LM12 Applications of Financial Statement Analysis

Part 2

5. Screening for Potential Equity Investments

Screening is a process to filter investments (for example stocks, bonds) based on a set of criteria. The criteria may be a set of financial ratios, or other metrics such as dividends paid, market capitalization, etc. One example of a stock screen is defined below.

The criteria are not limited to the factors mentioned above. It can be as detailed and as specific as required based on the investment requirement. For example, if an analyst wants to keep risk low, he might screen for companies with positive earnings and a low leverage ratio (assets/equity). If he wants low P/E firms which are financially strong, he might use criteria such as P/E less than 10, and debt/equity less than 0.2.

Types of Investors

Stock screens are used by both growth and value investors.

• Growth Investors: Focused on investing in high earnings growth companies. Screens use criteria related to growth or momentum.
• Value Investors: Investors focused on paying a relatively low share price in relation to earnings per share or book value per share (low P/E or low P/B). Screens use valuation ratios as criteria.
• Market-oriented Investors: Intermediate category of investors who cannot be classified as growth or value investors.

Back-testing

Often, an analyst may be interested in finding how a portfolio based on a stock screen would have performed historically. For instance, assume you go back 5 years and apply the same stock screen to form a portfolio of stocks to see how much the portfolio would have earned had the strategy been implemented. However, there are some limitations (biases) to this approach:

• Survivorship bias: Companies that are no longer in operation (or delisted) will be eliminated. The surviving companies appear to have performed better.
• Look-ahead bias: If companies have restated their financial statements, then there is a mismatch between what the investor would have known at the time of the investment decision and the information used now in back-testing.
• Data-snooping bias: The bias that may exist if excessive analysis is applied to the same data set.

6 – 8. Analyst Adjustments to Reported Financials

When comparing ratios of companies using different accounting standards, adjustments may be required. Before making adjustments, consider the following:

• Importance: Will any adjustments to an item materially affect the conclusion? For example, inventory for a bank has minimal impact. So, will it matter if one bank uses LIFO and the other FIFO?
• Body of standards: Is there a difference in accounting standards: IFRS, US GAAP or home-country GAAP? What does it impact the most?
• Methods: Is there a difference in accounting methods used? For example, cash/accrual based accounting, straight-line or accelerated depreciation, and LIFO/FIFO to measure inventories.
• Estimates: Is there a difference in estimates used by companies? For example, residual value or useful lives of similar assets by two companies.

Analyst Adjustments Related to Investments

Assume Company A classifies financial assets as “available for sale” and Company B classifies similar assets as “trading” securities. Adjustments must be made to classification of investments to facilitate comparison. Recall the following rules for classifying financial assets from the reading on balance sheets:

Analyst Adjustments for Inventory

Consider two companies reporting under US GAAP: one uses LIFO while the other uses FIFO. Companies using LIFO are also required to report a LIFO reserve. When LIFO reserve is added to LIFO inventory, we get inventory value under FIFO.

To make the results of the two companies comparable, the inventory values of the company following LIFO must be adjusted to FIFO using the following formula:

FIFO Inventory = LIFO inventory + LIFO Reserve

Analyst Adjustments Related to Property, Plant, and Equipment

Any company’s management exercises considerable discretion when it comes to estimates and accounting methods for depreciation. Depreciation expense can significantly impact the net income of company and fixed assets on the balance sheet. So, it depends whether a company is making aggressive or conservative estimates for the useful life and residual value of its assets.

Specific adjustments are usually not made for depreciation when comparing two companies. It is more of a qualitative factor. The table below is self-explanatory; it lists the relationships between assets and depreciation as seen in the balance sheet and income statement.

Analyst Adjustments Related to Goodwill

Goodwill arises when one business acquires another business. If the purchase price exceeds the sum of the fair value of the individual assets and liabilities of the acquired business, then the excess amount is recognized as goodwill. Let us assume that companies A and B are identical except that A has grown through acquisition and B has grown organically. What is the impact on goodwill and on total assets?

The company that has grown through acquisition will record higher goodwill, assets, and equity. Assets are higher for this company as they are capitalized and not expensed like the organically growing company. The ratios based on asset values, including profitability ratios, look better for the grown-by-acquisition company.

To make the two companies comparable, it is recommended to use tangible book value which removes the effect of goodwill and other intangible assets (i.e.. subtract goodwill and intangible assets from stockholder’s equity).

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