1 Is overvalued? An Introduction to Financial Analysis The fact that the stock price almost doubled during the last year, was evidence enough for many people to say that investors had gone crazy. Other people say that this price is totally justified and one just has to take a look at the fundamentals to see why. How can we decide, whom to believe? Maybe the answer to the question whether is overvalued or not is a matter of the point of view. The chartist, who sees all price data statistically, would say that on average, a very intense price jump is usually followed by a decline in that price. With a personal trading system that makes use of this observation, a chartist would make money with an average trade. The problem is that if we are talking about a concrete firm, we are not talking about arithmetic averages, so a chartist alone could give us little help in solving our question about apple. In order to get an answer, we have to collect more information and go deeper than just observing prices. This is where financial analysis begins. The purpose of financial analysis To get more information and not only to rely on market prices, the financial analyst uses accounting data. But he uses this data not as an accountant, who is primarily concerned with establishing income statements and balance sheets according to the IFRS or GAAP. The financial analyst reorganizes and mixes up numbers from both income statements and balance sheets using ratios, to identify critical relationships that might otherwise not be readily identifiable. Ratios have one big advantage over pure accounting data: you can make comparisons with them. You cannot do this if you only observe the numbers as stated in the balance sheet. It will help you very little if you know that one firm had an operating profit of 1M $ and another firm had an operating profit of 5M $. You can compare those firms a lot better if you know that the first had an operating return on assets of 20% and the second of only 5%. Also, you can compare the firm s current to the firm s past performance as well as the firm s ratios to the industry norm. There are many groups who are interested in those financial ratios, not only intelligent investors. Managers, for example, use financial ratios to identify deficiencies in the firm s performance and to take corrective action. Lenders use them to decide whether to make a loan to the company and credit-rating-agencies determine the firm s creditworthiness using ratios. We want to start our financial analysis now. We will do that by asking five important questions concerning apple s financial performance. The first is: 1. How liquid is the firm? Liquidity is the firm s ability to pay its bills on time. This ability is related to two things: First, the ease and quickness with which a firm can convert its noncash assets into cash. Second, the size of those noncash assets that could be converted into cash relative to its shortterm liabilities. If you increase either of the two, you will increase the firm s liquidity. The first aspect mentioned above for example is measured by the average collection period (lower = more liquidity) and the inventory turnover (higher = more liquidity).
2 Average collection period Inventory turnover 46 days 83X? 19.89X The second aspect of liquidity, the size of noncash assets relative to current liabilities is measured by the current ratio (higher = more liquidity). Current ratio Are managers creating adequate profits on the firm s assets? The operating return on assets (operating profits/total assets) is determined by the effectiveness with which the firm creates sales out of its assets (sales/total assets) and its management of operations, i.e. how much remains of the sales as operating profit (operating profits/sales). You can say for all three ratios: the higher the better. Operating Return on Assets (OROA) Operating profit margin Total asset turnover 29% 31.2% 0.93X 8.04% 7.35% 1.75X Operating Return on Assets (OROA) = Operating profit margin X Total asset turnover 3. How is the firm financing its assets? To describe how the firm s assets are financed, we usually calculate the debt ratio. Banks and other lenders want to know, whether the firm is likely to make its interest payments. To answer this question we can use the times interest earned ratio. Debt Ratio Times interest earned? 3.8 Note that interests are paid with cash, not earnings. The times interest earned ratio is only some crude measure.
3 4. Are the firm s managers providing a good return on the capital provided by the company s stockholders? Usually we determine the accounting return on the common stockholder s investment, if we want to answer this question Return on equity (ROE) 33.8% 15% The higher the OROA, the higher ROE. Note that you can easily increase the ROE, by using more debt (leverage effect). 5. Are the firm s managers creating shareholder value? One way to answer this question is to use market value ratios. The price/earnings ratio indicates, how much the investors are willing to pay for 1 $ of reported earnings. If this ratio is very high, investors either expect the company to grow or perceive their expected profits less risky. The price/book ratio is the relation between the market value of the firm and its value as reported in its balance sheet. If this ratio is greater than 1, the firm has created shareholder value. If it is less than 1, the firm destroyed shareholder value. P/E Price/book ratio now now Industry Norm 2.08 Conclusion has an average liquidity. Its long average collection period is outweighed by its high inventory turnover and its above-average current ratio. Although s asset efficiency is not so good, its OROA is outstanding, due to its outstanding operating profit margin. This high operating profit margin may either result from high mark-ups in product prices or very good management of operations. The high OROA enables to have a high return on equity although its debt ratio is low. The leverage effect is not working here, which means that s ROE is even less risky than that of its competitors. The fact that Investors are willing to pay more for 1$ book value in than for 1$ in other firms may result from the fact that a dollar of s book value just yields a higher return than the equity of other firms. The P/E ratio is close to the industry norm and remained almost constant over time, since earnings had been growing a lot while the price per share increased. The lower riskiness of apples earnings due to its lower debt ratio may justify a higher P/E and thus an even higher stock price. The same would be true if apple had some more growth potential. You can infer from these numbers that apple is an as good investment now as it was a year ago. We cannot speak of an overvaluation. s stock price just kept up with its financial performance.
4 Income Statement Period Ending Sep 23, 2011 Sep 24, 2010 Sep 25, 2009 Total Revenue 108,249,000 65,225,000 42,905,000 Cost of Revenue 64,431,000 39,541,000 25,683,000 Gross Profit 43,818,000 25,684,000 17,222,000 Operating Expenses Research Development 2,429,000 1,782,000 1,333,000 Selling General and Administrative 7,599,000 5,517,000 4,149,000 Non Recurring Others Total Operating Expenses Operating Income or Loss 33,790,000 18,385,000 11,740,000 Income from Continuing Operations Total Other Income/Expenses Net 415, , ,000 Earnings Before Interest And Taxes 34,205,000 18,540,000 12,066,000 Interest Expense Income Before Tax 34,205,000 18,540,000 12,066,000 Income Tax Expense 8,283,000 4,527,000 3,831,000 Minority Interest Net Income From Continuing Ops 25,922,000 14,013,000 8,235,000 Non-recurring Events Discontinued Operations Extraordinary Items Effect Of Accounting Changes Other Items Net Income 25,922,000 14,013,000 8,235,000 Preferred Stock And Other Adjustments Net Income Applicable To Common Shares 25,922,000 14,013,000 8,235,000
5 Balance Sheet Period Ending Sep 23, 2011 Sep 24, 2010 Sep 25, 2009 Assets Current Assets Cash And Cash Equivalents 9,815,000 11,261,000 5,263,000 Short Term Investments 16,137,000 14,359,000 18,201,000 Net Receivables 13,731,000 11,560,000 6,192,000 Inventory 776,000 1,051, ,000 Other Current Assets 4,529,000 3,447,000 1,444,000 Total Current Assets 44,988,000 41,678,000 31,555,000 Long Term Investments 55,618,000 25,391,000 10,528,000 Property Plant and Equipment 7,777,000 4,768,000 2,954,000 Goodwill 896, , ,000 Intangible Assets 3,536, , ,000 Accumulated Amortization Other Assets 3,556,000 2,263,000 2,011,000 Deferred Long Term Asset Charges - - 1,727,000 Total Assets 116,371,000 75,183,000 47,501,000 Liabilities Current Liabilities Accounts Payable 23,879,000 17,738,000 9,453,000 Short/Current Long Term Debt Other Current Liabilities 4,091,000 2,984,000 2,053,000 Total Current Liabilities 27,970,000 20,722,000 11,506,000 Long Term Debt Other Liabilities 10,100,000 5,531,000 3,502,000 Deferred Long Term Liability Charges 1,686,000 1,139, ,000 Minority Interest Negative Goodwill Total Liabilities 39,756,000 27,392,000 15,861,000 Stockholders' Equity Misc Stocks Options Warrants Redeemable Preferred Stock Preferred Stock Common Stock 13,331,000 10,668,000 8,210,000 Retained Earnings 62,841,000 37,169,000 23,353,000 Treasury Stock Capital Surplus - - -
6 Other Stockholder Equity 443,000 (46,000) 77,000 Total Stockholder Equity 76,615,000 47,791,000 31,640,000 Net Tangible Assets 72,183,000 46,708,000 31,187,000 Financials (yahoo finance, ) P/E: Price/book: 5.28 Number of shares outstanding (Sept 2011) 925M