ACCT6101 – Session #1: Introduction to Valuation
PART 1 – Background
1
ACCT7106 – Session #9: Ratio Analysis
overarching objective:
to conduct the fundamental valuation exercise for the purpose of estimating the ‘intrinsic value’ of a firm’s common shares
requires an understanding of the firm’s ‘value drivers’
need to accumulate a ‘tool kit’ as the basis for developing the pro forma Financial Statements
1
2
projected over the forecast horizon
core inputs into the valuation model x g
Balance Sheet (B/S)
Income Statement (I/S)
Statement of Cash Flows (SCF)
2
3
STEP 1
Understanding the past
Information collection
Understanding the business
Accounting analysis
Financial ratio analysis
Cash flow analysis
STEP 2
Forecasting the future
Structured forecasting
Income Statement forecasts
Balance sheet forecasts
Cash flow forecasts
STEP 3
Valuation
Cost of capital
Valuation models – AE, FCF, D
Valuation ratios
Complications
Negative values
Value creation and destruction
Figure 1.1 Lundholm & Sloan, Framework for Equity Valuation
Sessions #3 #10
Sessions #10 #11
Sessions #1 #3; #11 – #13
4
Financial Statements – AASB 101:
Balance Sheet
Income Statement and/or Statement of Comprehensive Income
Statement of Changes in Equity
Statement of Cash Flows
Notes to the financial statements
building blocks definitions specific to accounting
accounting principles AASB / IFRS rules to guide accounting decisions/choices
recognition (item to F/S) versus disclosure (notes)
‘accountability’ & ‘stewardship’
‘accountability’ preservation by management of the resources entrusted to them
‘stewardship’ efficient use by management of resources entrusted to them (earning a return)
‘articulation’ Financial Statements constitute an ‘integrated system’
5
beginning stock
Beginning Balance Sheet
Cash
+ Other assets
= Total Assets
– Liabilities
= Shareholders’ Equity (BVt-1)
Statement of Changes in S/E
Cash from operations
+ Net Income & OCI
= Net Change in S/E
Cash Flow Statement
Cash from operations
+ Cash from investing
+ Cash from financing
= Net change in cash
Income Statement
Revenue
– Expenses
= Net Income (NPAT)
Ending Balance Sheet
Cash
+ Other assets
= Total Assets
– Liabilities
= Shareholders’ Equity (BVt)
flows
ending stock
6
Objectives:
separate operating activities from financing activities
Operations: buying and selling goods and services
Financing: the company’s use of debt and equity to finance its operations, as well as the company’s investment in financial assets
Why? industrial companies generate value from their operations, not from their financial activities
alter several accounting classifications
for the Income Statement, separate revenues and expenses based on their driver (sales volume or other), and whether they are recurring or non-recurring
for Statement of Cash Flows, separate operating from financing activities; determine free cash flows operations-related cash flows split by operating versus investing; and separate equity and debt financing cash flows
Reformulation
7
Accounting Quality / Earnings Management
*** the identification of statements materially affected by earnings management activity is critical when deciding whether to rely on the Financial Statements as a basis for developing forecasts of the firm’s future financial performance
earnings management
choices by management to influence earnings in a systematic direction
mechanisms available to manage earnings:
accounting-based selection and/or application of accounting principles
real activities management business strategy / operations
definition: earnings quality
a firm’s reported earnings number is said to be of high quality if it accurately and reliably measures current economic value-added and is a good predictor of economic value likely to be added in the future
ongoing debate – ‘rules-based’ versus ‘principles-based’
rules-based
accounting standards prescribe in detail exactly how to account for various items and situations without providing discretion
more limited scope for earnings management type behaviour BUT also limited opportunity for management to use accounting policy choice as a means of communication
principles-based
accounting standards provide guidance on how various items and situations should be accounted for, but also provide flexibility for management to exercise judgement within the spirit of the guidance
more opportunity for management to use accounting policy choice as a means of communication BUT also increased scope for earnings management type behaviour
debate about trade-offs between costs and benefits of allowing discretion
8
The 3 basic questions that frame the notion of “power to detect” are the following:
Where is it most “profitable” to look?
under what set of circumstances is earnings management activity most likely to occur?
which firms are the most suspicious (in the most suspicious circumstances)?
what are management’s incentives? (earnings targets? contractual obligations? compensation?)
i.e., small positive earnings; small earnings increases; earnings volatility (smooth earnings)
2. What should be examined?
what should the search focus on? what ‘lever’ is management most likely to utilize to accomplish the earnings management?
i.e., accounting (accruals); real activities
3. How should the investigation be conducted? technique(s)?
**** our focus – accounting statements (especially Income Statement) accruals ****
9
10
Penman Figure 18.2 – Diagnostics to Detect Manipulation of Operating Income
Step #1 – investigate the quality of sales revenue
Step #2 – investigate the quality of core expenses
Step #3 – investigate unusual items
Step #1
note – much of the investigation will involve ratios (value of one account(s) relative to value of another account(s))
11
Step #2
Step #3
12
intended to shed light on how well a company is doing in achieving its objectives
earning a satisfactory return on investment
maintaining a sound financial position i.e., owners want capital protected from more than normal amount of risk
structure of analysis – an examination of the relationships between items in the F/S
in absolute terms
changes over a period of time
relative to other firms (in same industry)
three basic techniques for analysing the Financial Statements
ratio analysis
common-size financial statements
trend (indexed) financial statements
PART 2 – Financial Statement Analysis (in general)
13
1) Financial Ratios 5 basic categories of commonly used ratios (some overlap)
a) liquidity ratios access to cash to pay bills
b) leverage ratios dependency on debt financing & ability to make interest payments
c) profitability ratios earnings relative to sales, S/E, assets, etc.
d) activity ratios emphasis on productivity of assets
e) market ratios based on market value information (e.g., price-earnings (P/E), market-to book ratio (M/B))
2) Common Size Financial Statements
express accounts on the B/S as a % of total assets
express accounts on the I/S as a % of sales (total revenue)
can compare relative weights of various accounts across firms or with industry norm
3) Trend (Index) Analysis
establish a bench-mark year and set all accounts (or ratios) to 100 in that year
in subsequent years, express accounts relative to the base year
can identify relative (percentage) changes over time
14
Financial Ratios:
a) liquidity ratios access to cash to pay bills
e.g., current ratio = CA/CL (*ignores quality and liquidity of assets)
quick ratio = (CA – inventory)/CL
inventory turnover = COGS/inventory
receivables turnover = sales/AR
notes: liquidity refers to company’s ability to pay its current liabilities when due
solvency refers to company’s ability to repay its long-term obligations as well
relates to idea of financial flexibility company’s ability to alter its capital structure to take advantage of new investment opportunities or deal with economic change
15
b) leverage ratios dependency on debt financing & ability to make interest payments
e.g., debt to equity = (CL + L-T debt)/shareholders’ equity
times interest earned = (PBT + interest)/interest
c) profitability ratios earnings relative to sales, S/E, assets, etc.
e.g., profit margin = NI/rev
ROA = EBIT/total assets (or earnings after tax / total assets)
ROE = NI/(S/E)
d) activity ratios emphasis on productivity of assets
e.g., inventory turnover
receivables turnover
asset turnover = sales/(tot assets)
16
Coles Income Statement 2020 2019
Sales Revenue 37,408 38,176
Other operating revenue 376 288
Total operating revenue 37,784 38,464
Cost of sales (28,043) (29,253)
Gross Profit 9,741 9,211
Other income 108 428
Administrative expenses (8,081) (8,031)
Other expenses — (146)
Share – equity investments (6) 5
EBIT 1,762 1,467
Financing costs (443) (42)
PBT 1,319 1,425
Income tax expense (341) (347)
Profit from continuing operations 978 1,078
Profit from discontinued operations (after tax) — 357
Profit (NPAT) 978 1,425
OCI (12) (1)
Total Comprehensive Income 966 1,434
17
Coles Balance Sheet 2020 2019
Assets
Current Assets
cash & cash equivalents 992 940
receivables 434 360
inventories 2,166 1,965
income tax receivable 42 —
assets held for resale 75 94
other assets 70 47
Total current assets 3,779 3,406
Non-current Assets
property, plant and equipment 4,127 4,119
right-of-use assets 7,660 —
intangible assets 1,597 1,541
deferred tax assets 849 365
equity accounted investments 217 212
other assets 120 134
Total non-current assets 14,570 6,371
Total Assets 18,349 9,777
Liabilities 2020 2019
Current Liabilities
payables 3,737 3,380
provisions 861 743
lease liabilities 885 —
other 198 168
Total Current Liabilities 5,681 4,291
Non-current Liabilities
interest-bearing liabilities 1,354 1,460
provisions 472 598
lease liabilities 8,198 —
other 29 71
Total non-current liabilities 10,053 2,129
Total Liabilities 15,734 6,420
Net Assets 2,615 3,357
Shareholders’ Equity
contributed equity 1,611 1,628
reserves 43 42
retained earnings 961 1,687
Total Equity 2,615 3,357
18
Liquidity ratios 2020 2019
current ratio = CA / CL 0.665 0.794
quick ratio = (CA – inv) / CL 0.284 0.336
inventory turnover = COGS / inventory 12.947 14.887
days inventory = 365 / inventory turnover 29.192 24.518
receivables turnover = revenue / receivables 87.060 106.844
average collection period = 365 / receivables turnover 4.193 3.416
Leverage ratios
debt-to-equity = total liabilities / total equity 6.017 1.912
debt-to-assets = total liabilities / total assets 0.857 0.657
times interest earned = EBIT / interest 3.977 34.929
19
Profitability ratios 2020 2019
gross profit margin = gross profit / revenue 0.258 0.239
profit margin = NPAT / revenue 0.026 0.037
return on assets (ROA) = EBIT / total assets 0.096 0.150
return on equity (ROE) = NPAT / (S/E) 0.374 0.424
Activity ratios
inventory turnover = COGS / inventory 12.947 14.887
receivables turnover = revenue / receivables 87.060 106.844
asset turnover = revenue / total assets 2.059 3.934
20
Notes:
2019 and 2020 figures for Coles are largely non-comparable because of the changed treatment of leases (AASB 16) – perhaps the more appropriate comparison is with Woolworth’s 2020 figures, or against industry averages (but this assumes that they use the same accounting methods and format)
the calculations above are based on year-end B/S figures – more typically, they are based on ‘average’ balances (i.e., the average of 2019 and 2020 reported figures BUT there is no ‘right way’ or ‘wrong way’ – it is important to understand how the calculations have been done)
to illustrate inv turn2020 = COGS2020 / [(inv2019 + inv2020)/2] = 28,043 / [(2,166 + 1,965)/2] = 13.577 (vs 12.947)
the profitability ratios have been based on NPAT rather than Comprehensive Income (CI), although the latter is likely more defensible
more critically (‘concerning’), the profitability ratios have been calculated based on the reported figures – in contrast, we have argued that ‘reformulated’ figures are more defensible and insightful
21
Ratios Coles 2020 Woolies 2020
current ratio = CA / CL 0.665 0.616
quick ratio = (CA – inv) / CL 0.284 0.280
debt-to-equity = total liabilities / total equity 6.017 3.260
debt-to-assets = total liabilities / total assets 0.857 0.765
times interest earned = EBIT / interest 3.977 3.117
gross profit margin = gross profit / revenue 0.258 0.292
profit margin = NPAT / revenue 0.026 0.019
return on assets (ROA) = EBIT / total assets 0.096 0.068
return on equity (ROE) = NPAT / (S/E) 0.374 0.134
inventory turnover = COGS / inventory 12.947 10.173
days inventory = 365 / inventory turnover 29.192 35.881
receivables turnover = revenue / receivables 87.060 86.047
average collection period = 365 / receivables turnover 4.193 4.242
asset turnover = revenue / total assets 2.059 1.655
22
Finally
while trend and common size statements are relatively uninformative given the changed treatment of leases through the adoption of AASB16, their construction is illustrated in the next set of slides
Common-size statement all B/S items expressed as a % of total assets
all I/S items expressed as a % of revenue
Trend (indexed) statements all B/S and I/S items expressed as a % of their values in a base year (to display trends / growth over time)
23
Common-size Income Statement W – 2020 C – 2020 C – 2019
Sales Revenue — 0.990 0.993
Other operating revenue — 0.010 0.009
Total operating revenue 1 1 1
Cost of sales 0.708 0.742 0.761
Gross Profit 0.292 0.258 0.239
Other income 0.003 0.003 0.011
Administrative & Other expenses 0.253 0.214 0.213
EBIT 0.041 0.047 0.038
Financing costs 0.013 0.012 0.001
PBT 0.028 0.035 0.037
Income tax expense 0.009 0.009 0.009
Profit from continuing operations 0.019 0.026 0.028
Profit from discontinued operations (after tax) — — 0.009
Profit (NPAT) 0.019 0.026 0.037
Total Comprehensive Income 0.018 0.026 0.037
24
Common-size Balance Sheet W – 2020 C – 2020 C – 2019
Current Assets
cash & cash equivalents 0.054 0.054 0.096
receivables 0.019 0.024 0.037
inventories 0.115 0.118 0.201
income tax receivable — 0.002 —
assets held for resale 0.009 0.004 0.010
other assets 0.014 0.004 0.005
Total current assets 0.211 0.206 0.348
Non-current Assets
property, plant and equipment 0.227 0.225 0.421
right-of-use (lease) assets 0.314 0.417 —
intangible assets 0.201 0.087 0.158
deferred tax assets 0.034 0.046 0.037
equity accounted investments 0.004 0.012 0.022
other assets 0.005 0.007 0.014
Total non-current assets 0.789 0.794 0.652
Total Assets 1 1 1
25
Common-size Balance Sheet W – 2020 C – 2020 C – 2019
Current Liabilities
payables 0.195 0.204 0.346
provisions 0.049 0.047 0.076
lease liabilities 0.039 0.048 —
other 0.058 0.011 0.017
Total Current Liabilities 0.343 0.310 0.439
Non-current Liabilities
interest-bearing liabilities 0.050 0.074 0.149
provisions 0.024 0.026 0.061
lease liabilities 0.342 0.447 —
other 0.007 0.002 0.007
Total non-current liabilities 0.422 0.548 0.218
Total Liabilities 0.765 0.857 0.657
Shareholders’ Equity
contributed equity 0.157 0.088 0.167
reserves 0.010 0.002 0.004
retained earnings 0.061 0.052 0.173
Total Equity 0.235 0.143 0.343
26
Trend (Indexed) Income Statement C – 2020 C – 2019
Sales Revenue 0.980 1
Other operating revenue 1.306 1
Total operating revenue 0.982 1
Cost of sales 0.959 1
Gross Profit 1.058 1
Other income 0.252 1
Administrative & Other expenses 0.988 1
EBIT 1.201 1
Financing costs 10.548 1
PBT 0.926 1
Income tax expense 0.983 1
Profit from continuing operations 0.907 1
Profit (NPAT) 0.686 1
Total Comprehensive Income 0.674 1
27
Common-size Balance Sheet C – 2020 C – 2020
Current Assets Current Liabilities
cash & cash equivalents 1.055 payables 1.106
receivables 1.206 provisions 1.159
inventories 1.102 lease liabilities —
income tax receivable — other 1.179
assets held for resale 0.798 Total Current Liabilities 1.324
other assets 1.489 Non-current Liabilities
Total current assets 1.110 interest-bearing liabilities 0.927
Non-current Assets provisions 0.789
property, plant and equipment 1.002 lease liabilities —
right-of-use (lease) assets — other 0.408
intangible assets 1.036 Total non-current liabilities 4.722
deferred tax assets 2.326 Total Liabilities 2.451
equity accounted investments 1.024 Shareholders’ Equity
other assets 0.896 contributed equity 0.990
Total non-current assets 2.287 reserves 1.024
Total Assets 1.877 retained earnings 0.570
Total Equity 0.779
28
Objectives of ‘Reformulation’:
separate operating activities from financing activities
alter several accounting classifications (largely around equity)
for the Income Statement, separate revenues and expenses based on their driver (sales volume or other), and whether they are recurring or non-recurring
for Statement of Cash Flows, separate operating from financing activities; determine free cash flows operations-related cash flows split by operating versus investing; and separate equity and debt financing cash flows
PART 3 – Reformulated F/S & Profitability
29
Assets
=
Liabilities
+
Shareholders’ Equity
Operating Assets (OA)
Financial Assets (FA)
Operating Liabilities (OL)
Financial Obligations (FL)
accounting equation
30
AASB / IFRS Balance Sheet
Assets Liabilities & Equity
Operating Assets OA Operating Liabilities OL
Financial Assets FA Financial Obligations FO
Shareholders’ Equity S/E
Total Assets OA + FA Total Claims OL + FO + S/E
Reformulated Balance Sheet
Net Operating Assets Financial Obligations & Shareholder’s Equity
Operating Assets OA Financial Obligations FO
Operating Liabilities OL Financial Assets (FA)
Net Financial Obligations NFO
Shareholders’ Equity S/E
Total OA – OL Total NFO + S/E
AASB/IFRS Income Statement & Statement of Comprehensive Income
Sales
– COGS
= Gross margin
– Other expenses
= EBITDA
– Depreciation & amortisation
= EBIT
+ Interest revenue
– Interest expense
= PBT
– Income tax expense
= NPAT
+OCI (with tax effects)
= Comprehensive Income (CI)
Reformulated Income Statement
Core Operating Income from Sales (before-tax)
Core Other Operating Income (before-tax)
Unusual Operating Income (before-tax)
Net Financial Expense (before-tax)
Steps 1 and 2
Step 3
Step 4
31
Mark Wallis, UQ
Operating OCI (after-tax)
Financing OCI (after-tax)
Tax allocation:
Tax shield from NFE
Tax on Core Other OI
Tax on Unusual OI
Tax on Core OI from Sales
31
32
Reformulated Statement of Cash Flows
Adjusted Cash flow from operations C
Adjusted Cash investment in operating assets I
Free Cash Flow (FCF) C + I
Equity financing flows
dividends & share repurchases XX
share issuances (XX) E
Debt financing flows
net purchase of financial assets (XX)
interest on financial assets (after tax) XX
net issue of debt XX
interest on debt (after tax) (XX) F
Total Financing cash flows E + F
‘Uses’ of FCF in financing activities
Generation of FCF from operating activities
33
Reformulated Statement of Changes in Shareholders’ Equity
Beginning Book Value of Common Equity BVt-1
+ Net effect of Transactions with Common Shareholders
+ capital contributions (share issues)
– share repurchases
– cash dividends to common shareholders
= Net cash contributions
+ Effect of operations and non-equity financing
+ Net Income (from the I/S)
+ Other Comprehensive Income (OCI)
– preferred share dividends
= Comprehensive income available to common shareholders
Ending Book Value of Common Equity BVt
34
Penman – E10.6 & E12.3
Prepare a reformulated B/S and I/S
Calculate FCF for 2012
Calculate operating profit margin, asset turnover, and return on NOA for 2012
Calculate individual asset turnovers and show that they aggregate to the total asset turnover
Show that the financing leverage equation holds:
ROCE = RNOA + (FLEV x operating spread)
Calculate the after-tax net borrowing cost. If this borrowing cost were to be sustained in the future, what would the ROCE be if RNOA fell to 6% and FLEV decreased to 0.8?
The implicit cost of credit on A/P and accrued liabilities is 3%. Show that the following leverage equation holds:
RNOA = ROOA + [OLLEV x (ROOA – 3%)]
35
Net Operating Assets (NOA) 2012 2011 Net Financial Obligations (NFO) 2012 2011
Operating Assets (OA) Financial Assets (FA)
operating cash 60 50 short-term investments 550 500
accounts receivable 940 790
inventory 910 840 Financial Obligations (FO)
property & plant 2,840 2,710 long-term debt 1,840 1,970
Total Operating Assets 4,750 4,390
Operating Liabilities (OL) Net Financial Obligations (NFO) 1,290 1,470
accounts payable 1,200 1,040
accrued liabilities 390 450 Shareholders’ Equity (S/E) 1,870 1,430
Total Operating Liabilities 1,590 1,490
Net Operating Assets (NOA) 3,160 2,900
a) Reformulated Balance Sheet S/E = NOA – NFO
36
Reformulated Statement of S/E
2012
Beginning S/E (BVt-1) 1,430
Net transactions with Shareholders
share issues 822
share repurchases (720)
dividends (180)
(78)
Comprehensive Income
NPAT 468
OCI 50
Comprehensive Income (CI) 518
Ending S/E (BVt) 1,870
37
Reformulated Income Statement (to extent possible)
AASB I/S NPAT OCI = CI
from Statement of Shareholders’ Equity
Net Income (NPAT) 468
Other Comprehensive Income (OCI)
(unrealized gain on debt investment) 50
Comprehensive Income (CI) 518
Core Net Financing Expenses
from additional information
interest income 15
interest expense 98
net core NFE (before tax) (83)
tax shield = 83 @ 35% 29
Core NFE (after tax) (54)
Reformulated I/S OI – NFE = CI
from & above
Operating Income (after tax) ???
Net Financial Expenses (after tax)
core NFE (54)
financial OCI (unrealized gain) 50 (4)
Comprehensive Income (CI) 518
OI – 4 = 518 OI = 522
38
2012
Sales 3,726
Operating Expenses ?
Operating Income (before tax) ?
Core NFE (before tax)
interest expense (98)
interest income 15 83
Tax Allocation (split)
income tax expense ?
tax shield (83 @ 0.35) 29
tax on operating income ?
Operating Income (after tax) 522
Core NFE (after tax) (54)
NPAT 468
Financing OCI (after tax) 50
Comprehensive Income (CI) 518
Reformulated Income Statement (to extent possible)
39
b) Free Cash Flow (FCF) (Slide 56, Session #7)
FCF = OI (after tax) – NOA or FCF = NFE – NFO + E
= 522 – ( 3,160 – 2,900) = 4 – (1,290 – 1,470) + 78
= 262 = 262
c) profit margin = OI / Sales = 522 / 3,726 = 0.1401 14.01%
asset turnover = Sales / average NOA = 3,726 / [(3,160 + 2,900)/2] = 1.2297
RNOA = OI / average NOA = 522 / [(3,160 + 2,900)/2] = 0.1723 17.23%
note: RNOA = = profit margin asset turnover
= 0.1401 * 1.2297 = 0.1723
** based on reformulated statements !!
40
d) Further disaggregation of ‘total asset turnover’
NOA = {operating cash + receivables + inventory + property & plant}
– [accounts payable + accrued liabilities]
asset turnover =
+ + + – –
= + + + – – = 0.8132
asset turnover =
41
e) ‘financial leverage equation’
ROCE = RNOA + (FLEV x operating spread) = RNOA + FLEV x ( RNOA – NBC)
ROCE = = = 0.3139 31.39%
RNOA = 0.1723 17.23%
FLEV = 0.8364
net borrowing cost (NBC) = 0.0029
ROCE = 0.1723 + 0.8364(0.1723 – 0.0029) = 0.3139
return on NOA less cost of financing
42
f) modified
given RNOA = 6% FLEV = 0.80
net borrowing cost (NBC) = 0.0029
ROCE = 0.0600 + 0.80(0.0600 – 0.0029) = 0.1057 10.57%
43
g) ‘operating liability leverage equation’ RNOA = ROOA + [OLLEV x (ROOA – 3%)]
RNOA = 0.1723
implicit interest = 0.03 x average OL = 0.03[(1,590 + 1,490)/2] = 46.2
ROOA = 0.1243
operating liability leverage (OLLEV) = 0.5083
RNOA = 0.1243 + 0.5083(0.1243 – 0.03) = 0.1723 17.23%
44
So why does this all “work”? ‘conceptual foundation’
ROCE = =
return on S/E after removing implications of debt financing
levered measure of profitability
RNOA = = profit margin asset turnover
return on net operating assets before considering sources of financing
unlevered measure of profitability
PART 4 – ‘Conceptual Foundation’
45
at this stage, the difference between ROCE and RNOA appears to simply be whether consideration is given to (an adjustment made for) the implications of debt financing
net borrowing cost (NBC) = “borrowing rate” for financing NOA
FLEV = measure of financial leverage (essentially a debt-to-equity ratio)
now consider the following algebraic manipulation of the ROCE formula, starting with
ROCE = =
46
ROCE = = =
=
=
= +
= + {
ROCE = RNOA + FLEV { RNOA NBC}
47
In summary
ROCE is the return to the common shareholder after making the required payments to debtholders (interest expense)
RNOA is the return on the company’s operations (before separating that required to satisfy debtholders and the remainder available to shareholders)
RNOA – NBC (i.e., the spread) is difference between the return the company can earn on its operations and its cost of borrowing
if spread > 0, the company can increase its ROCE from increasing FLEV
for a profitable company, the extent of FLEV explains the difference between ROCE and RNOA, with ROCE > RNOA
48
For Coles (from Session #7 after adjusting for the implications of AASB16, leases, in 2019)
Reformulated I/S 2020 OI = 1,288.1
NFE = 322.1
CI = 966
Reformulated (and adjusted) B/S 2020 2019 ave
NOA 12,205 13,102 12,653.5
NFO 9,590 10,576 10,083.0
S/E 2,615 2,526 2,570.5
49
ROCE = 0.3758
RNOA = 0.1018
FLEV = 3.9226
NBC = 319 spread = (0.1018 – 0.0319) = 0.0699
ROCE = RNOA + FLEV {RNOA NBC}
= 0.1018 + 3.9226 {0.1019 – 0.0319} = 0.3758
50
51
ROCE = RNOA + FLEV {RNOA NBC} ‘first-level’ break down of ROCE
given RNOA = = profit margin asset turnover
ROCE = {profit margin asset turnover} + {FLEV spread} ‘second-level’ break down of ROCE
Clearly there are number of ways in which each of OI, profit margin, asset turnover, and leverage can be further broken down – there further breakdowns provide additional insights into how / why each of these measures or ratios have changed
We will consider some possible further dis-aggregations in Session #10
operations
financing
52
PART 5 – Penman: E10.10 & E12.9
53
54
55
56
57
Operating Assets (OA) 2007 2006 Operating Liabilities (OL) 2007 2006
Operating cash 40,000 40,000 Accounts payable 390,836 340,937
S-T invest – trading securities 73,588 53,496 Accrued compensation 332,331 288,963
Accounts receivable 287,925 224,271 Accrued occupancy costs 74,591 54,868
Inventories 691,658 636,222 Accrued taxes 92,516 94,010
Prepaid expenses/other CA 148,757 126,874 Other accrued expenses 257,369 224,154
DTA 129,453 88,777 Deferred revenue 296,900 231,926
Equity-accounted investments 258,846 219,093 Other long-term liabilities 354,074 262,857
property, plant & equipment 2,890,433 2,287,899 Total OL 1,798,617 1,497,715
Other assets 219,422 186,917
Other intangible assets 42,043 37,955 Net Operating Assets (NOA) 3,199,133 2,565,267
Goodwill 215,625 161,478
Total OA 4,997,750 4,062,982
a) Reformulated Balance Sheet
58
Financial Assets (FA) 2007 2006 Shareholders’ Equity (S/E) 2007 2006
financial cash 241,261 272,606 contributed capital 738 756
available for sale securities 104,867 93,353 other paid-in capital 39,393 39,393
346,128 365,959 retained earnings (R/E) 2,189,366 2,151,084
accumulated OCI 54,620 37,273
Financial Obligations (FO) Total S/E 2,284,117 2,228,506
commercial paper 710,248 700,000
long-term debt 550,896 2,720 Total NFO + S/E = NOA 3,199,133 2,565,267
1,261,144 702,700
Net Financial Obligation (NFO) 915,016 336,761
Reformulated Balance Sheet (cont)
59
Core OI from Sales (before tax) Unusual OI (before tax)
revenue 9,411,497 gain on asset sales 26,032
COGS (3,999,124)
Gross Margin 5,412,373 Total OI before tax 1,138,392
Other Operating Expenses
store operating expenses (3,215,889) Net Financial Expense (NFE) (before tax)
other operating expenses (294,136) interest income 19,700
depreciation & amortisation expense (467,160) interest expense (38,200)
general & administrative expense (489,249) realised gain on avail-for-sale investment 3,800
Core OI from Sales (before tax) 945,939 NFE (before tax) (14,700)
Core Other OI (before tax)
profit equity-accounted investments 175,334 Profit Before Tax (PBT) 1,123,692
other operating charges (8,913)
Core Other OI (before tax) 166,421
Reformulated Income Statement before tax
60
Core OI from Sales (before tax) 945,939
Core Other OI (before tax) 166,421
Unusual OI (before tax) 26,032
Total OI (before tax) 1,138,392
NFE (before tax) (14,700)
Profit Before Tax (PBT) 1,123,692
Reformulated Income Statement tax allocation
Tax Allocation (456,699 in total)
NFE (14,700 @ 0.384) 5,645
Tax on Unusual OI (26,032 @ 0.384) 9,996
Tax on Core Other OI (166,421 @ 0.384) 63,906
Tax on Core OI from Sales (balance)
= 451,054 + 5,645 – 9,996 – 63,906) 382,797
Tax to be allocated
reported tax expense 383,726
tax on equity-accounted investments** 67,328
Total 451,054
** 2007 I/S income from equity investees = 108,006 after tax (note 5)
before tax amount = 108,006 / (1 – 0.384) = 175,334
tax = 175,334 – 108,006 = 67,328
61
After-tax Amounts
Core OI from Sales (after tax) = 945,939 – 382,797 563,142
Core Other OI (after tax) = 166,421 – 63,906 102,515
Unusual OI (after tax) = 26,032 – 9,996 16,036
NFE (after tax) = (14,700) + 5,645 (9,055)
Net Profit After Tax (NPAT) 672,638
Other Comprehensive Income (OCI)
Operating OCI (after tax)
translation adjustment 37,727
Financing OCI (after tax)
unrealised holding loss (20,380)
Reformulated Income Statement after tax amount
62
Operating Income (after tax)
Core OI from Sales (after tax) 563,142
Core Other OI (after tax) 102,515
Unusual OI (after tax) 16,036
681,693
Operating OCI (after tax) 37,727
Total Operating Income (OI) (after tax) 719,420
Net Financing Expenses
NFE (after tax) (9,055)
Financing OCI (after tax) (20,380)
Total Financing Expenses (29,435)
Comprehensive Income 689,985
Reformulated Income Statement final form
63
b) ROCE = = = 0.3096 30.96%
RNOA = 0.2805 28.05%
net borrowing cost (NBC) = 0.0874
c) FLEV = 0.1511
ROCE = RNOA + (FLEV x operating spread) = RNOA + FLEV x ( RNOA NBC)
ROCE = 0.2805 + 0.1511(0.2805 – 0.0874) = 0.3097
(difference due to rounding to 4 decimal places only)
64
d) profit margin = = = 0.0764 7.64%
asset turnover = 3.6688
RNOA = = profit margin asset turnover
= 0.0764 3.6688 = 0.2803 (difference due to rounding to 4 decimal places only)
profit margin from sales = 0.0598 5.98%
65
e) OLLEV = 0.5838
f) Implicit interest on OL = 1,497,715 @ 0.036 = 53,918
ROOA = 0.1903
RNOA = ROOA + (OLLEV x OL spread) = ROOA + OLLEV x ( ROOA STBC)
= 0.1903 + 0.5838 (0.1903 – 0.036) = 0.2804
66
financial leverage use of debt financing with fixed ‘interest’ payments
ROCE = RNOA + FLEV x ( RNOA – NBC) RNOA ROCE
operating leverage use of operating liabilities (OL) to finance OA
RNOA = ROOA + OLLEV x (ROOA – STBC) ROOA RNOA
operating spread
financial leverage
PART 6 – Profitability & Leverage: Further Examples
operating leverage
OL spread
leverage, both financial (FLEV) and operating (OLLEV), magnifies profit (& loss) available to the common shareholder
67
Example 9-1 (typical firm profitable, RNOA > NBC)
Net operating assets (NOA) 28,000
Net financial obligations (NFO) 15,000
Shareholders’ Equity (S/E) 13,000
Operating income (OI) 2,000
Net Financial Expense (NFE) (500)
Comprehensive Income (CI) 1,500
ROCE = = = 0.1154 RNOA = 0.0714
FLEV = NBC = 0.0333
ROCE = RNOA + FLEV x ( RNOA – NBC) = 0.0714 + 1.1538(0.0714 – 0.0333) = 0.1154
use of debt financing (FLEV) magnifies ROCE relative to RNOA
68
Example 9-2 (loss firm A)
Net operating assets (NOA) 28,000
Net financial obligations (NFO) 15,000
Shareholders’ Equity (S/E) 13,000
Operating income (OI) (1,000)
Net Financial Expense (NFE) (500)
Comprehensive Income (CI) (1,500)
ROCE = = = 0.1154 RNOA = 0.0357
FLEV = NBC = 0.0333
ROCE = RNOA + FLEV x ( RNOA – NBC) = 0.0357 + 1.1538(0.0357 – 0.0333) =
use of debt financing (FLEV) magnifies negative loss to common shareholders
69
Example 9-3 (‘loss firm’ B)
Net operating assets (NOA) 28,000
Net financial obligations (NFO) 15,000
Shareholders’ Equity (S/E) 13,000
Operating income (OI) 1,000
Net Financial Expense (NFE) (1,500)
Comprehensive Income (CI) (500)
ROCE = = = 0.0385 RNOA = 0.0357
FLEV = NBC = 0.1000
ROCE = RNOA + FLEV x ( RNOA – NBC) = 0.0357 + 1.1538(0.0357 – 0.1000) = 0.0385
use of debt financing (FLEV) can even drive ROCE down into a loss from a positive RNOA
70
Example 9-4 (borrowing cost > earnings return)
Net operating assets (NOA) 28,000
Net financial obligations (NFO) 15,000
Shareholders’ Equity (S/E) 13,000
Operating income (OI) 2,000
Net Financial Expense (NFE) (1,500)
Comprehensive Income (CI) 500
ROCE = = = 0.0385 RNOA = 0.0714
FLEV = 1.1538 NBC = 0.1000
ROCE = RNOA + FLEV x ( RNOA – NBC) = 0.0714 + 1.1538(0.0714 – 0.1000) = 0.0384
NBC > RNOA means that the use of FLEV drives ROCE down relative to RNOA
71
72
Example 9-5 (net financial assets)
Net operating assets (NOA) 28,000
Net financial obligations (NFO) –15,000 i.e., net financial assets (NFA)
Shareholders’ Equity (S/E) 43,000
Operating income (OI) 2,000
Net Financial Income (NFI) 500 i.e., not an expense (NFE)
Comprehensive Income (CI) 2,500
ROCE = = = 0.0581 RNOA = 0.0714
FLEV = – 0.3488 RNFA = 0.0333
ROCE = RNOA + FLEV x ( RNOA – NBC) = 0.0714 – 0.3488(0.0714 – 0.0333) = 0.0581
lower return on NFA (3.33% versus 7.14% on NOA) drives ROCE down relative to RNOA
73
ROCE = RNOA + FLEV x ( RNOA – NBC)
Summary –
if profitable & RNOA > NBC ROCE > RNOA i.e., FLEV magnifies profit (example #9-1)
if unprofitable ROCE < RNOA i.e., FLEV magnifies (creates) loss (examples #9-2 & #9-3)
if NBC > RNOA ROCE < RNOA i.e., FLEV hurts if cost of borrowing is higher than return on investment in NOA (example #9-4)
if net financial assets (i.e., negative borrowing) RCOE < RNOA since return on financial assets (NFA) is typically lower than RNOA (example #9-5)
74
Example 9-6 (typical firm profitable, ROOA > STBC)
Net operating assets (NOA) 28,000 OA = 40,000 OL = 12,000
Net financial obligations (NFO) 15,000 FA = 2,000 FO = 17,000
Shareholders’ Equity (S/E) 13,000
Operating income (OI) 2,000
Net Financial Expense (NFE) (500)
Comprehensive Income (CI) 1,500
OLLEV = assume STBC = 0.07(1 – 0.3) = 0.049
implicit interest on OL = 12,000 * 0.049 = 588
ROOA = 0.0647
RNOA = ROOA + OLLEV(ROOA – STBC) = 0.0647 + 0.4286(0.0647 – 0.049) = 0.0714
75
Example 9-7 (loss firm A)
Net operating assets (NOA) 28,000 OA = 40,000 OL = 12,000
Net financial obligations (NFO) 15,000 FA = 2,000 FO = 17,000
Shareholders’ Equity (S/E) 13,000
Operating income (OI) (1,000)
Net Financial Expense (NFE) (500)
Comprehensive Income (CI) (1,500)
OLLEV = assume STBC = 0.07(1 – 0.3) = 0.049
implicit interest on OL = 12,000 * 0.049 = 588
ROOA = – 0.0103
RNOA = ROOA + OLLEV(ROOA – STBC) = -0.0103 + 0.4286(-0.0103 – 0.049) = – 0.0357
Summing Financial Leverage and Operating Liability Leverage Effects on ROCE
ROCE = ROOA + (RNOA – ROOA) + (ROCE – RNOA)
Return
With no leverage
Effect of
Operating Liabilities
Effect of
Financing Liabilities
profitable firm (examples #9-1 & #9-6)
0.1154 = 0.0647 + (0.0714 – 0.0647) + (0.1154 – 0.0714)
loss firm (examples #9-2 & #9-7)
-0.1154 = -0.0103 + (-0.0357 – 0.0103) + (-0.1154 – 0.0357)
76
77
overarching objective:
to conduct fundamental value for the purpose of estimating the ‘intrinsic value’ of a firm’s common shares
requires an understanding of the firm’s ‘value drivers’
need to accumulate a ‘tool kit’ as the basis for developing the pro forma Financial Statements
STEP 1
Understanding the past
Information collection
Understanding the business
Accounting analysis
Financial ratio analysis
Cash flow analysis
STEP 2
Forecasting the future
Structured forecasting
Income Statement forecasts
Balance sheet forecasts
Cash flow forecasts
STEP 3
Valuation
Cost of capital
Valuation models – AE, FCF, D
Valuation ratios
Complications
Negative values
Value creation and destruction
PART 7 – Summary
78
external environment
economic prospects
macroeconomic factors
socio-cultural forces
political / regulatory
Industry dynamics
Porter’s five forces
(suppliers, buyers, new entrants, substitutes, rivalry)
Analysis of Financial Statements
understanding current F/S
re-formulating the F/S
accounting quality
ratio analysis ** Sessions #9 & #10
analysts’ reports
management forecasts
financial press
???
0V =
tx
( 1+ tk
t)t =1
∞
∑ =
E( tx )
t
(1+k)t=1
n
∑ +
E( nx ) (1+ g)
k − g
1
n
(1+k)
0
V
=
t
x
(
1+
t
k
t
)
t=1
¥
å
=
E(
t
x
)
t
(1+k)
t=1
n
å
+
E(
n
x
)
(1+g)
k-g
1
n
(1+k)
/docProps/thumbnail.jpeg