Analysis of Financial Statements
Content
ANALYSIS OF FS
The Firm, Its Claimants, and the Capital market
The Capital Market: Trading Value The Investors: The claimants on value
The Firm: The Value generator
Cash from Loans Operating Activities Investing Activities Financing Activities
Debt holders
Interest and Loan repayments
Cash from Secondary sale of Debt Debt Holders
Cash from share issue
Shareholders
Dividends and cash from Share repurchase
Cash from Shareholders sale of Shares
Secondary
BUSINESS ACTIVITIES : All Stocks and Flows for a firm Products & Inputs markets
Customers
Firm OR
Net Operating Assets (NOA)
Capital Markets
C
Net financial Assets (NFA)
F
Debt holders or Debt issuers
Suppliers
OE
I
d
Shareholders
Operating activities
OR – OE = OI OI – ∆ NOA = C – I C – I – ∆ NFA + NFI = d
Financing activities
F = Net cash flows to debt holders and issuers ; d = Net cash flows to shareholders NFA (net financial assets) = financial assets – financial liabilities C= Cash flows from operations; I = cash investment NOA = Net operating assets = operating assets – operating liabilities OR = Operating revenue; OE = Operating expense; OI = operating income; NFI = Net financial income
Modeling a Business: A Simple Framework
#1 Raise Capital
#2 Invest in Business
#3 Generate Profit
Debt Equity
PPE Working Capital
NOPAT
#4 Reinvest/Return
Reinvest in Business Service/Paydown Debt Dividends/Buy-backs
Operating Operating revenue Operating expense (excluding goodwill, one time items, interest and expected return on plan assets for pensions) Income (loss) on operating associates = Pre-Tax Operating Profit (EBIT) Tax on operations is assumed to be at the statutory rate = NOPAT
Financing Interest income (expense) Dividend income Gain/Loss on financial investments Foreign currency gains (losses) Preferred dividends Pension interest cost Pension expected return on plan assets Implied interest expense on capitalized operating leases = Net Financial Income (Expense) Pretax Tax on financing is assumed to be at the statutory rate = Net Financial Income (Expense)
Other Income (loss) on nonoperating associates Other non-operating income (expense) Minority interest Tax adjustment = Other Income (Expense)
NOPAT + Net Financial Income (Expense) + Other Income (Expense) = Net Income
BALANCE SHEET Operating Assets – Operating Liabilities = Net Operating Assets Financial Liabilities – Financial Assets = Net Debt Other Assets – Other Liabilities = Net Other Assets
Total Assets Total Liabilities and Equity
Operating Liabilities Operating Assets Financial Obligations Shareholders’ Equity Financial Assets
Net Operating Assets
Total Capital (Book) Net Debt
Net Operating Assets
Shareholders’ Equity
BALANCE SHEET
GAAP BALANCE SHEET ( Conceptual stock of shareholder value)
Liabilities and Equity Operating liabilities Financial Obligations Common shareholders equity Total claims Rs. OL FO CSE ----------OL + FO + CSE Assets Operating Assets Financial Assets Rs. OA FA ----OA + FA
Total assets
Reformulated Balance Sheet
Fin. Obligations and Owner’s Equity Financial Obligations Financial Assets Net Financial Obligations Common shareholder equity Rs. FO (FA) ---------------NFO CSE ---------------NFO + CSE Operating Assets Operating Assets Operating Liabilities Rs. OA (OL)
Net operating Assets
----------------NOA
Issues to resolve: Cash, Long term equity investments, notes receivable (short term And long term), accrued expenses (interest), Deferred tax assets and liabilities, Minority interest, leases, dividends payable
Balance Sheet • A traditional balance sheet shows assets (left) and liabilities plus equity (right)
Cash Mkt Sec Assets Receivables Inventory PPE Assets
10 5 8 12 50 85
Payables Debt Equity
10 60 15
Liabilities Equity
L&E
85
•
An economic balance sheet shows NOA (left) and invested capital (right)
Receivables NOA Inventory PPE Payables NOA
8 12 50 (10) 60
Debt Cash Mkt Sec Equity Invested Cap
60 (10) (5) 15 60
Net debt
Equity
INCOME STATEMENT (Conceptual Flow or change in shareholder value)
GAAP Net revenue COGS Gross margin Operating expenses EBIT Income taxes EBIT(1-t) Extraordinary items Net income Preferred dividends Net income available to common Rs. xxx Xxx Xxx Xxx Xxx Xxx Xxx Xxx Xxx Xxx xxx Reformulated Income Statement Operating revenue Operating expense Operating income Finance expense xxx Finance revenue (xxx) Net finance expense Rs. OR (OE) OI
(NFE) --------Earnings
Issues to resolve :Income from subsidiary, currency gain or loss, income/ loss from discontinued operations, abnormal gain and losses on extraordinary items Interest on capitalized construction costs, interest income, tax allocation
Income Statement
•
Traditional income statement:
•
Economic income statement:
Revenue COGS SG&A EBIT
70 (40) (17) 13
Revenue COGS SG&A Tax on Ops NOPAT
70 (40) (17) (5) 8
NOPAT
Interest exp Interest inc EBT
(5) 1 9 Interest exp Interest inc Tax on NFE (5) 1 1 (3) NFE
Tax expense
(4)
NFE
Net income
5
Net income
5
Net income
CASH FLOW STATEMENT
GAAP Reformulated Statement of cash flows Cash flows from operations Cash investment Cash flows from operations + Cash flows from investing + Cash flows from financing = Change in cash flows xxx xxx xxx xxx Free Cash Flow Equity Financing flows: Dividends and share repurchase xxx Share issues (xxx) ------Debt Financing Flows: Net purchase of financial assets xxx Interest on Financial assets (xxx) Net issue of debt (xxx) Interest on debt xxx -------C I -----C–I
d
( The Accountants viewpoint)
F ------Total Financing Flows d+F (Reflects the thought process of the treasurer Or the CFO and they reflect management Activities)
Cash Flow
•
A traditional cash flow statement:
•
An economic cash flow statement:
Net income ∆ Receivables Operating ∆ Inventory ∆ Payables Depreciation Investing
5 (2) (3) 2 6 NOPAT ∆ Receivables ∆ Inventory ∆ Payables Depreciation 8 (2) (3) 2 6 (12) FCFO
Capital exp
(12)
Capital exp
Financing
∆ Principal debt Dividends
10 (1)
NFE ∆ Principal debt ∆ Cash
(3) 10 (5) FCFF
∆ Cash
5 Dividends 1 FCFE
Cash Flow = Income less Delta Balance Sheet Cash flow = Income Statement ∆ Balance Sheet
= NOPAT ∆ Receivables FCFO ∆ Inventory ∆ Payables Depreciation Capital exp 8 (2) (3) 2 6 (12) =
NOPAT
8
-
∆ Receivables ∆ Inventory ∆ Payables ∆ PPE
2 3 (2) 6 ∆ NOA
NFE FCFF ∆ Principal debt ∆ Cash
(3) 10 (5)
NFE
3
-
∆ Debt ∆ Cash ∆ Mkt Sec
10 (5) 0 ∆ Net debt
FCFE
Dividends
1
=
Net Income
5
-
∆ Equity
4
∆ Equity
The Operating Cycle
Revenue
Operating Asset Turnover (Revenue/NOA)
NOPAT Margin (NOPAT/Revenue)
Net Operating Assets
RNOA (NOPAT/NOA)
Operating Profit (NOPAT)
The Profitability Map
Operating Asset Turnover Low High High Multiple Target Area
Operating Margin
High
NOPAT Sales
x
Sales NOA =
NOPAT NOA = RNOA RNOA
NOPAT Margin x
Operating Asset Turnover =
Source: Morgan Stanley Research; Valuing and Measuring a Technological Edge: Finding the FASSTESTSM Companies, October 10, 2000
The “Pillars” of ROE
The Profitability Tree Operating × Asset Turnover + Leverage Effect
ROE
=
NOPAT margin
RNOA
Traditional DuPont Model Net Profit Sales Sales Assets Assets Equity
ROE
=
×
×
The Basic Connection
Sales less COGS SG&A R&D Taxes
OPERATING
Operating Income Operating Profit Margin
+
Financial Expense less G/(L) on Investments
Earnings
RNOA
x
Net Operating Asset Turnover
Net Financial Expense (NFE)
ROE
Operating Assets less Operating Liabilities
+
FINANCING
Leverage (NFO/Equity)
Net Operating Assets
+
Cash plus Investments less Debt
Equity
Leverage Effect
x
Spread RNOA – (NFE/NFO)
Net Financial Obligations (NFO)
Source: Morgan Stanley Research; “The Apples to Apples Earnings Monitor” Trevor Harris, December 10, 2000
ADJUSTMENTS • LIFO • PENSIONS AND OPEBs • GOODWILL – Amortisation, Impairment and unrecorded • Indefinite life intangibles • Available for sale securities • Equity investments • Securisation • Preferred dividends • Leases
Intrinsic Value: A Road Map
CASH FLOW RESIDUAL INCOME
VALUE OF OPERATIONS
DCF
Residual Income (operating)
VALUE TO EQUITY SHAREHOLDERS
DDM
Residual Income (equity)
Intrinsic Value Compare and Contrast Cash Flow Models • Cash flow models are easy to understand. These models are a form of the familiar NPV analysis. • Cash flow is not aligned with focus of forecast: Analysts/ investors typically focus on near-term earnings. Cash flow (and hence most of the value in a cash flow model) typically comes late in the lifecycle. Furthermore, cash flows require a forecast of the balance sheet. • Cash flows are volatile: Cash flows are more volatile and less predictable than earnings. They are difficult to forecast. Residual Income Models • Focuses predominantly on what we know: Current value book value and near-term residual income are usually the largest component and the terminal value component of value is often the smallest. • Returns can be benchmarked. Residual income equals the difference between what the firm earns in a period and what it was expected to earn given its beginning book value. • Connects the calculation of intrinsic value directly to the profitability tree, making it possible to uncover how changes in profitability affect residual income and value.
•
•
For entity-levels models (DCF and ROIM), consistency between operating and financing drivers is important. Be careful not to miss (or double count) items that don’t fall neatly into these categories, like associate income, minority interest, “other” categories, etc Don’t ignore a changing capital structure: WACC should reflect the leverage profile of the company over the forecast period.
REFORMULATED SHAREHOLDERS EQUITY Beginning BV of equity + Net effect of changes in shareholders equity + capital contributions - share repurchase - dividends = Net cash contributions ( negative net dividends) + Effective of operations and nonequity financing + Net income + Other comprehensive income* - Preferred dividends = Comprehensive income available to common shareholders Closing BV of equity *Other Comprehensive income includes translation gains and losses, unrealised gains or losses on available for sale securities, gain or loss on some derivative instruments (fair value hedges and cash flow hedges)
Drivers of Free Cash flows and the Disposition of Free cash 1. Free cash flow = Operating income – Change in Net operating Assets C – I = OI – ∆ NOA Free cash flow is also the dividend from operations 2. Free cash flow = Change in net financial assets – Net financial income + Net dividends C – I = ∆ NFA – NFI + d 3. Free cash flow = Net financial expenses – Change in net financial obligations + net dividends C – I = NFE – ∆ NFO + d
Drivers of Net Operating Assets and Net Indebtedness 1. Net operating assets (end) = Net operating assets (beginning) + operating income – Free cash flow NOA t = NOA t-1 + OI t – (C t – I t)
2. Change in Net operating assets = Operating income – Free cash flow ∆ NOA = OI t – ( C t – I t ) 3. Net Financial assets (end) = Net financial assets (begin) + Net financial income + Free cash flow - net dividends NFA t = NFA t-1 + NFI t + ( C t – I t ) – d t 4. Change in Net Financial Assets = Net income + Free cash flows – Net dividends ∆ NFA t = NFI t + ( C t – I t ) – d t
5. Net Financial Obligations (end) = Net financial obligations (beginning) + Net Financial expense – Free cash flow + Net dividends NFO t = NFO t -1 + NFE t - (C t – I t) + d t
6. Change in Financial Obligations = Net Financial expense – Free cash flow + net dividends ∆ NFO t = NFE t – ( C t – I t) + d t
What Generates Value 1. CSE t = CSE t-1 + earnings t – net dividends t 2. CSE t = NOA t – NFO t
Beginning stocks NOA t-1 NFO t-1 CSE t-1
Flows OI t – ( C t – I t) NFE t – ( C t – I t) + d t OI t – NFE t – d t
Ending stocks NOA t NFO t CSE t
Operating and Financial Accruals 1. OI = ( C – I ) + I + operating accruals OI = C + operating accruals
2. NFE = i + financing accruals
3. NOA t = NOA t-1 + I t + operating accruals 4. NFO t = NFO t-1 – ( C t – I t) + i t + financing accruals + d t
The Analysis of Profitability
ROCE=Earning / CSE = RNOA + (FLEV X SPREAD) Interest expense and MI
Level 1
RNOA= OI / NOA =*ROOA + (OLLEV x OLSPRREAD) FLEV= NFO/ CSE SPREAD = RNOA - NBC
NBC = NFE / NFO PM = OI / sales
Level 2
ATO = sales / NOA
Dell, Oracle, HUL, GM, MICROSOFT
Level 3
Sales PM
Other items PM
Gross margin Expense Ratios Ratio
Financial statement line items:
Other OI / sales Individual asset and Ratios liability turnovers
Borrowing cost drivers
Earnings = Comprehensive income, CSE = Common shareholders’ equity, OI = Operating Income ( after tax), NOA = Net operating Assets, NFE = Net financial expenses, NFO = Net Financial obligations.
Ratios:
ROCE = Return on equity, RNOA = Return on net operating Assets, ROOA = Return on operating Assets, NBC= Net borrowing cost, OLLEV= Operating liability leverage, OLSPREAD= Operating Liability leverage spread, FLEV= Financial leverage, SPREAD= Operating spread, PM= Operating profit margin, ATO= Asset turnover
Performance Indicators • Leverage : pipelines, utilities, hotels • Low leverage : business services, printing and publishing and chemicals • Low leverage but high operating leverage : business services • High financial and operating leverage : airlines, trucking • High margins and high turnovers : printing and publishing and chemicals • Low turnovers and high margins : pipelines, shipping, utilities and communications • High turnovers and low margins : food stores, apparels, retail stores
CHANGE IN ROCE
ROCE RNOA in financing
Level 1
Core OI from sales NOA
Core other items NOA
Unusual items NOA
SPREAD =
[RNOA – NBC]
FLEV
Core sales PM
ATO ATO x core Sales PM Core NBC Unusual financing items
Level 2 In core sales PM x ATO
Level 3
in core Sales PM drivers in ATO drivers in core other income components in unusual Item components in core NBC drivers
in unusual in NFO components components
CHANGE IN CSE
CSE
NOA NFO
Sales
1 ATO
Changes in sales for Business segments or product lines
Changes in individual Assets turnovers
Changes in NFO components
Forecasting Checks :UNUSUAL ITEMS Unusual items are those that won’t be repeated and also items that appear each Period but cannot be forecasted. Usually listed as extraordinary items. Gross margins may also be impacted by Unusual items ( special order or strike). Examples: ( adjusted for taxes) • Special charges • Nonrecurring items, assets write downs • Changes in estimates, Accounting changes • Start up costs expensed ( pre opening costs for Wal Mart, Target, Starbucks) • Profit and loss in asset sale, discontinued operations, currency gains and losses • Gains from share issues in subsidiaries, • Unrealized gains and losses on equity investments • Extraordinary operating items • Derivative gains and losses (operations)
Read Management Discussion and Analysis for clues
Issues with Sustainable Earnings • Restructuring charges, asset impairments (bleeding back) • R&D (Merck & Co) • Advertising ( Coco cola) • Pensions ( English Electric) • Changes in estimates • Realised gains and losses (cherry picking : beware of firms with huge investments) • Unrealised gains and losses on equity investments • Other income (includes interest income)
QUALITY OF EARNINGS • Unexplained changes in accounting, especially when performance is poor. • Unexplained transactions that boost profits ( e.g. asset sales). • Unusual increases in accounts receivable in relation to sales increases. • Unusual increases in inventories in relation to sales increases. • An increase gap between reported income and cash from operations. • An increasing gap between firms reported income and its tax income ( aggressive reporting, e.g. warranty expenses). • Unexpected large asset write off (may be due to changed business environment). • Qualified audit opinions or changes in independent auditors that are not well justified. • Related party transactions or transactions between related entities.
Key Drivers : Select Industries
Industry Automobiles Beverages Cellular phones Commercial real estate Computers Fashion clothing Internet commerce Non fashion clothing Pharma Retail
Key economic factors Model design and production efficiency Brand management and production innovation Population covered and churn rates Square footage and occupancy rates Technology path and competition Brand management and design Hits per hour Production efficiency Research and development Retail space and sales per square foot
Key ReOI drivers Sales and margins Sales Sales and ATO Sales and ATO Sales and margins Sales and advertising/sales Sales and ATO Margins Sales Sales and ATO
The Firm, Its Claimants, and the Capital market
The Capital Market: Trading Value The Investors: The claimants on value
The Firm: The Value generator
Cash from Loans Operating Activities Investing Activities Financing Activities
Debt holders
Interest and Loan repayments
Cash from Secondary sale of Debt Debt Holders
Cash from share issue
Shareholders
Dividends and cash from Share repurchase
Cash from Shareholders sale of Shares
Secondary
BUSINESS ACTIVITIES : All Stocks and Flows for a firm Products & Inputs markets
Customers
Firm OR
Net Operating Assets (NOA)
Capital Markets
C
Net financial Assets (NFA)
F
Debt holders or Debt issuers
Suppliers
OE
I
d
Shareholders
Operating activities
OR – OE = OI OI – ∆ NOA = C – I C – I – ∆ NFA + NFI = d
Financing activities
F = Net cash flows to debt holders and issuers ; d = Net cash flows to shareholders NFA (net financial assets) = financial assets – financial liabilities C= Cash flows from operations; I = cash investment NOA = Net operating assets = operating assets – operating liabilities OR = Operating revenue; OE = Operating expense; OI = operating income; NFI = Net financial income
Modeling a Business: A Simple Framework
#1 Raise Capital
#2 Invest in Business
#3 Generate Profit
Debt Equity
PPE Working Capital
NOPAT
#4 Reinvest/Return
Reinvest in Business Service/Paydown Debt Dividends/Buy-backs
Operating Operating revenue Operating expense (excluding goodwill, one time items, interest and expected return on plan assets for pensions) Income (loss) on operating associates = Pre-Tax Operating Profit (EBIT) Tax on operations is assumed to be at the statutory rate = NOPAT
Financing Interest income (expense) Dividend income Gain/Loss on financial investments Foreign currency gains (losses) Preferred dividends Pension interest cost Pension expected return on plan assets Implied interest expense on capitalized operating leases = Net Financial Income (Expense) Pretax Tax on financing is assumed to be at the statutory rate = Net Financial Income (Expense)
Other Income (loss) on nonoperating associates Other non-operating income (expense) Minority interest Tax adjustment = Other Income (Expense)
NOPAT + Net Financial Income (Expense) + Other Income (Expense) = Net Income
BALANCE SHEET Operating Assets – Operating Liabilities = Net Operating Assets Financial Liabilities – Financial Assets = Net Debt Other Assets – Other Liabilities = Net Other Assets
Total Assets Total Liabilities and Equity
Operating Liabilities Operating Assets Financial Obligations Shareholders’ Equity Financial Assets
Net Operating Assets
Total Capital (Book) Net Debt
Net Operating Assets
Shareholders’ Equity
BALANCE SHEET
GAAP BALANCE SHEET ( Conceptual stock of shareholder value)
Liabilities and Equity Operating liabilities Financial Obligations Common shareholders equity Total claims Rs. OL FO CSE ----------OL + FO + CSE Assets Operating Assets Financial Assets Rs. OA FA ----OA + FA
Total assets
Reformulated Balance Sheet
Fin. Obligations and Owner’s Equity Financial Obligations Financial Assets Net Financial Obligations Common shareholder equity Rs. FO (FA) ---------------NFO CSE ---------------NFO + CSE Operating Assets Operating Assets Operating Liabilities Rs. OA (OL)
Net operating Assets
----------------NOA
Issues to resolve: Cash, Long term equity investments, notes receivable (short term And long term), accrued expenses (interest), Deferred tax assets and liabilities, Minority interest, leases, dividends payable
Balance Sheet • A traditional balance sheet shows assets (left) and liabilities plus equity (right)
Cash Mkt Sec Assets Receivables Inventory PPE Assets
10 5 8 12 50 85
Payables Debt Equity
10 60 15
Liabilities Equity
L&E
85
•
An economic balance sheet shows NOA (left) and invested capital (right)
Receivables NOA Inventory PPE Payables NOA
8 12 50 (10) 60
Debt Cash Mkt Sec Equity Invested Cap
60 (10) (5) 15 60
Net debt
Equity
INCOME STATEMENT (Conceptual Flow or change in shareholder value)
GAAP Net revenue COGS Gross margin Operating expenses EBIT Income taxes EBIT(1-t) Extraordinary items Net income Preferred dividends Net income available to common Rs. xxx Xxx Xxx Xxx Xxx Xxx Xxx Xxx Xxx Xxx xxx Reformulated Income Statement Operating revenue Operating expense Operating income Finance expense xxx Finance revenue (xxx) Net finance expense Rs. OR (OE) OI
(NFE) --------Earnings
Issues to resolve :Income from subsidiary, currency gain or loss, income/ loss from discontinued operations, abnormal gain and losses on extraordinary items Interest on capitalized construction costs, interest income, tax allocation
Income Statement
•
Traditional income statement:
•
Economic income statement:
Revenue COGS SG&A EBIT
70 (40) (17) 13
Revenue COGS SG&A Tax on Ops NOPAT
70 (40) (17) (5) 8
NOPAT
Interest exp Interest inc EBT
(5) 1 9 Interest exp Interest inc Tax on NFE (5) 1 1 (3) NFE
Tax expense
(4)
NFE
Net income
5
Net income
5
Net income
CASH FLOW STATEMENT
GAAP Reformulated Statement of cash flows Cash flows from operations Cash investment Cash flows from operations + Cash flows from investing + Cash flows from financing = Change in cash flows xxx xxx xxx xxx Free Cash Flow Equity Financing flows: Dividends and share repurchase xxx Share issues (xxx) ------Debt Financing Flows: Net purchase of financial assets xxx Interest on Financial assets (xxx) Net issue of debt (xxx) Interest on debt xxx -------C I -----C–I
d
( The Accountants viewpoint)
F ------Total Financing Flows d+F (Reflects the thought process of the treasurer Or the CFO and they reflect management Activities)
Cash Flow
•
A traditional cash flow statement:
•
An economic cash flow statement:
Net income ∆ Receivables Operating ∆ Inventory ∆ Payables Depreciation Investing
5 (2) (3) 2 6 NOPAT ∆ Receivables ∆ Inventory ∆ Payables Depreciation 8 (2) (3) 2 6 (12) FCFO
Capital exp
(12)
Capital exp
Financing
∆ Principal debt Dividends
10 (1)
NFE ∆ Principal debt ∆ Cash
(3) 10 (5) FCFF
∆ Cash
5 Dividends 1 FCFE
Cash Flow = Income less Delta Balance Sheet Cash flow = Income Statement ∆ Balance Sheet
= NOPAT ∆ Receivables FCFO ∆ Inventory ∆ Payables Depreciation Capital exp 8 (2) (3) 2 6 (12) =
NOPAT
8
-
∆ Receivables ∆ Inventory ∆ Payables ∆ PPE
2 3 (2) 6 ∆ NOA
NFE FCFF ∆ Principal debt ∆ Cash
(3) 10 (5)
NFE
3
-
∆ Debt ∆ Cash ∆ Mkt Sec
10 (5) 0 ∆ Net debt
FCFE
Dividends
1
=
Net Income
5
-
∆ Equity
4
∆ Equity
The Operating Cycle
Revenue
Operating Asset Turnover (Revenue/NOA)
NOPAT Margin (NOPAT/Revenue)
Net Operating Assets
RNOA (NOPAT/NOA)
Operating Profit (NOPAT)
The Profitability Map
Operating Asset Turnover Low High High Multiple Target Area
Operating Margin
High
NOPAT Sales
x
Sales NOA =
NOPAT NOA = RNOA RNOA
NOPAT Margin x
Operating Asset Turnover =
Source: Morgan Stanley Research; Valuing and Measuring a Technological Edge: Finding the FASSTESTSM Companies, October 10, 2000
The “Pillars” of ROE
The Profitability Tree Operating × Asset Turnover + Leverage Effect
ROE
=
NOPAT margin
RNOA
Traditional DuPont Model Net Profit Sales Sales Assets Assets Equity
ROE
=
×
×
The Basic Connection
Sales less COGS SG&A R&D Taxes
OPERATING
Operating Income Operating Profit Margin
+
Financial Expense less G/(L) on Investments
Earnings
RNOA
x
Net Operating Asset Turnover
Net Financial Expense (NFE)
ROE
Operating Assets less Operating Liabilities
+
FINANCING
Leverage (NFO/Equity)
Net Operating Assets
+
Cash plus Investments less Debt
Equity
Leverage Effect
x
Spread RNOA – (NFE/NFO)
Net Financial Obligations (NFO)
Source: Morgan Stanley Research; “The Apples to Apples Earnings Monitor” Trevor Harris, December 10, 2000
ADJUSTMENTS • LIFO • PENSIONS AND OPEBs • GOODWILL – Amortisation, Impairment and unrecorded • Indefinite life intangibles • Available for sale securities • Equity investments • Securisation • Preferred dividends • Leases
Intrinsic Value: A Road Map
CASH FLOW RESIDUAL INCOME
VALUE OF OPERATIONS
DCF
Residual Income (operating)
VALUE TO EQUITY SHAREHOLDERS
DDM
Residual Income (equity)
Intrinsic Value Compare and Contrast Cash Flow Models • Cash flow models are easy to understand. These models are a form of the familiar NPV analysis. • Cash flow is not aligned with focus of forecast: Analysts/ investors typically focus on near-term earnings. Cash flow (and hence most of the value in a cash flow model) typically comes late in the lifecycle. Furthermore, cash flows require a forecast of the balance sheet. • Cash flows are volatile: Cash flows are more volatile and less predictable than earnings. They are difficult to forecast. Residual Income Models • Focuses predominantly on what we know: Current value book value and near-term residual income are usually the largest component and the terminal value component of value is often the smallest. • Returns can be benchmarked. Residual income equals the difference between what the firm earns in a period and what it was expected to earn given its beginning book value. • Connects the calculation of intrinsic value directly to the profitability tree, making it possible to uncover how changes in profitability affect residual income and value.
•
•
For entity-levels models (DCF and ROIM), consistency between operating and financing drivers is important. Be careful not to miss (or double count) items that don’t fall neatly into these categories, like associate income, minority interest, “other” categories, etc Don’t ignore a changing capital structure: WACC should reflect the leverage profile of the company over the forecast period.
REFORMULATED SHAREHOLDERS EQUITY Beginning BV of equity + Net effect of changes in shareholders equity + capital contributions - share repurchase - dividends = Net cash contributions ( negative net dividends) + Effective of operations and nonequity financing + Net income + Other comprehensive income* - Preferred dividends = Comprehensive income available to common shareholders Closing BV of equity *Other Comprehensive income includes translation gains and losses, unrealised gains or losses on available for sale securities, gain or loss on some derivative instruments (fair value hedges and cash flow hedges)
Drivers of Free Cash flows and the Disposition of Free cash 1. Free cash flow = Operating income – Change in Net operating Assets C – I = OI – ∆ NOA Free cash flow is also the dividend from operations 2. Free cash flow = Change in net financial assets – Net financial income + Net dividends C – I = ∆ NFA – NFI + d 3. Free cash flow = Net financial expenses – Change in net financial obligations + net dividends C – I = NFE – ∆ NFO + d
Drivers of Net Operating Assets and Net Indebtedness 1. Net operating assets (end) = Net operating assets (beginning) + operating income – Free cash flow NOA t = NOA t-1 + OI t – (C t – I t)
2. Change in Net operating assets = Operating income – Free cash flow ∆ NOA = OI t – ( C t – I t ) 3. Net Financial assets (end) = Net financial assets (begin) + Net financial income + Free cash flow - net dividends NFA t = NFA t-1 + NFI t + ( C t – I t ) – d t 4. Change in Net Financial Assets = Net income + Free cash flows – Net dividends ∆ NFA t = NFI t + ( C t – I t ) – d t
5. Net Financial Obligations (end) = Net financial obligations (beginning) + Net Financial expense – Free cash flow + Net dividends NFO t = NFO t -1 + NFE t - (C t – I t) + d t
6. Change in Financial Obligations = Net Financial expense – Free cash flow + net dividends ∆ NFO t = NFE t – ( C t – I t) + d t
What Generates Value 1. CSE t = CSE t-1 + earnings t – net dividends t 2. CSE t = NOA t – NFO t
Beginning stocks NOA t-1 NFO t-1 CSE t-1
Flows OI t – ( C t – I t) NFE t – ( C t – I t) + d t OI t – NFE t – d t
Ending stocks NOA t NFO t CSE t
Operating and Financial Accruals 1. OI = ( C – I ) + I + operating accruals OI = C + operating accruals
2. NFE = i + financing accruals
3. NOA t = NOA t-1 + I t + operating accruals 4. NFO t = NFO t-1 – ( C t – I t) + i t + financing accruals + d t
The Analysis of Profitability
ROCE=Earning / CSE = RNOA + (FLEV X SPREAD) Interest expense and MI
Level 1
RNOA= OI / NOA =*ROOA + (OLLEV x OLSPRREAD) FLEV= NFO/ CSE SPREAD = RNOA - NBC
NBC = NFE / NFO PM = OI / sales
Level 2
ATO = sales / NOA
Dell, Oracle, HUL, GM, MICROSOFT
Level 3
Sales PM
Other items PM
Gross margin Expense Ratios Ratio
Financial statement line items:
Other OI / sales Individual asset and Ratios liability turnovers
Borrowing cost drivers
Earnings = Comprehensive income, CSE = Common shareholders’ equity, OI = Operating Income ( after tax), NOA = Net operating Assets, NFE = Net financial expenses, NFO = Net Financial obligations.
Ratios:
ROCE = Return on equity, RNOA = Return on net operating Assets, ROOA = Return on operating Assets, NBC= Net borrowing cost, OLLEV= Operating liability leverage, OLSPREAD= Operating Liability leverage spread, FLEV= Financial leverage, SPREAD= Operating spread, PM= Operating profit margin, ATO= Asset turnover
Performance Indicators • Leverage : pipelines, utilities, hotels • Low leverage : business services, printing and publishing and chemicals • Low leverage but high operating leverage : business services • High financial and operating leverage : airlines, trucking • High margins and high turnovers : printing and publishing and chemicals • Low turnovers and high margins : pipelines, shipping, utilities and communications • High turnovers and low margins : food stores, apparels, retail stores
CHANGE IN ROCE
ROCE RNOA in financing
Level 1
Core OI from sales NOA
Core other items NOA
Unusual items NOA
SPREAD =
[RNOA – NBC]
FLEV
Core sales PM
ATO ATO x core Sales PM Core NBC Unusual financing items
Level 2 In core sales PM x ATO
Level 3
in core Sales PM drivers in ATO drivers in core other income components in unusual Item components in core NBC drivers
in unusual in NFO components components
CHANGE IN CSE
CSE
NOA NFO
Sales
1 ATO
Changes in sales for Business segments or product lines
Changes in individual Assets turnovers
Changes in NFO components
Forecasting Checks :UNUSUAL ITEMS Unusual items are those that won’t be repeated and also items that appear each Period but cannot be forecasted. Usually listed as extraordinary items. Gross margins may also be impacted by Unusual items ( special order or strike). Examples: ( adjusted for taxes) • Special charges • Nonrecurring items, assets write downs • Changes in estimates, Accounting changes • Start up costs expensed ( pre opening costs for Wal Mart, Target, Starbucks) • Profit and loss in asset sale, discontinued operations, currency gains and losses • Gains from share issues in subsidiaries, • Unrealized gains and losses on equity investments • Extraordinary operating items • Derivative gains and losses (operations)
Read Management Discussion and Analysis for clues
Issues with Sustainable Earnings • Restructuring charges, asset impairments (bleeding back) • R&D (Merck & Co) • Advertising ( Coco cola) • Pensions ( English Electric) • Changes in estimates • Realised gains and losses (cherry picking : beware of firms with huge investments) • Unrealised gains and losses on equity investments • Other income (includes interest income)
QUALITY OF EARNINGS • Unexplained changes in accounting, especially when performance is poor. • Unexplained transactions that boost profits ( e.g. asset sales). • Unusual increases in accounts receivable in relation to sales increases. • Unusual increases in inventories in relation to sales increases. • An increase gap between reported income and cash from operations. • An increasing gap between firms reported income and its tax income ( aggressive reporting, e.g. warranty expenses). • Unexpected large asset write off (may be due to changed business environment). • Qualified audit opinions or changes in independent auditors that are not well justified. • Related party transactions or transactions between related entities.
Key Drivers : Select Industries
Industry Automobiles Beverages Cellular phones Commercial real estate Computers Fashion clothing Internet commerce Non fashion clothing Pharma Retail
Key economic factors Model design and production efficiency Brand management and production innovation Population covered and churn rates Square footage and occupancy rates Technology path and competition Brand management and design Hits per hour Production efficiency Research and development Retail space and sales per square foot
Key ReOI drivers Sales and margins Sales Sales and ATO Sales and ATO Sales and margins Sales and advertising/sales Sales and ATO Margins Sales Sales and ATO
