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 Reorganise the financial statements to reflect economic, instead of accounting, performance.  Measure and analyse the company’s return on invested.

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Presentation on theme: " Reorganise the financial statements to reflect economic, instead of accounting, performance.  Measure and analyse the company’s return on invested."— Presentation transcript:


2  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


4  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  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 +NOA = Total Funds Invested = (D+DE) + (E + EE)  Invested capital = OA – OL



9  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  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.



13  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  FCF = NOPLAT + Non-Cash Expenses – Investments in Invested Capital  Cash flow from non-operating assets should be evaluated separately from core operations




18  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  The book value of net property, plant and equipment is always included in the operating assets.

20  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  Operating lease  Expensed investments: advertising, and research and development

22  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  Unfunded retirement liabilities  Operating lease  Reserves for plan decommissioning  Reserve for restructuring

24  Deferred tax liability ◦ To be consistent use cash taxes to compute NOPLAT


26  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


28  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  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  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 = 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


33  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 = 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  ROIC =  (1 – Cash tax rate) × (EBITA/Revenues) × (Revenues/ Average invested capital)

36  Components of ROIC

37  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  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  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)


41  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  IBM: Revenue Growth analysis (Per cent) [Ref: Valuation Mc Kinsey Exhibit 7.16]

43  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  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  Revenue Growth Analysis: Retail Chain (Per cent) (Ref: Valuation, McKinsey, Exhibit 7.19

46  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


48  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  ROE = ROIC + [ROIC – (1 – T) k d ] × (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.


51  Look back as far as possible (at least 10 years) ◦ This allows to determine whether the company and industry tend to revert to some normal level of performance, and whether short-term trends are likely to be permanent.  Disaggregate value drivers, both ROIC and revenue growth ◦ If possible, link operational performance measures with each key value driver.  If there is any radical change in performance, identify the source. ◦ Determine whether the change is temporary or permanent, or merely an accounting effect.


53  Value the operating leases: Capitalise the asset value on the balance sheet, and the implied debt as liability ◦ Rental Expense t = Asset Value t - 1 × [k d + (1/Asset Life)] ◦ Asset Value t – 1 = [Rental Expense t ] ÷ [k d + (1/Asset Life)]  Break down the rental expenses into two components: interest expense and depreciation ◦ Implied interest payment should be added back to EBITA and taxes should be adjusted to remove the interest tax shield

54  Capitalising R&D expense: ◦ Choose an amortisation period, for example 10 years; use product and industry characteristics to guide your choice  Unlike ROIC, FCF does not change when expenses are capitalised

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