would its profit margins be growing or diminishing? What does this mean?Price to Earnings Ratio (P/E)P/E Ratio•= Price per share / Earnings per share– Look at company’s earnings relative to its price•Most basic valuation method of company– How do you we use it? •Ex. If BIG OIL co. has P/E ratio of 15 and has solid fundamentals, and the industry average is 40, then the BIG OIL would be considered undervaluedPrice to Earnings Ratio (P/E)•Use as a guide, not a guarantee in your analysis•Sometimes, there is a reason for high or low P/E ratios (understanding business and industry is important)– High P/E ratios: investors may be willing to pay more for less earnings because its expect higher growth rates in the future– Low P/E ratios: may seem like a bargain, but low ratio may signal questionable future prospectsReturn on Equity (ROE)Return on Equity (ROE)•= Net Income / Shareholder’s Equity– how much profit a company can generate with the money shareholders have invested– Is it a profit-making machine or an inefficient clunker?•Useful for comparing profitability and efficiency of a company to other firms in same industry– can indicate whether a company is growing without pouring new capital into business•Growing ROE also shows management making better use of money invested by shareholdersReturn on Equity (ROE)PC Industry Example (Dell vs. Gateway vs. HP)DellHPGatewayDebt-to-Equity RatiosDebt / Equity Ratio•= Total Liabilities / Shareholder’s Equity– Proportion of equity and debt to
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