1. Equity Valuation and Analysis with eVal
Chapter 5
Financial Analysis

2. Framework for Business Analysis and Valuation

3. 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

4. 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

5. 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)

6. Financial Analysis Tools
Financial Ratio Analysis
Techniques
Caveats
Dupont Framework
Cash Flow Analysis

7. 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

8. 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

9. Basic Dupont Framework

10. 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

11. 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

12. Advanced Dupont Framework

13. The Margin versus Turnover Trade-Off

14. 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

15. 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

16. 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.

17. 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

18. 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