0:15

>> Let's move on now and think about the income statement.

Â Okay? So now we're going to talk about financial ratios

Â that we're going to calculate using data

Â from the income statement.

Â The first thing we need to think

Â about is what does the income statement measure?

Â Okay? Here you have an example

Â of an income statement for DirecTV, okay.

Â First thing is there is this term LTM.

Â Which is defined here in the bottom.

Â What this means is that it's the data for the latest 12 months.

Â So if this is March 31, 2015, this means is

Â that you have the data from April 1

Â of 2014 to March 31 of 2015.

Â Okay? So it's a year, right?

Â And so in many cases the most current data

Â that you can get is going to be the latest 12 month figure.

Â Right? So essentially what you have an income statement is data

Â on profits and costs.

Â So you have revenue, right?

Â You have cost, your profits, right?

Â And so the key formation really that you can get

Â from the income statement is profitability.

Â How profitable a company is.

Â 1:34

The asset turnover, they are defined here.

Â Asset turnover, net profit margin, return on assets,

Â and return on equity, and you can see that for some

Â of these ratios we are going

Â to use this important measure which I call OPAT.

Â 1:59

Okay? And as we are going to discuss next,

Â OPAT is a really good measure to use when you're trying to figure

Â out how profitable a company is.

Â Okay? The return on equity measure

Â which is measure number 4 uses net income instead of OPAT.

Â That we're going to talk-- the first thing for us to talk

Â about is what is the difference between OPAT and net income,

Â and to do that let's look

Â at Cablevision's income statement again.?

Â Okay? So here you have the latest 12 month figures.

Â Okay, let's use those.

Â Right? You have revenues, costs, profits,

Â operating income is here.

Â 2:39

It's at the top of the income statement.

Â Okay? That's the key thing.

Â Operating income is right there at the top

Â so it only includes operating revenues and costs.

Â Okay? So revenues and costs that we really have

Â to do with the business.

Â Right? For a company that Cablevision,

Â they sell digital TV and Internet, right?

Â So these are the revenues that they get from their customers

Â and those of the cost of operating the company.

Â Right? Operating income is going to be a measure of that.

Â And then after that we're going

Â to have the non-operating expenses and revenues.

Â Right? So we have interest expense,

Â we have interest income, okay?

Â And you can see here that there is a net interest expense.

Â That's the amount of interest that the company paid.

Â So your net income is going to be a profit figure

Â that is reported after interest payments

Â and other non-operating items.

Â Net income is at the bottom of the income statement.

Â Okay? If you work out the math here, right,

Â what would be your OPAT,

Â your OPAT would be the operating income minus taxes, right?

Â I've done the calculation there for you,

Â so the OPAT for Cablevision

Â in this latest 12 month period would be $764 million.

Â 4:01

Right? And if you do the math, you know, the interest is 100--

Â sorry, the interest is $580 million so you can check that in

Â and come is approximately OPAT minus interest.

Â The difference between OPAT and net income is mostly

Â that net income is in after interest measure.

Â 4:22

Okay? So, was the right way to think about that we if you think

Â about OPAT and ratios that are based off of Pat like ROA,

Â what you're going to keep doing is measuring profitability

Â for the company as a whole.

Â 4:39

Right? So they're up there and income statement for Cablevision

Â for example, you're measuring the profit

Â for the entire company.

Â If you use net income, or return on equity, you're going

Â to be measuring profitability

Â from the perspective of shareholders only.

Â 4:57

Okay? Because net income is a profit measure that is reported

Â after interest and ROE is a financial ratio

Â that is based off of net income, so we're not going

Â to be including-- essentially,

Â we're going to be deducting interest payments

Â and other non-operating stuff from your profit measure.

Â Okay? So, this might be okay,

Â but as we Artie discussed a little bit in this course,

Â net income is at the bottom of the income statement

Â so one problem is that net income is busily affected

Â by accounting manipulation and one-time items.

Â Right? So if the company has a one-time expense,

Â you know like a legal settlement, for example,

Â if Cablevision gets sued in a given year,

Â that has to be reported in your income statement, and it's going

Â to reduce your net income, right?

Â And there are many ways

Â that companies can manipulate the accounts

Â to change your net income.

Â Operating income is usually a more solid measure.

Â Okay? So for many companies, ROA is going to be a better measure

Â of profitability then net income because of these two reasons.

Â Okay? It's based-- it computes profits for the entire company

Â and since it's at the top of the income statement, it's a measure

Â that is a little bit harder to manipulate then net income.

Â 6:21

And here comes a question for you.

Â All right?

Â We talked about using the market value of assets

Â and the market value of equity

Â to compute leverage ratios, right?

Â We just did leverage ratios, and that if you want to figure

Â out how solvent a company is, we have to use the market values.

Â Okay? Now we are computing profitability ratios.

Â Right? So, for example, you know,

Â just to give an example here for you

Â to understand what we're talking about, ROA is going

Â to be defined as OPAT assets, right?

Â 7:28

Okay? Why you want to compare profits to capital

Â that is invested in the company.

Â Okay? And remember that a company's market value is going

Â to measure the company's total value, right.

Â It also increase the value of future cash flows.

Â 7:46

Okay? So it's not really a measure

Â of how much capital has been invested in that company,

Â it's not a measure of how many dollars investors putting

Â [phonetic] in that company, really is a measure

Â of the value of the company.

Â Okay? One way to think about this, let me go back here,

Â because this is an important idea, okay?

Â If you use market values to measure profitability,

Â what you would be doing, right,

Â so in the numerator you have current profits.

Â 8:39

Right? So a company that is--

Â you know, suppose you find a company

Â that has a lot of future profits.

Â Okay? That, you know, and you use market value of assets,

Â this companies going to have low profitability ratios,

Â 9:07

you have to use book value of assets and book value of equity

Â if you can in the denominator.

Â Okay? Let us now give some examples

Â for Cablevision and DirecTV.

Â Here I have a simplified snapshot

Â of the Cablevision balance sheet for you.

Â Again, so you can see the value of assets.

Â We already computed OPAT, which is down there, right,

Â OPAT for Cablevision is $764 million.

Â Right? So what you need to do is divide OPAT by the total value

Â of assets if you want to compute ROA.

Â So the assets, the value of assets is here.

Â It should be really simple.

Â Cablevision ROA should be 0.11.

Â And you can get the data that I provided

Â and of course I will provide these calculations as well

Â for you, see you can get the data and verify

Â that you can get these numbers.

Â Which should be really easy to compute.

Â 10:13

Right? ROE.

Â Let's go back here again, okay.

Â ROE is what?

Â ROE is net income divided by equity, and remember,

Â do we use market equity or book?

Â 10:35

But we know that book equity for these companies is negative.

Â Okay? Book equity for these companies is negative.

Â So you really could not use ROE to measure profitability

Â for our Cablevision and DirecTV.

Â So it's a measure that does not make much sense.

Â It would be very useful for you.

Â Okay? And it's, you know, this is a common problem.

Â Book equity is a problematic figure to use.

Â And that is why in general, I prefer, okay I prefer to look

Â at profitability measures that measure profits

Â for the company as a whole, like ROA.

Â ROE is going to prompt.

Â Okay? Finally, let's talk about earnings-per-share.

Â 11:22

Okay? This is a profit measure that we talked

Â about in the beginning of this module already, right?

Â Is essentially net income divided by shares outstanding.

Â It looks like a stock price, right?

Â But it's based off of net income instead

Â of the market value of equity.

Â Okay? And we discussed already some of the problems

Â with net income, okay?

Â So, of course, you're going to have some of the same problems

Â as ROE because you're basing all profitability on that income

Â which is after interests, so it does not compute profits

Â for the company as a whole, it is subject

Â to manipulation and all that.

Â It's affected by one-time items, okay?

Â In addition to that, there is an additional problem which is

Â that you are dividing net income by shares outstanding.

Â 12:15

Okay? And as we already discussed,

Â shares outstanding can be easily manipulated.

Â It's very easy to change the number of shares outstanding

Â that a company has with something

Â as simple as a stock split.

Â 12:28

Okay? And then, of course, the one thing you could do is

Â to just your profitability measures.

Â Try to get at the actual profits, but, you know,

Â it's much simpler just to not use earnings-per-share

Â to compare profitability across firms.

Â Okay? You know, so my recommendation is

Â that we do not use earnings-per-share

Â to compare profitability, you know, since the number

Â of shares can be easily changed.

Â You know, it's not-- we're not going to be able to say

Â that a company that has higher EPS

Â than another company is more profitable.

Â Okay? So EPS is not a great measure of profitability,

Â at least the way I see it.

Â