Valuation Ratios

Financial Statement Analysis for Modeling
Integrated Financial Management
Oct 24, 2008
Financial Statement Analysis Contents
Overview and objective of financial statement analysis Review and Re-formatting Statements for Financial Model Income Statement EBITDA and NOPLAT Cash Flow Statement - Free Cash Flow and Equity Cash Flow
Financial ratio analysis Management Performance Valuation Credit Analysis Financial Model Drivers
Reference Financial Ratio Calculations Discussion of Economic Profit
Oct 24, 2008
Financial Statement Analysis - Introduction
Corporate models involve making a projection of the financial statements of a company or a segment of a company. You should be comfortable in reading various different financial statements to be effective at financial modeling and financial analysis. Financial statement analysis is also important in: Assessing management performance of a company and whether projections of improvement or sustainability are reasonable. Assessing the value of a company from historic performance. Assessing the reasonableness of financial projections provided by a company or the validity of earnings projections Assessing whether the financial structure of a company is of investment grade quality
Oct 24, 2008
Objectives of Financial Statement Analysis
Financial Statement Analysis is Like Detective Work How can we use information in financial statements to make assessments of various issue: How can we quickly review the income statement, balance sheet and cash flow statement to determine how the stock market value of a company compares to inherent value. How can we look the financial statements and assess risks associated with a company and whether the company has sufficient cash flow to pay off debt. Finance and valuation are about projecting the future -- how can financial statement analysis be used in making projections. The problem in any financial analysis and valuation is that measuring risk is very difficult
Oct 24, 2008
Financial Statement Analysis and Financial Projections
In corporate models, financial performance is measured and value is assessed with various financial ratios. Some of the uses of financial ratios in assessing corporate models include: Relate financial ratios to economic drivers in making financial forecasts Use financial ratios to determine whether management is generating economic profit compute ROIC and growth to examine sustainability. Evaluate the sustainability of economic profit over the long-term in financial models attempt to gather 10 years of data to find trends. Assess the potential for growth in economic profit ROIC less WACC Value the equity of the company relative to the stock price Review the credit quality of the firm with financial ratios
Oct 24, 2008
Double Counting and Judgments in Financial Ratio Analysis

In analyzing financial statements judgments must be made in computing key data such as EBITDA and in developing financial ratios. Examples Other Income in or out of EBITDA If not in EBITDA, then mush add non-consolidated subsidiary companies Exploration Expenses taken out of EBITDA Make consistent between companies with different accounting policies Goodwill (ROIC without goodwill) Minority Interest (Include or exclude income and balance) Total in EBITDA, must account for minority interest in financing of total EBITA Deferred Debit Amortization A key principle is that the financial data and the financial ratios are consistent and logical work through simple examples
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Income Statement
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Income Statement
Review trends in EBITDA, EBIT, EBT and Net Income and explain what is happening to the company EBITDA includes operating earnings and other income, but it does not include foreign exchange gains or losses, minority interest, extraordinary income or interest income. EBITDA is a rough proxy for free cash flow EBITDA is not generally shown on Income Statement Potential Adjustments for items such as exploration expense Compare EBIT to Net Assets and Net Capital
Ratio of EBITDA to Revenues should be shown for historic and projected periods EBITDA is related to un-levered cash flow while Net Income and EPS are after leverage NOPLAT is computed by EBIT less adjusted taxes, where taxes are computed through adjusting income taxes.
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Problems with EBITDA

EBITDA is useful in its simplicity, and can be a good reference for comparison of debt and value, but it has weaknesses: EBIT is more important than DA In credit analysis, EBITDA works better for low rated credits than high rated credits. (Moodys) EBITDA is a better measure for companies with long-lived assets EBITDA can be manipulated through accounting policies (operating expenses versus capital expenditures) EBITDA ignores changes in working capital, does not consider required re-investment, says nothing about the quality of earnings, and it ignores unique attributes of industries.
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Simplified Income Statement

Sales = + = = = = COGS Gross Margin SG&A Other Expenses Other Income EBITDA Depreciation and Amortization EBIT Interest Expense (income) EBT Income Taxes Minority Interest Net Income
In this case, do not include in EBITDA and remove the asset balance from the invested capital. Must be consistent One school of thought (McKinsey) is that they should be valued separately since they will have different cost of capital etc. There is a debate about how to handle other income from non-consolidated subsidiary companies.
NOPLAT = EBIT x (1-tax rate) NOPLAT = Net Income + Interest Expense x (1-tax)
Integrated Financial Management 10 Oct 24, 2008
Analysis of Income Statement Computation of EBITDA, Minority Interest, Preferred Dividends, Exploration Expense
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Income Statement Analysis
Example of Adjustments to EBITDA Exploration Expenses (EBITDAX) Rental and Lease Payments (EBITDR)
EBITDA Computation Top Down move other income Bottom-up (Indirect)
EBITDA Notes Interest Income out of EBITDA Interest Expense not in EBITDA Understand Non-cash Expenses Deferred Mining Costs Equity Income Minority Interest
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Employee Stock Options

One can debate the treatment of employee stock options for EBITDA, free cash flow and valuation. Think of options as giving stock to employees If the treatment has changed over the years and it is a significant expense, make adjustments to current or prior statements for consistency. Think of options as giving free shares to employees. The value of existing shareholders is diluted. One can argue that this is two things First, employees are compensated and the cash should be accounted for Second, invested capital is increased and the new equity should be refelected
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Cash Flow Statement
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Cash Flow Statement

Cash Flow has fundamental separation between Operations Capital expenditures (to maintain and grow operations) and Financing Operating Cash Flow Add back items from the income statement that do not use cash (depreciation, dry hole costs etc) Analyze how much cash flow the company generated and how it raised funds or disposed funds Use Cash Flow statement as a basis to compute free cash flow although cash flow not presented on the statement
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Cash Flow Statement

A. Operating Cash Flows 1) Cash Flow from Operations 2) Cash Collections 3) Cash Outflows 4) Interest & Dividends Received 5) Interest Paid 6) Taxes B. Investing Cash Flows 1) Cash Flow from Investments 2) Cap Ex (Purchases) 3) Sale of Property, Plant, & Equipment 4) Inter-Corporate Investment C. Financing Cash Flows 1) Cash Flow from Financing 2) Dividend Payments 3) Proceeds from Equity or Debt Issuance 4) Equity Repurchased 5) Debt Principal Payments
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Cash Flow Statement Example
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The Notion of Free Cash Flow

In practice the term cash flow has many uses. For example, operating cash flow is net income plus depreciation. Free cash flow is the cash flow that is available to investors FREE of obligations such as capital expenditures and taxes -- to both debt and equity investors after re-investing in plant, and financing and paying taxes. Accountants define cash flow from operations as net income plus depreciation and other non-cash items less changes in working capital. However, this cash flow is not available for distribution to equity holders and debt holders. The free cash flow must account for capital expenditures, repayments of debt, deferred items and other factors. Free cash flow consists of Cash flow to equity holders Cash flow to debt holders
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Importance of Free Cash Flow

Alternative Definitions, but one correct concept Free Cash Flow Is Also Known As Unleveraged Cash Flow Unleveraged Cash Flow Is Not Distorted By The Capital Structure Free Cash Flow should not change when the capital structure changes Free Cash Flow should be the same as equity cash flow if no debt is outstanding and not cash balances are built up. Free Cash Flow in Valuation PV of Free Cash Flow Defines Enterprise Value The Relevant Discount Rate Is The Unlevered Discount Rate or the Weighted Average Cost of Capital IRR on Free Cash Flow is the Project IRR Free Cash Flow in Economic Value FCF Carrying Charge = Economic Profit
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Fundamental Distinction in Financial Analysis Free Cash Flow and Equity Cash Flow
Free Cash flow that is independent from financing Valuation Performance in managing assets Claims on free cash flow Cash flow to pay debt obligations Comparisons unbiased by capital structure policy Equity cash flow Valuation of equity securities Performance for shareholders
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Cash Flow Statement in Financial Model
Analysis in Cash Flow Statements Compute Cash Flow before Financing Operating Cash Flow minus Capital Expenditures Use Cash Flow Before Financing in Deriving Free Cash Flow Equity Cash Flow Dividends less Cash Investments Cash Flow Before Financing less Maturities plus New Debt Issues Last Line on Cash Flow Statement Includes Change in Cash Balance Change in Short-term Debt or Overdrafts Beginning Balance + Change = Ending Cash Beginning Balance of STD + Change = Ending Short-term Debt
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Free Cash Flow Formulas

Free cash flow can be computed from the income statement or from the cash flow statement. From the cash flow statement, the formula is: Cash Before Financing Plus: Interest Expense Less: Tax Shield on Interest From the income statement, the formula is: EBITDA Less: Taxes on EBIT Less: Working Capital Investment Less: Capital Expenditures From Net Income Net Income Add: Net of Tax Interest Add Depreciation, Deferred Taxes and Other Non-Cash Changes Less: Changes in Working Capital Less: Capital Expenditures Some argue that free cash flow should not include non-operating items. Here the non-consolidated companies are treated in a similar manner as liquid investments
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Free Cash Flow from NOPLAT

Free cash flow can be computed using the notion of net operating profit less adjusted tax as follows (assuming no extraordinary income) Step 1: Compute NOPLAT Net Income Plus Net Interest after Tax Plus Deferred tax Equals NOPLAT Step 2: Compute Free Cash Flow NOPLAT Plus: Depreciation Less: Change in Working Capital Less: Capital Expenditures Equals Free Cash Flow
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Free Cash Flow Example
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Balance Sheet
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Balance Sheet Issues

Treat surplus cash as negative debt and debt as negative cash Rule of thumb cash is 2% of revenues Example when developing a basic cash flow model, group the cash and the debt as one account and then separate this account on the balance sheet. Unfunded pension expenses should be treated like debt they involve a fixed obligation and they can be replaced with debt when they are funded. Deferred taxes depend on the way deferred taxes are modelled for cash flow purposes. If you model future changes in deferred taxes and take account of these in projections, do not put deferred taxes as a component of equity.
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Plant Balances and Retirements

You can account for capital expenditures by subtracting accounts from the balance sheet. Be careful with retirements Retirements reduce both the plant balance and the accumulated depreciation Accumulated depreciation difference can be compared to the current depreciation expense and the difference is retirement. The retirements are then use along with plant balance changes to derive the capital expenditures
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Balance Sheet
Maintains value of assets from original cost rather than market value and may be conservative Used for base for many financial ratios debt to capital, depreciation rates, return on average equity, return on invested capital Use to establish the historical analysis and where money was earned and where it is spent Important as an audit tool in financial modeling
Total Assets = Total Liabilities + Total Equity
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Balance Sheet Adjustment

In modeling the balance sheet, a number of adjustments should be made from actual balance sheets: Surplus cash must be separated from other current assets Short-term debt should be separated from other current liabilities Current Portion of Long-term Debt should be classified as long-term debt for reconciliation Common equity can be aggregated
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Balance Sheet Issues

Selected Balance Sheet Issues for Financial Analysis Definition of Capital Minority Interests Short-term Debt Preferred Stock All Common Equity Components of Equity Capital Definition of Book Value per Share Deferred Debits and Credits
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Balance Sheet
Total Assets breaks into: A. Current Assets 1) Cash & Cash Equivalents 2) Marketable Securities 3) Accounts Receivable 4) Inventories B. Fixed Assets 1) Net Property Plant and Equipment 2) Goodwill (Type 1) 3) Other
Total Liabilities breaks into: A. Current Liabilities 1) Accounts Payable 2) Current Portion of Long-Term Debt 3) Current Capital Lease Obligation B. Long Term Liabilities 1) Long-Term Debt 2) Capital Leases 3) Pension Liabilities 4) Others (Deferred Tax Liability, etc) Total Equity breaks into: A. Stock 1) Preferred 2) Common 3) Treasury
B. Retained Earnings C. Other (Translation Gains/Losses, etc)
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Balance Sheet Example
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Balance Sheet Issues in Modeling

Compute Debt Balance from Separate Debt Balance Understand Deferred Debits and Deferred Credits (for example deferred compensation or long-term pre-paid expenses) Equity Balance from Retained Earnings Statement can be Incorporated in Statement Incorporation of Asset write-ups or write-downs
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Financial Ratio Analysis
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Contents
Introduction Management Performance Ratios Valuation Ratios Credit Analysis Ratios
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Tension between Equity Analysis and Asset Analysis
Free Cash Flow Project IRR ROIC (ROCE) WACC Enterprise Value EV/EBITDA Market to Replacement Cost
Equity Cash Flow Equity IRR ROE Cost of Equity Market Cap P/E Market to Book
Value = Value of Business Units = Debt + Equity Value
In ratio analysis, cash = negative debt
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Financial Ratio Analysis

Purpose : Evaluate relation between two or more economically important items (one is the starting point for further analysis) Cautions: Accounting analysis is important (deferred taxes etc.) Interpretation is key What does the P/E mean Is an interest coverage of 3.5 good Why is the ROIC low Should we use MB, PE or EV/EBITDA Document financial ratios (numerator and denominator) with footnotes and comments Show components of numerator and denominator in rows above the ratio calculation
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General Discussion of Financial Ratios

Financial Ratios Often Compares Income Statement or Cash Flow with Balance Sheet In developing ratios, understand why the formula is developed (e.g. other income and other investments in return on invested capital) There is Not Necessarily One Single Correct Formula For example, pre-tax or after-tax return on assets. Keep the numerator consistent with the denominator Financial Ratios should be evaluated in the context of benchmarks Credit ratios and bond rating standards Returns and cost of capital Operating ratios and history
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Classes of Financial Ratios

Management Performance Ratios that measure the historic economic performance of management and evaluate whether the economic performance can be maintained (e.g. ROIC) Valuation Ratios that are used to give an indication of the value of the company (e.g. P/E) Credit Analysis Ratios that gauge the credit quality and liquidity of the company (e.g. Interest coverage and current ratio) Model Evaluation Ratios used to evaluate the assumptions and mechanics of financial forecasts
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Ratios that Measure Management Performance
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Class 1: Financial Indicators of Management Performance
Evaluate Whether Management is Doing a Good Job with Investor Funds (Not if the company is appropriately valued) Return on Invested Capital Return on Assets Return on Equity Market/Book Ratio Market Value/Replacement Cost
Key Issue Evaluate relative to risk ROE versus Cost of Equity ROIC versus WACC
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Basic Economic Principles, ROIC and Financial Analysis When you measure value, you are gauging the ability of a firm to realize economic profit. For example, when you compare the equity IRR with the equity cost of capital. When you assess assumptions in a financial forecast, you must assess whether economic profit implicit in the assumptions can in fact be realized. For example, if the financial forecast has a very high ROE, is that reasonable. When you interpret financial statistics, you are gauging the strategy of the company in terms of whether economic profit is being realized. In reviewing the return on invested capital, does this demonstrate that the company has the potential to earn economic profit.
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Return on Invested Capital Analysis
ROIC is not distorted by the leverage of the company ROIC can be used to gauge economic profit and whether the company should grow operations ROIC can be used to assess the reasonableness of projections For example, if ROIC is very high and the company is in a competitive business with few barriers to entry, the forecast is probably not realistic. ROIC can be computed on a division basis EBIT and allocation of capital to divisions from net assets to gauge the profit of parts of the company ROIC comes from sustainable competitive advantage and high market share
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Formula for Return on Invested Capital
The return in invested capital formula can be for a division or an entire corporation. It is after tax and after depreciation. Cash balances should be excluded from the denominator and interest income from the numerator. Goodwill and goodwill amortization should be excluded. Formula: ROIC = EBITAT/Invested Capital Where: EBITAT: Earnings before Interest Taxes and Goodwill Amortization less taxes on EBITAT Taxes on EBITAT: Cash Income Taxes Less Tax on Interest Expense and Interest Income and Tax on Non-operating Income Invested Capital less cash balance
Adjustments Other Assets Cash Balances Goodwill Other
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Issues in Management Performance Evaluation

Basic Formula: ROIC versus WACC How to compute ROIC NOPLAT/Average Invested Capital May or may not include goodwill If goodwill is not included, compute NOPLAT without subtracting goodwill write-off and subtract net goodwill from invested capital Reduce the invested capital by surplus cash balances Some dont include other income then the invested capital should be reduced by other investments Can compute with ratios EBIT Margin x (1-t) * Asset Turn Asset Turn = Sales/Assets; EBIT Margin = EBIT/Sales ROCE vs ROIC ROCE is generally computed in an indirect way by starting with net income, and adding net of tax interest and adding minorities
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Exxon Mobil Return on Average Capital Employed

Return on average capital employed (ROCE) is a performance measure ratio. From the perspective of the business segments, ROCE is annual business segment earnings divided by average business segment capital employed (average of beginning and end-of-year amounts). These segment earnings include ExxonMobils share of segment earnings of equity companies, consistent with our capital employed definition, and exclude the cost of financing. The corporations total ROCE is net income excluding the after-tax cost of financing, divided by total corporate average capital employed. The corporation has consistently applied its ROCE definition for many years and views it as the best measure of historical capital productivity in our capital intensive longterm industry, both to evaluate managements performance and to demonstrate to shareholders that capital has been used wisely over the long term. Additional measures, which tend to be more cash flow based, are used for future investment decisions.
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Exxon Mobil Return on Capital Employed Where are they making expenditures
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Exxon Mobil Return on Capital
Return on average capital employed Net income Financing costs -after tax Third-party debt ExxonMobil share of equity companies All other financing costs net -1 Total financing costs Earnings excluding financing costs
2005 -millions of dollars $ 36,130.00 (1.00) (144.00) (295.00) (440.00) $ 36,570.00
2004 $ 25,330.00 (137.00) (185.00) 54.00 (268.00) $ 25,598.00
2003 $ 21,510.00 (69.00) (172.00) 1,775.00 1,534.00 $ 19,976.00
Average capital employed Return on average capital employed corporate total
$ 116,961.00 31.30
$ 107,339.00 23.80
$ 95,373.00 20.90
(1)
All other financing costs net in 2003 includes interest income (after tax) associated with the settlement of a U.S. tax dispute.
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Illustration of Invested Capital Computation
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ROE and ROIC Note how to compute growth rates from ROE and Retention
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Example of Return on Capital Employed (Return on Invested Capital) in Financial Analysis

The argument has been made that the best measure to evaluate management performance that is not distorted by leverage (as in the case of ROE) or has the problems of ROA is the return on invested capital. An example of use of this ratio is in the Exxon Mobile Merger: J.P. Morgan reviewed and analyzed the return on capital employed ("ROCE") of both Exxon and Mobil since 1993. J.P. Morgan observed that Exxon's ROCE has consistently been 2-3% above that of Mobil. J.P. Morgan's analysis indicated that if Mobil were to be merged with Exxon, the combined entity's capital productivity would eventually be higher than the pro forma capital productivity of Exxon and Mobil. J.P. Morgan indicated that it would be reasonable to assume that the benefits of this capital productivity increase would occur within three years of the closing of the merger.
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Relationship Between Various Ratios and DuPont Analysis

Profitability
Asset Utilization Working Capital/ Sales Plus: Long-term capital/ Sales Equals:Capital employed/ Sales 1 divided by Capital Employed/ Sales Equals: Asset Turnover (Sales/ Capital Employed)
Gross Margin = Gross profit/ Sales Less: Operating costs/ Sales Equals EBIT Margin (EBIT/ Sales)
Multiplied by
ROCE(EBIT/ Capital Employed ) Multiplied by (1 minus Tax Rate) ROCE(EBIT after Tax/ Capital Employed )
Drivers of Value and Free Cash Flow from Financial Ratios

Revenues Growth in Revenues EBITDA Margin Multiplied by Revenues = EBITDA Less: Depreciation Rate Multiplied by Fixed Assets = EBIT Fixed Assets = Sales x Sales/Assets (Turnover) Ratios Needed: Growth in Revenues, EBITDA Margin, Depreciation Rate and Asset Turnover
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Example of Using Ratios to Compute Free Cash Flow
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Class 2: Financial Indicators of Market Value
Financial Ratios can be used to analyze whether the valuation of a company is appropriate. Analysts should understand the drivers of different ratios. Valuation Ratios include: Universal Financial Ratios Price to Earnings Ratio Enterprise Value/EBITDA PEG (P/E to Earnings Growth) Ratio Market to Book Ratio Industry Specific Financial Ratios Value/Reserve Value/Customer Value/Plane Seat
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Valuation Ratios and Benchmarks

Valuation ratios measure the stock market value of a company relative to some accounting measure such as EPS, EBITDA, Book Value/Share or growth in EPS The ratios can be used as benchmarks in valuing non-traded companies by using industry average valuation ratios. Example to value non-traded company: Value of company = EPS of Company x Industry Average P/E Ratio Valuation ratios will be further discussed in the portion of the course where corporate models are used to value companies.
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P/E Ratio
The P/E Ratio is the most prominent valuation ratio. It is affected by estimated earnings growth, the ability of a company to earn economic profits and the growth in profitable operations. Formula: Share Price/Earnings per Share Issues Trailing Twelve Months and Forward Twelve Months Generally use forward EPS Formula: (1-g/r)/(k-g) Problems Affected by earnings adjustments Causes too much focus on EPS Distortions created by financing
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Illustration of EV Ratios and Computation of Market Value of Balance Sheet Components
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Investment Banker Analysis of Comparable Multiples
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Investment Banker Analysis of Multiples
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Use of PE in Valuation
The long-run P/E ratio is often used in valuation. This process involves: Project EPS Compute Stable EPS Compute P/E Ratio using formula P/E = (1-g/r)/(k-g) g growth in EPS or Net Income r rate of return earned on equity k cost of equity capital Related Formula for terminal value with NOPLAT (EBITAT) (1-g/ROIC)/(WACC g) The formula demonstrates where value really comes from
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Liquidity and Solvency

Credit worthiness: Ability to honor credit obligations (downside risk)
Liquidity Ability to meet short-term obligations Focus: Current Financial conditions Current cash flows Liquidity of assets
Solvency Ability to meet long-term obligations

Focus: Long-term financial conditions Long-term cash flows Extended profitability
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Solvency Ratios
Ratios are the center of traditional credit analysis that assesses whether a company can re-pay loans. These ratios should be compared to benchmarks. Solvency Debt Payback Ratios Funds from Operations to Total Debt Debt to EBITDA Leverage Ratios Debt to Capital (Include Short-term Debt) Market Debt to Market Capital Payment Ratios Interest Coverage Debt Service Coverage [Cash Flow/(Interest + Principal)] Capital Investment Coverage Operating Cash Flow/Capital Expenditures
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Liquidity
Current Ratio Current Assets to Current Liabilities Current Assets less Inventory to Current Liabilities Model Working Capital Current Assets less Cash and Temporary Securities minus Current liabilities less Short-term Debt Liquidity Assessment Debt Profile (Maturities) Bank Lines (Availability, amount, maturity, covenants, triggers) Off Balance Sheet Obligations (Guarantees, support, take-or-pay contracts, contingent liabilities) Alternative Sources of Liquidity (Asset sales, dividend flexibility, capital spending flexibility)
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Financial Ratios in Credit Analysis

Analyze financial ratios after determining the riskiness of a company. There are hundreds of ratios that could be analyzed, only certain key ratios need to be analyzed to complete an effective assessment. Four ways to assess ratios: Absolute Levels Trends in historic ratios Forecast ratios Comparison with industry peers
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Interest and Debt Service Coverage Ratios

Measure how many times the companys earned income covers interest charges, etc. Used to determine the probability of default A coverage ratio of 1 indicates that income just covers interest Can be calculated either before- or after-tax Consistency is important Analysts also consider the stability and trend of earnings
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S&P Benchmarks
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S&P Benchmark for Manufacturing and Service Companies Funds from Operations/Total Debt
The benchmark ratios differ according to the risk profile of a company as illustrated on the chart below.
Company Business Risk Profile Well Above Average Above Average Average Below Average Well Below Average
AAA 30% 20%
AA
BBB 60% 50% 40% 35% 25%
BB 70% 60% 55% 45% 35%
40% 50% 25% 40% 15% 30% 25%
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S&P Benchmarks
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S&P Utility Benchmarks
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S&P Benchmarks
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S&P Ratio Definitions
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Objective of Analysis is Bankruptcy Probability
Credit agencies use the ratios that differ by industry in establishing rating criteria Criteria can often be determined by industry
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Bond Ratings and Yield Spread
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Dont Put Miscellaneous Un-Explained Factors

Test
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Class 4: Model Assessment

Various ratios that some use to assess management performance are most appropriate for testing the validity of a model. Examples of these ratios include: EBITDA/Revenue Working Capital Activity Ratios Inventory Turnover AR/Revenues; AP/Expenses Income Tax Payable/Income Taxes Depreciation Rate Depreciation Expense/Gross PP&L Depreciation Expense to Cap Exp Average Interest Rate Interest Expense/Average Debt Capital Expenditure/Capacity
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Other Ratios in Financial Modeling

Other ratios should be computed in financial models to test the validity of assumptions and the structure of the model. For these ratios, the historic levels can be used to make forecasts of relevant assumptions. Examples include average interest rate, depreciation rate, working capital ratios, dividend payout ratio, EBITDA/Sales
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Financial Ratio Assignment - Work with the PE Ratio
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PE Ratio Exercise
Find the file named P/E Ratio exercise Complete the cork screw for determining the equity balance
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Steps in the PE Ratio Exercise Open the File
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Step 1: Enter Switch Variables for the Holding Period

Use true, false switches to establish the holding period and the terminal period Do not use if statement Rather, = year <= final_year for the holding period = year = final_year for the terminal period When you multiply variables by the true or false, the then the numbers are zero or one
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Step 2: Compute the Equity Balance, Net Income and Dividends with a Cork Screw
Start with the beginning equity balance Income = ROE x Beginning balance Dividends = Income x Payout Ratio Ending Balance = Beginning Balance + Income Dividends
In subsequent periods Beginning balance = Prior Period Ending Balance
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Step 3: Compute Cash Flow in Holding Period and in Terminal Period

In the holding period Cash flow = dividends In the terminal period Cash flow = dividends + Multiple x earnings per share Where Multiple = P/E Ratio from formula (1-g/r)/(k-g) Use switch to make sure cash flow is not counted after the holding period Cash Flow = dividends x switch
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Step 4: Compute the Value of Cash Flow

Assume the discount rate is the hurdle rate Each year the discount factor is 1/(1+r)^year The value of cash flow is: Discount factor x cash flow
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Step 5: Compute the P/E Ratio

Compute the total value of the share Value = cash flow x discount factor Fill in Components P/E = Value/First Year Earnings
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Experiment with P/E Ratio Using Microsoft Data

Assume ROE = 17% Cost of Equity = 17% Payout Ratio = 50% What is the P/E Why Assume ROE = 17% Cost of Equity = 12% Payout Ratio = 100% What is the P/E Why
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Experiment with P/E Ratio

Assume ROE = 17% Cost of Equity = 12% Dividend Payout = 50% What is the P/E Why
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Reference: Financial Ratio Formulas to Assess Management Performance
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Introduction: Two Components of Trade
The heart of any financial analysis is measurement of value through assessing risk and return. The primary subject in financial statement analysis is how can we read financial statements and evaluate the return of a company relative to the risk of a company. As the growth of trade transformed the principles of gambling into the creation of wealth, the inevitable result was capitalism, the epitome of risktaking. But capitalism could not have flourished without two new activities The first was bookkeeping, a humble activity but one that encouraged the dissemination of the new techniques of numbering and counting. The other was forecasting, a much less humble and far more challenging activity that links risk taking with direct payoffs.
The Remarkable Story of Risk
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Case Study of Financial Statement Analysis

Examples of Financial Statement Review You receive financial projections as part of an offering memorandum or as part of a financing proposal. How would you determine whether the projections are reasonable by comparing the projections to history. You are assigned to perform a valuation of a company. You must assess whether the earnings guidance from investment analysts are reasonable. You are structuring an M&A transaction. You must determine the amount of debt and equity that can be used in the transaction.
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Profitability Analysis
ROE = Net Income/ Avg. Common Equity ROA = EBIT/ Total Assets ROIC = EBIT x (1-t)/ (Avg. Total Debt + Avg. Total Equity) Market Value per Share/Book Value per Share Market Value of Assets/Replacement Cost of Assets Gross Profit Margin = Gross Profit/ Sales Operating Margin = EBITDA/Sales Profit Margin = Net Income/ Sales
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Return on Equity
Defines how much income management has made from the equity investment made by investors the return is net income and the investment is the equity. Formula: Net Income/(Beginning + Ending Equity)/2 Net Income after Preferred Dividends/(Average Common Equity) The problem with ROE it that it mixes operating performance with financial structure, making it difficult to understand the underlying performance. Return on equity should be related to the risk associated with earnings -- volatile earnings should imply a higher average return on equity High or low return on equity in models High returns check your assumptions Low returns problems with management performance
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Return on Assets
Return in assets measures the amounts of income produced relative to investment in assets. The ratio is generally pre-tax and total assets can distort the ratio. Formula: EBIT/Average Total Assets Problems: Difference between capital and asset balance means that investment not measured (examples, deferred taxes, deferred credits). Pre-tax means that taxes not considered even though taxes are real. Financing by current liabilities not considered (for example ROA is the same for businesses that have different funding from suppliers)
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Formula for Return on Invested Capital
The return in invested capital formula can be for a division or an entire corporation. It is after tax and after depreciation. Cash balances should be excluded from the denominator and interest income from the numerator. Goodwill and goodwill amortization should be excluded. Formula: ROIC = EBITAT/Invested Capital Where: EBITAT: Earnings before Interest Taxes and Goodwill Amortization less taxes on EBITAT Taxes on EBITAT: Cash Income Taxes Less Tax on Interest Expense and Interest Income and Tax on Non-operating Income Invested Capital less cash balance Adjustments Other Assets Cash Balances Goodwill Other
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ROIC and Economic Profit

ROIC is the foundation for analyzing performance in EVA. If a division or company, then it should be earning economic profit. Alternative measures can be used to measure economic profit: Economic Profit Formula: Economic profit = Invested Capital x (ROIC - WACC) Economic profit = EBITAT - Capital Charge Economic profit = EBITAT - WACC x Invested Capital
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Market to Book Value

Management performance can be evaluated by measuring what equity investors think about the value of the company. Todays market value compared to the amount invested by shareholders (directly or indirectly through not retaining earnings) is measured by the market to book ratio. The ratio measures how much value management has created relative to the amount initially invested. If the ratio is 1.0, management has not created value, if it is 2.0, management has doubled value relative to the amount invested. The ratio is related to ROE because if the ROE is greater than the cost of capital, the market value should be above the book value. Formula: Market Price/Book Value per Share Problems: Investment does not inflate Incorporates benefits or costs of equity value from changes in the liability structure of the company.
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Example of Market to Book Ratio
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Oct 24, 2008
Market Value to Replacement Cost (Tobins Q)
Theoretical problems with the market to book ratio are addressed with a ratio known as Tobins Q. This ratio compares market value to replacement cost rather than book value. If replacement cost is lower than market value, then shareholders are better off by liquidating the company and selling assets in the market. The more the value is above replacement cost, the better job management is doing in managing assets: Formula Tobins Q = Enterprise Value/Replacement Cost Where Enterprise Value = Market Value of Equity plus market value of Debt Problems How to measure replacement cost Adjusting replacement cost for asset age
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Oct 24, 2008
Reference: Formulas for Valuation Ratios
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Enterprise Value, Equity Value and Equity Value per Share
Before discussing valuation ratios it is helpful to define market capitalization and enterprise value. Formulas: Market Capitalization = Share Price x Number of Outstanding Shares (fully diluted) Enterprise value = Market Capitalization plus Market Value of Debt
In theory, enterprise value is the present value of free cash flow plus the present value of residual. In practice, the value of debt can often be estimated by the book value as long as the average interest rate is similar to the market yields on the company debt.
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Oct 24, 2008
P/E Ratio
The P/E Ratio is the most prominent valuation ratio. It is affected by estimated earnings growth, the ability of a company to earn economic profits and the growth in profitable operations. Formula: Share Price/Earnings per Share
Issues Trailing Twelve Months and Forward Twelve Months Formula: (1-r/g)/(k-g)
Problems Affected by earnings adjustments Causes too much focus on EPS Distortions created by financing
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Enterprise Value/EBITDA
Some of the problems with the P/E ratio are rectified by the ratio of EV/EBITDA. This ratio is not affected by leverage, accounting adjustments and can more effective comparisons across companies can be made. EBITDA - Pre-tax, pre depreciation operating income is a proxy for cash flow, so market value is compared to cash flow: Formula: EV/EBITDA = Enterprise Value/EBITDA Where Enterprise Value = Book value of debt plus market value of equity
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Price to Cash Flow

To correct the P/E ratio for accounting adjustments that are non-cash such as depreciation and goodwill amortization, a ratio known as Price to cash flow is computed. This is similar to the P/E ratio except the denominator is cash flow rather than earnings. Cash Flow measure is very simple and not generally the free cash flow Cash Flow is generally the net income plus depreciation
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Oct 24, 2008
Price to Earnings Growth (PEG)

Due to the importance of earnings growth in the P/E ratio, this ratio attempts to measure the relative value of a company after accounting for earnings growth. If a company has higher earnings growth, its price should be higher. Therefore, the valuation of two companies can be compared even if they have different earnings growth. Formula: PEG = PE Ratio/Consensus Earnings Growth
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Internal Rate of Return

Application to project finance rather than investment analysis Equity IRR analogous to the ROE Project IRR analogous to the ROIC Free cash flow used for project IRR Equity cash flow used for equity IRR Return on Equity Cash Flow in Gaza Strip Project
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Reference: Financial Ratio Formulas for Credit Analysis
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Ratio Analysis
Activity Analysis Inventory Turnover = COGS/Avg. Inventory Avg. Days in Stock = 365/ Inventory TO Receivables Turnover = Sales/ Avg. Receivables Avg. Days Receivables Out = 365/ Receivables Working Capital Turnover = Sales/ Avg. Working Cap Total Asset Turnover = Sales/ Average Total Assets Liquidity Analysis Operating Cycle = Avg. Days in Stock + Avg. Days Receivables Out Cash Cycle will be less, depending on use of credit Current Ratio = CA/CL Quick Ratio = (CA - Inventories)/ CL CFO Ratio = CFO/ CL Solvency Analysis Debt-to-Cap = Total Debt/Total Capital Debt to Equity = Total Debt/ Total Equity (market values are preferable in this ratio) Times Interest Earned = EBIT/ Interest Expense Fixed Charge Coverage = EBIT (and before other fixed expenses)/Fixed Charges Cap Ex Ratio = CFO/ Cap Ex
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Credit Analysis Ratios

A traditional use of financial ratios has been to assess the value of debt and the chance of default. Liquidity ratios measure the ability of a company to meet short-term obligations while interest coverage, debt service and capitalization ratios measure the ability to meet long-term obligations. Credit ratios have been formalized into regression analysis by relating the defaults on companies to various financial ratios. (Note that credit ratios are not considered adequate for many assessments, but they are a starting point.)
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Classes of Credit Ratios

Interest Coverage EBIT/Interest Debt Service Coverage Ratio After tax coverage
Debt to Capital Total debt to capital Debt to equity Long term versus short term Market value versus book value
Debt to Cash Flow Liquidity Current Ratio Quick Ratio
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Interest and Debt Service Coverage

The interest coverage and debt service ratios measure the amount of buffer or comfort above interest expense and/or debt service that cash flow provides before obligations cannot be met from current operations. EBIT/Interest is used more than the debt service coverage in corporate modeling because of the lumpiness in cash flow that occurs from bullet maturities: Formula: EBIT/Interest = EBIT/(Long + Short term Interest) DSCR = (Operating Cash + Interest)/(Interest + Maturities)
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Debt to Capital Ratio

The debt to capital ratio measures from a book perspective, the amount of debt that is financing assets. The ratio has not been a very good predictor of bankruptcy. It should include long and short term debt as well as capitalized lease payments. In some cases, the capitalized value of contracts has been included. Formula: Debt to Capital = (Long-term debt + Short-term debt)/(Long and Short term debt + Equity)
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Oct 24, 2008
Debt to Cash Flow

This ratio compares the cash flow with the amount of debt. The less cash flow relative to debt, the worse the credit and the higher the probability of default. Inquisitively, the ratio can be considered the number of years of cash flow it takes to pay-off all of the debt. Formula: Debt/Cash Flow = (Long and Short term debt)/EBITDA Note that EBITDA is an approximation of cash flow and it does not include capital expenditures.
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Liquidity Ratios
Liquidity ratios measure the ability of a company to meet obligations that are coming due in the short-term. Liquidity ratios are relevant for suppliers and contractors. A ratio below 1.0 suggests that more is coming due then is on hand to pay the liabilities. The quick ratio excludes inventories because they are not liquid. Formulas: Current Ratio Current Assets/Current Liabilities Quick Ratio Current Assets Inventory/Current Liabilities (Cash + Marketable Securities + A/R)/Current Liabilities
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Activity Ratios
Inventory turnover CGS/Average Inventory Days Inventory in Stock = 365/Inventory Turnover Receivables Turnover = Sales/AR Days Receivables Outstanding = 365/Receivables Turnover
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Depreciation Rate
In simple models, forecasts of depreciation expense can be made by applying the depreciation rate to gross plant property and equipment. Depreciation Rate Formula: Depreciation Rate = Depreciation Expense/Gross Plant Depreciation Expense divided by average gross plant balance One divided by depreciation rate gives you the average life of plant
Accumulated Depreciation/Plant Balance Indication of average age of the plant Higher depreciation is older average age of the plant
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Financial Ratio Formulas for Model Assessment
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EBITDA Margin
As explained above, the EBITDA margin can be a good ratio to determine if assumptions are reasonable: Relationship between revenues and operating expenses Compare forecast to history and evaluate why changes are occurring
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Average Interest Rate

The average interest rate is the interest expense divided by the average debt balance. This can be used to assess whether the project interest rate is reasonable particularly for long-term debt. Average interest rate is the interest expense divided by the average debt balance The average interest rate can be compared to prevailing interest rates
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Capital Intensity
Capital intensity is often discussed in finance. The capital intensity does not affect value or credit, but it is helpful in background on the business. Formula: Capital Intensity = Capitalization/Revenues Driven by Life of Asset Capital Cost Relative to Operating Cost Required Return on Assets
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Financial Ratio Output in Corporate Models
Use financial ratios to test the validity of models (can the industry really sustain high profits) Use financial ratios to develop valuation from earnings multiples (P/E and EBIDA/Enterprise Value) Use financial ratios in residual value calculations
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Examples of Financial Ratio Analysis in Corporate Model
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Oct 24, 2008
Examples of Financial Ratio Analysis in Corporate Model
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Oct 24, 2008
Financial Ratios and Ability to Earn Economic Profit
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The Economics of Value Creation and Strategic Planning

In this section we review how value is created by business activity including how valuation relates to economic profit. The section covers the basic economic drivers of value in different circumstances and the actual value creation activities of various firms.
1. Microeconomics and the creation of value 2. Models of strategic choice and value 3. Assumption of efficient financial markets 4. Value Drivers, strategy and financial management
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Why Does Economic Profit Depend on Barriers to Entry
Recall your basic economics course: Economic profit is the net revenues earned by a company less all costs including opportunity cost (opportunity cost includes the risk adjusted cost of capital). If companies are earning economic profit, more firms will enter the industry. If companies are not making economic profit, firms will exit the industry. Therefore, to sustain economic profit (a sustainable competitive advantage), firms must be able to keep up barriers to entry.
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This Graph Implies that Value is Created as Follows:
Economic Profit = Price x Quantity less Direct Costs less Opportunity Cost
If price is above long-run marginal cost because of barriers to entry, economic profit can exist If prices can be bundled for products, it may be possible to extend market power in one business to another business and realize economic profit If a firm in a commodity industry makes investments when the commodity prices are high and hits the cycle, economic profit can exist If direct cost for a company is less than the direct cost for other firms in the industry because of efficient operations, economic profit can exist
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Examples of Economic Profit that Could not be Sustained
Internet Companies The internet bubble occurred because companies had business models that suggested high growth. But in order to really make profit, there had to be barriers to entry. In the industry, the business models were easy to copy and economic profit was very hard to realize.
Enron Enrons business plan was to make money from being a player in commodity markets where there is a zero sum game. It is difficult to realize long term significant economic profit by making trades where there is an equal number of winners and losers.
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Examples of Economic Profit that Could not be Sustained
Investments in Electricity Generation After price spikes in electricity, many firms such as Calpine and Natural Gas companies made significant investments in electricity generation. The investments caused prices to decline and only early entrants made money.
AT&T and NCR The merger between AT&T and NCR did not contemplate achieving cost savings from the merger. Without cost savings or revenue enhancements, the merger could not add value and it turned out to be a disaster.
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Examples of Sustainable Economic Profit from Product Differentiation and Barriers to Entry
Microsoft It can be argued that Microsoft makes its money not from extremely creative and innovative products, but from the ability to keep away competitors through standardization of platforms that are required with the internet.
General Electric General electric operates in highly technical areas where it is difficult to enter the market. If you are building a turbine, maintaining a turbine or requiring a jet engine, other firms cannot simply enter the market.
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Example of Economic Profit from an Efficient Cost Structure
Southwest Airlines versus United Airlines Southwest Airlines has the same type of planes, motivates its employees, has extremely short layovers, low prices and high load factors. United Airlines has union problems, higher prices and lower load factors.
Freeport McMoran Freeport developed a copper mine in a remote part of Indonesia where the ore grade was high and the copper could be mined from the surface.
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Barriers to Entry
In thinking about barriers to entry, the types of business activities that lead to barriers can be complex:
In classic economic theory, capital intensive industries such as steel firms and automobile firms were thought to have market power from barriers to entry. However, excess capacity can exist in the capital intensive businesses and size alone has not turned out to be an effective barrier.
More interesting barriers to entry are from a strong name in the advertising and financial services business, a highly skilled work force in financial services and software, standardization of computer platforms and even barrier to entry from high stock prices.
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Financial Statements and Reflection of Business Activities
Investing
Current:
q
q q q
Planning Operating
Sales q Cost of Goods Sold q Selling Expense q Administrative Expense q Interest Expense q Income Tax Expense
q q
q q q
Financing
Current:
Notes Payable Accounts Payable Salaries Payable Income Tax Payable Bonds Payable Common Stock Retained Earnings
Cash Accounts Receivable Inventories Marketable Securities Land, Buildings, & Equipment Patents Investments
Noncurrent:
q
Noncurrent:
q
q q
q q
Net Income Income statement
Liabilities & Equity Balance Sheet Statement of Shareholders Equity

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Assets Balance Sheet
Cash Flow Statement of Cash Flows
Traditional Financial Ratio Analysis Comparative Trend Analysis

Purpose of trend analysis: Evaluation of consecutive financial statements Output of trend analysis: Determine the direction, speed, and extent of any trends to evaluate whether the trends will continue Types of trend analysis: Year-to-year Change Analysis (Ln(revenue(t)/revenue(t-1)) (revenue(t)/revenue(t-1)-1) Index-Number Trend Analysis Prior x (1+growth)
Accounting Analysis in Financial Statements
Process to evaluate and adjust financial statements to better reflect economic reality
Comparability problems across firms and across time Manager estimation error Distortion problems Earnings management Distortion of business
Accounting Risk
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Ratio Analysis
Analysis Issues Absolute Levels Trends Industry Benchmarks Industry Specific Ratios\ Common size analysis Income statement and balance sheet for companies in an industry Express income statement items as percent of revenues Express balance sheet items as percent of total assets
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Example of P/E and PEG
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Oct 24, 2008

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Financial Statement Analysis for Modeling

Integrated Financial Management

Oct 24, 2008

Financial Statement Analysis Contents

Reference Financial Ratio Calculations Discussion of Economic Profit

Integrated Financial Management

Oct 24, 2008

Financial Statement Analysis - Introduction

Integrated Financial Management

Oct 24, 2008

Objectives of Financial Statement Analysis

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Oct 24, 2008

Financial Statement Analysis and Financial Projections

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Double Counting and Judgments in Financial Ratio Analysis

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Oct 24, 2008

Integrated Financial Management

Oct 24, 2008

Integrated Financial Management

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Problems with EBITDA

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Oct 24, 2008

Simplified Income Statement

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Oct 24, 2008

Income Statement Analysis

EBITDA Computation Top Down move other income Bottom-up (Indirect)

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Oct 24, 2008

Employee Stock Options

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Oct 24, 2008

Cash Flow Statement

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Oct 24, 2008

Cash Flow Statement

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Oct 24, 2008

Cash Flow Statement

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Cash Flow Statement Example

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Oct 24, 2008

The Notion of Free Cash Flow

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Oct 24, 2008

Importance of Free Cash Flow

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Integrated Financial Management

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Cash Flow Statement in Financial Model

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Oct 24, 2008

Free Cash Flow Formulas

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Oct 24, 2008