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The Iowa Electronic Markets

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The Iowa Electronic Markets

The Iowa Electronic Markets

    Financial Statement Analysis Curriculum using the IEM

    Prepared for the Fall 2000 IEM*IDEA/NSF Conference

    By Thomas A. Rietz, University of Iowa

     Marilyn Dutton, North Carolina Central University

     Cynthia J. Brown, University of Texas-Pan American

    September 2000

    Financial Statement Analysis Assignment

    Introduction to the IEM

    The Iowa Electronic Market (IEM for short) is a computerized market on which financial contracts can

    be traded (bought or sold). For this assignment, you will be using a series of contracts based on three

    popular companies, Apple Computers (AAPL), IBM (IBM) and Microsoft (MSFT), and an important

    index called the S&P500 index. Shares of the firms trade over the counter (NASDAQ) and on the New

    York Stock Exchange (NYSE). Similarly, a daily index value is determined for the S&P500 based upon

    the stock prices of the 500 companies that compose of it.

    The contracts you will be using are based on the shares of Apple computers, IBM and Microsoft, and

    on the value of the S&P500. These contracts are listed on the IEM under the market label “Computer

    Industry Returns Market” or “Comp_Ret” for short. These contracts are described briefly later in this

    note and in more depth in the IEM prospectus for the market. The prospectus and other information for

    these markets are available at the IEM website:

    http://www.biz.uiowa.edu/iem/markets/computer.html

    The objectives of the IEM assignments are to help you apply class concepts in a "real world," unstructured way to learn how to:

    1. Utilize information from financial statements to predict future earnings and valuation.

    2. Understand the impact of information on share prices.

    3. Combine predictions and information to develop a trading strategy.

    All students need to open an account with the Iowa Electronic Market. This involves a minimum deposit of ____ dollars. Funds remaining in your account are refundable at the end of the semester. You can open an IEM account over the Internet. To do so, go to the sign-up web page:

    http://iemweb.biz.uiowa.edu/signup/

    and follow the instructions given to you by your instructor. (DO NOT use forms other than those given to you by your instructor. Using other forms may result in fees or decreased deposits in your account.) After filling out your signup forms, you may need to deposit cash with the IEM office (W283 PBAB, phone 335-0881). Your instructor will give you details about any deposits you need to make. You can access the IEM through its website address:

    http://www.biz.uiowa.edu/iem/

    The IEM market has several contracts trading under it. The contracts of interest for our course are the Computer Industry Returns Market (Comp_Ret, for short).

    You access your trading account from the market pages or directly at:

    http://iemweb.biz.uiowa.edu/

    The Computer Industry Returns Contracts consist of a series of contracts. Every month, existing contracts in the series are liquidated and payments are made as described below. Then, new contracts are created as described below. These events occur on the Monday after the exchange-traded options for the underlying stocks expire (the Monday after the third Friday of each month). The liquidation values for the contracts in this market are determined solely by the rates of return of Apple Computers Common Stock (AAPL), IBM Common Stock (IBM), Microsoft Common Stock

    (MSFT) and the S&P500 index (SP500). Whichever of these has the highest rate of return as specified below will payoff $1.00 per share. The remaining contracts will payoff zero. Thus, to do well in this market, you will need to understand what determines real stock market returns.

    Contracts are designated by a ticker symbol and a letter denoting the month of contract liquidation. Thus, the contracts traded in this market for liquidation in month “m” are:

    AAPLm Apple Computers $1.00 if AAPL Return Highest

    IBMm IBM $1.00 if IBM Return Highest

    MSFTm Microsoft $1.00 if MSFT Return Highest

    SP500m S&P 500 Market Index $1.00 if SP500 Return Highest

In these contract codes, “m” refers to the month of expiration as given by the following table:

    January a May e September i

    February b June f October j

    March c July g November k

    April d August h December l

    For AAPLm, IBMm and MSFTm, the dividend-adjusted rate of return is computed based on closing stock prices of the underlying listed firm between the third Friday in the liquidation month and the third Friday in the previous month. For these purposes, closing prices as reported in the Midwest edition of the Wall Street Journal are used. In particular, this return is calculated as follows. First, the raw return on the underlying stock is computed (as the closing price on the third Friday of the liquidation month, minus the closing price from the third Friday of the previous month, plus any dividends on ex-dividend dates). Then, we divide the raw return by the closing stock price from the previous month to arrive at the dividend-adjusted rate of return.

    For the SP500 contract, the return is computed as the capital gains rate of return. To do this, subtract the closing index value on the third Friday of the previous month from the closing index value on the third Friday of the liquidation month. Then, divide by the previous month‟s closing index value.

    You can trade on the IEM in several ways. First, you can buy or sell unit portfolios (called “bundles”). A unit portfolio is a set of all contracts in the market such as AAPLm, IBMm, MSFTm and SP500m for the Computer Industry Returns market. You can always buy or sell such portfolios for $1.00 each. Thus, when you start to trade and do not own any contracts, you can buy a unit portfolio and then start to trade. (To do this, select the appropriate contract under “Buy Bundles” or “Sell Bundles” in the “Market Order” drop down menu. Enter a quantity and press the “Market Order” button.)

    Second, you can buy or sell using a "market order." On the market screen, you will see that some individuals have posted an order to buy or to sell a contract (e.g., MSFTi, the contract for September liquidation in the Computer Industry Returns Market) at a specific price. If you believe that a posted order represents a good deal, you can buy or sell at the posted price. (To do this, select the appropriate contract under “Buy at Best Ask” or “Sell at Best Bid” in the “Market Order” drop down menu. Enter a quantity and press the “Market Order” button.)

    Third, you can buy or sell using a "limit order." To do so, you state the price at which you are willing to buy or sell a contract and post a limit order on the screen. In doing so, you are waiting for someone who is willing to buy or sell at your stated price. In this manner, when your order executes, it will execute at your stated price, not at somebody else‟s. The negative is that the order may never execute because nobody likes your price because it is too high or low. (To place a limit order, select the appropriate contract under “Post a Bid” or “Post an Ask” in the “Limit Order” drop down menu. Enter a price, quantity and expiration date and press the “Limit Order” button.)

    As you can see below, the IEM assignments are extensive, multi-part assignments that draw together many concepts from the class. It would be wise to work on the various parts of the assignments as we go over the relevant topics in class. To prepare the assignments for submission, please use the following guidelines:

    1. Each assignment must be typed. Label clearly each assignment with a cover page giving your

    name, student number, and section number.

    2. Complete each part in a separate section clearly labeling them Part 1, Part 2, etc. 3. Within each section, give the requested information, including sources of information gathered and

    equations used to calculate results.

    4. Turn in your completed assignment to your instructor on the date it is due.

    Financial Statement Analysis Assignment

    Part 1: Finding Financial Information DUE: ___________ In this part of the assignment, you will learn where to find historical financial information about companies and the aggregate values for the industry in which they operate.

    NOTE: There are three different time periods over which people commonly calculate ratios: (1) Annual (based on annual accounting statements), (2) Quarterly (based on quarterly financial statements) and (3) Trailing-Twelve-Month or ttm for short (based on aggregated information for the last 12 months). We will be looking at the most recent quarterly and trailing-twelve-month ratios. Our purpose will be to compare and contrast these numbers. For example, we will have you compute some and compare to others that are pre-computed for you. It is important that you keep them straight. To help, we put the descriptive terms in bold italics.

    Historical financial statements

    Collect the most recent quarterly financial statements and annual information on

    the ratios that make up the DuPont system (Profit Margin (PM), Asset Turnover (AT), Return on Assets (ROA), Return on Equity (ROE) and the Equity Multiplier (EM)) as well as the debt-to-assets ratio, price-to-earnings (P/E) ratio and market-to-book ratios for Apple Computer, IBM and Microsoft.

To get the quarterly financial statements, trailing-twelve-month ratios and

    industry comparisons for Apple Computer, go to the website

    http://www.moneycentral.msn.com/investor, enter the ticker symbol (e.g., AAPL)

    and click on the Financial Results link on the left hand side of the screen. The

    Statements link allows you to select the particular financial statement of interest and view (select quarterly) using pull-down boxes. The Key Ratios link gives

    lists ratios in which you can find each of ratios needed along with industry standards. (The net profit margin, listed under “profit margins;” ROA and ROA,

    listed under “investment returns;” and asset turnover, listed under “management

    efficiency” are all for the trailing 12 months. The equity multiplier is also known

    as the “Leverage Ratio” and can be found under “financial condition.”)

Repeat the process for IBM and MSFT.

    Historical share prices

    Get each stock‟s closing price for the last date covered by the quarterly financial

    statements.

    Historical share price information can also be obtained at the website http://www.moneycentral.msn.com/investor. After entering the ticker symbol,

    selection the Charts link. Selecting Export Data from the File menu will put the

    historical data in a spreadsheet.

    Industry Ratios

    Make up a table that contains share price information and all of the above

    trailing-twelve-month ratios for AAPL, IBM and MSFT and their respective

    industries. (Industry ratios appear with the firm‟s ratios obtained above.)

    Financial Statement Analysis Assignment Part 2: Predicting Earnings and Valuations DUE: ___________

    In this part of the assignment, you will analyze the trailing-twelve-month financial ratios of Apple, IBM

    and Microsoft that you collected in Part 1. You will compare each company to their respective industry

    and utilize this information to predict future earnings and valuations.

    Analyzing Ratios

    Using the trailing-twelve-month ratios you have collected for the three firms and

    their industries:

    1. Explain what information each ratio conveys about the firms.

    2. Compare the firms and analyze the performance achieved by each firm. As

    you do this, think about the relationships in the DuPont system.

Firm Performance versus Industry Benchmarks

    Evaluate the firms‟ performance compared to others in their industry. Are your

    firms performing better or worse than others in their industry? Explain how you

    know with reference to the ratios.

Predicting Earnings and Valuation

    Based on your analysis, what predictions would you make regarding the

    valuation ratios (P/E and market/book) of the firms?

    Which firm would you expect to have the higher valuation ratios? Explain your

    reasoning with reference to the DuPont ratios.

    Do the actual valuation ratios bear out your expectations?

    Discuss some reasons why the connection between the DuPont ratios and the

    valuation ratios may not perfect.

Financial Statement Analysis Assignment

    Part 3: Computing Financial Ratios DUE: ___________

    In this part of the assignment, you will learn how to compute quarterly financial ratios using recent

    quarterly financial statements for Apple, IBM and Microsoft.

    Computing Financial Ratios

    Using the most recent quarterly financial statements obtained in Part 1, compute the ratios that make up the DuPont system (PM, AT, ROA, ROE, EM) as well as the debt/assets, sustainable growth rates, and P/E and market/book ratios for AAPL, IBM and MSFT.

    Make up a table that contains all of the above ratios for the three firms.

Analyzing Changes in Ratios

    Compare the quarterly ratios you have computed to the trailing-twelve-month ratios

    for each firm. Are they the same? What kinds of possible problems or improvements within the firm are revealed by changes in the ratios? Explain with reference to specific ratios.

Financial Statement Analysis Assignment

    Part 4: Role of Expectations in Share Price DUE: ___________

    In this part of the assignment, you will have to use information about the company and the economic

    environment to form expectations about share prices.

    Letter to the Shareholders

    Obtain a copy of the “management discussion” from the most recent annual reports

    of Apple, IBM, and Microsoft. (You can obtain these from the annual reports.

    Typically, you can view annual reports from the company‟s website under “investor

    relations.” You can also get annual reports directly from the Securities and

    Exchange Commission at their website: http://www.sec.gov. Select the link Search

    the Edgar Database. Do a Quick Forms Lookup for the company‟s 10-K (annual

    report). Finally, the easiest way to see this discussion is to click on the “SEC filings

    link on MoneyCentral, select the most recent annual report and click on the “Mgmt

    Disc” link.)

    What information in this discussion might influence expectations about future

    earnings and thus the valuations of the companies?

    News Articles

    Obtain at least three recent news articles about each company.

    What information in these articles might influence expectations about future earnings

    and thus the valuations of the companies?

    Predictions of Earnings and Valuation

    Evaluate the information you gathered from the annual report and recent news

    articles.

    Explain the impact that you expect these to have on each firm‟s future earnings, its

    share price, its valuation ratios (p/e and market/book) and its sustainable growth rate.

Financial Statement Analysis Assignment

    Part 5: Verifying Predictions DUE: ___________

    In this part of the assignment, you will use historical stock price and IEM data to check your prediction

    of the impact of performance and news on stock prices and the prices of contracts in the IEM. Stock Prices and Prices in the IEM

    Obtain daily closing stock prices for AAPL, IBM and MSFT for the period during

    which you gathered news on the three firms. You can obtain closing prices as

    discussed in Part 1.

    Obtain daily closing price history for the contracts in IEM‟s Computer Industry

    Returns Market. You can obtain prices from the IEM website for the Computer

    Industry Returns Market at http://www.biz.uiowa.edu/iem by selecting the link

    Computer Returns followed by Data and IEM Daily Price History.

    Comparison

    Look at the stock price on the days surrounding each news event. Did you correctly

    predict the change in the stock price change in response to the news event?

    Did the contract price in the IEM change in the same direction as the stock price? Discussion

    Discuss possible reasons why prices may not have responded to the news in the

    way you expected.

    Discuss possible reasons why the IEM contracts may not have moved in the same

    direction as the stock prices.

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