1. Dynamically Assessing Corporate Performance 2016 ACC Annual Meeting Eddie Riedl October 19, 2016 1

2. What’s the first question to assess performance? 2 What is net income? So what is it? What are the key assets? Values for the key ratios? No. NO. NOOO!!!! My first question is: what is the firm’s strategy? This session: a framework to assess firm performance (and the key role accounting plays)

3. Assessing Corporate Performance: A Framework ACCOUNTING ANALYSIS FINANCIAL ANALYSIS PROSPECTIVE ANALYSIS STRATEGY ANALYSIS 3

4. Assessing Corporate Performance: Strategy Analysis ACCOUNTING ANALYSIS FINANCIAL ANALYSIS PROSPECTIVE ANALYSIS STRATEGY ANALYSIS (1) First, you must understand the firm’s strategy Identify key success factors (e.g., barriers to entry, brand, patent) and key risk factors (e.g., competition, innovation, regulation) This includes assessing macro/industry/firm level drivers: Macro: interest rates, commodity prices Industry: level of competition, rate of consolidation Firm: senior management, customer base, products 4

5. Assessing Corporate Performance: Accounting Analysis ACCOUNTING ANALYSIS FINANCIAL ANALYSIS PROSPECTIVE ANALYSIS STRATEGY ANALYSIS (2) Link strategy to financial statements (F/S) Identify where F/S reflect these success/risk factors (usually within a handful of balance sheet / income statement accounts) If F/S do not reflect these factors, we can adjust the F/S to better reflect the underlying economics Some common adjustments include: (1) revenue recognition (2) overstatement of assets (3) leases / off-balance sheet financing 5

6. 6 Accounting = Economic Truth + Measurement Error + Bias Accounting Analysis: How to Think About Accounting #’s Economic Truth is the center – the economic event we wish to capture Measurement Error is that some economic events are hard to measure – but it is not systematic ME Bias is systematically too low or too high – usually driven by incentive(s) – useful to know likely incentives (bonus payout; maintain stock price) Bias

7. 7 Accounting = Economic Truth + Measurement Error + Bias Accounting Analysis: How to Think About Accounting #’s Example: measurement error low – cash balance Cash – ME Low Example: measurement error high – expected litigation damage – restructuring charges – pension liabilities Litigation – ME High

8. 8 Accounting = Economic Truth + Measurement Error + Bias Accounting Analysis: How to Think About Accounting #’s Example: biasing too high – what: reporting high net income – why: to obtain higher bonus payout Net Income – Bias High Example: biasing too low – what: reporting low net income – why: avoid regulatory scrutiny (pharma, oil and gas) Net Income – Bias Low

9. ACCOUNTING ANALYSIS FINANCIAL ANALYSIS PROSPECTIVE ANALYSIS STRATEGY ANALYSIS (3) Assess past/current performance to see if firm is achieving strategy Strategy analysis guides which ratios to use (usually only need handful) Accounting analysis (including any adjustments) ensures knowing (a) appropriate inputs into chosen ratios (b) quality of inputs into chosen ratios Assessing Corporate Performance: Financial Analysis 9

10. ACCOUNTING ANALYSIS FINANCIAL ANALYSIS PROSPECTIVE ANALYSIS UNDERSTAND THE FIRM’S STRATEGY (4) Making decisions using insights obtained from assessing the firm’s strategy, financial statements, and past/recent performance. 10 Decisions internal to the firm: (a)assess segment performance (b)resource allocations (c)forecasting sales/performance Decisions external to the firm: (a)valuing a firm (acquisitions) (b)assess competitor performance (c)identify market sizes Assessing Corporate Performance: Prospective Analysis

11. Let’s apply the framework to two well-known firms 11 Major competitors. Same industry. Both S&P 500 firms. (Using 2011) both are very, very profitable. But let’s take a closer look... Net Income = $8.5 Billion Net Income = $15.9 Billion

12. Step (1) – Strategy Analysis ACCOUNTING ANALYSIS FINANCIAL ANALYSIS PROSPECTIVE ANALYSIS STRATEGY ANALYSIS 12

13. Operating Strategy -Acquisition-driven -High-end products Financing Strategy -Need funding for acquisitions -Moderate leverage Operating Strategy -Some acquisitions -High-end products Financing Strategy -Provide customer financing -High leverage -Share buyback plan Step (1) – Strategy Analysis 13 How do we figure out a firm’s strategy? Corporate disclosures (annual report, MD&A) Senior mgt (communications – conf calls, past behavior) Larry Ellison (CEO): serial acquirer Sam Palmisano (CEO): double EPS (“Roadmap 2015”)

14. Step (2) – Accounting Analysis ACCOUNTING ANALYSIS FINANCIAL ANALYSIS PROSPECTIVE ANALYSIS STRATEGY ANALYSIS 14

15. Operating Strategy -Acquisition-driven -High-end products Financing Strategy -Need funding for acquisitions -Moderate leverage Operating Strategy -Some acquisitions -High-end products Financing Strategy -Provide customer financing -High leverage -Share buyback plan Step (2) – Accounting Analysis 15 Intangible Assets What key accounts reflect these operating and financing strategies? (Financial statements should reflect firm’s major strategies!) Intangible Assets R&D, profit margins Liquid Assets Liabilities Receivables Liabilities Treasury stock

16. 16 $28,848 Intangible assets $29,413 Limited Liabilities $33,290 Acquisition-Driven Limited Leverage Liquid Assets

17. 17 R&D $4,519 Net Income $8,547 Higher end products Revenue $35,622

18. 18 Some intangibles $29,405 Customer Financing $29,104 Liabilities $96,197 Higher Leverage Share Buybacks Treasury Stock $110,963

19. 19 Revenue $106,916 R&D $6,258 Net Income $15,855

20. ACCOUNTING ANALYSIS FINANCIAL ANALYSIS PROSPECTIVE ANALYSIS STRATEGY ANALYSIS Step (3) – Financial Analysis 20

21. Step (3) – Financial Analysis 21 ROE (Return on Equity) NI Equity 8,547 40,245 = 21% 15,855 20,236 = 78% Profit Margin NI Revenue = x Asset Utilization Revenue Total Assets Equity x Leverage “Dupont Decomposition” Profitability How strong are profit margins Efficiency How well using assets Leverage How much debt in capital structure Higher = more profit per $1 revenue Higher = more efficient: revenue per $1 assets Higher = more levered: ↑ ROE, but also ↑ fin’l risk What is the relative performance of Oracle versus IBM?

22. Step (3) – Financial Analysis 22 ROE (Return on Equity) NI Equity 8,547 40,245 = 21% 15,855 20,236 = 78% Profit Margin NI Revenue = x Asset Utilization Revenue Total Assets Equity x Leverage 8,547 35,622 = 24% 15,855 106,916 = 15% 35,622 73,535 = 48% 106,916 116,433 = 92% 73,535 40,245 = 183% 116,433 20,236 = 575% Oracle is higher margin IBM is more efficient... IBM is much more leveraged but Oracle has high intang assets

23. Assessing Corporate Performance: A Framework ACCOUNTING ANALYSIS FINANCIAL ANALYSIS PROSPECTIVE ANALYSIS STRATEGY ANALYSIS 23 Assessing performance requires a strong framework. The “dynamic” is that (i) each analysis feeds into the other (ii) accounting analysis #’s can be adjusted (iii) financial ratios can be “drilled down”

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25. 25 Thank You!