Earnings Volatility and Equity Risk Earnings Volatility and Equity Risk

1

EARNINGS VOLATILITY AND EQUITY RISK

EarningsVolatility and Equity Risk: Earnings Volatility and Equity Risk

EarningsVolatility and Equity Risk:

Cashflow versus earnings

  • Lifecycle comparison of cash flow and earnings

ForNoble Corp PLC CompanyNorbleCorp PLC has thefreecashflowUSD mil of -604 meaningthatthecompanyhas moreexpensethan theincomeitearns.Freecashflowper shareUSD showssomesmallearningsper sharealthoughits spending outweighstheir earnings.Comparisonof cashflowandearningsshowsthatthecompanyis in maturestageof thebusinesslifecycle becauseof negativecashflowsince a maturestageof thelifecycleis associatedwith thenegativecashflowandmeansthere is a dropdown in profitmargins.ForChesapeake Energy Corp CompanyChesapeakeEnergy Corp has thefreecashflowof -1959 USD andthiscashflowshowsthatthespending of thecompanyis muchmoretheearning.Freecashflowper USD has mostnegativevalueindicatingthatits earningis toolowcomparedto their incomegeneration.Comparisonof thecashflowandearningshowsthatthecompanyis in maturestageof a lifecyclesince in maturestagethecashflowis negative,andthere is a dropdown in theprofitmarginsfrom earnings.ForExxon Mobil CorporationExxonMobil Corporation has thecashfreecashflowUSD mil of 12922 USD. Thiscompanyhas a magnificentcashflowimplyingthatithas moreearningsthan expenses.Thefreecashflowper shareUSD show the company can earn more income from its shares. Cashflowandearningscomparisonsshowthatthecompanyis at theexpansionstageof thelifecycle becauseitcan acquiremorefundsandgainmoremarketas wellas increaseits salesandrevenueearnings.ForLululemon Athletica IncFree Cash Flow USD Mil is 172 meaning that,theearningis morethan theexpenditure.LululemonAthletica Inc is in an excellentfinancialstatusandcan improvemoreon its financialearningsas itreducesorkeepsconstantthecost.Hasfreecashflowper share(USD) that showsa goodearningon their shares.Incomparingthecashflowandearningof thecompany,showsthatitis in theexpansionstageof thelifecyclesince ithas a positivecashflowandhas an increasing earningon theshare.Atthisstage,thecompanycan capturea newmarketandincreasesaleshencemorerevenueearningstherebyimprovingitscashflowmuchbetter.ForNetflix Inc CompanyFreeCash Flow USD Mil is 31 dollars,andthismeansthatthecompanyhas a realcashstatus,andtheearning is morethan expenditurebecauseof thepositivecashflowfigure.Hasfreecashflowper share(USD) that showsa fairearningontheir sharesto caterfortheir expenses.Incomparingthecashflowandearning,itwasfoundthatthecompanyis in theestablishedstageof thelifecycle.ForAbercrombie &amp Fitch Co Class A CompanyFreeCash Flow USD Mil is 12 dollars.Heretheincomeearnedby thecompanyis morethan theexpensesmetby it.Thefinancialstatusis betteras comparedto their earningto expensesHasfreecashflowper share(USD) that showsa fairreceiving on their sharesto caterfortheir expenses.Comparisonof thecashflowandearningshowsthatthecompanyis in thegrowthstageof thelifecycle.ForGoodyear Tire &amp Rubber CompanyTheCompany has a freeCash Flow USD Mil of -974 andnegative cashisassociatedwith thematurityof thecompany.Hasfreecashflowper share(USD) that showstheearningon their sharesis littleandcannot enableitto caterforall their expensesandremainwith someincomeat theend.Lookingat thecashflowandearnings,itwasfoundthatthecompanyis in maturestageof thelifecyclebecausein maturestagethecashflowin alreadyin negativethatmeansitisearningin lessthan theexpenses.ForAmgen Inc CompanyTheCompany has a freeCash Flow USD Mil of 5677 meaningthatthecompanyhas morerevenueandcan caterforall its expensesandremainwith enoughincomeafter meetingall its expenses.Hasfreecashflowper share(USD), which is goodandcan makeitmeetall its expensesandremainwith realrevenueat theend.Comparisonof thecashflowandearningsindicatesthatthecompanyis in theexpansionstageof thelifecyclesince ithas a positivecashflowandhas an increasing earningon theshare.Atthisstage,thecompanycan capturea newmarketandincreasesaleshencemorerevenueearningstherebyimprovingitscashflowmuchbetter.

Comparisonof thevolatilityof earningsandcashflownumbersForNoble Corp PLC CompanyThenetincome(revenue)is 889 dollarsandcashflowis -604 dollarsmeaningthatthecompanyhas highincomebutwith a veryhighfinancialexpensesthat makethecompanynot be in a goodpositionto favorablybalancethecostsandtheearnings.Thecompanyis sovolatilein termsof spendingcomparedto earnings.ForChesapeake Energy CorpTheCompany has thevalueis 1091 andhas thecashflowof -1959 therefore,thecompanyis proneto highrisksassociatedwith theearningsandhencethecompanyis volatilein termsof earningandexpenditure.Expendituresexceedearningputtingthecompanyat a highriskForExxon Mobil CorporationTheCompanyhas thevalue(netincome)32180 dollarsandthecashflowof 12922, therefore,thecompanystandsa betterchancein its financialstatusandhenceithas a good.Sincethecompany’scashflowis positiveandthenetincomeis high,itis in a betterchanceof expandingits financialstrengthandmeetsall its expenseswhileremainwith a goodincomeat theend.Thecompany’scashflowis not volatilebecauseof muchdisparityin netincomeearnedandthecashflow.ForLululemon Athletica Inc companyHasthenetincomeof 280 dollarsandthecashflowof 172 dollarsimplyingthattheexpensesmetby thecompanyis lessthan theearning, therefore,thecompanyis sovolatilewhenitmeetsall its expenses.Thelevel of volatilityof thecashflowof is little.ForAbercrombie &amp Fitch Co Class ATheCompanyhas thenetincomeof 163 dollarsandthecashflowof 31 dollarsmeaningthatits level of volatilityin termsof expensesas comparedto earningsof lowbecauseithas highrevenueandpositivecashflow.Itcan transformits financialstatusto earnmuchmoreincome.ForGoodyear Tire &amp Rubber CompanyTheCompany has netincome(earnings)of 55 dollarsandthecashflowof 12 dollarstherefore,itis not sovolatilebecauseof thewidedispersionof earnings,andcashflowis high.Thecompanycan earnmuchincomefrom anyinvestmentitengagesin.ForGoodyear Tire &amp Rubber CompanytheCompany has thenetincomeearningto 545 dollarsandthecashflowof -794 dollars.Thecompany’scashflowis sovolatilebecausethedispersionis toolittle,anditis in negative.Thecompanyrisksclosingdown should be an increasein its expenditure.ForAmgen Inc CompanyThecompanyhas thenetincomeearningis 4720 dollarsandthecashflowof 5677 dollars,therefore,thecompany’scashflowis not volatileandthereforethecompanyis a realstatusagainst an additionalexpensewhenitincreasesits expenditureas theymaintainthecurrentfinancialearnings.

  • Companies whose cash flow appears more volatile are those companies with the negative cash flows because their expenses are more than the income they earned.

  • The companies whose earnings are more volatile are those companies with which the dispersion (gap) between earnings and cash flow is small making it not to be in a good position to cater for their expenses while remaining with an active cash flow

Pfizer:

(1)

Year

Total assets (x)

Total Liability and equity (y)

Mean (assets) X

Mean (Liability and equity) Y

(x-X)2

(y-Y)2

1995

12729.3

12729.3

1591.16

1591.16

124051480

124051480

1996

14667.0

14667.0

1833.38

1833.38

167701802

167701802

1997

15336.0

15336.0

1971.00

1971.00

178543044

178543044

1998

18302.0

18302.0

2287.75

2287.75

247881408

247881408

1999

20574.0

20574.0

2571.75

2571.75

324081005

324081005

2000

33510.0

33510.0

4188.75

4188.75

859735702

859735702

2001

39153.0

39153.0

4894.13

4894.13

1173670174

1173670174

2002

46356.0

46356.0

5794.45

5794.45

1645239338

1645239338

2003

116775.0

116775.0

14596.86&nbsp

14596.86&nbsp

10440372290

10440372290

2004

123684.0

123684.0

&nbsp15460.50

&nbsp15460.50

11712325950

11712325950

2005

117565.0

117565.0

14695.63

14695.63

10582107280

10582107280

2006

114837.0

114837.0

&nbsp14354.63

&nbsp14354.63

10096706680

10096706680

2007

115268.0

115268.0

&nbsp14408.50

&nbsp14408.50

12963985740

12963985740

2008

111148.0

111148.0

13893.50&nbsp

13893.50&nbsp

9458437770

9458437770

&nbsp

&nbsp

&nbsp

&nbsp

&nbsp

&nbsp= 69974839663

&nbsp=69974839663

Returnon asset (ROA)

Forassets

Meanof squared difference = (124051480+ 167701802+ 178543044 + 324081005 +859735702 +1173670174+1645239338+ 10440372290 + 11712325950 + 10582107280 + 10096706680 +12963985740 + 9458437770)/14

Mean= 4998202833

ForLiabilityand equity

Meanof squared difference = (124051480+ 167701802+ 178543044 + 324081005 +859735702 +1173670174+1645239338+ 10440372290 + 11712325950 + 10582107280 + 10096706680 +12963985740 + 9458437770)/14

=4998202833

StandardDeviation (SD) =

WhereN is the number of years (= 14)

SD=

SD= 5382679974

Informationcoefficient (IC) = (mean)/standard deviation

IC= 69974839663/5382679974

IC= 13

(2)

Year

Revenue (x)

Operating income

(y)

Earning before tax

Earning after tax

Net income

(x-X)2

(y-Y)2

1995

10021.4

2299.2

2299.2

1561.2

1572.9

44563769

3176686

1996

11306.4

2804

2804

1935

1929

490728393

26331369

1997

12504

3088

3088

2223

2213

439103224

23497384

1998

13544

5882

2594

1952

3351

396598861

4340597

1999

16204

4448

4448

3204

3179

297727778

12162029

2000

29574

5781

5781

3732

3726

682004193

4641482

2001

32259

10329

10329

7768

7788

1439496

5729273

2002

32373

11796

11796

9187

9126

1178940

14904155

2003

45188

3163

3163

1642

3910

137574367

22775897

2004

52516

14007

14007

11342

11361

363177253

36864205

2005

51298

11534

11534

8110

8080

318237413

12949850

2006

48371

13028

13028

11036

19337

222374007

25934473

2007

48418

9278

9278

8255

8144

223777964

1802548

2008

48296

9694

9694

8049

8104

220142801

3092639

&nbsp2009

50009

11900

10800

8620

8630

273909451

15717974

&nbsp= 2741691194

&nbsp= 4112537910

Mean(for operating income) (Y)= (2299.2+ 2804 + 5882 + 4448 + 5781 + 10329 + 11796 + 3163 + 14007 + 11534 +13028 + 9278 + 9694 + 11900)/15

Mean(Y) = 7935.41

Meanof revenue (X) =(10021.4+11306.4+12504+13544+16204+29574+32259+32373+45188+52516+51298+48371+48418+48296+50009)/15

X= 33458.79

StandardDeviation (SD) =

WhereN is the number of years (= 15)

SD=

SD= 182779413

Informationcoefficient (IC) =

IC=

IC= 13.2

ROCE=

ROCE=

ROCE= 0.2

ROCE= 20%

3Thenumber(standarddeviation)obtainedusingtheoriginaldatais higherthan thestandarddeviationobtainedusingadjusteddata.Itis becausetheadjusted datahas a numberof expensesassociatedwith it,andthismadeitclearforthedifferencesin thetwo valuesobtained.Thenumberobtainedusingtheoriginaldatacontainstheassets valuesandtheliabilityvaluesthat wereanalyzedjustin termsof their valuesonly.Foradjusteddata, thenumberobtainedincludedtherevenuethat wassubjectedto taxesandotheroperatingexpenses.Theapproachthat gavea higheraveragewasusingtheoriginaldatathemethodthat gavethegreatestIC wastheadjusted data.ThePfizer’s resultschangedcomparedto othermethodsof analysisbecausethePfizer approachwasusingtheadjusteddatathat wassubjectto variouschangesin thetax.Therefore,thePfizer approachhas seriesof factorsthat ledto its variation.

Reference

Brodersen,S., &amp Pysh, P. (2014).&nbspWarrenBuffett accounting book: Reading financial statements for valueinvesting.