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Unit 9: Fundamental Analysis 3: Company Analysis

The ratio of d /e is known as dividend payout ratio. From the above model it is obvious that, Notes
io io
to determine the appropriate earnings multiplier an analysis must consider the following:
 The earnings of the security
 The risk of the security
 The growth rate of the dividend stream
 The duration of the expected growth and
 The dividend payout ratio

9.2.1 Earnings Analysis

As seen earlier, to value common stocks or other risky assets, the present value model is
employed.
Present value = AQ
Where t = time period

This model gives rise to two questions:
1. How does the investor measure the income from the common stocks?
2. What discount or capitalization rate should be used?

The income question is discussed here:
Income concepts: Accountants and economists have provided two different concepts of income.
Accountant’s income is the revenue over the above all the costs incurred. Economists define the
income of a firm as the maximum amount, which can be consumed by the owners of the firm in
any period without decreasing their future consumption opportunities.
Adjusting for economic income: Since income, which is very important is determining the value
of a security, is vaguely reported by accountants, it is necessary to adjust or normalize it in a
consistent manner.
Fundamental analysts find it necessary to significantly alter the income statements, to obtain
estimates for two reasons.
1. The accountant has used an accounting procedure, which is inappropriate for the relevant
economic transaction and/or
2. The accountant, perhaps under the pressure of top management, has adopted a procedure
to minimise the firm’s income taxes or window dress the firm’s financial statements.
We will now discuss the differences in accounting procedures. These are only illustrative of the
controversy in reporting incomes.

1. Sales – Revenue Recognition Principle: Sales can be either cash sales or credit sales. Sales
can be recognized as early as the date the sale order is signed. However, in the case of
long-term construction contracts the sale may not be recognized until as late as the day the
cash is fully paid. Between these two extremes, the accountant may choose a suitable time
point to recognize the sales revenue in the financial statements. He may do it either in an
attempt to improve current income or because he has grown confident about its
collectability. In the case of credit sales, companies may factor their accounts receivable
and realize cash proceeds. One firm may recognize this immediately, whereas another
firm may wait until the customer’s final cash payment is actually received.

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