Equity Valuation and Analysis with eVal

Chapter 5

Financial Analysis

Framework for Business Analysis and Valuation

STEP 1 Understanding the Past

1. Information Collection

2. Understanding the

Business

3. Accounting Analysis

4. Financial Ratio Analysis

5. Cash Flow Analysis

STEP 2 Forecasting the Future

1. Structured

Forecasting 2. Income Statement

Forecasts

3. Balance Sheet Forecasts

4. Cash Flow Forecasts

STEP 3 Valuation

1. Cost of Capital 2. Valuation Models

Residual Income-Based Valuation

Cash Flow-Based Valuation

3. Valuation Ratios

4. Complications

Negative Values Value Creation and

Destruction though Financing Transactions

The Discounted Residual Income Valuation Model

We can rewrite the dividend discounting formula as:

Value0 = Equity0 + RI1/(1+r) + RI2/(1+r)2 …

where Equity = book value of equity; and

RI = residual income

r = discount rate RI = Income - (r x Equity) RI = ((Income/Equity) - r) x Equity RI = (ROE- r) x Equity

Normal earnings

Return on Equity

The Key Drivers of Value

ROE Create value by generating long-run ROE that exceeds r Business strategy and competitive environment Accounting distortions affect short-run ROE

Growth in Equity Magnifies value created by ROE If ROE>r, then growth creates value If ROE<r, then growth destroys value

Financial Analysis

Evaluate the financial performance of a firm, identifying the underlying drivers of any unusual performance

Key performance metric is ROE (return on equity)

Financial Analysis Tools

Financial Ratio Analysis Techniques Caveats Dupont Framework

Cash Flow Analysis

Techniques of Ratio Analysis

Time-Series Analysis: Comparing a firm’s ratios across time

– Facilitates the identification of changes in performance and the detection of the underlying causes

Cross-Sectional Analysis (comps): Comparing a firm’s ratios with the ratios of comparable firms

– Facilitates the identification of differences in performance and the detection of the underlying causes

Three Caveats of Ratio Analysis

There is no generally accepted set of rules for computing ratios

Ratios do not provide answers, they just help direct you in your search for answers

Managers know investors fixate on certain ratios, and many window-dress accordingly

Basic Dupont Framework

Return on Equity (Income/Equity) Net Profit Margin x Asset Turnover x Total Leverage (Income/Sales) x (Sales/Assets) x (Assets/Equity) detailed detailed detailed solvency margin analysis turnover analysis and liquidity anlysis

Advanced Dupont Framework: Terminology

Goal is to distinguish between operating performance and the impact of financial leverage

Define: tax=effective tax rate=(income tax expense)/(earnings before taxes) net financing expense (NFE) = interest expense×(1-tax) + preferred dividends +

minority interest in earnings net operating income (NOI) = net income + net financing expense

net financial obligations (NFO) = debt + minority interest + preferred stock net operating assets (NOA) = common equity + NFO = invested capital = total

assets – (total liabilities + debt) = total assets – operating liabilities

return on net operating assets (RNOA) = NOI/NOA net borrowing cost (NBC) = NFE/NFO leverage = NFO/common equity

Advanced Dupont Formula

ROE = RNOA + leverage×(RNOA-NBC)

If we assume all financing is either debt or common equity, then

leverage = debt / common equity

NBC = (interest expense / debt)×(1 – tax) = interest rate×(1-tax) = i×(1-tax)

ROE = RNOA + (debt/equity)×(RNOA - i×(1-tax))

Spread

Spread

Advanced Dupont Framework Return on Equity (Income/Equity) RNOA + ( Spread × Financial Leverage ) (NOI/NOA) (RNOA – i×(1-tax)) (Debt/Equity) __________________ Operating Profitability × Turnover (NOI/Sales) (Sales/NOA) detailed detailed detailed solvency margin analysis turnover analysis and liquidity analysis

The Margin versus Turnover Trade-Off

0%

5%

10%

15%

20%

25%

30%

35%

0 1 2 3 4 5 6 7 8 9 10 11

Turnover

Pro

fit

Mar

gin

ROE=10%

ROE=20%

Strategic Choices Influencing the Margin vs. Turnover Trade-Off

Lower turnover ( and higher margins) result from:– following a product differentiation versus a cost

leadership strategy– following a vertical integration versus an outsourcing

strategy– providing customer financing or holding inventory for

customers

Detailed Margin Analysis

The general approach to detailed margin analysis is to express each of the operating expenses in the income statement as a proportion of sales (i.e., common size income statement).

Time-series margin analysis using common size income statements is a required component of the MD&A

Commonly encountered margins are the gross margin, and the EBIT margin

Detailed Turnover Analysis

The general approach to detailed turnover analysis is to see how frequently each operating asset and liability is ‘turned’ by dividing an appropriate measure of operating activity by the operating asset/liability.

The measure of operating activity used is usually sales, but CoGS is used for inventory and purchases is used for payables

An alternative approach is to compute the average ‘days outstanding’. This is derived by taking the reciprocal of the ‘turns’ and multiplying by the number of days in the period.

Recap

Dupont framework for ratio analysis facilitates the systematic evaluation of ROE

Ratio analysis does not provide answers, it just helps guide you in your search for answers

Ratios should be interpreted in the context of the firm’s business environment

Use of canned ratio analysis software simplifies ratio analysis BUT you must know how ratios have been computed and what the underlying amounts represent

Financial Analysis with eVal

Open eval software (available on bSpace) Load company data (S&P 500 data and instructions

available on bSpace) Click ‘View Ratio Analysis’ button

– time-series analysis Load competitors’ data

– cross-sectional analysis You can use eVal for the ‘Interpreting Margins and

Turnover Ratios’ case. But feel free to use other tools (e.g., Facstet, Bloomberg)

Application to Overstock.com, Questions 7-9