25 gl i 20 1ii 15 iii cost bby tjx rp ho tgt cl pep

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2.5 Gl > 0 I: 2.0 ~ 1ii 1.5 III III « 1.0 0.5 COST + \ BBY '\\. TJX r.p~ HO",- +TGT"",,-- CL PEP + AAPL JNJ •• ~CSCO ~VZ PG + PFE I I I 0.0 0.0% 20.0% 25.0% 5.0% 10.0% 15.0% Profit Margin eturn on Equity Another important analysis measure is return on equity (ROE), which is defined as net income divided by average stockholders' equity, where average equity is commonly defined as (beginning- year equity + ending-year equity)/2. In this case, company earnings are compared to the level of stockholder (not total) investment. ROE reflects the return to stockholders, which is different from the return for the entire company (ROA). ANALYSIS DECISION .... You Are the Chief Financial Officer You are reviewing your company's financial performance for the first six months of the year and are unsatisfied with the results. How can you disaggregate return on assets to identify areas for improvement? [Answer, p. 1-32] STEP 3-FORECASTING FINANCIAL NUMBERS Forecasting is a step where we proceed from our understanding of the company's current environ- ment (Step 1) and what has occurred with the company (Step 2) to a prediction of what will occur next. This step is crucial to decision making and valuation, and it is arguably a very difficult task. When we formalize predictions and state them in the form of financial projections, the quality of our forecasts is dependent on at least two factors. First, the quality of our analysis performed in Steps 1 and 2 in understanding the business environment and in adjusting and assessing finan- cial information is crucial. If we fail to effectively understand the context in which a company operates, we will not be able to make appropriate estimates going forward. The quality of our adjustments and assessments made to the company's financial information drives the quality of our forecasts. For example, if we fail to realize the existence of off-balance-sheet financing, lever- age is likely understated and then anticipated future financing needs are inaccurately forecasted.
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1-23 Module 1 I Framework for Analysis and Valuation Knowledge of Future Earnings Yields Excess Returns Another example would be not recognizing the negative implications for future operations of growing inventory levels combined with flat or declining sales. Second, the quality of our fore- casts is dependent on our assumptions being realistic and achievable. For example, is a company, which has recently experienced sales declines, likely to become the industry leader? Can a com- pany increase sales when confronting a new entrant in the industry? Part of our task is to objec- tively examine what evidence supports, or not, the forecast assumptions we make. In sum, the importance of forecast quality cannot be overemphasized as it is vital to our estimates of where a company is going, which are direct inputs to valuation. RESEARCH INSIGHT Evidence shows that knowledge of future earn- ings is valuable and useful to investors and oth- ers. The theoretical linkage between earnings and stock prices is as follows: current earnings predict future earnings, and future earnings help determine expected future dividends, and these future dividends,
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