Decoding Financial Statements

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Jan. 4, 2012

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Donald W. Reynolds National Center

For Business Journalism

At Arizona State University

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

gary.trennepohl@okstate.edu

Topics Wednesday:

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

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

Thursday: 8:30 am to 11:15 am – Financial Markets in 2012:

Where are the Stories?

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I. Decoding Financial Statements

1. Financial Ratios – what they tell us

2. Profitability Model – how the firm generates profits

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Ratios to Measure Financial Health

Liquiditycurrent 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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Ratios (con’t)

Profitability

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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Profitability Ratios (con’t)

Factors affecting profitability

inventory turnover =

accounts receivable

collection period =

cost of goods sold

inventory

accounts receivable

(sales/365 days)

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Ratios (con’t)

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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Ratios (con’t)

What return is generated for common stockholders?

return on equity =EACS

common equity

The Profitability Model

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Evaluating a Company Using The Profitability Model

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

ROE is a function of all three factors

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The Profitability Model (con’t)

Return on equity =

NPM X total asset turnover X equity multiplier

ROE =

net profit

salesX sales

total assetsX

common equity

total assets

II. Investing in Time of Uncertainty; WSJ calls it “Macro” Investing

1. What is Risk and Uncertainty?

2. Historical Perspective on Return and Risk in the Market.

3. How Country Demographics will drive Investment and Returns in the Coming Decades

Macro Uncertainty Examples Natural Disasters:

Katrina, The Japanese earthquake

Political Turmoil The Arab Spring Terrorist Attacks European Debt Crisis

Economic Events The 2008 Recession Bankruptcy of Lehman Bros.

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Perspective over Past 60 Years U.S. stocks enjoyed a great boom in the 1980’s and

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

annually. A survey in 1951 about investing showed:

49% favored bonds, then real estate then bank deposits Only 6% favored stocks. 28% said they would not hold

stocks because of “lack of safety.”

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World Events Over thePast two Generations

A world war that cost 50 million lives Korean Conflict A cold war and Iron Curtain that threatened world

destruction. The Vietnam Conflict, the Oil Embargo in 1974,

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

Two wars in the Middle East, and 9/11/2001. The 2000’s that gave us a real estate bubble, toxic

mortgage securities, and near collapse of the world banking system.

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What this Means for Investors

Put your fears into perspective: Warren Buffett: “We have usually made our best

purchases when apprehensions about some macro event were at a peak.”

Is fear warping your perception of risk? Take selective risks:

If you endured the past decade, hang in there. Exposure to factors like illiquidity, credit concerns,

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

Invest with a global perspective19

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

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What about the Decade Of 2000 to 2010?

Many news sources have reported that the “’00s” were the lost decade for returns for stocks, but it depends on which numbers you choose. S&P 500 - .4% DJIA + 2.5% Small Cap + 6.2% World Index + 1.3% Brazil +21.0% U.S. T-Bonds+ 8.3%

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*Matt Moran, CBOE seminar, Oct. 29, 2010

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

about market uncertainty over the next 30 days. 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.

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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So, What Does All Of This Data Tell Us?

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

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

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

Diversification is a key strategy for investing.

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Did the Markets Really Change in 2008? Probably not, but two factors are changing

investing in profound ways: Technology that makes market information

instantly available Globalization of financial markets is linking

economies around world.

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What is Really 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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Italy

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Germany

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United States

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Brazil

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India

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China

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So, What Will the Next Decade Bring Us?

Here’s some data to help you decide

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“The Bond Buyer’s Dilemma” By Burton Malkiel in the WSJ, Dec 7, 2011

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

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

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

High quality U.S. stocks with generous dividend yields

Abbott Labs, ATT, Exxon, J&J, P&G.

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Story Ideas1. What do investors and investment

advisors say about market volatility?

2. Are investors/advisors investing in international markets? If so, where and why?

3. What will happen to bond prices and interest rates in 2012-2014?