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Analysing Historical Performance

Analysing Historical Performance. Steps in Analysing Historical Performance. Reorganise the financial statements to reflect economic, instead of accounting, performance.

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Analysing Historical Performance

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  1. Analysing Historical Performance

  2. Steps in Analysing Historical Performance • Reorganise the financial statements to reflect economic, instead of accounting, performance. • Measure and analyse the company’s return on invested capital (ROIC) and economic profit to evaluate the company’s ability to create value • Break down revenue growth into four components: organic revenue growth, currency effects, acquisitions and accounting changes • Assess the company’s financial health and capital structure to determine whether it has the financial resources to conduct business and make short-and long-term investments

  3. Reorganising The Accounting Statements

  4. Reorganising The Accounting Statements: Key Concepts • Separate operating performance from non-operating items and the financing obtained to support the business. • ROIC and Free Cash Flow (FCF) are independent of leverage and focus solely on the operating performance of the business.

  5. Invested Capital: Key Concepts • OA +NOA = OL + (D +DE) + (E + EE) • OA = Operating assets • NOA = Non-operating assets • OL = Operating liabilities • D = Debt • DE = Debt equivalent • E = Equity • EE =Equity equivalents

  6. Invested Capital: Key Concepts (Contd.) • Invested Capital +NOA = Total Funds Invested = (D+DE) + (E + EE) • Invested capital = OA – OL

  7. Invested Capital: Key Concepts (Contd.) • ACCOUNTANT’S BALANCE SHEET

  8. Invested Capital: Key Concepts (Contd.) • INVESTED CAPITAL

  9. Net Operating Profit Less Adjusted Taxes (NOPLAT): Key Concepts • Interest is not subtracted from operating profit. • It is considered a payment to company’s financial investors. • Exclude any non-operating income, gains, or losses generated from assets excluded from invested capital. • Effects of interest expense and non-operating income are removed from taxes. • Start with reported taxes, add back the tax shield caused by interest expense, and remove taxes paid for non-operating income.

  10. Net Operating Profit Less Adjusted Taxes (NOPLAT): Key Concepts • Model all financing cost (including interest and tax shield) in the cost of capital. • Taxes on non-operating income should be netted against operating income.

  11. Net Operating Profit Less Adjusted Taxes (NOPLAT): Key Concepts • ACCOUNTANT’S INCOME STATEMENT

  12. Net Operating Profit Less Adjusted Taxes (NOPLAT): Key Concepts • NOPLAT

  13. Return on Invested Capital • ROIC = (NOPLAT/Invested Capital) • ROIC is used to measure how the company’s core operating performance has changed and how the company compares with its competitors, without the effects of financial structure and non-operating items distorting the analysis.

  14. Free Cash Flow: Key Concepts • FCF = NOPLAT +Non-Cash Expenses – Investments in Invested Capital • Cash flow from non-operating assets should be evaluated separately from core operations

  15. Free Cash Flow: Key Concepts (Contd.) • ACCOUNTANT’S CASH FLOW

  16. Free Cash Flow: Key Concepts (Contd.) • FREE CASH FLOW

  17. Reorganising The Accounting Statements: In Practice

  18. Operating Working Capital • Specifically excess cash and marketable securities are excluded. • Excess cash represents temporary imbalances in the company’s cash position. • Operating liabilities should not be considered as a form of financing. • Assumption that operating liabilities are a form of financing is inconsistent with the definition of NOPLAT.

  19. Net Property Plant and Equipment • The book value of net property, plant and equipment is always included in the operating assets.

  20. Acquired Intangibles and Goodwill • Adjust reported goodwill upwards to recapture historical amortisation and impairments. • To maintain consistency, amortisation and impairments are not deducted from revenues to determine NOPLAT. • An unrecorded goodwill should be added to recorded goodwill.

  21. Hidden Assets and Their Respective Financing • Operating lease • Expensed investments: advertising, and research and development

  22. Non-Operating Assets • Excess cash and marketable securities. • To asses the minimum cash needed to support operations, look for a minimum clustering of cash to revenue across the industry. • Illiquid investments, non-consolidated subsidiaries and other equity investments. • Pre-paid and intangible pension assets

  23. Debt Equivalent • Unfunded retirement liabilities • Operating lease • Reserves for plan decommissioning • Reserve for restructuring

  24. Equity Equivalent • Deferred tax liability • To be consistent use cash taxes to compute NOPLAT

  25. NOPLAT: In Practice

  26. NOPLAT Calculation • Earnings before interest, tax, and amortisation of goodwill (EBITA) is the starting point • Exclude non-operating incomes, gains and losses • Adjust income for hidden assets • Consider operating cash taxes on EBITA • Use marginal tax rate to eliminate tax effect • Use cash taxes actually paid • Subtracting the increase in deferred taxes lead to cash taxes • Reconcile net income to NOPLAT to ensure that the reorganisation is complete

  27. Free Cash Flow In Practice

  28. Gross Cash Flow • It represents the cash available for investment and investor payout, without having to sell non-operating assets or raise additional capital. • Gross cash flow has two components: NOPLAT and Non-cash operating expenses. • The two most common non-operating expenses are depreciation and employee stock option. • ESOPs represent value being transferred from shareholders to company employees. • If ESOPs are added back to NOPLAT, those must be valued separately. • If they are not added back, there is no need to value them separately.

  29. Gross Investment • Change in operating working capital • Net capital expenditure • It is estimated by taking the change in the net PP&E plus depreciation. • Change in the gross PP&E should not be considered as gross investment because when assets are retired gross PP&E is reduced without any cash flow implication. • Change in capitalised operating leases

  30. Gross Investment (Contd.) • Investment in acquired intangibles and goodwill • For acquired intangible assets, where cumulative amortisation has been added back, investment is estimated by computing the change in net acquired intangibles. • For intangibles that are being amortised, the method that is being used for estimating net investment in PP&E is used. • Change in other long-term operating assets, net of long-term liabilities. • Non-cash increase should be adjusted (e.g. exchange difference, and change in fair value)

  31. Reinvestment Ratio • Reinvestment ratio = Gross investment/Gross cash flow • If the ratio is rising without a corresponding increase in growth, examine: • Whether the company’s investments are taking longer to blossom than expected; or • Whether the company is adding capital in efficiently

  32. Analysing Return on Invested Capital

  33. ROIC • ROIC = NOPLAT/Average Invested Capital • When ROIC is used to measure historical performance for company’s shareholders, ROIC should be measured with goodwill. • ROIC excluding goodwill measures the company’s internal performance and is useful for comparing operating performance across companies and for analysing trends.

  34. Economic Profit • Economic profit = Invested capital × (ROIC – WACC) • Invested capital is measured at the beginning of the year. • Economic profit measures the one-year performance on historical book value. • The change in market value measures changing expectations about future economic profits.

  35. Decomposing ROIC • ROIC = • (1 – Cash tax rate) × (EBITA/Revenues) × (Revenues/ Average invested capital)

  36. Decomposing ROIC (Contd.) • Components of ROIC

  37. Analysis of ROIC • Compare historical value drivers with drivers of other companies in the same industry • What are the sources of competitive advantage? • Is the competitive advantage sustainable?

  38. Line Item Analysis • Convert every line item to some type of ratio, for example: • Operating ratios • Each line item in the balance sheet as a percentage of revenue

  39. Non-Financial Ratios • If, available, analyse the operating data. • By evaluating operating drivers, one can better assess the sustainability of financial spreads among competitors. • Example: Airlines industry • (Labour expense/Revenue) = • (Labour expense/Total employees) × • (Total employees/Available seat miles flown ) × • (Available seat miles flown /Revenue)

  40. Analysing Revenue Growth

  41. Growth • Value of a company is driven by ROIC, WACC and growth • Growth is defined as growth in cash flows • Assuming profit margins and reinvestment rates stabilise to a long-term level, long-term growth in cash flows will be directly ties to long-term growth in revenues. • By analysing historical revenue growth, one can assess the potential for growth going forward.

  42. Revenue Growth Analysis • IBM: Revenue Growth analysis (Per cent) [Ref: Valuation Mc Kinsey Exhibit 7.16]

  43. Currency Effects • Revenues earned in different currencies are translated in the reporting currency. • Reported revenue is affected by the weakening or strengthening o currencies against the reporting currency during the reporting period. • Thus a rise in revenue may not reflect increased pricing power or greater quantities sold, but just a depreciation of the company’s home currency.

  44. Decomposing Revenue Growth • Revenues = (Revenue/Unit) × Units • Revenue per unit does not represent the price • If revenue per unit is rising, the change could be due to rising prices or due to the change in the product mix from low-priced to high-priced items

  45. Decomposing Revenue Growth • Revenue Growth Analysis: Retail Chain (Per cent) (Ref: Valuation, McKinsey, Exhibit 7.19

  46. Decomposing Revenue Growth (Contd.) • New store development is an investment choice, where as same-store sales growth reflects store-by-store operating performance. • New stores require large capital investments, where as comparable (that is, year-to-year sale store sales) requires little incremental capital. • Higher revenue and less capital leads to higher ROIC

  47. Credit Health And Capital Structure

  48. Coverage: Ability to Meet Short Term Obligations • Interest coverage ratio • EBIT/Interest or EBIDTA/Interest • (EBITA/Interest) measures the company’s ability to repay interest without having to cut expenditures intended to replace depreciating equipment. • EBITDAR/(Interest + Rental Expense) • Important for companies engaged in industries like retailing business

  49. Leverage • ROE = ROIC + [ROIC – (1 – T) kd] × (D/E) • ROE is a direct function of its ROIC, its spread of ROIC over its after-tax cost of debt, and book-based debt-equity ratio • To assess leverage, measure company’s (market) debt-to-equity ratio over time and against peers.

  50. General Consideration for Historical Analysis

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