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
Teaching Objectives
Financial Statement Analysis
Motivation
- Financial statements are the “language” of business.
- Financial statements show the current state of the firm.
- Ratios are used to evaluate firm performance.
Access balance sheet and income statements from the web
Students should be able to:
1. Find financial information on publicly traded companies on the web.
Compute, understand and interpret some common ratios
Students should be able to:
1. Compute common financial ratios from a company’s financial statements.
2. Understand the performance objectives measured by the ratios.
3. Interpret the financial ratios and evaluate the company’s performance relative to industry standards.
Use DuPont analysis to predict P/E and valuation ratios
Students should be able to:
1. Utilize financial ratios to perform DuPont analysis.
2. Use DuPont analysis to predict valuation ratios.
Trade in IEM based on earnings and valuation predictions.
Students should be able to:
1. Use current information to form expectations on the firm’s future financial performance.
2. Combine current information with analysis of past financial performance to trade in the IEM Computer Industry Returns market.
3. Observe the relationship between a firm’s financial performance and its share price and returns.
Lecture Outline
Financial Statement Analysis
1. Introduction
2. Financial Statements
a. Balance Sheet
b. Income Statement
3. Financial Ratios
a. Liquidity
b. Operating
c. Debt
d. Profitability
e. DuPont
4. Predicting valuation ratios
5. Role of Information in Share Price
6. Combining predictions and information to trade in IEM
7. Conclusion
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
Objectives
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.
Opening an IEM Account
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 webpage:
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.
Accessing the IEM
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/
Computer Industry Returns Contracts
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:
Code / Underlying Asset / Liquidation ValueAAPLm
IBMm
MSFTm
SP500m / Apple Computers
IBM
Microsoft
S&P 500 Market Index / $1.00 if AAPL Return Highest
$1.00 if IBM Return Highest
$1.00 if MSFT Return Highest
$1.00 if SP500 Return Highest
In these contract codes, “m” refers to the month of expiration as given by the following table:
Month / Designation / Month / Designation / Month / DesignationJanuary
February
March
April / a
b
c
d / May
June
July
August / e
f
g
h / September
October
November
December / i
j
k
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.
Trading on the IEM
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.)
Completing Your Assignments and Submitting Them
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: ______
GOAL
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: ______
GOAL
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: ______
GOAL
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.