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هيئـة األوراق الماليـة والسلـع

متطلبات وأدوات التحليل المالي

د. منذر بركات

م2007سبتمبر

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What is Financial Analysis Financial analysis: To evaluate and valuate. Evaluate determinants of financial

performance Determine and put a value to

performance parameters Make a decision

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Determinants of Financial Performance External Environment

Financial System Financial sector The mechanics of moving resources Economic forces Industry factors

Internal Environment Inputs, Operations, Outputs and supporting activities The various departments Corporate governance and agency problems Company risk and return

The Future Forecasted cash flows Forecasted growth rates

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The Financial System The type of financial system that the

company operates in has a great impact on its performance and value

Less developed financial systems lead to lower economic growth; hence, poor performance and lower value for operating companies

The financial infra structure facilitates the movement of resources efficiently.

Efficiency means availability at low cost.

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The UAE Financial System Although the Islamic culture is

dominant, the financials system here is still a capitalist one.

Such system has the following components: Participants Financial sector Interest rates and money supply

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The Financial SystemFinancial

System

I/M Fin. Sec.

Participants-

Government.

- Businesses- Individuals- Foreigners

- Financial Markets- Financial

Institutions

- Interest rates- Money Supply

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The Financial SectorFinancial Sector

Financial InstitutionsFinancial Markets

Long TermEquityDebt

Short TermMoneyFOREX

Non-depositoriesInvestment

CompaniesSecurities firmsContractual

DepositoriesBanksCredits Unions

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How Does It Work

Flow of Funds Through the Financial System

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Interest Rates and Money Supply Interest is the rent of money Equal to the real growth rate of GDP plus the

expected inflation rate plus a premium to compensate for the riskness of the company being analyzed.

Money supply is the amount of liquidity that is being allowed by the UAE central bank. The company being analyzed benefits if the amount of liquidity is near the healthy level.

Both interest rates and money supply have a great effect on the performance and value of the company and need to be taken into consideration in any financial analysis.

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Technological change Inventions--new ideas or technologies Innovations--inventions that can be

replicated reliably on a meaningful scale

Company products may become obsolete due to new technological advances; e.g. carbon paper

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Regulations Among the most significant determinants of organizational

success Governments provide and enforce the rules by which

organizations operate Level of interference from government varies from country

to country and industry to industry The worldwide trend is towards deregulation and

privatization

In the UAE, significant political/legal influence comes from: lawmakers and regulatory agencies; nevertheless, considered liberal in the international arena.

How the company under analysis is affected by legal changes is the purpose of regulatory analysis in the external environment

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Demographic changes Changes in the population mix and their

needs. In the UAE a growing percentage of the population

is foreign and from certain concentrated ethnicities. This will greatly affect the growth of the revenues and hence cash flows of the company being analyzed.

Changes in the tastes and cultural influences. Religion is having a growing role in the UAE, this

has a great influence on the textile industry, especially in women's wear.

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Political environment Security and stability has a great influence on the volatility of

growth and cash flows. The UAE is a peaceful country and the government is stable via

the support of its people. This is leading to the internationally noted growth.

Peace and healthy relations lower the systematic risk of the country, hence lowering the cost of capital and increasing growth and value.

Again, the UAE is known to have peaceful relations with its neighbors and the world, this is the reason for the growth of international business in the UAE as a source of international diversification.

The global integration that is set by the new international order.

The UAE was able to benefit from the new international order in many respects. The new steadily high oil prices, the new opening of international borders had also pumped the needed resources for the UAE and its companies to support the notable vast growth.

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Economic Indicators Leading economic indicators like

inflation, unemployment, consumer confidence, labor productivity, level of interest rates, exchange rates, ….

In the UAE, other than moderate inflation pressures motivated by temporary real estate rental and property value, the LEI point towards solid and steady growth.

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Effect The effect of these determinants of

growth, risk and cash flows, varies from one entity to another. For, instance, peace times are not good for weapon manufacturers. Times of economic growth are not good for inferior goods producers.

In essence, one needs to be careful when analyzing a company for the purpose of determining its financial performance and value.

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Industry Factors The five forces that impact a

company’s ability to compete, grow and add value in a given market. Rivalry Entry Substitutes Suppliers Customers

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Rivalry Lower prices, higher advertising costs, extended warranties,

payment facilities, higher quality, product improvements and new products. All costly, may increase growth, but will lower cash inflows and increase risk.

In the UAE, competition is wide open amongst domestic firms and with international ones.

The intensity of rivalry happens when: Competitors are equal in size and abilities Slow growth industry Lack of differentiation Lack of switching costs High exit barriers Large number of competitors

In the UAE, for most industries (excluding Laundromats and the likes) and due to fast growth in demand, rivalry is not very intense but is expected to be so in the near future.

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Entry Factors that limit entry to industries are:

Economies of Scale and Scope Government policies Expected retaliation Product differentiation Switching costs Capital requirements Access to distribution channels

Financial analysts need to look at these factors to figure out whether new entrants to the industry are likely and whether they will increase the intensity of rivalry and to assess its effects on growth, risk, cash flow and value.

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Substitutes Now and in the future

Examples would be electronic security systems instead of security guards.

Existence of good substitutes has a great effect on the pricing of products and hence on growth, risk and cash flows of the company being analyzed.

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Suppliers Suppliers can affect cost and hence affect the

growth and cash flows, especially when the product is price elastic.

Suppliers are capable of driving down value if: The number of suppliers is small We are not large The needed product does not have good substitutes

and is an important component of our final product High switching costs The supplier can produce the final product easily and

enter the market as a competitor.

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Customers Customers can affect revenue and hence affect

the growth and cash flows, especially when the product is price elastic.

Customers are capable of driving down value if: The number of buyers is small We are not large compared to the number of buyers

or the volume of product needed The needed product has good substitutes and is not

important Low switching costs Buyer has full information and can choose between

products.

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Internal Analysis Analyzing the company as a whole and by

department especially the finance department to evaluate its performance and to prepare financial information for financial analysis.

Human resources Knowledge and learning resources Physical resources General organizational resources And most importantly financial resources

Financial analysts do visit companies and can ask questions and inspect operations physically.

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Human Resources

Managers – CEO and top

management team Employees – recruitment, training

programs, rewards system Owners/board of directors

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Knowledge and Learning Resources Organizational learning leads to

strengths in other resource areas. It involves: Knowledge creation Knowledge retention Knowledge sharing Knowledge utilization

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Physical Resources Tangible resources such as machinery,

plants and products – easy to imitate, but the processes to create them are not

Locations – competitive clusters can provide advantages to companies and consumers

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General Organizational Resources Some general organizational resources

are hard to imitate and are therefore excellent sources of sustainable competitive advantage: Organizational reputation Corporate brands Unique configurations of stakeholder

relationships – joint venture, long-term contracts and other types of partnerships and alliances

Organizational structure and internal systems Organizational culture

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Financial Resources Strong cash flow, low levels of debt, strong credit rating, access to

low interest capital and reputation for creditworthiness can increase strategic flexibility – more responsive to new opportunities.

Diagnose problems• Declining profitability• Insufficient liquidity• Leverage too high or too low• Internal mismanagement

Essential comparisons • Firm to competitors• Firm to itself over time

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Some Commonly Used Ratios Profitability

• Gross Profit Margin• Net Profit Margin• ROA• ROE

Liquidity• Current• Quick

Leverage• Debt to Equity• Total Debt to Total Assets (Asset Ratio)

Activity• Asset Turnover Average Collection Period• Accounts Receivable Turnover Inventory Turnover

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The Value Chain Primary Activities

Inbound Logistics Operations Outbound Logistics Marketing and Sales Service

Activities that Support the Primary Activities

Administration Technology Development Human Resource Development Procurement

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Corporate Governance Corporate governance is the system by which business

corporations are directed and controlled. The corporate governance structure specifies the distribution of rights and responsibilities among different participants in the corporation, such as, the board, managers, shareholders and other stakeholders, and spells out the rules and procedures for making decisions on corporate affairs. By doing this, it also provides the structure through which the company objectives are set, and the means of attaining those objectives and monitoring performance.

Of great importance in financial analysis and due to their effect on performance and value are the following relations:

Board of Directors Managers Auditors Regulators Market for corporate control

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Board of Directors The board of directors:

Hires, fires, supervises and compensates top management Approves major strategic decisions Ensures that the firm and its managers are acting responsibly Provides advice to top management Provides a social network that helps firms acquire resources

Factors that determine the success of the board to create value:

Institutional Vs. Individual Shareholder Vs. External Men Vs. Women Educated Vs. Not Educated Old Vs. Young

The strength of the board is a major factor in assigning a discount rate and in assessing growth and cash flow forecasts.

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Manager – Shareholder Agents--managers with a fiduciary duty to act in the best interests of

owners Agency problem--managers maximize their own self-interests at the

expense of owners High salaries of CEOs Emphasis on short-term performance at expense of long-term performance Empire building for status perquisites

The burden is to align the interests of the manager with those of the shareholders

This puts a DRAIN on the performance and value of the firm. Tactics used to align interest:

Manager part owner Stock options Bonuses Cash dividends Debt Monitoring Corporate control markets

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Shareholder – Debt holder The conflict of interest arises here when the

firm is over indebted. Shareholders will get into high risk – high

return investments, if such investments materialize, shareholders will reap most of the benefit (debt holders are paid a fixed percentage and the residual goes to the shareholders), if not most of the loss will be on the side of the debt holders.

The solution is covenants The financial analyst needs to assess such

situation in the process of determining a risk premium among other things.

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Shareholder - Shareholder A rises in companies with subsidiaries

and affiliates The interests of the subsidiary

shareholders are not in line with those of the shareholders of the parent companies

Appears in capital budgeting decisions especially when the parent and the subsidiary are in two different tax and regulatory regimes

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Auditors Auditors are prone to be lenient in

auditing financial statements and in valuing business because they are paid by the very same party they are auditing or do not want to lose future business opportunities.

Such considerations need to be taken into account when financially analyzing a firm.

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Regulators The regulators interests may be

different from those of the company being analyzed

The regulator may enact regulations that hurt the company for the public good; levying taxes is an example.

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The Market for Corporate Control Participants in the financial markets are

monitoring each other to capitalize on opportunities of buying an undervalued firm.

Firms that have corporate governance problems are prone to incur higher rate of return due to the risk premium added from such problems.

The financial analyst needs to incorporate such factors in estimating and forecasting required rates of return and future cash flows.

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Company Risk and Return The analyst needs to incorporate specific analysis of the

riskness of the company to reflect that on the required rate of return on investing sums of money in such company.

Many measures of risk, the most important ones are the most simple ones, because they are the ones used most in industry practice.

Beta Sigma VaR Many more like: down side risk, coefficient of variatuin,

regressions, time series, FF two factor model, FF multi factor models, Merton intertemporal model, stochastic models, stress tests under various distributions …..

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Types of Financial Analysis Fundamental: use of all relevant

information and to predict value – assumes markets efficiency.

Technical: use of past price, trading volume and people behavior to predict value – assumes market inefficiency.

Naïve: Financial ratios and some calculated indicators – limited usefulness.

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Fundamental Analysis The value of an asset is equal to

the present value of all of its future net cash flow.

Need to take previous factors into account when forecasting cash flows, growth rates and required rates of return.

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Is stock price maximization the same as profit maximization?

No, despite a generally high correlation amongst stock price, EPS, and cash flow.

Current stock price relies upon current earnings, as well as future earnings and cash flow.

Some actions may cause an increase in earnings, yet cause the stock price to decrease (and vice versa).

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Factors that affect stock price Projected cash flows to shareholders Timing of the cash flow stream Riskiness of the cash flows

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Basic Valuation Model

To estimate an asset’s value, one estimates the cash flow for each period t (CFt), the life of the asset (n), and the appropriate discount rate (k)

n

1tt

t

nn

22

11

.k)(1CF

k)(1CF

k)(1CF

k)(1CF Value

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Dividend Discount Models Constant growth Two growth Multi growth Stochastic

Additive w and w/o bankruptcy Geometric w and w/o bankruptcy

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Multipliers PE PB V/EBIT P/S P/CF

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Forecasting Example

Cash & sec. $ 20 Accts. pay. & accruals $ 100

Accounts rec. 240 Notes payable 100Inventories 240 Total CL $ 200

Total CA $ 500 L-T debt 100Common stock 500

Net fixed Retained assets 500 earnings 200

Total assets $1,000 Total claims $1,000

Balance sheet, in millions of dollars

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Sales $2,000.00Less: Var. costs (60%) 1,200.00

Fixed costs 700.00EBIT $ 100.00

Interest 16.00EBT $ 84.00

Taxes (40%) 33.60Net income $ 50.40Dividends (30%) $15.12Add’n to RE $35.28

Income statement, in millions of dollarsForecasting Example

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Key assumptions Operating at full capacity in 2006. Each type of asset grows proportionally

with sales. Payables and accruals grow

proportionally with sales. 2002 profit margin (2.52%) and payout

(30%) will be maintained. Sales are expected to increase by $500

million. (%GS = 25%)

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Determining additional funds needed AFN

AFN = (A*/S0)ΔS – (L*/S0) ΔS – M(S1)(RR)

= ($1,000/$2,000)($500) – ($100/$2,000)($500) – 0.0252($2,500)(0.7)= $180.9 million.

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How shall AFN be raised? The payout ratio will remain at 30

percent (d = 30%; RR = 70%). No new common stock will be issued. Any external funds needed will be

raised as debt, 50% notes payable and 50% L-T debt.

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Forecasted Income Statement

Sales $2,000 1.25 $2,500Less: VC 1,200 0.60 1,500

FC 700 0.35 875 EBIT $ 100 $ 125Interest 16 16 EBT $ 84 $ 109Taxes (40%) 34 44Net income $ 50 $ 65Div. (30%) $15 $19Add’n to RE $35 $46

ForecastBasis

2007Forecast2006

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20071st Pass

Forecasted Balance Sheet (2007) - Assets

2006Forecast

BasisCash $ 20 0.01 $ 25Accts. rec. 240 0.12 300Inventories 240 0.12 300 Total CA $ 500 $ 625Net FA 500 0.25 625 Total assets $1,000 $1,250

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20071st Pass2006

ForecastBasis

Forecasted Balance Sheet (2007) - Liabilities and Equity

AP/accruals $ 100 0.05 $ 125Notes payable 100 100 Total CL $ 200 $ 225L-T debt 100 100Common stk. 500 500Ret.earnings 200 +46* 246 Total claims $1,000 $1,071

* From income statement.

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What is the additional financing needed (AFN)?

اضافي تمويل الى الحاجة حساب Required increase in assets = $ 250 Spontaneous increase in liab. = $ 25 Increase in retained earnings = $ 46 Total AFN = $ 179

NWC must have the assets to generate forecasted sales. The balance sheet must balance, so we must raise $179 million externally.

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How will the AFN be financed?

Additional N/P 0.5 ($179) = $89.50

Additional L-T debt 0.5 ($179) = $89.50

But this financing will add to interest expense, which will lower NI and retained earnings. We will generally ignore financing feedbacks.

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20072nd Pass

20071st Pass AFN

Forecasted Balance Sheet (2007) - Assets

Cash $ 25 - $ 25Accts. rec. 300 - 300Inventories 300 - 300 Total CA $ 625 $ 625Net FA 625 - 625 Total assets $1,250 $1,250

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20072nd Pass

20071st Pass AFN

Forecasted Balance Sheet (2007) - Liabilities and Equity

AP/accruals $ 125 - $ 125Notes payable 100 +89.5 190 Total CL $ 225 $ 315L-T debt 100 +89.5 189Common stk. 500 - 500Ret.earnings 246 - 246 Total claims $1,071 $1,250

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Advanced Forecasting Use of regressions for each item Use of iterations in finding interest

income and expense Forecasting with stock dividends,

stock repurchase, stock issuance, stock splits, ….

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Technical Charts Point and figure Candlesticks OHLC Price lines Moving averages ……

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Technical Indicators Candlesticks: hammer, bullish engulfing,

morning star, bearish engulfing, hanging man, harami, Marubozu, three white soldiers, …. Many more.

Technical indicators: moving averages, exponential moving averages, Bollinger bands, slow stochastic, fast stochasitc, Trin, Trix, Money flow index, RSI, Average directional index, Williams %R, Price rate of change, Oscillators, …. Many more.

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Use of Mathematics Not at this time Just for fun …

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Exotic Financial Analysis Stochastic models in forecasting

items and future interest rates and discount rates, and the previously mentioned stochastic dividend discount models.

Real Options Abandonment Options