Equity Valuation and Analysis with eVal Chapter 5 Financial Analysis

Framework for Business Analysis and Valuation

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

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

The Margin versus Turnover Trade-Off

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