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
3. Legal proceedings
4. Submission of matters to a vote of security holders
5. Market for registrants common equity, related stockholder matters and issue purchases of
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
10. Directors and executive officers
11. Executive compensation
12. Security ownership of certain beneficial owners and management and related stockholder
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.”
Cash (or any equivalent)
Other current assets
Total Current Assets 6Property, plants, equipment
Less accumulated depreciation
Net property, plants and equipment
Intangible assets (intellectual property, patents)
Current maturities of long-term debt
Total Current Liabilities
Deferred Tax assets (if IRS owes you a refund)
Investments or Marketable Securities
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.
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
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
Net Sales Cost of goods sold (depreciation may go
Selling & General Administrative
Expenses: Salaries, Rent, (or depreciation
may go here)
Research & Development
Loss on sales
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.
- OPERATING EXPENSES
= OPERATING INCOME
- FINANCIAL EXPENSES
= 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
- 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
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
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.
- 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.
- 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.
- 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.