Lecture 4 Interpreting and using financial statements for valuation II Financial ratio analysis
Agenda Use of financial ratios ROE decomposition Growth, risk, and, cash flow 2
What are financial ratios used for? To analyze a company s financial position and development profitability operating efficiency financial strategy dividend policy To compare company ratios with competitors and industry To calculate inputs and sanity checks for valuation formulas 3
Strategy and financial policy drive profitability and growth Recall lecture 2: a firm with sustainable competitive strategy will have a product market strategy leading to high revenues, low costs, and/or low invested capital Financial policy can also be for higher growth and profitability: higher leverage can be used to enhance profitability with a risk no dividends leads to higher growth 4
Basic return on equity concepts Accounting (book value) based returns Return on Equity (ROE) = Net Profit Shareholders' Equity Market based return Holding period return (t) = (Price(t) - Price(t-1)) + Dividends(t) Price(t-1) Required rate of return = (equilibrium, e.g. CAPM) price of equity 5
Return on equity (ROE) is the accounting counterparty to market return on equity Measurement ROE is return for all equity (common, preferred, minority) Equity should be measured as average total equity during fiscal year, but analysts often use ending balance, Palepu et al. use beginning balance in Chapter 5 Using ROE to measure value creation Maximizing ROE is not the same thing as maximizing value. Why? ROE depends on leverage of the company ROE changes if interest rates or accounting policies change ROE has a tendency to revert to normal levels 6
ROE decomposition separates operating performance from asset turnover and financial strategy Standard 2-step ROE-decomposition ROE = ROA x Equity multiplier = Net Profit Total Assets x Total Assets Shareholders' Equity Standard 3-step ROE-decomposition ROE = Profit margin x Asset turnover x Equity multiplier = Net Profit x Total Assets x Total Assets Shareholders' Equity ROE-decomposition is also known as the DuPont analysis Problems: operating and financing performance in net profit and asset ownership not separated 7
Advanced ROE decomposition separates return on business assets and leveraged return Advanced 2-step ROE-decomposition ROE = Return on Business Assets (ROBA) + Spread x Financial Leverage where ROBA = NOPAT+NIPAT Business Assets Spread = ROBA Interest expense after tax / Debt Debt Financial leverage = Equity Interest expense after tax = Interest expense * (1 Tax Rate) Net operating profit after taxes (NOPAT) = Net profit NIPAT + Interest expense after tax Net Investment Profit After Taxes (NIPAT) = (Investment income + Interest income) * (1 Tax Rate) Business assets = Net operating and investment assets 8
3-step version further separates operating asset and investment asset performance Advanced 3-step ROE-decomposition ROBA NOPAT Business Assets NIPAT Business Assets NOPAT Operating assets Operating assets Business assets NIPAT Investment assets Investment assets Business assets Return Operating assets on operating assets Business assets Investment assets Return on investment assets Business assets ROE = Return on operating assets x % of operating assets + Return on investment assets x % of investment assets + Spread x Financial leverage 9
Exact definitions for the 3-step anvanced ROE decomposition Operating assets = Operating working capital + Net (non-current) operating assets Investment assets = Minority equity investments + Other nonoperating investments + Excess cash and marketable securities Debt = Total interest-bearing non-current liabilities + Current debt and current portion of non-current debt Operating working capital = (Current assets Excess cash and marketable securities) (Current liabilities Current debt and current portion of non-current debt) Net non-current operating assets = Non-current tangible and intangible assets + (Net) derivatives (Net) deferred tax liability - Non-interest-bearing non-current liabilities 10
Advanced ROE decomposition example What conclusions can you make based on these numbers? 11
Common profitability measures Net Profit x Total Assets x Total Assets Shareholders' Equity Net profit margin = Gross profit margin = Net Profit x Total Assets x Total Assets Shareholders' Equity - Cost of EBITDA margin = EBIT margin = NOPAT margin = Earnings Before Interest, Taxes, Depreciation and Amortization Earnings Before Interest and Taxes Net Operating Profit After Taxes For each profitability measure, describe a situation in which this measure would be the most relevant metric 12
Net Profit Common asset turnover (efficiency) measures x Total Assets x Total Assets Shareholders' Equity Working capital turnover = / Working capital Operating working capital turnover = /Operating working capital Fixed asset turnover = / Fixed assets Non-current asset turnover = / Non-current assets Total asset turnover = / Total assets Trade receivables turnover = / Trade receivables Trade payables turnover = Purchases / Trade payables Inventories turnover = Cost of sales / Inventories For each asset turnover measure, describe a situation in which this measure would be the most relevant metric 13
Asset turnover metrics example Net Profit x Total Assets x Total Assets Shareholders' Equity What conclusions can you make based on these numbers? 14
Difference between liquidity and long-term solvency How would you verbally define liquidity? When is liquidity rather than long-term solvency important? How would you verbally define long-term solvency? When is long-term solvency rather than liquidity important? 15
Net Profit x Total Assets x Total Assets Shareholders' Equity Common financial leverage ratios liquidity Current Ratio = Quick Ratio = Cash Ratio = Operating Cash Flow Ratio = Current Assets Current Liabilites Cash and Marketable Securities + Trade Receivables Current Liabilites Cash and Marketable Securities Current Liabilites Cash Flow From Operations Current Liabilities 16
Liquidity metrics example Net Profit x Total Assets x Total Assets Shareholders' Equity What conclusions can you make based on these numbers? 17
Common financial leverage ratios longterm solvency Equity Multiplier = Total Assets Total Equity Debt-to-Equity = Current Debt + Non-Current Debt Shareholders' Equity Debt-to-Capital = Current Debt + Non-Current Debt Current Debt + Non-Current Debt + Shareholders' Equity Should you use market or book values for these measures? 18
Agenda Use of financial ratios ROE decomposition Growth, risk, and, cash flow 19
Sustainable growth rate analysis tells you in which direction profitability and solvency ratios are heading Value generation ROE = Profit margin x Asset turnover x Equity multiplier ROE = Return on business assets + Spread x Financial leverage Value distribution Dividend payout ratio = Cash dividends paid / Net profit 20
How quickly can a firm grow? Internal growth rate How quickly can the firm grow without any external financing? < Sustainable growth rate (g*) How quickly can the firm grow with external debt financing, but still keeping D/E ratio constant? 21
Sustainable growth rate sets growth rate with current capital structure It is useful also to examine the growth rate that can be maintained without any further equity issues. This growth rate allows further debt issues which maintain the capital structure, i.e. the level of Equity/Assets, at the present level. This sustainable growth rate can be determined as follows: Sustainable growth rate (g*) = Plowback ratio (= 1 Dividend payout ratio) x Return on equity 22
What happens if planned growth does not match sustainable growth rate? If planned growth (g) > g*, what has the company do? What happens if the company fails to do one or more of these actions? 23
Sustainable growth rate adds one more layer to the ROE decomposition 24
Interest and debt service ratios are popular metrics especially from debtholders perspective (1/2) Interest coverage (Earnings basis) Net Profit + Interest Expense + Tax Expense Interest Expense Interest coverage (Cash flow basis) Cash Flow From Operations + Interest Expense + Tax Expense Interest Expense 25
Interest and debt service ratios are popular metrics especially from debtholders perspective (2/2) Debt service coverage ratio (DSCR, earnings basis) Debt service coverage ratio (DSCR, cash flow basis) Sometimes the numerator adds back non-cash charges. What is the intuition for doing this? 26
Cash flow analysis is a sibling of the financial ratio analysis Why cash flow analysis? Why not just financial ratio analysis? Cash (vs accrual) based view on company s financial situation: what is the earnings quality? How much cash do operations produce? How much cash is used for working capital and non-current asset investments? Is this very different from depreciation? Does company finance growth by internal or external funds? How easily can company pay debt obligations? Is debt needed to pay out dividends? 27
Cash flow analysis example What conclusions can you make based on these numbers? Which of these conclusions you cannot do based on earningsbased financial analysis? 28