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Bodie−Kane−Marcus:
Essentials of Investments,
Fifth Edition
IV. Security Analysis 13. Financial Statement
Analysis
© The McGraw−Hill
Companies, 2003
investors could expect to earn for themselves (on a risk-adjusted basis) in the capital market.
Think back to Table 13.9, where we showed that plowing back funds into the firm increases
share value only if the firm earns a higher rate of return on the reinvested funds than the op-
portunity cost of capital, that is, the market capitalization rate. To account for this opportunity
cost, we might measure the success of the firm using the difference between the return on as-
sets, ROA, and the opportunity cost of capital, k. Economic value added (EVA), or residual
income, is the spread between ROA and k multiplied by the capital invested in the firm. It
therefore measures the dollar value of the firm’s return in excess of its opportunity cost.
Table 13.11 shows EVA for a small sample of firms drawn from a larger study of 1,000
firms by Stern Stewart, a consulting firm that has done much to develop and promote the con-
cept of EVA. Microsoft had one of the highest returns on capital, at 51.8%. Since the cost of
capital for Microsoft was only 12.6% percent, each dollar invested by Microsoft was earn-
ing about 39.2 cents more than the return that investors could have expected by investing in
equivalent-risk stocks. Applying this 39.2% margin of superiority to Microsoft’s capital base
of $20.03 billion, we calculate annual economic value added as $7.85 billion.
3
Note that
ExxonMobil’s EVA was larger than Intel’s, despite a far smaller margin between return on
capital and cost of capital. This is because ExxonMobil applied this margin to a larger capital
base. At the other extreme, AT&T earned less than its opportunity cost on a very large capital
base, which resulted in a large negative EVA.
Notice that even the EVA “losers” in this study generally had positive profits. For example,
AT&T’s ROA was 4.4%. The problem is that AT&T’s profits were not high enough to com-
pensate for the opportunity cost of funds. EVA treats the opportunity cost of capital as a real

cost that, like other costs, should be deducted from revenues to arrive at a more meaningful
“bottom line.” A firm that is earning profits but is not covering its opportunity cost might be
able to redeploy its capital to better uses. Therefore, a growing number of firms now calculate
EVA and tie managers’ compensation to it.
13 Financial Statement Analysis 467
economic value
added, or
residual income
A measure of the
dollar value of
a firm’s return
in excess of its
opportunity cost.
3
Actual EVA estimates reported by Stern Stewart differ somewhat from the values in Table 13.11 because of other
adjustments to the accounting data involving issues such as treatment of research and development expenses, taxes,
advertising expenses, and depreciation. The estimates in Table 13.11 are designed to show the logic behind EVA.
TABLE 13.11
Economic value
added, 1999
Economic
Value Added Capital Return on Cost of
($ billions)
($ billions) Capital Capital
A. Some EVA winners
Microsoft $7.85 $20.03 51.8% 12.6%
ExxonMobil $6.32 $180.04 11.7% 8.2%
Intel $5.48 $29.83 30.6% 12.2%
Merck $3.66 $29.55 23.1% 10.7%
General Electric $3.59 $75.83 17.2% 12.5%

B. Some EVA losers
AT&T Ϫ$8.54 $176.87 4.4% 9.2%
WorldCom Ϫ$4.92 $94.02 5.6% 10.8%
Lucent Ϫ$2.55 $65.59 9.8% 13.7%
Loews Ϫ$2.38 $19.95 Ϫ2.4% 9.5%
Bank One Corp Ϫ$1.60 $45.56 8.5% 12.0%
Source: Stern Stewart.
Bodie−Kane−Marcus:
Essentials of Investments,
Fifth Edition
IV. Security Analysis 13. Financial Statement
Analysis
© The McGraw−Hill
Companies, 2003
13.6 AN ILLUSTRATION OF
FINANCIAL STATEMENT ANALYSIS
In her 2003 annual report to the shareholders of Growth Industries, Inc., the president wrote:
“2003 was another successful year for Growth Industries. As in 2002, sales, assets, and oper-
ating income all continued to grow at a rate of 20%.”
Is she right?
We can evaluate her statement by conducting a full-scale ratio analysis of Growth Indus-
tries. Our purpose is to assess GI’s performance in the recent past, to evaluate its future
prospects, and to determine whether its market price reflects its intrinsic value.
Table 13.12 shows some key financial ratios we can compute from GI’s financial state-
ments. The president is certainly right about the growth in sales, assets, and operating income.
Inspection of GI’s key financial ratios, however, contradicts her first sentence: 2003 was not
another successful year for GI—it appears to have been another miserable one.
ROE has been declining steadily from 7.51% in 2001 to 3.03% in 2003. A comparison of
GI’s 2003 ROE to the 2003 industry average of 8.64% makes the deteriorating time trend
especially alarming. The low and falling market-to-book-value ratio and the falling price–

earnings ratio indicate that investors are less and less optimistic about the firm’s future
profitability.
The fact that ROA has not been declining, however, tells us that the source of the declining
time trend in GI’s ROE must be due to financial leverage. And we see that, while GI’s lever-
age ratio climbed from 2.117 in 2001 to 2.723 in 2003, its interest-burden ratio fell from 0.650
to 0.204—with the net result that the compound leverage factor fell from 1.376 to 0.556.
The rapid increase in short-term debt from year to year and the concurrent increase in in-
terest expense make it clear that, to finance its 20% growth rate in sales, GI has incurred siz-
able amounts of short-term debt at high interest rates. The firm is paying rates of interest
greater than the ROA it is earning on the investment financed with the new borrowing. As the
firm has expanded, its situation has become ever more precarious.
In 2003, for example, the average interest rate on short-term debt was 20% versus an ROA
of 9.09%. (We compute the average interest rate on short-term debt by taking the total inter-
est expense of $34,391,000, subtracting the $6 million in interest on the long-term bonds, and
dividing by the beginning-of-year short-term debt of $141,957,000.)
GI’s problems become clear when we examine its statement of cash flows in Table 13.13.
The statement is derived from the income statement and balance sheet in Table 13.8. GI’s cash
flow from operations is falling steadily, from $12,700,000 in 2001 to $6,725,000 in 2003. The
468 Part FOUR Security Analysis
TABLE 13.12
Key financial ratios of Growth Industries, Inc.
(1) (2) (3) (4) (5) (6) (7)
Net Compound
P
rofit Pretax EBIT Sales Leverage
Pretax P
rofit Sales Assets Assets Factor ROA
Year ROE Profit EBIT (ROS) (ATO) Equity (2) ؋ (5) (3) ؋ (4) P/E P/B
2001 7.51% 0.6 0.650 30% 0.303 2.117 1.376 9.09% 8 0.58
2002 6.08 0.6 0.470 30 0.303 2.375 1.116 9.09 6 0.35

2003 3.03 0.6 0.204 30 0.303 2.723 0.556 9.09 4 0.12
Industry average 8.64 0.6 0.800 30 0.400 1.500 1.200 12.00 8 0.69
Bodie−Kane−Marcus:
Essentials of Investments,
Fifth Edition
IV. Security Analysis 13. Financial Statement
Analysis
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Companies, 2003
firm’s investment in plant and equipment, by contrast, has increased greatly. Net plant and
equipment (i.e., net of depreciation) rose from $150,000,000 in 2000 to $259,200,000 in 2003.
This near doubling of the capital assets makes the decrease in cash flow from operations all
the more troubling.
The source of the difficulty is GI’s enormous amount of short-term borrowing. In a sense,
the company is being run as a pyramid scheme. It borrows more and more each year to main-
tain its 20% growth rate in assets and income. However, the new assets are not generating
enough cash flow to support the extra interest burden of the debt, as the falling cash flow from
operations indicates. Eventually, when the firm loses its ability to borrow further, its growth
will be at an end.
At this point, GI stock might be an attractive investment. Its market price is only 12% of its
book value, and with a P/E ratio of 4, its earnings yield is 25% per year. GI is a likely candi-
date for a takeover by another firm that might replace GI’s management and build shareholder
value through a radical change in policy.
4. You have the following information for IBX Corporation for the years 2001 and
2004 (all figures are in $millions):
2004 2001
Net income $ 253.7 $ 239.0
Pretax income 411.9 375.6
EBIT 517.6 403.1
Average assets 4,857.9 3,459.7

Sales 6,679.3 4,537.0
Shareholders’ equity 2,233.3 2,347.3
What is the trend in IBX’s ROE, and how can you account for it in terms of tax
burden, margin, turnover, and financial leverage?
13 Financial Statement Analysis 469
TABLE 13.13
Growth Industries
statement of cash
flows ($thousands)
2001 2002 2003
Cash flow from operating activities
Net income $ 11,700 $ 10,143 $ 5,285
ϩ Depreciation 15,000 18,000 21,600
ϩ Decrease (increase) in accounts receivable (5,000) (6,000) (7,200)
ϩ Decrease (increase) in inventories (15,000) (18,000) (21,600)
ϩ Increase in accounts payable 6,000 7,200 8,640
$ 12,700 $ 11,343 $ 6,725
Cash flow from investing activities
Investment in plant and equipment* $(45,000) $(54,000) $(64,800)
Cash flow from financing activities
Dividends paid
†
$0$0 $0
Short-term debt issued 42,300 54,657 72,475
Change in cash and marketable securities
‡
$ 10,000 $ 12,000 $ 14,400
Concept
CHECK
<

*Gross investment equals increase in net plant and equipment plus depreciation.
†
We can conclude that no dividends are paid because stockholders’ equity increases each year by the full amount of net income, implying a
plowback ratio of 1.0.
‡
Equals cash flow from operations plus cash flow from investment activities plus cash flow from financing activities. Note that this equals
the yearly change in cash and marketable securities on the balance sheet.
Bodie−Kane−Marcus:
Essentials of Investments,
Fifth Edition
IV. Security Analysis 13. Financial Statement
Analysis
© The McGraw−Hill
Companies, 2003
13.7 COMPARABILITY PROBLEMS
Financial statement analysis gives us a good amount of ammunition for evaluating a com-
pany’s performance and future prospects. But comparing financial results of different compa-
nies is not so simple. There is more than one acceptable way to represent various items of
revenue and expense according to generally accepted accounting principles (GAAP). This
means two firms may have exactly the same economic income yet very different accounting
incomes.
Furthermore, interpreting a single firm’s performance over time is complicated when in-
flation distorts the dollar measuring rod. Comparability problems are especially acute in this
case because the impact of inflation on reported results often depends on the particular method
the firm adopts to account for inventories and depreciation. The security analyst must adjust
the earnings and the financial ratio figures to a uniform standard before attempting to compare
financial results across firms and over time.
Comparability problems can arise out of the flexibility of GAAP guidelines in accounting
for inventories and depreciation and in adjusting for the effects of inflation. Other important
potential sources of noncomparability include the capitalization of leases and other expenses,

the treatment of pension costs, and allowances for reserves, but they are beyond the scope of
this book.
Inventory Valuation
There are two commonly used ways to value inventories: LIFO (last-in, first-out) and FIFO
(first-in, first-out). We can explain the difference using a numerical example.
Suppose Generic Products, Inc. (GPI), has a constant inventory of 1 million units of
generic goods. The inventory turns over once per year, meaning the ratio of cost of goods sold
to inventory is 1.
The LIFO system calls for valuing the million units used up during the year at the current
cost of production, so that the last goods produced are considered the first ones to be sold.
They are valued at today’s cost. The FIFO system assumes that the units used up or sold are
the ones that were added to inventory first, and goods sold should be valued at original cost.
If the price of generic goods were constant, at the level of $1, say, the book value of in-
ventory and the cost of goods sold would be the same, $1 million under both systems. But sup-
pose the price of generic goods rises by 10 cents per unit during the year as a result of
inflation.
LIFO accounting would result in a cost of goods sold of $1.1 million, while the end-of-year
balance sheet value of the 1 million units in inventory remains $1 million. The balance sheet
value of inventories is given as the cost of the goods still in inventory. Under LIFO, the last
goods produced are assumed to be sold at the current cost of $1.10; the goods remaining are
the previously produced goods, at a cost of only $1. You can see that, although LIFO ac-
counting accurately measures the cost of goods sold today, it understates the current value of
the remaining inventory in an inflationary environment.
In contrast, under FIFO accounting, the cost of goods sold would be $1 million, and the
end-of-year balance sheet value of the inventory is $1.1 million. The result is that the LIFO
firm has both a lower reported profit and a lower balance sheet value of inventories than the
FIFO firm.
LIFO is preferred over FIFO in computing economics earnings (that is, real sustainable
cash flow), because it uses up-to-date prices to evaluate the cost of goods sold. A disadvan-
tage is that LIFO accounting induces balance sheet distortions when it values investment in

inventories at original cost. This practice results in an upward bias in ROE because the in-
vestment base on which return is earned is undervalued.
470 Part FOUR Security Analysis
LIFO
The last-in first-out
accounting method
of valuing inventories.
FIFO
The first-in first-out
accounting method
of valuing inventories.
Bodie−Kane−Marcus:
Essentials of Investments,
Fifth Edition
IV. Security Analysis 13. Financial Statement
Analysis
© The McGraw−Hill
Companies, 2003
In computing the gross national product, the U.S. Department of Commerce has to make
an inventory valuation adjustment (IVA) to eliminate the effects of FIFO accounting on the
cost of goods sold. In effect, it puts all firms in the aggregate onto a LIFO basis.
Depreciation
Another source of problems is the measurement of depreciation, which is a key factor in com-
puting true earnings. The accounting and economic measures of depreciation can differ
markedly. According to the economic definition, depreciation is the amount of a firm’s oper-
ating cash flow that must be reinvested in the firm to sustain its real cash flow at the cur-
rent level.
The accounting measurement is quite different. Accounting depreciation is the amount of
the original acquisition cost of an asset that is allocated to each accounting period over an
arbitrarily specified life of the asset. This is the figure reported in financial statements.

Assume, for example, that a firm buys machines with a useful economic life of 20 years at
$100,000 apiece. In its financial statements, however, the firm can depreciate the machines
over 10 years using the straight-line method, for $10,000 per year in depreciation. Thus, after
10 years, a machine will be fully depreciated on the books, even though it remains a produc-
tive asset that will not need replacement for another 10 years.
In computing accounting earnings, this firm will overestimate depreciation in the first
10 years of the machine’s economic life and underestimate it in the last 10 years. This will
cause reported earnings to be understated compared with economic earnings in the first
10 years and overstated in the last 10 years.
Depreciation comparability problems add one more wrinkle. A firm can use different de-
preciation methods for tax purposes than for other reporting purposes. Most firms use accel-
erated depreciation methods for tax purposes and straight-line depreciation in published
financial statements. There also are differences across firms in their estimates of the deprecia-
ble life of plant, equipment, and other depreciable assets.
The major problem related to depreciation, however, is caused by inflation. Because con-
ventional depreciation is based on historical costs rather than on the current replacement cost
of assets, measured depreciation in periods of inflation is understated relative to replacement
cost, and real economic income (sustainable cash flow) is correspondingly overstated.
The situation is similar to what happens in FIFO inventory accounting. Conventional de-
preciation and FIFO both result in an inflation-induced overstatement of real income because
both use original cost instead of current cost to calculate net income.
For example, suppose Generic Products, Inc., has a machine with a three-year useful life
that originally cost $3 million. Annual straight-line depreciation is $1 million, regardless of
what happens to the replacement cost of the machine. Suppose inflation in the first year turns
out to be 10%. Then the true annual depreciation expense is $1.1 million in current terms,
while conventionally measured depreciation remains fixed at $1 million per year. Accounting
income therefore overstates real economic income.
Inflation and Interest Expense
While inflation can cause distortions in the measurement of a firm’s inventory and deprecia-
tion costs, it has perhaps an even greater effect on the calculation of real interest expense.

Nominal interest rates include an inflation premium that compensates the lender for inflation-
induced erosion in the real value of principal. From the perspective of both lender and
borrower, therefore, part of what is conventionally measured as interest expense should be
treated more properly as repayment of principal.
13 Financial Statement Analysis 471
Bodie−Kane−Marcus:
Essentials of Investments,
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IV. Security Analysis 13. Financial Statement
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For example, suppose Generic Products has debt outstanding with a face value of $10 mil-
lion at an interest rate of 10% per year. Interest expense as conventionally measured is $1 mil-
lion per year. However, suppose inflation during the year is 6%, so that the real interest rate is
4%. Then $0.6 million of what appears as interest expense on the income statement is really
an inflation premium, or compensation for the anticipated reduction in the real value of the
$10 million principal; only $0.4 million is real interest expense. The $0.6 million reduction in
the purchasing power of the outstanding principal may be thought of as repayment of princi-
pal, rather than as an interest expense. Real income of the firm is, therefore, understated by
$0.6 million.
This mismeasurement of real interest means that inflation results in an underestimate of
real income. The effects of inflation on the reported values of inventories and depreciation that
we have discussed work in the opposite direction.
5. In a period of rapid inflation, companies ABC and XYZ have the same reported
earnings. ABC uses LIFO inventory accounting, has relatively fewer depreciable as-
sets, and has more debt than XYZ. XYZ uses FIFO inventory accounting. Which
company has the higher real income and why?
Quality of Earnings and Accounting Practices
Many firms make accounting choices that present their financial statements in the best pos-

sible light. The different choices that firms can make give rise to the comparability problems
we have discussed. As a result, earnings statements for different companies may be more or
less rosy presentations of true “economic earnings”—sustainable cash flow that can be paid to
shareholders without impairing the firm’s productive capacity. Analysts commonly evaluate
the quality of earnings reported by a firm. This concept refers to the realism and conser-
vatism of the earnings number, in other words, the extent to which we might expect the re-
ported level of earnings to be sustained.
Examples of the accounting choices that influence quality of earnings are:
• Allowance for bad debt. Most firms sell goods using trade credit and must make an
allowance for bad debt. An unrealistically low allowance reduces the quality of reported
earnings. Look for a rising average collection period on accounts receivable as evidence of
potential problems with future collections.
• Nonrecurring items. Some items that affect earnings should not be expected to recur
regularly. These include asset sales, effects of accounting changes, effects of exchange rate
movements, or unusual investment income. For example, in 1999, which was a banner
year for equity returns, some firms enjoyed large investment returns on securities held.
These contributed to that year’s earnings, but should not be expected to repeat regularly.
They would be considered a “low-quality” component of earnings. Similarly gains in
corporate pension plans can generate large, but one-time, contributions to reported
earnings. For example, IBM increased its year 2000 pretax income by nearly $200 million
by changing the assumed rate of return on its pension fund assets by 0.5%.
• Reserves management. In the 1990s, W. R. Grace reduced its earnings by offsetting high
earnings in one of its subsidiaries with extra reserves against unspecified future liabilities.
Why would it do this? Because later, it could “release” those reserves if and when
earnings were lower, thereby creating the appearance of steady earnings growth. Wall
Street likes strong, steady earnings growth, but Grace planned to provide such growth
through earnings management.
• Stock options. Many firms, particularly start-ups, compensate employees in large part with
stock options. To the extent that these options replace cash salary that otherwise would
472

Part FOUR Security Analysis
Concept
CHECK
>
quality of
earnings
The realism and
sustainability of
reported earnings.
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IV. Security Analysis 13. Financial Statement
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need to be paid, the value of the options should be considered as one component of
the firm’s labor expense. But GAAP accounting rules do not require such treatment.
Therefore, all else equal, earnings of firms with large employee stock option programs
should be considered of lower quality.
• Revenue recognition. Under GAAP accounting, a firm is allowed to recognize a sale
before it is paid. This is why firms have accounts receivable. But sometimes it can be hard
to know when to recognize sales. For example, suppose a computer firm signs a contract
to provide products and services over a five-year period. Should the revenue be booked
immediately or spread out over five years? A more extreme version of this problem is
called “channel stuffing,” in which firms “sell” large quantities of goods to customers, but
give them the right to later either refuse delivery or return the product. The revenue from
the “sale” is booked now, but the likely returns are not recognized until they occur (in a
future accounting period). According to the SEC, Sunbeam, which filed for bankruptcy in
2001, generated $60 million in fraudulent profits in 1999 using this technique. If you see

accounts receivable increasing far faster than sales, or becoming a larger percentage of
total assets, beware of these practices. Global Crossing, which filed for bankruptcy in
2002, illustrates a similar problem in revenue recognition. It swapped capacity on its
network for capacity of other companies for periods of up to 20 years. But while it seems
to have booked the sale of its capacity as immediate revenue, it treated the acquired
capacity as capital assets that could be expensed over time. Given the wide latitude firms
have to manipulate revenue, many analysts choose instead to concentrate on cash flow,
which is far harder for a company to manipulate.
• Off-balance-sheet assets and liabilities. Suppose that one firm guarantees the outstanding
debt of another firm, perhaps a firm in which it has an ownership stake. That obligation
ought to be disclosed as a contingent liability, since it may require payments down the
road. But these obligations may not be reported as part of the firm’s outstanding debt.
Similarly, leasing may be used to manage off-balance-sheet assets and liabilities. Airlines,
for example, may show no aircraft on their balance sheets but have long-term leases that
are virtually equivalent to debt-financed ownership. However, if the leases are treated as
operating rather than capital leases, they may appear only as footnotes to the financial
statements.
Enron Corporation, which filed for bankruptcy protection in December 2001, presents an
extreme case of “management” of financial statements. The firm seems to have used several
partnerships in which it was engaged to hide debt and overstate earnings. When disclosures
about these partnerships came to light at the end of 2001, the company was forced to restate
earnings amounting to almost $600 million dating back to 1997. Enron raises the question of
where to draw the line that separates creative, but legal, interpretation of financial reporting
rules from fraudulent reporting. It also raises questions about the proper relationship between
a firm and its auditor, which is supposed to certify that the firm’s financial statements are pre-
pared properly. Enron’s auditor, Arthur Andersen LLP, actually earned more money in 2000
doing nonauditing work for Enron than it did for its external audit. The dual role of the audit-
ing firm creates a potential conflict of interest, since the auditor may be lenient in the audit to
preserve its consulting business with the client. Andersen’s dual role has become common in
the auditing industry. However, in the wake of the Enron bankruptcy, many firms have volun-

tarily decided to no longer hire their auditors as consultants, and this practice may be banned
by new legislation. Moreover, big auditors such as KMPG, Ernst & Young, Pricewaterhouse-
Coopers, and Deloitte Touche Tohmatsu either have spun off their consulting practices as
independent firms or have announced their intention to separate the audit and consulting
businesses.
13 Financial Statement Analysis 473
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IV. Security Analysis 13. Financial Statement
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474
Deciphering the Black Box: Many Accounting Practices,
Not Just Enron’s, Are Hard to Penetrate
Just 30 years ago, the rules governing corporate ac-
counting filled only two volumes and could fit in a brief-
case. Since then, the standards have multiplied so
rapidly that it takes a bookcase shelf—a long one—to
hold all the volumes.
As the collapse of Enron has made painfully clear,
the complexity of corporate accounting has grown
exponentially. What were once simple and objective
concepts, like sales and earnings, in many cases have
become complicated and subjective. Add the fact that
many companies disclose as little as possible, and the
financial reports of an increasing number of companies
have become impenetrable and confusing.
The result has been a rise in so-called black-box

accounting: financial statements, like Enron’s, that are
so obscure that their darkness survives the light of day.
Even after disclosure, the numbers that some com-
panies report are based on accounting methodologies
so complex, involving such a high degree of guesswork,
that it can’t easily be determined precisely how they
were arrived at. Hard to understand doesn’t necessarily
mean inaccurate or illegal, of course. But, some com-
panies take advantage of often loose accounting rules
to massage their numbers to make their results look
better.
The bottom line: There is a lot more open to inter-
pretation when it comes to the bottom line.
Why has corporate accounting become so difficult
to understand? In large part because corporations, and
what they do, have become more complex. The ac-
counting system initially was designed to measure the
profit and loss of a manufacturing company. Figuring
out the cost of producing a hammer or an automobile,
and the revenue from selling them, was relatively easy.
But determining the same figures for a service, or for a
product like computer software, can involve a lot more
variables open to interpretation.
Companies have evolved ever-more complex ways
to limit risk. Baruch Lev, accounting and finance pro-
fessor at New York University, says a venture into for-
eign markets creates a need for a company to use
derivatives, financial instruments that hedge invest-
ments or serve as credit guarantees. Many companies
have turned to off-the-books partnerships to insulate

themselves from risks and share costs of expansion.
This is where the accounting has a hard time keep-
ing up—and keeping track of what is going on fi-
nancially inside a giant, multifaceted multinational.
Accounting rules designed for a company that makes
simple products can end up being inadequate to por-
tray a concern like Enron, which in many ways exists as
the focal point of a series of contracts—contracts to
trade broadband capacity, electricity and natural gas,
and contracts to invest in other technology start-ups.
Unfortunately, Enron was hardly alone in preparing financial statements of questionable
quality or utility. The nearby box points out that financial statements have increasingly be-
come “black boxes,” reporting data that are difficult to interpret or even to verify. As we noted
in the previous chapter, however, the valuations of stocks with particularly hard-to-interpret
financial statements have been adversely affected by the market’s new focus on accounting
uncertainty. The incentives for clearer disclosure induced by this sort of market discipline
should foster greater transparency in accounting practice.
International Accounting Conventions
The examples cited above illustrate some of the problems that analysts can encounter when
attempting to interpret financial data. Even greater problems arise in the interpretation of
the financial statements of foreign firms. This is because these firms do not follow GAAP
guidelines. Accounting practices in various countries differ to greater or lesser extents from
U.S. standards. Here are some of the major issues that you should be aware of when using the
financial statements of foreign firms.
Reserving practices Many countries allow firms considerably more discretion in
setting aside reserves for future contingencies than is typical in the United States. Because
additions to reserves result in a charge against income, reported earnings are far more subject
to managerial discretion than in the United States.
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Germany is a country that allows particularly wide discretion in reserve practice. When
Daimler-Benz AG (producer of the Mercedes Benz, now DaimlerChrysler) decided to issue
shares on the New York Stock Exchange in 1993, it had to revise its accounting statements
in accordance with U.S. standards. The revisions transformed a $370 million profit for 1993
using German accounting rules into a $1 million loss under more stringent U.S. rules.
Depreciation As discussed above, in the United States firms typically maintain separate
sets of accounts for tax and reporting purposes. For example, accelerated depreciation is used
for tax purposes, while straight-line depreciation is used for reporting purposes. In contrast,
most other countries do not allow dual sets of accounts, and most firms in foreign countries
use accelerated depreciation to minimize taxes despite the fact that it results in lower reported
earnings. This makes reported earnings of foreign firms lower than they would be if the firms
were allowed to follow the U.S. practice.
Intangibles Treatment of intangibles can vary widely. Are they amortized or expensed?
If amortized, over what period? Such issues can have a large impact on reported profits.
Figure 13.2 summarizes some of the major differences in accounting rules in various coun-
tries. The effect of different accounting practices can be substantial.
A study by Speidell and Bavishi (1992) recalculated the financial statements of firms in
several countries using common accounting rules. Figure 13.3, from their study, compares P/E
ratios as reported and restated on a common basis. The variation is considerable.
475
(concluded)
“The boundaries of corporations are becoming in-
creasingly blurred,” says Mr. Lev. “It’s very well defined
legally what is inside the corporation but . . . we must
restructure accounting so the primary entity will be the

economic one, not the legal one.”
Because of the leeway in current accounting rules,
two companies in the same industry that perform iden-
tical transactions can report different numbers. Take
the way companies can account for research-and-
development costs. One company could spread the
costs out over 10 years, while another might spread the
same costs over five years.
Both methods would be allowable and defensible,
but the longer time frame would tend to result in
higher earnings because it reduces expenses allocated
annually.
Another area that allows companies freedom to de-
termine what results they report is in the accounting for
intangible assets, such as the value placed on goodwill,
or the amount paid for an asset above its book value.
At best, the values placed on these items as recorded
on company balance sheets are educated guesses. But
they represent an increasing part of total assets.
Further complicating matters for investors, many
companies have taken to providing pro forma earnings
that, among other things, often show profits and losses
without these changes in intangible values. The result
has been virtually a new accounting system without any
set rules, in which companies have been free to show
their performance any way they deem fit.
Finally, add to the equation the increasing impor-
tance of a rising stock price, and investors face an un-
precedented incentive on the part of companies to
obfuscate. No longer is a higher stock price simply de-

sirable, it is often essential, because stocks have be-
come a vital way for companies to run their businesses.
The growing use of stock options as a way of compen-
sating employees means managers need higher stock
prices to retain talent. The use of stock to make ac-
quisitions and to guarantee the debt of off-the-books
partnerships means, as with Enron, that the entire part-
nership edifice can come crashing down with the fall of
the underlying stock that props up the system.
And the growing use of the stock market as a place
for companies to raise capital means a high stock price
can be the difference between failure and success.
Hence, companies have an incentive to use aggres-
sive—but, under the rules, acceptable—accounting to
boost their reported earnings and prop up their stock
price. In the worst-case scenario, that means some
companies put out misleading financial accounts.
Source: Abridged version of the article of the same title by Steve
Liesman for “Heard on the Street,” The Wall Street Journal,
January 21, 2002.
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476 Part FOUR Security Analysis
FIGURE 13.2
Comparative accounting rules

Source: Center for International Financial Analysis and Research, Princeton, NJ; and Frederick D. S. Choi and Gerhard G. Mueller, International Accounting,
2d. ed. (Englewood Cliffs, NJ: Prentice Hall, 1992).
Quarterly data
*
Accruals for
deferred taxes
Consolidation of
parent and majority
owned subsidiaries
**
Discretionary or
hidden reserves
Immediate deduction
of research and
development costs
†
* In Austria companies issue only annual data. Other countries besides the U.S. and Canada issue semiannual data. In the Netherlands,
companies issue quarterly or semiannual data.
** In Austria, Japan, Hong Kong, and West Germany, the minority of companies fully consolidate.
† In Austria, Hong Kong, Singapore, and Spain, the accounting treatment for R&D costs—whether they are immediately deducted or capitalized
and deducted over later years—isn't disclosed in financial reports.
Accounting rules
vary worldwide
All company financial
reports include:
Australia
Austria
Britain
Canada
France

Hong Kong
Japan
Netherlands
Singapore
Spain
Switzerland
W. Germany
U.S.
FIGURE 13.3
Adjusted versus
reported price–
earnings ratios
Source: Lawrence S.
Speidell and Vinod
Bavishi, “GAAP Arbitrage:
Valuation Opportunities in
International Accounting
Standards,” Financial
Analysts Journal,
November–December
1992, pp. 58–66.
Copyright 1992.
Association for Investment
Management and Research.
Reproduced and
republished from Financial
Analysts Journal with
permission from the
Association for Investment
Management and Research.

All Rights Reserved.
0 102030 40506070 80
Australia
France
Germany
Japan
Switzerland
United Kingdom
24.1
9.1
12.6
11.4
26.5
17.1
78.1
45.1
12.4
10.7
10.0
9.5
Reported P/E
Adjusted P/E
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Such differences in international accounting standards have become more of a problem as

the drive to globally integrate capital markets progresses. For example, many foreign firms
would like to list their shares on the New York Stock Exchange in order to more easily tap the
U.S. equity markets, and the NYSE would like to have those firms listed. But the Securities
and Exchange Commission (SEC) will not allow such shares to be listed unless the firms pre-
pare their financial statements in accordance with U.S. GAAP standards. This has limited the
listing of non-U.S. companies dramatically.
In contrast to the U.S., most large non-U.S. national stock exchanges allow foreign firms
to be listed if their financial statements conform to International Accounting Standards (IAS)
rules. IAS disclosure requirements tend to be far more rigorous than those of most countries,
and they impose greater uniformity in accounting practices. Its advocates argue that IAS rules
are already fairly similar to GAAP rules and provide nearly the same quality financial infor-
mation about the firm. While the SEC does not yet deem IAS standards acceptable for listing
in U.S. markets, negotiations are currently underway to change that situation.
The Enron and other accounting debacles have given U.S. regulators a dose of humility
concerning GAAP standards. While European IAS regulation tends to be principle-based,
GAAP regulation tends to be rules-based. GAAP mandates lengthy, detailed, and specific
rules about the widest range of allowed accounting practices. Critics argue that by doing so, it
gives legal protection to firms that use clever accounting practice to misportray their true
status while still satisfying a legalistic checklist approach to their financial statements. In the
aftermath of Enron, Harvey Pitt, chairman of the SEC, stated his intention to move the U.S.
more in the direction of principle-based standards and to require firms to explain both why
they have chosen their accounting conventions and how their results would be affected by
changes in those accounting assumptions.
13.8 VALUE INVESTING: THE GRAHAM TECHNIQUE
No presentation of fundamental security analysis would be complete without a discussion
of the ideas of Benjamin Graham, the greatest of the investment “gurus.” Until the evolution
of modern portfolio theory in the latter half of this century, Graham was the single most
13 Financial Statement Analysis 477
WEBMASTER
Accounting in Crisis

The headlines in the last quarter of 2001 and the first half of 2002 were dominated by
stories related to the meltdown and bankruptcy of the energy giant Enron. As the story
unfolded, issues related to the accounting industry made the front pages of the financial
press and stories related to Enron were featured on the evening news. The January issue
of BusinessWeek contained a special report entitled “Accounting in Crisis,” which can be
found at http://www
.businessweek.com/magazine/content/02_04/b3767712.htm.
After reading the article, identify and briefly describe the seven steps that the article
discussed for reform of the accounting industry.
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important thinker, writer, and teacher in the field of investment analysis. His influence on
investment professionals remains very strong.
Graham’s magnum opus is Security Analysis, written with Columbia Professor David Dodd
in 1934. Its message is similar to the ideas presented in this chapter. Graham believed careful
analysis of a firm’s financial statements could turn up bargain stocks. Over the years, he de-
veloped many different rules for determining the most important financial ratios and the crit-
ical values for judging a stock to be undervalued. Through many editions, his book has had a
profound influence on investment professionals. It has been so influential and successful, in
fact, that widespread adoption of Graham’s techniques has led to elimination of the very bar-
gains they are designed to identify.
In a 1976 seminar Graham said
4
I am no longer an advocate of elaborate techniques of security analysis in order to find superior
value opportunities. This was a rewarding activity, say, forty years ago, when our textbook

“Graham and Dodd” was first published; but the situation has changed a good deal since then. In
the old days any well-trained security analyst could do a good professional job of selecting under-
valued issues through detailed studies; but in the light of the enormous amount of research now
being carried on, I doubt whether in most cases such extensive efforts will generate sufficiently
superior selections to justify their cost. To that very limited extent I’m on the side of the “efficient
market” school of thought now generally accepted by the professors.
Nonetheless, in that same seminar, Graham suggested a simplified approach to identify
bargain stocks:
My first, more limited, technique confines itself to the purchase of common stocks at less than
their working-capital value, or net current-asset value, giving no weight to the plant and other
fixed assets, and deducting all liabilities in full from the current assets. We used this approach ex-
tensively in managing investment funds, and over a thirty-odd-year period we must have earned
an average of some 20% per year from this source. For awhile, however, after the mid-1950s, this
brand of buying opportunity became very scarce because of the pervasive bull market. But it has
returned in quantity since the 1973–1974 decline. In January 1976 we counted over 100 such is-
sues in the Standard & Poor’s Stock Guide—about 10% of the total. I consider it a foolproof
method of systematic investment—once again, not on the basis of individual results but in terms
of the expectable group outcome.
There are two convenient sources of information for those interested in trying out the
Graham technique. Both Standard & Poor’s Outlook and The Value Line Investment Survey
carry lists of stocks selling below net working capital value.
478 Part FOUR Security Analysis
SUMMARY
• The primary focus of the security analyst should be the firm’s real economic earnings
rather than its reported earnings. Accounting earnings as reported in financial statements
can be a biased estimate of real economic earnings, although empirical studies reveal that
reported earnings convey considerable information concerning a firm’s prospects.
• A firm’s ROE is a key determinant of the growth rate of its earnings. ROE is affected
profoundly by the firm’s degree of financial leverage. An increase in a firm’s debt/equity
ratio will raise its ROE and hence its growth rate only if the interest rate on the debt is less

than the firm’s return on assets.
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4
As cited by John Train in Money Masters (New York: Harper & Row, Publishers, Inc., 1987).
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• It is often helpful to the analyst to decompose a firm’s ROE ratio into the product of
several accounting ratios and to analyze their separate behavior over time and across
companies within an industry. A useful breakdown is
ROE ϭϫϫϫϫ
• Other accounting ratios that have a bearing on a firm’s profitability and/or risk are fixed-
asset turnover, inventory turnover, days receivable, and the current, quick, and interest
coverage ratios.
• Two ratios that make use of the market price of the firm’s common stock in addition to its
financial statements are the ratios of market to book value and price to earnings. Analysts
sometimes take low values for these ratios as a margin of safety or a sign that the stock
is a bargain.
• A major problem in the use of data obtained from a firm’s financial statements is
comparability. Firms have a great deal of latitude in how they choose to compute various
items of revenue and expense. It is, therefore, necessary for the security analyst to adjust
accounting earnings and financial ratios to a uniform standard before attempting to
compare financial results across firms.
• Comparability problems can be acute in a period of inflation. Inflation can create
distortions in accounting for inventories, depreciation, and interest expense.
Assets

Equity
Sales
Assets
EBIT
Sales
Pretax profits
EBIT
Net profits
Pretax profits
13 Financial Statement Analysis 479
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KEY
TERMS
accounting earnings, 456
acid test ratio, 463
asset turnover, 459
average collection
period, 462
balance sheet, 452
current ratio, 462
days receivables, 462
earnings yield, 465
economic
earnings, 456
economic value
added, 467
FIFO, 470
income statement, 452
interest coverage
ratio, 463

leverage ratio, 460
LIFO, 470
market-to-book-value
ratio, 463
price–earnings ratio, 464
profit margin, 459
quality of earnings, 472
quick ratio, 463
residual income, 467
return on assets, 457
return on equity, 456
return on sales, 459
statement of cash
flows, 454
times interest earned, 463
PROBLEM
SETS
1. The Crusty Pie Co., which specializes in apple turnovers, has a return on sales higher
than the industry average, yet its ROA is the same as the industry average. How can you
explain this?
2. The ABC Corporation has a profit margin on sales below the industry average, yet its
ROA is above the industry average. What does this imply about its asset turnover?
3. Firm A and firm B have the same ROA, yet firm A’s ROE is higher. How can you
explain this?
4. Which of the following best explains a ratio of “net sales to average net fixed assets” that
exceeds the industry average?
a. The firm added to its plant and equipment in the past few years.
b. The firm makes less efficient use of its assets than other firms.
c. The firm has a lot of old plant and equipment.
d. The firm uses straight-line depreciation.

5. A company’s current ratio is 2.0. If the company uses cash to retire notes payable due
within one year, would this transaction increase or decrease the current ratio and asset
turnover ratio?
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6. The information in the following table comes from the 1997 financial statements of
QuickBrush Company and SmileWhite Corporation:
NOTES TO THE 1997 FINANCIAL STATEMENTS
QuickBrush SmileWhite
Goodwill The company amortizes The company amortizes
goodwill over 20 years. goodwill over 5 years.
Property, plant, The company uses a straight-line The company uses an accelerated
and equipment depreciation method over the depreciation method over the
economic lives of the assets, economic lives of the assets, which
which range from 5 to 20 years range from 5 to 20 years for
for buildings. buildings.
Accounts The company uses a bad debt The company uses a bad debt
receivable allowance of 2% of accounts allowance of 5% of accounts
receivable. receivable.
Determine which company has the higher quality of earnings by discussing each of the
three notes.
7. An analyst applies the DuPont system of financial analysis to the following data for a
company:
• Leverage ratio 2.2
• Total asset turnover 2.0

• Net profit margin 5.5%
• Dividend payout ratio 31.8%
What is the company’s return on equity?
8. An analyst gathers the following information about Meyer, Inc.:
• Meyer has 1,000 shares of 8% cumulative preferred stock outstanding, with a par value
of $100, and liquidation value of $110.
• Meyer has 20,000 shares of common stock outstanding, with a par value of $20.
• Meyer had retained earnings at the beginning of the year of $5,000,000.
• Net income for the year was $70,000.
• This year, for the first time in its history, Meyer paid no dividends on preferred or
common stock.
What is the book value per share of Meyer’s common stock?
9. The cash flow data of Palomba Pizza Stores for the year ended December 31, 2001, are
as follows:
Cash payment of dividends $ 35,000
Purchase of land 14,000
Cash payments for interest 10,000
Cash payments for salaries 45,000
Sale of equipment 38,000
Retirement of common stock 25,000
Purchase of equipment 30,000
Cash payments to suppliers 85,000
Cash collections from customers 250,000
Cash at beginning of year 50,000
a. Prepare a statement of cash flows for Palomba in accordance with FAS 95 showing:
480 Part FOUR Security Analysis
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• Net cash provided by operating activities.
• Net cash provided by or used in investing activities.
• Net cash provided by or used in financing activities.
b. Discuss, from an analyst’s viewpoint, the purpose of classifying cash flows into the
three categories listed above.
10. The financial statements for Chicago Refrigerator Inc. (see Tables 13.14 and 13.15) are
to be used to compute the ratios a through h for 1999.
a. Quick ratio.
b. Return on assets.
c. Return on common shareholders’ equity.
d. Earnings per share of common stock.
e. Profit margin.
13 Financial Statement Analysis 481
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TABLE 13.14
Chicago Refrigerator
Inc. balance sheet,
as of December 31
($ thousands)
1998 1999
Assets
Current assets
Cash $ 683 $ 325
Accounts receivable 1,490 3,599
Inventories 1,415 2,423
Prepaid expenses 15 13

Total current assets $3,603 $6,360
Property, plant, equipment, net 1,066 1,541
Other 123 157
Total assets $4,792 $8,058
Liabilities
Current liabilities
Notes payable to bank $ — $ 875
Current portion of long-term debt 38 115
Accounts payable 485 933
Estimated income tax 588 472
Accrued expenses 576 586
Customer advance payment 34 963
Total current liabilities $1,721 $3,945
Long-term debt 122 179
Other liabilities 81 131
Total liabilities $1,924 $4,255
Shareholders’ equity
Common stock, $1 par value 1,000,000 shares
authorized; 550,000 and 829,000 outstanding,
respectively $ 550 $ 829
Preferred stock, Series A 10%; $25.00 par value; 25,000
authorized; 20,000 and 18,000 outstanding, respectively 500 450
Additional paid-in capital 450 575
Retained earnings 1,368 1,949
Total shareholders’ equity $2,868 $3,803
Total liabilities and shareholders’ equity $4,792 $8,058
\
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f. Times interest earned.
g. Inventory turnover.
h. Leverage ratio.
11. In an inflationary period, the use of FIFO will make which one of the following more
realistic than the use of LIFO?
a. Balance sheet
b. Income statement
c. Cash flow statement
d. None of the above
12. A company acquires a machine with an estimated 10-year service life. If the company
uses the Accelerated Cost Recovery System depreciation method instead of the straight-
line method:
a. Income will be higher in the 10th year.
b. Total depreciation expense for the 10 years will be lower.
c. Depreciation expense will be lower in the first year.
d. Scrapping the machine after eight years will result in a larger loss.
13. Why might a firm’s ratio of long-term debt to long-term capital be lower than the
industry average, but its ratio of income-before-interest-and-taxes to debt-interest
charges be lower than the industry average?
a. The firm has higher profitability than average.
b. The firm has more short-term debt than average.
c. The firm has a high ratio of current assets to current liabilities.
d. The firm has a high ratio of total cash flow to total long-term debt.
14. During a period of falling price levels, the financial statements of a company using
FIFO instead of LIFO for inventory accounting would show:
a. Lower total assets and lower net income.

b. Lower total assets and higher net income.
c. Higher total assets and lower net income.
d. Higher total assets and higher net income.
15. Scott Kelly is reviewing MasterToy’s financial statements in order to estimate its
sustainable growth rate. Using the information presented in Table 13.16
a. Identify and calculate the components of the DuPont formula.
b. Calculate the ROE for 1999 using the components of the DuPont formula.
c. Calculate the sustainable growth rate for 1999 from the firm’s ROE and
plowback ratios.
482 Part FOUR Security Analysis
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TABLE 13.15
Chicago
Refrigerator Inc.
income statement,
years ending
December 31
($ thousands)
1998 1999
Net sales $7,570 $12,065
Other income, net 261 345
Total revenues $7,831 $12,410
Cost of goods sold $4,850 $ 8,048
General administrative and marketing expenses 1,531 2,025
Interest expense 22 78
Total costs and expenses $6,403 $10,151
Net income before tax $1,428 $ 2,259
Income tax 628 994
Net income $ 800 $ 1,265
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16. In a cash flow statement prepared in accordance with FASB 95, cash flow from
investing activities excludes:
a. Cash paid for acquisitions.
b. Cash received from the sale of fixed assets.
c. Inventory increases due to a new (internally developed) product line.
d. All of the above.
17. Cash flow from operating activities includes:
a. Inventory increases resulting from acquisitions.
b. Inventory changes due to changing exchange rates.
c. Interest paid to bondholders.
d. Dividends paid to stockholders.
18. Janet Ludlow is a recently hired analyst. After describing the electric toothbrush
industry, her first report focuses on two companies, QuickBrush Company and
SmileWhite Corporation, and concludes:
QuickBrush is a more profitable company than SmileWhite, as indicated by the 40% sales
growth and substantially higher margins it has produced over the last few years. Smile-
White’s sales and earnings are growing at a 10% rate and produce much lower margins. We
13 Financial Statement Analysis
483
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TABLE 13.16
MasterToy, Inc.:
Actual 1998 and
Estimated 1999

financial statements
for fiscal year ending
December 31
($ millions, except
per-share data)
1998 1999
Income Statement
Revenue $4,750 $5,140
Cost of goods sold 2,400 2,540
Selling, general, and administrative 1,400 1,550
Depreciation 180 210
Goodwill amortization 10 10
Operating income $ 760 $ 830
Interest expense 20 25
Income before taxes $ 740 $ 805
Income taxes 265 295
Net income $ 475 $ 510
Earnings per share $1.79 $1.96
Average shares outstanding (millions) 265 260
Balance Sheet
Cash $ 400 $ 400
Accounts receivable 680 700
Inventories 570 600
Net property, plant, and equipment 800 870
Intangibles 500 530
Total assets $2,950 $3,100
Current liabilities $ 550 $ 600
Long-term debt 300 300
Total liabilities $ 850 $ 900
Stockholders’ equity 2,100 2,200

Total liabilities and equity $2,950 $3,100
Book value per share $7.92 $8.46
Annual dividend per share 0.55 0.60
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do not think SmileWhite is capable of growing faster than its recent growth rate of 10%
whereas QuickBrush can sustain a 30% long-term growth rate.
a. Criticize Ludlow’s analysis and conclusion that QuickBrush is more profitable, as
defined by return on equity (ROE), than SmileWhite and that it has a higher
sustainable growth rate. Use only the information provided in Tables 13.17 and
13.18. Support your criticism by calculating and analyzing:
• The five components that determine ROE.
• The two ratios that determine sustainable growth: ROE and plowback.
484 Part FOUR Security Analysis
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TABLE 13.17
QuickBrush
Company
financial
statements:
Yearly data
($000 except
per share data)
December December December
Income Statement 1997 1998 1999

Revenue $3,480 $5,400 $7,760
Cost of goods sold 2,700 4,270 6,050
Selling, general, and admin. expense 500 690 1,000
Depreciation and amortization 30 40 50
Operating income (EBIT) $250 $400 $660
Interest expense 0 0 0
Income before taxes $250 $400 $660
Income taxes 60 110 215
Income after taxes $190 $290 $445
Diluted EPS $0.60 $0.84 $1.18
Average shares outstanding (000) 317 346 376
December December December 3-Year
Financial Statistics 1997 1998 1999 Average
COGS as % of sales 77.59% 79.07% 77.96% 78.24%
General & admin. as % of sales 14.37 12.78 12.89 13.16
Operating margin (%) 7.18 7.41 8.51
Pretax income/EBIT (%) 100.00 100.00 100.00
Tax rate (%) 24.00 27.50 32.58
December December December
Balance Sheet 1997 1998 1999
Cash and cash equivalents $460 $50 $480
Accounts receivable 540 720 950
Inventories 300 430 590
Net property, plant, and equipment 760 1,830 3,450
Total assets $2,060 $3,030 $5,470
Current liabilities $860 $1,110 $1,750
Total liabilities $860 $1,110 $1,750
Stockholders’ equity 1,200 1,920 3,720
Total liabilities and equity $2,060 $3,030 $5,470
Market price per share $21.00 $30.00 $45.00

Book value per share $3.79 $5.55 $9.89
Annual dividend per share $0.00 $0.00 $0.00
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b. Explain how QuickBrush has produced an average annual earnings per share (EPS)
growth rate of 40% over the last two years with an ROE that has been declining. Use
only the information provided in Table 13.17.
19. The DuPont formula defines the net return on shareholders’ equity as a function of the
following components:
• Operating margin
• Asset turnover
• Interest burden
13 Financial Statement Analysis 485
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TABLE 13.18
SmileWhite
Corporation
financial
statements:
Yearly data
($000 except
per share data)
December December December
Income Statement 1997 1998 1999
Revenue $104,000 $110,400 $119,200

Cost of goods sold 72,800 75,100 79,300
Selling, general, and admin. expense 20,300 22,800 23,900
Depreciation and amortization 4,200 5,600 8,300
Operating income $ 6,700 $ 6,900 $ 7,700
Interest expense 600 350 350
Income before taxes $ 6,100 $ 6,550 $ 7,350
Income taxes 2,100 2,200 2,500
Income after taxes $ 4,000 $ 4,350 $ 4,850
Diluted EPS $2.16 $2.35 $2.62
Average shares outstanding (000) 1,850 1,850 1,850
December December December 3-Year
Financial Statistics 1997 1998 1999 Average
COGS as % of sales 70.00% 68.00% 66.53% 68.10%
General & admin. as % of sales 19.52 20.64 20.05 20.08
Operating margin (%) 6.44 6.25 6.46
Pretax income/EBIT (%) 91.04 94.93 95.45
Tax rate (%) 34.43 33.59 34.01
December December December
Balance Sheet 1997 1998 1999
Cash and cash equivalents $ 7,900 $ 3,300 $ 1,700
Accounts receivable 7,500 8,000 9,000
Inventories 6,300 6,300 5,900
Net property, plant, and equipment 12,000 14,500 17,000
Total assets $33,700 $32,100 $33,600
Current liabilities $ 6,200 $ 7,800 $ 6,600
Long-term debt 9,000 4,300 4,300
Total liabilities $15,200 $12,100 $10,900
Stockholders’ equity 18,500 20,000 22,700
Total liabilities and equity $33,700 $32,100 $33,600
Market price per share $23.00 $26.00 $30.00

Book value per share $10.00 $10.81 $12.27
Annual dividend per share $1.42 $1.53 $1.72
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• Financial leverage
• Income tax rate
Using only the data in Table 13.19:
a. Calculate each of the five components listed above for 1998 and 2002, and calculate
the return on equity (ROE) for 1998 and 2002, using all of the five components.
b. Briefly discuss the impact of the changes in asset turnover and financial leverage on
the change in ROE from 1998 to 2002.
486 Part FOUR Security Analysis
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TABLE 13.19
Income statements
and balance sheets
1998 2002
Income statement data
Revenues $542 $979
Operating income 38 76
Depreciation and amortization 3 9
Interest expense 3 0
Pretax income 32 67
Income taxes 13 37
Net income after tax $ 19 $ 30

Balance sheet data
Fixed assets $ 41 $ 70
Total assets 245 291
Working capital 123 157
Total debt 16 0
Total shareholders’ equity $159 $220
1. Use Market Insight (www.mhhe.com/edumarketinsight) to find the profit margin
and asset turnover for firms in several industries. What seems to be the
relationship between margin and turnover? Does this make sense to you?
2. Choose a few firms in similar lines of business, and compare their return on
assets. Why does one firm do better or worse than others? Use the DuPont
formula to guide your analysis. For example, compare debt ratios, asset
turnover, and profit margins.
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Essentials of Investments,
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IV. Security Analysis 13. Financial Statement
Analysis
© The McGraw−Hill
Companies, 2003
13 Financial Statement Analysis 487
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WEBMASTER
Financial Statement Analysis
Go to />and review the financial results for EMC
Corporation (EMC) and Network Appliance Inc. (NTAP). The financial result area has
sections on highlights, key ratios, and statements. You will need information on all
three to answer the following questions.
1. Compare the price-to-book and price-to-sales ratios of the companies. How do
they compare with the average for the S&P 500?

2. Are there any substantial differences in the gross and net profit margins for
the companies?
3. Compare the profitability ratios of the companies as measured by return on
equity and return on assets.
4. Are there any significant differences in efficiency ratios?
5. Are there any significant differences in the financial condition ratios?
6. Compare the growth in sales and income for the two companies over the last
five years.
SOLUTIONS TO
1. A debt/equity ratio of 1 implies that Mordett will have $50 million of debt and $50 million of
equity. Interest expense will be 0.09 ϫ $50 million, or $4.5 million per year. Mordett’s net profits
and ROE over the business cycle will therefore be
Nodett Mordett
Scenario EBIT Net Profits ROE Net Profits* ROE
†
Bad year $5M $3M 3% $0.3M 0.6%
Normal year 10 6 6 3.3 6.6
Good year 15 9 9 6.3 12.6%
*Mordett’s after-tax profits are given by: 0.6(EBIT Ϫ $4.5 million).
†
Mordett’s equity is only $50 million.
Concept
CHECKS
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Essentials of Investments,
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IV. Security Analysis 13. Financial Statement
Analysis
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Companies, 2003
2. Ratio decomposition analysis for Mordett Corporation:
(1) (2) (3) (4) (5) (6)
Net Compound
P
rofit Pretax EBIT Sales Leverage
Pretax P
rofit Sales Assets Assets Factor
ROE Profit EBIT (ROS) (ATO) Equity (2) ؋ (5)
a. Bad year
Nodett 0.030 0.6 1.000 0.0625 0.800 1.000 1.000
Somdett 0.018 0.6 0.360 0.0625 0.800 1.667 0.600
Mordett 0.006 0.6 0.100 0.0625 0.800 2.000 0.200
b. Normal year
Nodett 0.060 0.6 1.000 0.100 1.000 1.000 1.000
Somdett 0.068 0.6 0.680 0.100 1.000 1.667 1.134
Mordett 0.066 0.6 0.550 0.100 1.000 2.000 1.100
c. Good year
Nodett 0.090 0.6 1.000 0.125 1.200 1.000 1.000
Somdett 0.118 0.6 0.787 0.125 1.200 1.667 1.311
Mordett 0.126 0.6 0.700 0.125 1.200 2.000 1.400
3. GI’s ROE in 2003 was 3.03%, computed as follows
ROE ϭϭ0.0303, or 3.03%
Its P/E ratio was $21/$5.285 ϭ 4.0 and its P/B ratio was $21/$177 ϭ .12. Its earnings yield was
25% compared with an industry average of 12.5%.
Note that in our calculations the earnings yield will not equal ROE/(P/B) because we have
computed ROE with average shareholders’ equity in the denominator and P/B with end-of-year
shareholders’ equity in the denominator.
4. IBX Ratio Analysis
(1) (2) (3) (4) (5) (6) (7)

Net Compound
P
rofit Pretax EBIT Sales Leverage
Pretax P
rofit Sales Assets Assets Factor ROA
Year ROE Profit EBIT (ROS) (ATO) Equity (2) ؋ (5) (3) ؋ (4)
2004 11.4% 0.616 0.796 7.75% 1.375 2.175 1.731 10.65%
2001 10.2 0.636 0.932 8.88 1.311 1.474 1.374 11.65
ROE went up despite a decline in operating margin and a decline in the tax burden ratio
because of increased leverage and turnover. Note that ROA declined from 11.65% in 2001 to
10.65% in 2004.
5. LIFO accounting results in lower reported earnings than does FIFO. Fewer assets to depreciate
result in lower reported earnings because there is less bias associated with the use of historic cost.
More debt results in lower reported earnings because the inflation premium in the interest rate is
treated as part of interest.
$5,285
0.5($171,843 ϩ $177,128)
488 Part FOUR Security Analysis
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Bodie−Kane−Marcus:
Essentials of Investments,
Fifth Edition
V. Derivative Markets Introduction
© The McGraw−Hill
Companies, 2003
PA RT FIVE
DERIVATIVE MARKETS
H
orror stories about large losses incurred
by high-flying traders in derivatives mar-

kets such as those for futures and op-
tions periodically become a staple of the
evening news. Indeed, there were some amaz-
ing losses to report in the last decade: several
totaling hundreds of millions of dollars, and a
few amounting to more than a billion dollars. In
the wake of these debacles, some venerable in-
stitutions have gone under, notable among
them, Barings Bank, which once helped the
U.S. finance the Louisiana Purchase and the
British Empire finance the Napoleonic Wars.
These stories, while important, fascinat-
ing, and even occasionally scandalous, often
miss the point. Derivatives, when misused, can
indeed provide a quick path to insolvency.
Used properly, however, they are potent tools
for risk management and control. In fact, you
will discover in these chapters that one firm
was sued for failing to use derivatives to hedge
price risk. One headline in The Wall Street
Journal on hedging applications using deriva-
tives was entitled “Index Options Touted as
Providing Peace of Mind.” Hardly material for
bankruptcy court or the National Enquirer.
Derivatives provide a means to control
risk that is qualitatively different from the
techniques traditionally considered in portfolio
theory. In contrast to the mean-variance analy-
sis we discussed in Parts Two and Three, deriv-
atives allow investors to change the shape of

the probability distribution of investment re-
turns. An entirely new approach to risk man-
agement follows from this insight.
The following chapters will explore how
derivatives can be used as parts of a well-
designed portfolio strategy. We will examine
some popular portfolio strategies utilizing
these securities and take a look at how deriva-
tives are valued.
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>
14 Options Markets
15 Option Valuation
16 Futures Markets
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Essentials of Investments,
Fifth Edition
V. Derivative Markets 14. Options Markets
© The McGraw−Hill
Companies, 2003
14
490
AFTER STUDYING THIS CHAPTER
YOU SHOULD BE ABLE TO:
Calculate the profit to various option positions as a function
of ultimate security prices.
Formulate option strategies to modify portfolio risk-return
attributes.
Identify embedded options in various securities and
determine how option characteristics affect the prices of

those securities.
>
>
>
OPTIONS MARKETS
Bodie−Kane−Marcus:
Essentials of Investments,
Fifth Edition
V. Derivative Markets 14. Options Markets
© The McGraw−Hill
Companies, 2003
D
erivative securities, or simply derivatives, play a large and increasingly impor-
tant role in financial markets. These are securities whose prices are deter-
mined by, or “derive from,” the prices of other securities. These assets also
are called contingent claims because their payoffs are contingent on the prices of
other securities.
Options and futures contracts are both derivative securities. We will see that
their payoffs depend on the value of other securities. Swaps, which we discussed in
Chapter 10, also are derivatives. Because the value of derivatives depends on the
value of other securities, they can be powerful tools for both hedging and speculation.
We will investigate these applications in the next three chapters, beginning in this
chapter with options.
Trading of standardized options on a national exchange started in 1973 when
the Chicago Board Options Exchange (CBOE) began listing call options. These con-
tracts were almost immediately a great success, crowding out the previously existing
over-the-counter trading in stock options.
Options contracts now are traded on several exchanges. They are written on
common stock, stock indexes, foreign exchange, agricultural commodities, precious
metals, and interest rate futures. In addition, the over-the-counter market also has

enjoyed a tremendous resurgence in recent years as its trading in custom-tailored op-
tions has exploded. Popular and potent for modifying portfolio characteristics, options
have become essential tools that every portfolio manager must understand.
This chapter is an introduction to options markets. It explains how puts and calls
work and examines their investment characteristics. Popular option strategies are
considered next. Finally, we will examine a range of securities with embedded options
such as callable or convertible bonds.
Related Websites
/> />education
These sites contain online option education material.
They have extensive programs to learn about the use of
options, options pricing, and option markets.
/>This site has extensive links to many other sites. It
contains sections on education, exchanges, research,
and quotes, as well as extensive sources related to
futures markets.

This site provides extensive educational material
including access to the freely available Options Toolbox.
The toolbox is an excellent source that allows you to
simulate different options positions and examine the
pricing of options.

/>The above sites have extensive links to numerous
options and other derivative websites, as well as
educational material on options.

The above sites are exchange sites.