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Meeting Notes 10

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Meeting Notes 10

    Meeting Notes 10.24.2007

Reading Material (referenced throughout Meeting Notes):

    1) Damodaran, A. Investment Valuation. Second Edition. John Wiley & Sons: New York, 2002.

    2) Peterson, P. P. & Fabozzi, F. J.. Analysis of Financial Statements. Second Edition.

    John Wiley & Sons: Hoboken, New Jersey, 2006.

    ACCOUNTING PRINCIPLES & FINANCIAL STATEMENTS

    by Joe Citarrella

- Scientists with a finance background have an advantage for investing in pharmaceutical

    or biotechnology companies (P/B) because they can understand the science behind each company: One needs to understand P/B’s pipeline and intellectual property to have an investment advantage.

    - Everything that matters is the future projection of the stock value.

    - Consider: How do you choose a company? What company in New Haven would you buy? Product quality, quantity/volume, etc.

     1,2- How do you decide if a company has a competitive advantage?Look at the financials.

     1 Examples of financials: 10K Report (for “annual disclosure of financial information required of all publicly traded companies; due 90 days following the company’s fiscal year-end.” Peterson & Fabozzi, 9.);

    10Q (for “quarterly disclosure by publicly traded companies; required 45 days following the end of each of the company’s first three fiscal quarters.” Peterson & Fabozzi, 9.); 8K (“filed to unscheduled, material

    events or events that may be considered of importance to shareholders of the SEC.” Peterson & Fabozzi, 9).

     2Peterson & Fabozzi, “Exhibit 1.4 Required Disclosures of the Form 10K Filing,” 11.

    Contents of the 10K Annual Report

    “Part I

    1. Business

    2. Properties

    3. Legal proceedings

    4. Submission of matters to a vote of security holders

PartII

    5. Market for registrants common equity, related stockholder matters and issue purchases of

    equity securities

    6. Selected financial data

    7. Management’s discussion and analysis of financial conditions and results of operations

    7A. Quantitative and qualitative disclosures about market risk

    8. Financial statements, and supplementary data

    9. Changes in and disagreement with accountants on accounting and financial disclosure

    9A. Controls and procedures

    9B. Other information

Part III

    10. Directors and executive officers

    11. Executive compensation

    12. Security ownership of certain beneficial owners and management and related stockholder

    matters

    13. Certain relationships and related transactions

- Three Financial Statements:

    1. Balance Sheet

    2. Cash Flow Statement

    3. Income Statement

     31) BALANCE SHEET = shows what a company owns

ASSETS = LIABILITIES + EQUITY

     4- Assets = “anything that the company owns that has a value.”

     5BALANCE ASSETS

    Cash (or any equivalent)

    Accounts receivable

    Other current assets

    Total Current Assets 6Property, plants, equipment

    Less accumulated depreciation

    Net property, plants and equipment

    Intangible assets (intellectual property, patents)

    Total Assets

    BALANCE LIABILITIES

    Accounts payable

    Current maturities of long-term debt

    Total Current Liabilities

    Deferred Tax assets (if IRS owes you a refund)

    Total Liabilities

    Minority interest

    Investments or Marketable Securities

    Accumulated Depreciation

    Total Shareholders’ Equity

    Total Liabilites and Shareholders’ Equity

- Current assets = things that can be realized in a year; types of current assets include 7Cash, Marketable securities, Accounts receivable, Inventories

    14. Principal accounting fees and services

    15. Exhibits and financial statement schedules”

     3 “The balance sheet is a report of the assets, liabilities, and equity of a firm at a point in time, generally at

    the end of a fiscal quarter or fiscal year. Assets are resources of the business enterprise, which are

    comprised of current or long-lived assets…Liabilities are obligations of the business enterprise that must be

    repaid at a future point in time, whereas equity is the ownership interest of the business enterprise.”

    Peterson & Fabozzi, 36. 4 Peterson & Fabozzi, 36. 5 As presented by Joe Citarrella and clarified from Peterson & Fabozzi, 38. 6 “Net plant and equipment = Gross plant and equipment – Accumulated depreciation.” Peterson & Fabozzi, 37. 7 As presented by Joe Citarrella and verified by Peterson & Fabozzi, 36.

    - Noncurrent or Long-time assets = things not realized within a year, like a facility being built, etc.

- Hidden assets = (example) increased value of land overtime.

BALANCE LIABILITIES

    Debt/loans bonds are considered debt (no net effect)

    Payables = I bought something on credit and owe somebody credit

    - Lawsuits are tricky because if they can not reliably predict settlement, then they cannot go under obligations.

    ASSETS LIABILITIES = EQUITY = net asset value (this is how business is financed)

PROFIT = REVENUE COST

    - Always have equal and opposite reactions recorded in the statements.

Question by member: How do you find if the numbers are accurate?

    Some equity researchers do not pay attention to the balance sheet but one needs to

    know how much equity they have, how much debt they have, etc. Look in the footnotes. If a company is making $30 million with $5 billion debt, then is not making any profit. Private equity researchers are a bit savvier about readjusting the balance sheet, but equity research usually leaves it alone. Smart investors should care about all three Financial

    Statements.

Depreciation = making the estimate of what you have that will lose value or “the 8allocation of the cost of an asset over its useful life.”

Depreciation = (cost salvage)/years

    Depreciation of Intangibles (e.g. IP) is difficult to evaluate and always depends on whether you bought the patent or developed it.

    On the balance sheet, a company may overstate the value of what they own by not accurately forecasting depreciation.

    For the team valuations, look at the Cash Flow Statement: Pharma & Biotech usually not very capital intensive.

    Question by member: Why not just wait 20 years, then report the accurate value of something instead of forecasting depreciation? Most companies used straight-line

    method. Companies report an accelerated estimate because it looks better to investors.

     8 Peterson & Fabozzi, 37.

Question by member: How about the intangibles? Cost of a patent, what you think it is

    worth does not matter, the company still has to report how much they paid for it not

    necessarily how much it is worth (could be nothing, could be billions if the drug is promising). As an investor in P/B should not care about cost of patent, but estimated value of profits made from the patent of that drug.

Question: How do you know when the patent will run out? If the information is not

    available in the 10K, then call the company, call an analyst, etc.

    EXAMPLE: For a $1000 premium, I bought an insurance policy half way through the year. So incurred $500 worth of expenses on income statement. BUT spent $1000 in cash, deducted from balance sheet. Prepaid expenses +$500 on balance sheet. Now, Assets must = Liabilities + Equities, Assets is -1000, no liability b/c already paid for, Equity -500.

    At end of year Assets -1000, and Equity becomes -1000, and Income Statement records a -1000 in net income.

- If I don’t understand it, then I don’t invest in it.

     92) INCOME STATEMENT

    REVENUE COSTS

    Net Sales Cost of goods sold (depreciation may go

    here)

     Selling & General Administrative

    Expenses: Salaries, Rent, (or depreciation

    may go here)

     Research & Development

     Interest

     Loss on sales

     Taxes

     Bottom-line = Net Profit

- If I sold something, I book revenue.

GROSS PROFIT = REVENUE COST

     9 In addition to Joe Citarrella’s explanation of the Income Statement, Damodaran summaries it briefly in a similar figure to the one below. See Damodaran, 27 for details.

    REVENUES

    - OPERATING EXPENSES

    = OPERATING INCOME

    - FINANCIAL EXPENSES

    - TAXES

    = NET INCOME BEFORE EXTRAORDINARY ITEMS

    - (+) EXTRAORDINARY LOSSES (PROFITS)

    - INCOME CHANGES ASSOCIATED WITH ACCOUNTING CHANGES

    - PREFERRED DIVIDENDS

    = NET INCOME TO COMMON STOCKHOLDERS

    PHARMA EXAMPLE: Hire 10 people for 1 year x $10 per person. So R&D -100. Bought a patent for 100. Now R&D -200. Next year drug makes 300, but manufacturing cost 50 and sales people 50. Now made 100 profit in first year.

    - Operating Profit = other expenses incurred that do not have anything to do with operating the business like non-recurring expenses.

- R&D used to be considered an investment, but now illegal take it as an entire expense

    upfront.

    - GAAP in US definitely different than international companies, like in Hong Kong land is appraised, not at selling price.

3) CASH FLOW STATEMENT = most important for our purposes.

- Always starts with Net Income.

    - Then reconcile transactions for which you have not yet received the cash.

     10OPERATING CASH FLOW

    Net Income

    Depreciation

    Changes in Working Capital

    Cash Flows from Investments (an example of negative cash flow from expenses: bought expensive land = Purchases of Property and Equipment, which is a good indicator of how much it costs to run the company; if a company has a huge number here it probably means that the company is growing) (CapEx)

    Sale of Investments

    Cash Flow from Financing (issue a bond, sell stock, buy back stock)

    - Options = an expense and a dilution of the stock, so tricky. Just know that they are included in SG&A. Usually can find a Blacks-Sholes excel spreadsheet to see how they are calculating its value.

    - Even if a company is growing per share, they may just be diluting the value of the previous shares, in which case there no actual gain in value.

    - When a company sells stock, there is no profit b/c all they did was transfer an imaginary chunk of the company to an individual.

- Try to understand the financial statements do not try to memorize the principles of

    accounting.

     10 Simplified Statement of Cash Flows from Damodaran, 28.

    CASH FLOWS FROM OPERATIONS

    + CASH FLOWS FROM INVESTING

    + CASH FLOWS FROM FINANCING

    = NET CHANGE IN CASH BALANCE

    - Buying back shares is bullish, as a long-term shareholder is good; but sometimes

    is a technique used by a company to raise the price of their stock, in which case

    that is bad.

PERFORMANCE INDICATORS

    - Return on Equity = Net Income / Average Stockholder’s Equity

    Measures the rate of return on the ownership interest (shareholder’s equity) of the

    common stock owners. It measures a firm's efficiency at generating profits from every dollar of net assets (assets minus liabilities) and shows how well a company uses investment dollars to generate earnings growth. ROE is equal to a fiscal year's net income (after preferred stock dividends but before common stock dividends) divided by total equity (excluding preferred shares), expressed as a percentage. The more sustainable this measure, the better the company; Coke for example has been maintaining 25 RE for 25-30 years.

    - Big Pharma usually has good returns on equity because no one can compete with them.

- GOOD return on equity = 20; Avg Company = 12-13

- Return on investment capital (ROIC) = (Net Income Dividends) / Total Capital

    This ratio is used to assess a company's potential to be a quality investment by determining how well (i.e. profitable) a company's management is able to allocate capital into its operations. Comparing a company's ROIC with its cost of capital (WACC) reveals whether invested capital was used effectively.

- Profit Margin = Net Income / Net Sales Revenue

    (depends on business model, like Walmart has 1% profit margin, but no one can compete with its volume); many different kinds of margins by dividing anything by revenue. The larger the margin, the more cushion you have for costs. )

    - To truly understand a business, MUST understand how they are making their money.

    - Debt-To-Equity Ratio = Total Liabilities / Shareholders Equity

    A measure of a company's financial leverage calculated by dividing its total liabilities by stockholders' equity. It indicates what proportion of equity and debt the company is using to finance its assets. Joe doesn’t think most pharmas have much

    leverage because they have lots of cash from investors until they get their product to market.

- If a company does have high debt, need to see how liquid the company is how

    capable they are of paying that debt. Look at interest coverage how tight of a margin

    do they have. Want to make sure they have cash flow to cover their interests. Make sure they are not going to go bankrupt anytime soon.

EXTERNAL RATIOS

- Price to Book Ratio

    A financial ratio used to compare a company's book value to its current market price. Book value is an accounting term denoting the portion of the company held by the shareholders; in other words, the company's total assets less its total liabilities. The calculation can be performed in two ways, but the result should be the same each way. In the first method, the company's market capitalization can be divided by the company's total book value from its balance sheet. The second way, using per-share values, is to divide the company's current share price by the book value per share (i.e. its book value divided by the number of outstanding shares).

    - Price to Earnings ratio (P/E ratio) = Price per Share / Earnings per Share A measure of the price paid for a share relative to the income or profit earned by the firm per share. A higher P/E ratio means that investors are paying more for each unit of income. It is a valuation ratio included in other financial ratios.

- Price to Cash Flow Ratio = Share Price / Cash Flow per Share

    A measure of the market's expectations of a firm's future financial health. Since this measure deals with cash flow, the effects of depreciation and other non-cash factors are removed.

Other comments:

    - Price is independently set by a market. If a company is earning, make sure it grows.

    - Free Cash Flow = cash leftover after paying debt; usually approximates profit; look at price-to-free cash flow (12 is good, some under 10 is great)

    - Liquidation value of the company is useful, too. A low price-to-book ratio means the company is cheap if it is trading at a price below this value.

    - Don’t put too much stock into ratios b/c they tend to make investors more confident in an investment than they should be.

    - If you know nothing about the company, then find whatever you can about it. Read the 10K, call them if you have questions, pay attention to news from the Wall Street Journal, Morningstar.com, Yahoo Finance, etc.

    Question by member: Is it safe to say if it is an early stage company, pay less attention to the financial statements and more on the quality of the products? Pharma is a fickle

    industry Joe can not evaluate the science, so scientists have an advantage by evaluating the company’s products. But one can not rely so much on the products and finances of

    the past. Pharma is not like management poor management in the past is usually an

    indicator of poor management in the future. Always leave yourself a margin of safety. With Discounted Cash Flow model, garbage in, then garbage out.

    - If he thinks that a company is worth $20/share, Joe would not buy it unless it is selling at $12 or $13.

    - Mindset of investing: Look for a reason NOT to buy a company.

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