Calculating Value-Steps 3 & 4: The Projected Income Statement (Post 7)

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Calculating value



This is by far the most time consuming step of them all. Here is where you are going to really get to know the company and do your due diligence like a pro investor. When you get good at doing a company valuation you will see that steps 1-2 and steps 5-10 will take you no more than 20 minutes. Step 3 and 4 on the other hand will always be time consuming and you should never rush through it. This is the most important step in our valuation and we are going to be spending quite some time learning how to do this properly

The ultimate objective of step 3 and 4 is to create a projected 4 year income statement.

Since this is such an important step, and a difficult one, I am going to be explaining more theory than usual and providing more examples than any other step. I want to be clear that you do NOT need an accounting degree or any previous accounting experience in order to perform these next two steps. You are also in good hands when it comes to learning about income statements. As some of you might know I have a master’s degree in accounting and I also happen to have been an accounting tutor for the athletic department at my university. When I taught accounting all of my students improved on average 2 letter grades. My “secret” to teaching success is simply UNDERSTANDING my students and their knowledge. I base my teaching approach and their learning on this foundation. I understand that most of my students have never used any sort of financial statement let alone prepare one. If you fall in this category you can ease your fears right now because I have taught just about anyone how to successfully create financial statements.

The reason I am giving you so much reassurance is because I know some of you are very skeptical about your abilities. As always; be patient and persistent in your learning.

This step deals with the subject of accounting and not finance. Preparation of financial statements is accounting, an analysis of financial statements is finance, profiting from your analyses….that is investing. Successful investing I might add.

Brief Accounting History

Let’s look at some history behind the accounting profession and the environment before we actually learn how anything is done.

In the early 2000’s there was the Enron and WorldCom accounting scandals. These two giant companies committed what is probably considered the worst accounting fraud of all time. They had shocked the world with what they had done and sent a rippling effect through the entire industry. This whole ordeal put a dark cloud over the industry and investors had lost a lot of confidence in the accounting profession and the regulatory bodies that were responsible for overseeing public companies.

In the aftermath of the Enron and WorldCom scandals the industry as a whole would change entirely. Accounting standards as we knew back then would take a 360 degree turn. The Public Company Accounting Oversight Board (PCAOB) would be created which would have the responsibility of “auditing the auditors”. Sarbanes Oxley (SOX) would also come into effect which would, among other things, change internal control standards within public companies.

Over the years the accounting industry has undergone many changes. The key words over the past decade have been disclosure and transparency. If you are a publicly traded company you are required to disclose just about everything in your financial statement notes and your company has to be as transparent as air.

When it comes to the preparation of financial statements there is still a lot of scrutiny from the public as some believe companies are still able to manipulate numbers using legal methods. The ultimate goal of a company’s financial statements are to “Represent fairly in all material respects the financial position of the company” Sure there is still the possibility of companies manipulating numbers, but for now it’s the best we can do.

Now that we have some understanding of the profession let’s look at the mechanics of financial statements.

Accounting 101

There are 3 major financial statements that a company presents and are always easily accessible:

1) Income Statement
2) Balance Sheet
3) Statement of Cash Flows

In addition to these 3 statements there is also the Statement of Retained Earnings and the Statement of Comprehensive Income (Which very few people know about)
The one that we are going to focus on entirely for this step is the income statement.
In its simplest form an income statement represents revenue minus expenses to give us profit.


Profit is sometimes called net income or earnings. I will refer to it as earnings when we start preparing our statements. In-between the simplicity of revenue minus expenses we have a whole bunch of accounts that represent various forms of revenues and expenses.

Before we get into “crunching” the numbers as they say I would like to take you through the dynamics of the income statement. I want to explain each line item and show you how to interpret the numbers better. This accounting 101 introduction will also help you once you start digging into the company’s documents, as you will have a better understanding of the terms that are being used.

The website that we are going to be getting our income statement from is MorningStar. I have looked at many websites’ financial statements and I have found MorningStar to be the best. Some are way too complicated and have too much info on them, which might be good if you are really looking for a detailed analysis, but for our purposes and the template we are going to be using MorningStar is the best. The website is free to use so everyone will have access to it. They do have a premium version but we won’t be needing that.

Here is how we get to our income statements:

1) Go to


2) Type in your stock quote


3) Once the stock profile opens, click on “Financials”


4) Make sure the income statement is displayed


One of the awesome features of the income statement on Morning Star’s website is that you can switch from the dollar view to a percentage view. You do this by clicking the “%” symbol underneath the view heading. This capability is very important to our valuation because we use a lot of the percentages when performing certain calculations.


Let’s start with the first line on the income statement:


The first line (top line) is some sort of revenue. It can be service revenue or sales revenue. However the company makes the most of its money will be on the top line.

Cost of Revenue:

The next line is cost of revenue or cost of sales (sometimes referred to as cost of goods sold or COGS).Not to get into too much detail on this topic because it can get very complicated, but cost of revenue is what it costs the company to generate this revenue. Think of this as the product or service cost. It just relates to the costs that are directly incurred to generate the revenue.

Gross Profit (Margin)

Revenue less cost of revenue gives GROSS profit. It’s important to understand that this is GROSS profit and not NET profit. There are still other expenses that will come along that will affect net profit. Gross profit divided by revenue gives us “margin” of margin percentage. This is a very commonly used word and margins are important to a company’s operation regardless of the industry.

Operating Expenses:

Operating expenses are expenses that the company incurs from its day to day operations. The list can be endless, but the main line items here are usually Research and Development (R&D), Selling, General and Administrative (SGA) and everything else is usually bundled up into “other” operating expenses.

Operating Income:

Gross profit less operating expenses gives us operating income or income from operations. This is the income that is generated by the company from its normal business operations. Things that are usual in nature to the company. Any income or expenses that are not considered normal to the company’s operations are reported elsewhere.

In some cases you might see operating income being labeled as EBIT, or EBITDA. EBIT stands for Earnings Before Interest and Taxes. EBITDA stands for Earnings Before Interest, Taxes, Depreciation and Amortization. Some companies like to separate these items and exclude it from operating income because they don’t believe these expenses to be a true reflection of their operations. On Morning Star’s income statements you will see income from operations reflect EBIT. I do however want to explain to you what depreciation and amortization are because companies make reference to these items in their filings with the SEC. If you look at the bottom of the statement on MorningStar you will see that EBITDA is displayed separately on its own line.


Depreciation is a NON-cash expense. The company does not pay out money due to depreciation expense. Every time you buy an asset such as machinery you are in almost all cases as a public company required to depreciate it over time as it wears and tears. One of the reasons depreciation is required is because it represents the value of the asset over time. There are various methods company’s use to depreciate their assets which we don’t need to get into because that is beyond the scope of this book. In a very small nutshell I want to show you how depreciation is used to “value” an asset. A company buys a machine for $20,000 and decides to use what is called “the straight line method” of depreciation. They depreciate it over its useful life of 8 years at $2000 a year. After year one the depreciation expense that the company will report on its income statement is $2000. Now they didn’t have to PAY anyone $2000 and yet this is considered an expense. This $2000 also “accumulates” in a separate account called accumulated depreciation which is the total of depreciation expense recorded over the years of the assets useful life. This accumulated depreciation is put on the balance sheet as a “contra asset” and is used to provide a book value for the asset. For instance after year one the accumulated depreciation on this asset is $2000. The book value of the asset will be the cost less the accumulated depreciation= $18000 ($20000-$2000). The use of depreciation expense has received some scrutiny from the accounting profession and investors. Some people don’t think that it is a true cost to the company since they aren’t paying anything out and yet are reporting it as an expense. Others have said that it is necessary to show the expense a company incurs from the asset losing value.


Amortization is similar to depreciation in the sense that it expenses the assets reduction in value over the period of its useful life. The difference is that amortization is used on intangible assets, whereas depreciation is used on tangible assets. Intangible assets are assets that are not physical in nature. Physical assets would be machinery and equipment, and intangible assets would be goodwill and patents. In the case of patents; the cost incurred to create the patent would be spread out over the course of the patents useful life. The actual accounting involved for intangible assets is very complex and beyond the scope of this book. Most of you might be familiar with amortization in loans, where you pay off a portion of the loan each year to reduce the principal.

Interest Expense:

The next line we have is interest expense and after that we have “other” income (loss). This is just anything the company feels should not be included in income from operations because it won’t be a true reflection of their operations. Often times you will see this number as zero because they might not have any other income or loss.


The next item that we have is provision for income taxes, or income tax expense. This is the portion that goes to the government. Just like individuals pay their taxes, so do corporations.
Now the next three lines you can ignore. The reason for this is because the way the income statements are structured on Morning Star makes these lines slightly confusing. They are usually not material to the rest of the statement. The next line we are going to look at is net income or often referred to as “the bottom line” The reason that it’s referred to as the bottom line is that in the past it was actually the last line on the income statement. Now with more advanced income statements and disclosure requirements there are other items that come after that and net income is no longer the literal bottom line.

Net Income:

The way that Morning Star labels net income on their statements is “net income from continuing operations” In some cases companies might have discontinued operations and extra ordinary items that they separate from net income to provide more transparency.

Discontinued operations

Discontinued operations are exactly what they sound like; operations that the company has discontinued for some or other reason and they will be displayed on a separate line to net income.

Extra-ordinary items:

Extra ordinary items are items that are reported after net income and are infrequent and unusual in nature. In today’s accounting world for a company to have an extra-ordinary item it really needs to be an unusual event. For example; after the Sept 11 attacks some companies in the World Trade Center were completely destroyed and lost all their operations. They were not allowed to count these devastating losses as extra-ordinary items because the World Trade Center had been attacked before and therefore this event was not considered infrequent in occurrence. (Just an interesting side story)

Income available to common shareholders:

The next line in the case of this particular example is income available to common shareholders. I call this EATC (Earnings available to common). Sometime EATC might not be the very next line after net income. Sometimes there is an additional line squeezed in there called preferred. This is income paid out to preferred shareholders, and what is left after that is EATC. Basically if you see preferred after net income then you know to just subtract that from net income to get EATC, therefore:

EATC=Net income-preferred.

EPS and Weighted average shares outstanding:

The next two items are Earnings Per Share (EPS) and Weighted average shares outstanding. When we make our income statement we might switch these around just so that our EPS can be the last item since this is what we are working towards. You will see that there are two numbers listed under each of these items: basic and diluted. The one that we are going to be concentrating on is BASIC. Basic EPS does not take into consideration the amount of outstanding convertible securities the company has issued, whereas diluted EPS does.

These are things such as employee based stock options and warrants and convertible preferred shares. Diluted EPS measures what EPS would be should these convertible securities be exercised.



This is the first part of making our projections. This part isn’t difficult but it is time consuming. A quantitative projection for our purposes is one where we look at past data to make future predictions. We are going to look at historical financial statements to give us an idea of earnings growth, EPS growth, increases in margin, changes in expenses, etc. This first part of our projections analysis is entirely from a numbers standpoint. All that we will do is average out five years of data to create a 4 year projected statement.

I’m going to take you through the process of taking the numbers from the income statement on Morning Star and putting them into the income statement template we will be using shown below:

The Income Statement Template:


You can go ahead and create something like this on paper or on excel; whichever you prefer as long as it has all of the required line items.

Next we are going to get the income statement for the company we are analyzing. For this example I am going to be using Under Armor, and here is what their current income statement looks like:


Once we have our income statement and template set up, we are going to create the base income statement. This is going to be the base or foundation statement that we are going to work off of as we move through our projections. Basically what you will be doing here is averaging the past couple of years and using that to create a projected income statement. I call it a base statement because it’s just a foundation and not the final statement. It’s nothing more than a reference point that we use when creating the final statement

The first thing that we setup on our template is the year 0 numbers. On your income statement this will be the TTM numbers on the far right corner.


Here is how this is done:

Copy the number from the revenue line exactly as it is:


Then switch over to the % view instead of the $ view. You will take the % of “income before taxes” as the next line and this will be our margin percentage



Take the above percentage and multiply it by REVENUE to get the $ amount for margin.

Operating Income=203

The next line is Earnings Before Taxes (EBT) and you will just copy the above number onto the EBT line.

Operating Income=EBT

Switch back into the % view and take the percentage of taxes and then multiply that by REVENUE to get taxes. Keep in mind that all of these percentages are based on REVENUE!

Provision for income taxes=75

Deduct taxes from EBT to arrive at net income

Net Income=128

If there is any preferred line, deduct that from net income. If there is no preferred line, then Net Income is equal to EATC.
Net Income=EATC

Take the BASIC weighted average shares outstanding

Weighted average shares outstanding=104

Divide EATC by weighted average shares outstanding to arrive at EPS

EATC/Weighted average shares outstanding

Take all of these numbers and put it on our template’s first column under year 0.


Now that we have our year 0 column complete we can go ahead and start averaging out our numbers.

The first line that we need to average out is the top line: revenue. In order to average out the past 5 years of revenue we will be taking the percentage increase/decrease between each year and then taking the average over the past 5 years.

To make this easy to understand the best thing to do is organize the numbers in order:



Now to average this out we are going to first work out the percentage difference between all of these years and then we are going to average the total. Here is how this is done:

2008 to 2009

2009 to 2010

2010 to 2011

2011 to 2012

Use these numbers to get the average revenue growth:
18.07% + 24.30% + 38.44% + 24.58% = 105.39%
105.39/4 = 26.35

According to these calculations revenue grew at an average rate of 26.35% over the past 5 years.

We don’t stop here though. We have to get the actual numbers that we are going to put on our income statement template.

Take the average from the above step and add 100%:
26.35% + 100% = 126.35%

To figure each years’ revenue we multiply this percentage by the previous year’s revenue. Our starting revenue is from year 0 which is $1,835

Year 1: 1,835*126.35%=2,319
Year 2: 2,319*126.35%=2,930
Year 3: 2,930*126.35%=3,702
Year 4: 3,702*126.35%=4,677


Calculating margin is much easier. You will just average out the past 5 years (Remember that for margin you will take the percentage from the “INCOME BEFORE TAXES” line):


The average of these percentages is calculated as follows:

9.64% + 9.62% + 10.24% + 10.65% + 11.09%= 51.24

Your average margin is 10.25% and this will stay constant through all 4 projected years.

Operating income:

On the next line we calculate operating income. To calculate this you will use the calculations from revenue and margin. Multiply the revenue of each year by the margin percentage of 10.25%
Year 1: 2,319*10.25%=238
Year 2: 2,930*10.25%=300
Year 3: 3,702*10.25%=379
Year 4: 4,677*10.25%=479

Earnings Before Taxes (EBT):

EBT will be the above numbers:

Year 1=238
Year 2=300
Year 3=379
Year 4=479


Taxes are handled the same way as margin is handled. The percentage that you will be using is under the “provision for income taxes” line. Average out the percentage of all the years and use that to figure tax dollars:


Take the average of these years:

4.37% + 4.16% + 3.80% + 4.07% + 4.07% = 20.47%

Remember that this is a percentage based on REVENUE, and so you need to multiply this number by the revenue of the respective year.

Year 1: 2,319*4.1%=95
Year 2: 2,930*4.1%=120
Year 3: 3,702*4.1%=152
Year 4: 4,677*4.1%=192

Net Income:

To calculate net income; subtract out your tax provision from EBT:

Year 1:238-95=143
Year 2:300-120=180
Year 3:379-152=227
Year 4:479-192=287

Since we don’t have any preferred, the net income will equal our EATC.

Earnings Available to Common Shareholders (EATC):
Year 1=143
Year 2=180
Year 3=227
Year 4=287

Weighted average stock outstanding (Basic):

This is also an averaging calculation:



This number is going to remain constant throughout the years.

Earnings Per Share (EPS):

Finally we come to the number that we have been working towards. EPS is calculated by dividing the weighted average shares outstanding by EATC:

Year 1:143/101=1.42
Year 2:180/101=1.78
Year 3:227/101=2.25
Year 4:287/101=2.84


Example: Base Income Statement
Starting out we first have to create our skeleton, or base income statement that we work from. We use the TTM numbers in the far right corner. Here is the income statement for MRK and below I have transferred the numbers from their income statement onto our template.




That’s our year 0 updated on the base statement. Notice that I didn’t get the exact same EPS number as the income statement on Morning Star. I got 2.07 instead of 2.03. This is because I excluded the confusing section of “other income” This will not make a material change to the overall analysis and if later I feel it does, I will go back and change it.

Next we need to calculate each line item for year 1 through 4.




2008 to 2009

2009 to 2010

2010 to 2011

2011 to 2012

Take the average of these percentages:


Our overall sales growth average for the next 4 years will be 21.49%. We then add 100% to this number to get the actual percentage we use for calculation purposes

Year 1=47,267*121.49%=57,425
Year 2=57425*121.49%=69,766
Year 3=69766*121.49%=84,759
Year 4=84759*121.49%=102,974

At first glance these sales figures seem quite inflated, however; this is just a base and we will definitely adjust it once we complete the entire valuation.



This will stay the same for all the projected years

Operating Income:

Year 1: 57,425*13.9%=7,982
Year 2: 69,766*13.9%=9,697
Year 3: 84,759*13.9%=11,782
Year 4: 102,974*13.9%=14,313

Earnings Before Taxes (EBT):

Year 1=7,982
Year 2=9,697
Year 3=11,782
Year 4=14,313



This will stay the same for all the projected years and remember this percentage is based on revenue!

Year 1: 57,425*5.05%=2,900
Year 2: 69,766*5.05%=3,523
Year 3: 84,759*5.05%=4,280
Year 4: 102,974*5.05%=5,200

Net Income:

Year 1: 7,982-2,900=5,082
Year 2: 9,697-3,523=6,174
Year 3: 11,782-4,280=7,502
Year 4: 14,313-5,200=9,113

Since there are no preferred items; Net Income will equal EATC

Earnings available to common shareholders (EATC):

Year 1=5,082
Year 2=6,174
Year 3=7,502
Year 4=9,113

Weighted average shares outstanding (Basic):


This will stay the same for all the projected years

Earnings Per Share (EPS):

Year 1: 5,082/2722=1.87
Year 2: 6,174/2722=2.27
Year 3: 7,502/2722=2.76
Year 4: 9,113/2722=3.35


Initially my thoughts were that sales were way too inflated and that it would come out to an unrealistic measure, but actually it worked out really well with the low margin. The EPS number came out more or less where I wanted it to for a base income statement. Now that we have this we can move onto doing some more company analyses and adjusting these numbers. Please remember that when you are calculating taxes or anything else that uses a percentage that you are multiplying that percentage by the TOP number, ie; revenue/sales.

With our base statement complete we are done with our quantitative analysis and we can move onto the next part of the valuation.



Here is where you will spend most of your time during this valuation process. This is where you are going to get to know the company backwards and think like a PRO investor!
We are going to dig into the company’s annual report, learn about the business, learn about the risks and try figure out where this company is headed. The information under this heading alone is priceless. This is how most analysts do their research. They read through the company’s reports and start forming opinions and doing further analysis from there. I’m going to show you what professionals look for when analyzing a company, and I’m going to teach you how to think for yourself instead of having to read articles from others. I’m going to show you how to form your OWN opinions instead of relying on someone else. If you’re not excited to learn this part by now then you should start getting excited because it’s extremely valuable knowledge that I’m about to teach you.

We are first going to download the company’s latest annual report and then go through it and read about the company’s plans, opportunities and risks.

An annual report is a report that every public company has to file with the SEC that discloses their activity and financial position to the public. These reports have full blown audits performed on them at the cost of millions of dollars to the company to ensure their accuracy. Every report that a public company files with the SEC has a name and corresponding number or code. An annual report is called a “10-K” or “10K”. A quarterly report is called a “10-Q” or “10Q”.

These reports are always available on the SEC’s database website called EDGAR. They are also most likely available on your broker’s website for download. We are going to go ahead and download them from the SEC’s database. Here is how we get to these reports.

1) First we will go to the SEC website at


2) Hover your mouse over “Filings” and click on “Search for company filings” On a side note you should definitely check out the EDGAR tutorial and descriptions of SEC forms under the filings tab.


3) Once you get to the next page; you should click on the first available link “Company or fund name, ticker symbol…..”


4) From here the best way to search is by ticker symbol. It will give you the company you are searching for immediately. Select the second option to search under ticker symbol, type the company you want and click on “Find Companies”. The company I searched for in this example was Merck & Co (MRK)


5) On the next page you will have a listing of all the documents the company has filed with the SEC. If you want to get a better understanding of what all these documents are you should check out the descriptions of SEC forms under the filings tab. Scroll down to find the first 10-k form. You will see that next to the 10-K and 10-Q forms there is an option for “Interactive data” this will take you to see all of the company’s financial data as well as descriptions of their accounting practices. Click on the link that says “documents”. This will open the 10-K report.


6) On the next screen click on the red link that has the description of “FORM 10-K”


Now that you have the 10K in front of you it’s time that you get accustomed to it. I’m going to take you through of the important things on this document. A lot of it is not necessary for our particular analysis.

The front page of the 10K is going to have some general information on it.

1) The date that it was filed with the SEC
2) The name of the form
3) The name and address of the company
4) The state of incorporation
5) The company’s tax ID number
6) The exchange that it is listed on


If you scroll down to the contents page you will see that every 10K is formatted the same way or at least very similar. Every company will have more or less the same headings in their content section; the only difference will be the actual content itself. That’s the great thing about this is that I can show you an example of a company in a completely different industry to the one you are analyzing and they will have similar looking 10K’s.

Notice that this report is extremely long. It’s 150 pages long with microscopic text! There are a lot of items we are going to skip over. I might briefly tell you what they are, but they won’t be important for our analysis. The 3 main sections that we are going to focus on are; Business, Risk Factors and most importantly; Management’s Discussion and Analysis of Financial Condition and Results of Operations.

I’m really excited for all of you reading right now because you are about to take your investing knowledge to the next level with what I am about to show you.

As you should know by now I’m a big advocate of people managing their own money, analyzing their own stocks and making their own decisions. Forget about reading articles from the “experts” and having them put biases into your own opinion. You are about to become your OWN expert. I want to remind you that this is a game of THINKING. It is my goal to have you get sick of hearing me say that you need to THINK harder than you have ever thought before.

Starting with section one:


Item 1 on the 10K is usually a very detailed description on the nature of the business you are analyzing. It is so detailed that after reading through it you will feel like you are ready to take over the company. The first paragraph is an introduction to the company, it usually tells you a little bit about the company, its products and services and how it makes the bulk of its money. The next couple of pages provide more detail on some of the items discussed in the introduction.

The business section is where you will learn about the company’s products and services. Every company is different but for the most part they will talk about their products and how they have performed and some of the challenges they have faced. Usually they will have a table showing the sales of each individual product. Further down you will see things that might have some sort of effect on their products or services. They might talk about things like licenses or patents on their products or services.
Moving down the document you will see information about the company’s competition and operating environment. Here you will get a feel for the external factors of the company and the outside forces affecting the company. They will usually discuss current economic conditions and how that might impact future sales of their products.

Depending on the company the rest of this chapter could vary. Usually the thing it comprises most of is talk about the products or services. Anything that is relevant to the product or service will be discussed under the business heading.

Some of you might not have the time or willingness to read through all of the necessary material. With that in mind I am going to mention some parts that you CAN’T skip over, but remember how much you put in is how much you get out. It is very important that you have a good understanding of what the company does and how it operates. The first page that gives a brief description of the business and every page under the “overview” heading should not be skipped over. It’s only about 2-4 pages long and it will give you an understanding of the company and how it makes money. If you read through the overview and you feel like you’re not really sure what the company does, then I suggest you either read through it again or keep reading further.

The other important heading under this item is the company’s competition and environment. It is very important that you understand who the company’s competition is and even more important how the state of the economy affects it. If you look at it this way you only have to read two headings; overview and competition/environment. That is the bare minimum that you should read through, and if you have more time and are willing you should be reading everything under the business heading.
…..and remember the most important thing to do while reading is to THINK. (More on that later)

Risk factors:

This section outlines the risks that a company faces. Don’t be alarmed or discouraged when reading through this section. Understand that every company that is operational faces some sort of risk. This section will highly depend on the industry you are analyzing. Banks talk about different risks compared to utility companies. The first time you ever read through a company’s risk factors on the 10K you might think it’s time to run for the hills. It might sound like the end of the world since there is a long list and a number of pages just describing how much risk the company faces. Understand that it is a regulatory requirement for public companies to disclose risk factors in detail and that every company faces risk! Once you get more experienced with your analyses you will learn exactly what to look for.

Here are just some questions that should be floating in your brain while reading through risk factors:

Does this risk affect the industry as a whole or just the company?

Does this risk involve economic conditions and affect almost all companies regardless of industry?

If this risk is a potential risk how likely is it to become a reality?

How severe are these potential risks should they materialize?

These are just some of the questions you should ask yourself when reading through this section. While reading you should already be thinking about how this will affect your investment. I like companies that have “vague” risks in their description. What I mean by this is that most of their risks are ones that are faced by every company in the industry regardless of their position. While reading through risk factors you should try and pick up on companies who have descriptions of risk that seem vague and not specific. Things that you might think are obvious to the industry. This means that they put those disclosures in there mostly for legal purposes. If a company doesn’t talk about very SPECIFIC risks to major products or services you can make the assumption that it contains a lower level of risk.

On the other hand you might have companies who talk very specifically about certain risk factors or one risk in particular. If you read a company repeatedly mentioning one specific risk and that risk affects a key product/service or is at the core of its business model then you should proceed with caution.

There is no substitute here for practice. Knowing what a specific risk is versus a risk that affects the industry as a whole is a skill that you need to learn. Knowing how severe a risk and the potential that it materializes is will also be a skill that you will learn with practice. A good exercise that I recommend you do is to pick three different companies in completely different industries and read through their risk factors. This is for you to learn that different industries have different risk factors. Next you should pick one company who you might think contains the most risk. Then pick 2 of its closest competitors and read through their risk factors. Compare the companies to see which one you think has the most risk and why, and which has the least risk and why.

Here is a quick example on what you should be looking for when reading through risk factors:
When I was analyzing Pandora Media (P) right before its IPO, I was reading through the risk factors that it faced. Besides some vague risks that could pertain to all companies in the industry, there was one risk that they just kept on mentioning. It was basically the risk of their ever increasing “content acquisition costs”. They mentioned this risk over and over again and so I figured it must be a pretty big deal. The way their business model works (or doesn’t work should I say) is that they had to pay royalties to the artists whose songs they played. These costs just kept on increasing, and as their business grew and they had more and more listeners so did their content acquisition costs. I thought that it’s definitely not a good thing if your expenses are sure to increase at a faster rate than your income. In this case there was a specific business risk that they outlined and made it clear that it was important. With some experience I figured that these risks definitely outweigh the benefits of the company. It is really important to analyze a company and not jump in on impulse. If you look at Pandora; it is an awesome concept, but the business’ model and ability to make money is terribly flawed. You have to THINK while reading how these risk factors will affect the company and your potential investment

Finally we get to the 3rd and most important heading of them all….

Management’s discussion and analysis (MDA)

The previous two sections; business and risk factors, were for the most part concerned with things that are already known. This section is where you should get the majority of the knowledge and estimations for your income statement projections because this section deals with discussion of previous results AND management’s outlook on the future of the company.

Since every 10K is structured in a similar manner, MDA will be easy to navigate regardless of the industry the company is in. It will start with sales, and then move onto expenses, and then other items such as taxes and net income. Everything that you read under the MDA heading is important to your projections. You have to think long and hard about how any information in this section could affect your final statement, in fact; most of your time in step 4 should be spent reading and dissecting the information under MDA.

What you are looking for here are the following keywords:


Sales/Revenue (Growth, Performance, Increases, Decreases)

You are looking at the future outlook for revenue. There is surely a detailed discussion of sales and sales trends. This is your top line and it is one of the most important factors when putting together your projections. You need to read carefully and pause when you see anything related to sales growth or decline. If the company mentions something about growth potential you need to immediately start thinking how it’s going to affect the first line on your projected income statement. Do they seem positive about the future growth of their sales, or do they see it only increasing at a normal rate? Do they talk about any risks or uncertainties that will result in the decrease of sales? Things such as patents expiring, increasing competition, etc.

Products/Services (New services, New products being developed, obsolete products, pending lawsuits, patent expiration)

In the sales section, the company should discuss quite a bit about the products they sell or the services they provide. You need to take note of how optimistic they are about new products and services and how you believe it will fit into the current economy. Did the sales of one product increase or decrease and what is the forecast for the future? Are the new products going to be revolutionary or will they just be upgrades of existing products?

Things such as patents expiring are especially important to note as this can have a dramatic decrease on sales. Is the competition among these products increasing? Anything that you believe will affect the company’s products or services needs to be noted!

Margin (Growth/increases, decreases)

What is the company saying about the margin on their product or services? Are their margins going to contract and are they going to see smaller profits? Sales and margin will go hand in hand. When you read about sales be sure to take specific notice about mentions of margin increases or decreases. If there are “potential” increases or decreases; what are the possible causes of these changes and how probable are they?

Expenses (Increases/Decreases/Onetime expenses, Restructuring costs, Acquisition costs)

Read about the expenses the company has incurred and how it can potentially affect the future margins on their sales or services. A lot of times you will see that there are certain “one-time” expenses that were incurred in previous years. These might not be recurring expenses and they might increase the margin on operating income in future years. Look at the trends in the expenses of the company, have they been increasing or decreasing over the years? Consider the discussion about new procedures that will make the company more efficient and thus reducing expenses and increasing margin. Have they had large layoffs recently that reduced expenses in the previous year? Are they planning on increasing marketing efforts? What about their selling and administrative staff?
Take notice of their talk about taxes. What has their tax rate been over the past couple of years? If there have been huge changes what has been the cause of these changes? Going forward how does the company think the tax environment will affect their business?
Read and THINK!

Future (Anything)

Anything that management discusses about the future is extremely important information, regardless of what the topic might be. If management is discussing future results you better believe that it needs to be considered somewhere in your projections. Again it comes down to thinking about how something might affect your projections. If you read about future results, expenses, sales, margins, or any event you should highlight it or write it down. Reflect on it, think about it and consider it in your analysis.

Example: Final Income Statement

Here is an example of how I perform this qualitative analysis. In quotation marks are some of the highlights from the 10K that I believe are important. The whole point of reading through this is to think about how this information is going to affect your decisions. Take note of everything that you think is important and be sure to question every note you take.

“Merck continued to execute on its strategic priorities during 2012 despite facing several business challenges, including the August U.S. patent expiration for Singulair, a medicine indicated for the chronic treatment of asthma and the relief of symptoms of allergic rhinitis. Worldwide sales were $47.3 billion in 2012, a decline of 2% compared with 2011, including a 3% unfavorable effect from foreign exchange. Excluding the impact of foreign exchange, sales increased 1% reflecting growth of key products and within key geographic regions which offset the impact of the U.S. Singulair patent expiration. The Company also reduced operating expenses by efficiently managing costs through targeted reductions. In addition, the Company generated new clinical data and advanced certain key research and development pipeline programs.”

The first thing I notice is the patent expiration. Immediately I’m thinking how this will affect the future performance of sales. Did the patent expire on a key product? What was the overall impact on sales? It seems there is some good news despite the patent expiration; growth in other products picked up the slack. The very next part of the paragraph mentions unfavorable foreign currency exchange. This is something that is very difficult to account for and even though I do take note of it, I don’t get too caught up trying to figure out how I can accurately take this into consideration. I would keep this in the back of my mind until I read further into the 10k.

My overall thoughts from reading this paragraph was I liked the fact that the company had some sales growth in key products, and managed to reduce expenses. The most important part of this paragraph is the last sentence which talks about products that are in the pipeline. For a pharmaceutical company their future hinges on their ability to produce innovative products. My conclusion from reading this paragraph was that I need to decrease the sales forecast for the next year since they had a patent expiration in August. So as of right now I’m set on decreasing the sales in year 1 by about 3%, however; they did have growth in key products over the year which is extremely important. The foreign currency risk is harder to account for than growth in sales. Lastly the advancement in certain key research sounds appealing but I’m going to have to read further to see what this means. This is just the introductory paragraph and by no means will I base my projections entirely from just this one paragraph. The introduction should give you a good starting point for the rest of your research.

“Beginning with the Company’s sales performance in its largest markets during 2012, despite the adverse effects of the U.S. Singulair patent expiry which caused a significant and rapid decline in U.S. Singulair sales, sales in the United States were relatively flat compared to the prior year reflecting strong growth of key brands including Januvia and Janumet, treatments for type 2 diabetes, Zostavax, a vaccine to help prevent shingles (herpes zoster), Gardasil, a vaccine to help prevent certain diseases caused by four types of human papillomavirus (“HPV”), Victrelis, a treatment for chronic hepatitis C, and Isentress, an antiretroviral therapy for use in combination therapy for the treatment of HIV-1 infection. Turning to Europe and Canada, the Company continues to experience positive volume growth trends for many of its key brands, including Victrelis, Januvia, Janumet, and Simponi, a treatment for inflammatory diseases; however, this growth only partially offset increased generic erosion and the price declines stemming from the economic issues and related fiscal austerity measures in this region.”

The first sentence again mentions that patent expiration on Singulair. The patent expiration definitely did hurt sales, however; they were offset by strong growth of key brands. The net effect was that sales were relatively flat. The company saw positive volume growth trends in Europe and Canada, however; the growth in these regions only partially offset the current economic state. Overall the Singulair patent expiration will cause sales in the coming year to decline and I believe, following that year, growth will increase quite a bit. In addition I also think the economic condition in Europe will cause a drag on sales in the next 2-3 years, but I believe that sales will increase once Europe slowly tries to pull itself out of its current economic state.

"With respect to research and development efforts, the Company continued the advancement of drug candidates through its pipeline in 2012. The Company currently has three candidates under review with the U.S. Food and Drug Administration (the “FDA”): MK-4305, suvorexant, an investigational treatment for insomnia; MK-8616, sugammadex sodium injection, a medication for the reversal of certain muscle relaxants used during surgery; and MK-0653C, an investigational combination of ezetimibe and atorvastatin for the treatment of primary or mixed hyperlipidemia. MK-8109, vintafolide, an investigational cancer candidate, is under review in the European Union"

With this paragraph it is really difficult to give any predictions. They have a couple of products currently under review with the FDA and they could be big hits or complete flops for all we know. FDA approval is an extremely long process so if these developments do get approved it will only benefit the later years. I’m going to put these three candidates they have in consideration for my sales forecast for years 3 and 4.

Pharmaceutical competition involves a rigorous search for technological innovations and the ability to market these innovations effectively. With its long-standing emphasis on research and development, the Company is well positioned to compete in the search for technological innovations. Additional resources required to meet market challenges include quality control, flexibility to meet customer specifications, an efficient distribution system and a strong technical information service. The Company is active in acquiring and marketing products through external alliances, such as joint ventures and licenses, and has been refining its sales and marketing efforts to further address changing industry conditions. However, the introduction of new products and processes by competitors may result in price reductions and product displacements, even for products protected by patents. For example, the number of compounds available to treat a particular disease typically increases over time and can result in slowed sales growth for the Company’s products in that therapeutic category.

The above is an example of risk factors. What I really like about the above paragraph is that the risks seem broad and they would apply to any company in the industry. I didn’t see a recurring risk factor that was very specific to the company or its product. This is good news, and just from experience I know that Merck is a good company with sound management and that they will always be positioned to compete in the industry.

"Worldwide sales totaled $47.3 billion in 2012, a decline of 2% compared with $48.0 billion in 2011. Foreign exchange unfavorably affected global sales performance by 3%. The sales decrease was driven primarily by Singulair, which lost market exclusivity in the United States in August 2012 resulting in a significant and rapid decline in U.S. Singulair sales. The sales decline was also driven by lower sales of Remicade, a treatment for inflammatory diseases, largely as a result of the arbitration settlement agreement with J&J in 2011 as discussed below. In addition, lower sales of Cozaar and Hyzaar, treatments for hypertension, Clarinex, a non-sedating antihistamine, Fosamax, for the treatment of osteoporosis, Vytorin, a cholesterol modifying medicine, Primaxin, an anti-bacterial product, and Avelox, a broad-spectrum fluoroquinolone antibiotic for the treatment of certain respiratory and skin infections, as well as lower revenue from the Company’s relationship with AstraZeneca LP (“AZLP”) also contributed to the sales decline in 2012. These declines were largely offset by higher sales of Januvia, Gardasil, Victrelis, Zostavax, Janumet, Isentress, Zetia, a cholesterol modifying medicine, Dulera, a combination medicine for the treatment of asthma, as well as by higher sales of the Company’s animal health and consumer care products."

This paragraph is just a more detailed explanation of the sales trends over the past 2 years. I already discussed in the first paragraph what I plan on doing with sales. After reading this paragraph I must say that my original predictions still stand. I’m sticking to my verdict of a reduction in sales over the next year, a flat sales figure or slow increase in year 2 and a more rapid increase in year 3 and 4.

"International sales were $26.9 billion in 2012, a decline of 2% compared with $27.6 billion in 2011. Foreign exchange unfavorably affected international sales performance by 4% in 2012. Declines in Europe and Canada were partially offset by growth in Japan and certain of the emerging markets, particularly in China. Lower sales of Remicade led the decline, along with lower sales of Cozaar, Hyzaar, Singulair, Fosamax and Clarinex, partially offset by growth in Januvia, Victrelis, Gardasil and Janumet. International sales represented 57% of total sales in both 2012 and 2011."

Again just explaining sales trends except these are international sales. Also what we should take note of is the mention of emerging markets. These markets are going to eventually play a huge role in the growth of the company. These events I believe will not benefit sales in the next year or two, which adds further evidence to the increase in sales in later years.

"Materials and production costs were $16.4 billion in 2012, $16.9 billion in 2011 and $18.4 billion in 2010. Costs include expenses for the amortization of intangible assets recorded in connection with mergers and acquisitions which totaled $4.9 billion in each of 2012 and 2011 and $4.6 billion in 2010. Additionally, expenses in 2011 and 2010 include $89 million and $2.0 billion, respectively, of amortization of purchase accounting adjustments to Schering-Plough’s inventories recognized as a result of the Merger. Costs in 2011 include an intangible asset impairment charge of $118 million. The Company may recognize additional non-cash impairment charges in the future related to product intangibles that were measured at fair value and capitalized in connection with mergers and acquisitions and such charges could be material. Also included in materials and production were costs associated with restructuring activities which amounted to $188 million, $348 million and $429 million in 2012, 2011 and 2010, respectively, including accelerated depreciation and asset write-offs related to the planned sale or closure of manufacturing facilities. Separation costs associated with manufacturing-related headcount reductions have been incurred and are reflected in restructuring costs as discussed below."

Moving on from all this sales talk, we come to expenses. I like the trend in declining expenses as outlined by the first sentence. What I really like is that they mentioned the amortization of intangible assets. While this is not extremely relevant to my projections right now I am glad that I have an example here of why explaining all those accounting terms in the previous step was worth reading. My only concern in this paragraph is that the company could recognize additional non-cash impairment charges in the future. While this is not a disaster by any means, especially since it’s not a cash expense, it will potentially have a negative impact on margins. My overall take here is that management is doing a good job of managing expenses and as they become more efficient, a further decrease in expenses will be seen.

"Gross margin was 65.2% in 2012 compared with 64.9% in 2011 and 60.0% in 2010. The amortization of intangible assets and purchase accounting adjustments to inventories, as well as the restructuring and impairment charges noted above reduced gross margin by 10.7 percentage points in 2012, 11.4 percentage points in 2011 and 15.2 percentage points in 2010. Excluding these impacts, the gross margin decline in 2012 as compared with 2011 reflects the significant decline in Singulair sales as a result of the loss of U.S. market exclusivity, partially offset by improvements resulting from other changes in product mix. The Company anticipates that gross margin will continue to be negatively affected by the Singulair U.S. patent expiry which occurred in August 2012 and by the Singulair patent expires in major European markets which occurred in February 2013. In addition, anticipated generic competition in the United States for Maxalt and Propecia will also negatively impact gross margin in 2013. The gross margin improvement in 2011 as compared with 2010 reflects changes in product mix and manufacturing efficiencies, as well as a benefit from foreign exchange.
Restructuring costs were $664 million, $1.3 billion and $985 million in 2012, 2011 and 2010, respectively. Nearly all of the costs recorded in 2012 and 2011 relate to the Merger Restructuring Program. Of the restructuring costs recorded in 2010, $915 million related to the Merger Restructuring Program, $77 million related to the global restructuring program initiated in 2008 (the “2008 Restructuring Program”)"

From this paragraph the company explains its restructuring costs from its “restructuring program”. Since they mention this program and have material costs as a result we need to look further into what this is. The trend in the last 2 years has caused a huge drop in the cost from this program and I believe it will lower the costs moving on in the future. This just adds further confirmation to my previous thoughts of the company effectively lowering costs.

"The Company is involved in various claims and legal proceedings of a nature considered normal to its business,"

I just threw this line in there to explain litigation and legal proceedings because you are definitely going to be seeing a lot of this during your analysis. If you see that a company mentions they have various legal claims pending it does not mean that you have to run for the hills. It is perfectly normal for a public company to have a number of open lawsuits. They have an army of lawyers in their offices for these purposes. Since this is “considered normal to its business” you don’t have anything to worry about here. If you saw something along the lines of:

“We have a pending lawsuit against us that could result in a material detriment to the company”


“We have a claim against us and could possibly lose a patent on our key products”
….then you have something to be worried about (potentially)

My overall verdict; I believe that the patent expiration on Singulair will negatively impact sales for the next 2 years. I think that it was a big deal for the company to have that patent expire but I only think it will impact the next 2 years until the company develops new drugs. I think that their sales will increase in years 3 and 4 as they position themselves better after the Singulair patent expiration.
International sales should increase as Europe slowly recovers. This would be beneficial for year 3 and 4. (Possibly only year 4)

Emerging markets I believe will also benefit sales but only in the latter years. As these emerging markets get better healthcare and access to more drugs sales should increase. Again this is also a longer term outlook and will not affect the sales figures for the next 2 years.

The company did mention the affordable care act AKA Obama care. I’m not an expert on Obama care and I don’t need to be, but I believe it won’t affect drug makers in a negative way. I do think that as more people have access to healthcare that the sale of drugs will increase, however; most sales will increase in the less expensive generic brands. Overall I don’t think Obama care will be much of a benefit or detriment to MRK during the time scope of this valuation period.

When it comes to expenses I believe Merck will be able to continually decrease their expenses. They had some major expenses in the past couple of years due to that restructuring program. Margin in the next year should be pretty heavily hit by the Singulair patent expiration in Europe which is fine as it is partially offset by other process improvements.

Here are the actual numbers:

Year 1:

For year 1 I have decided that sales are going to decrease 3% from year 0. Margin for year 1 will increase by about 1.5% from the base rate. Taxes and shares outstanding will remain what they are on the base statement.

Revenue: 47,267-3%=45,849
Margin: 13.9%+1.5%=15.4%
Taxes: 5.05%
Weighted avg shares outstanding: 2722

Year 2:

For year 2 I have decided to have a 1% decrease in sales from year 1 sales. Margin will remain the same, taxes, and shares outstanding will remain the same.

Revenue: 45,849-1%=45,391
Margin: 15.4%
Taxes: 5.05%
Weighted avg shares outstanding: 2722

Year 3:

For year 3 I believe that sales should increase quite a bit and so I have decided for an increase in 17% from year 2 sales. I also think that expenses will be reduced and thus operating margin will increase by about 3%. Taxes and shares outstanding remain the same.

Revenue: 45,391+17%=53,107
Margin: 15.4%+3%=18.4%
Taxes: 5.05%
Weighted avg shares outstanding: 2722

Year 4:

For the final year, I believe that this is when sales can really start to increase and so I’m going to go for an increase of 35% from year 3. I will also increase margin 1%. Taxes will stay the same and shares outstanding will also stay the same.

Revenue: 53,107+35%=71,694
Margin: 18.4%+1%=19.4%
Taxes: 5.05%
Weighted avg shares outstanding: 2722

Now we put these numbers into our final income statement.


There you have it. That’s how you create your own income statement. Remember that this step really requires practice and ALWAYS remember to be patient with yourself and more importantly with your learning. On a side note when I did eventually go through the entire process of valuing MRK it came out to a final price of $47.02. I valued it at a time when it was around $41.50. At the time of writing this it is currently at $47.92 and I believe it can go a lot higher. I think that I might have been too harsh on years 1 and 2 which ended up not valuing the stock high enough, but either way the end result was a solid valuation.

Before we move onto the next couple of steps in this valuation I have to point out a few things. We are doing the best analysis that we can on our companies by reading through the documents and thinking about how certain factors can impact the future of the company. With that being said there are varying risks between industries. Consumer staples have steadier earnings and are easier to predict than companies in the tech industry. You have to keep that in mind. If you’re analyzing companies in industries that are volatile and harder to predict then you have to understand that the risk will be higher.

Also I want to point out that your year 4 EPS number is the most important. You will see at the end of the valuation why this is the case.

The shortcut

I wasn’t sure if I wanted to include this in my eBook, but I figured I should provide a shortcut to this whole process for those of you who are not really willing to put in the time to go through all this reading and number crunching. Since our EPS number is the reason we do this whole analysis, we can just go ahead and average out the growth of EPS over the years and then use that as the final number instead of the base. This is the same thing we did for sales, except that now we are going to do it for EPS.
Our information is as follows:

2009= $0.34
2010= $1.05
2012= $2.25
2013= $2.87

We are going to take the percentage increase from these years and then average it out to figure the EPS growth over the past 5 years.

First thing that I want to point out is that I will NOT be using 2009’s number. Notice how the 2009 to 2010 jump was much larger than any of the other years. If you were to use this it will distort your information, so when you see a very unusual change you can skip over that year.

2010 to 2011

2011 to 2012

2012 to 2013

Average EPS growth:

I’m not entirely happy with this average just because in the 2010 to 2011 period there was a 75% jump as opposed to the other two years that were in the 20’s. From experience this tells me that the 2009 to 2010 which we didn’t use at all for our basis and the 2010 to 2011 will make our data distorted. In this case we are just going to use the most recent years because the averages are closer together.

Year 0= 2.87
Year 1=2.87*124.92% =3.59
Year 2=3.59*124.92%=4.48
Year 3=4.48*124.92%=5.60
Year 4=5.60*124.92%=7.00

There you have it, the shortcut method!

Even if you do decide to go with the shortcut method I still strongly recommend that you glance through the 10-K sections that I mentioned earlier so that you can at least understand the business structure and potential risks that the company faces.

The actual example income statement that I am going to work with through the latter parts of this eBook is going to be the one below:


We were working towards the EPS projection for year 1 through 4. With this step complete the last thing that needs to be done is to put these numbers onto the diagram:


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