Today s Agenda. Deriving the Du Pont Identity. Nike & Reebok s Profitability Ratios

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Andrew Gardner
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1 Today s Agenda DuPont Identity Market Value Ratios Financial Statement Analysis Uses & Problems Introduction to Bond Valuation Nike & Reebok s Profitability Ratios Profitability Ratios Nike Reebok Profit margin 7.7% 4.4% 4.5% 4.0% Return on assets (ROA) 12.0% 6.9% 7.9% 6.8% Return on equity (ROE) 19.8% 11.9% 15.2% 14.3% Deriving the Du Pont Identity ROE = NI / TE Multiply by 1 and then rearrange ROE = (NI / TE) (TA / TA) ROE = (NI / TA) (TA / TE) = ROA * EM Multiply by 1 again and then rearrange ROE = (NI / TA) (TA / TE) (Sales / Sales) ROE = (NI / Sales) (Sales / TA) (TA / TE) ROE = PM * TAT * EM 1

2 Using the Du Pont Identity ROE = PM * TAT * EM Profit margin is a measure of the firm s operating efficiency how well does it control costs Total asset turnover is a measure of the firm s asset use efficiency how well does it manage its assets Equity multiplier is a measure of the firm s financial leverage The DuPont Indentity Also, the equity multiplier (assets/equity) can be written in terms of the total debt ratio and debt/equity ratio. assets sales Net Income ROE= x x equity assets sales assets 1 1 totalliabilities = = = 1+ equity 1 totaldebt ratio totalliabilities 1 equity totalassets Nike and Reebok DuPont Identity DuPont Identity Nike Reebok Profit margin 7.7% 4.4% 4.5% 4.0% Total asset turnover Equity mulitiplier Return on equity (ROE) 19.8% 11.9% 15.2% 14.3% 2

3 DuPont Example What total debt ratio was needed by Reebok in in order to match Nike s ROE assuming all other ratios constant? Final Du Pont Indenty comments When a firm uses no debt financing, the equity multiplier = 1 and ROE = ROA. Using more financial leverage will increase ROE when the return on new assets (investment) exceeds the interest rate on the new debt. 3

4 Market Value Ratios PE Ratio = Price per share / Earnings per share Market-to-book ratio = market value per share / book value per share Nike & Reebok Market Value Ratios Market Value Ratios Nike Reebok Stock price $71.15 $55.99 $39.32 $29.40 EPS $3.59 $1.79 $2.65 $2.13 PE Ratio Total equity (book value) 4, , , Shares outstanding Book value per share $18.18 $15.14 $17.34 $14.69 Market-to-Book ratio Why Evaluate Financial Statements? Internal uses Performance evaluation compensation and comparison between divisions Planning for the future guide in estimating future cash flows External uses Creditors Suppliers Customers Stockholders 4

5 Benchmarking Ratios are not very helpful by themselves; they need to be compared to something Time-Trend Analysis Used to see how the firm s performance is changing through time Internal and external uses Peer Group Analysis Compare to similar companies or within industries SIC and NAICS codes Potential Problems There is no underlying theory, so there is no way to know which ratios are most relevant Benchmarking is difficult for diversified firms Globalization and international competition makes comparison more difficult because of differences in accounting regulations Varying accounting procedures, i.e. FIFO vs. LIFO Different fiscal years Extraordinary events Chapter 5 Valuing Bonds 5

6 Chapter 5 Topic Overview Bond Characteristics Annual and Semi-Annual Bond Valuation Reading Bond Quotes Finding Returns on Bonds Bond Risk and Other Important Bond Valuation Relationships Bond Characteristics Face (or Par) Value = stated face value that is the amount the issuer must repay, usually $1,000 Coupon Interest Rate Coupon (cpn) = Coupon Rate x Face Value Maturity Date = when the face value is repaid. This makes a bond s cash flows look like this: Characteristics of Bonds Bonds pay fixed coupon (interest) payments at fixed intervals (usually every 6 months) and pay the face value at maturity. cpn/2 cpn/2 cpn/2 cpn/2 cpn/2+par n 6

7 Bonds WARNING The coupon rate IS NOT the discount rate used in the Present Value calculations. The coupon rate merely tells us what cash flow the bond will produce. Since the coupon rate is listed as a %, this misconception is quite common. Bond Pricing The price of a bond is the Present Value of all cash flows generated by the bond (i.e. coupons and face value) discounted at the required rate of return. cpn cpn ( cpn + par) PV = ( 1+ r) ( 1+ r) ( 1+ r) t Bond Valuation Discount the bond s cash flows at the investor s required rate of return. the coupon payment stream (an annuity). the face (par) value payment (a single sum). PV = cpn (PVAF r, t) + par /(1+r)t cpn cpn cpn+par n 7

8 Bond Valuation Example #1 Duff s Beer has $1,000 par value bonds outstanding that make annual coupon payments. These bonds have an 8% annual coupon rate and 12 years left to maturity. Bonds with similar risk have a required return of 10%, and Moe Szyslak thinks this required return is reasonable. What s the most that Moe is willing to pay for a Duff s Beer bond? 8

Chapter 3 Financial Statements Analysis

Chapter 3 Financial Statements Analysis 1 Acknowledgement This work is reproduced, based on the book [Ross, Westerfield, Jaffe and Jordan Core Principles and Applications of Corporate Finance ]. This work