Faculty Insight: Risk, Uncertainty and Financial Analysis

Article by Dr. Ben Nunnally

 

The best strategy for your business is one that is well-informed – and the best way to become well-informed is by a true understanding of your company and its competition. The recent history of your company and its competitors is all contained in your financial statements and the operating, financing, and investment data – or cash flow information – from your competitors. Do you know how to read it?

Financial statements help decision makers forecast their firm’s short-term cash needs, understand the components of cash flow, understand and measure their firm’s sustainable rate of growth, and realize the underlying, and very important role, of capital markets.

Watch this recent TV interview with Dr. Nunnally on Good Day Fox 46.

Knowing your company and industry is certainly essential, so is understanding what is, and is not controlled by management, when alternatives are considered, and decisions made. The successful decision maker will be conversational with the operating, financing, and investing characteristics of the business – insight gained primarily from the analysis of financial statements.

Though benchmarking data is outside your own company, understanding it allows you to put into context the larger implications of internal decisions. The context of information can be just as important as the data itself.

Let’s take a look. Only given the information below, which company’s stock represents the best value, and why?  

  Price/Earnings Ratio Return on Equity
Company A 16x 19%
Company B 30x 7%

S&P 500 (data at year-end 2016; ttm)

22x 18%

 

 

 

 

 

A given in investing is to “buy low and sell high.” A fine rule. However, it is crucial to understand the meaning of “low” and “high” in this context. The two companies, A and B, should be compared to a reasonable benchmark. In this case, Standard and Poor’s 500 list of common stocks. Again, using only the data shown, Company A is the better choice.

The “market” is valued at 22 times earnings, but Company A is below that level, meaning it is selling low as of the date of the data shown. Moreover, its return on equity is better than the market. Therefore, Company A is performing well in terms of investor return, and is not “overpriced” relative to the benchmark (the S&P 500).

The opposite is the case for Company B. While the foregoing information can be gleaned from financial statements, the statements contain comprehensive company information, allowing for a much deeper valuation analysis than what is described in this example.  See, for example, “Financial Reporting and Firm Valuation: Relevance Lost or Relevance Regained?” by Luzi Hail; University of Pennsylvania, the Wharton School. Accessed from www.ssrn.com.

Clearly, financial information is valuable.  Are you using it to inform strategy? Any decisions should take into account risk and uncertainty – central concerns of the financial analyst in any decision making process. Risk has measurable probabilities of outcome. Uncertainty has no measurable probability of outcome.

“New uncertainty” is the effect of policy changes over the next 3-5 years at both the international and national levels – the effect of such changes will be very specific in terms of speed and degree, by industry and company. A real understanding of financial information not only helps you understand your company and evaluate competition and opportunity, but perhaps most important, allows you to reduce risk and better manage inherent uncertainty.

Dr. Ben Nunnally is Professor of Finance Emeritus at UNC Charlotte. Before beginning his academic career, he was a capital budgeting analyst at the BF Goodrich Company. During his 30-plus years at UNC Charlotte, Dr. Nunnally has co-authored several finance textbooks and has consulted with many area businesses on company valuation and strategic planning.

Discover more through a two-day course entitled Financial Statements in Context: Financial Analysis for Strategic Decision Making, brought to the business community by UNC Charlotte Executive Education.

 

Date Published: 
Wednesday, April 12, 2017