Analyzing Historical Performance. 1 The Importance of Historical Analysis Understanding a...

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Analyzing Historical Performance

Transcript of Analyzing Historical Performance. 1 The Importance of Historical Analysis Understanding a...

Page 1: Analyzing Historical Performance. 1 The Importance of Historical Analysis Understanding a company’s past is essential for forecasting its future. Using.

Analyzing Historical Performance

Page 2: Analyzing Historical Performance. 1 The Importance of Historical Analysis Understanding a company’s past is essential for forecasting its future. Using.

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The Importance of Historical Analysis

• Understanding a company’s past is essential for forecasting its future. Using historical

analysis, we can test a company’s ability to

• create value over time by analyzing trends in operating and financial metrics

• compete effectively within the company’s industry

• In this presentation, we will examine how to effectively evaluate a company’s previous

performance, competitive position, and ability to generate cash in the future by:

• rearranging the accounting statements,

• digging for new information in the footnotes,

• making informed assumptions where needed

• A good historical analysis will focus on the drivers of value: return on invested capital

(ROIC) and growth. ROIC and growth drive free cash flow, which is the basis for

enterprise value.

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Evaluating Historical Performance

To analyze a company’s historical performance, we proceed in four steps:

Reorganize the company’s financial statementsFirst convert the company’s financial statements to reflect economic, rather than

accounting performance, creating such new terms as net operating profit less

adjusted taxes (NOPLAT), invested capital, and free cash flow.

Analyze ROIC & Economic ProfitReturn on invested capital (ROIC) measures the economic performance of a

company’s core business. ROIC is independent of financial structure and can be

disaggregated into measures examining profitability and capital efficiency.

Analyze Revenue GrowthBreak down revenue growth into its four components: organic revenue growth,

currency effects, acquisitions, and accounting changes.

Evaluate credit health and financial structureAssess the company’s liquidity and evaluate its capital structure in order to

determine whether the company has the financial resources to conduct business

and make short and long-term investments.

Step 1:

Step 2:

Step 3:

Step 4:

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• Traditional measures of performance, such as ROE and ROA, include non-operating

items and financial structure that impair their usefulness.

• ROE mixes operating performance with capital structure, making peer group

analysis and trend analysis less meaningful. ROE rises with leverage if ROIC is

greater than the after-tax cost of debt.

• ROA measures the numerator and denominator inconsistently (even when profit

is computed on a pre-interest basis).

• To ground our historical analysis, we need to separate operating performance

from non-operating items and the financing to support the business.

The Problems with Traditional Financial Analysis

Why do we need to reorganize the company’s financial statements?

Equity

Debt)kROIC( ROIC

Equity

ReturnD

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Modern Financial Analysis

• To prevent non-operating items and capital structure from distorting the company’s

operating performance, we must reorganize the financial statements. We will create

two new terms:

• NOPLAT. The income statement will be reorganized to create net operating profit less

adjusted taxes (NOPLAT). NOPLAT represents the after-tax operating profit available to

all financial investors.

• Invested Capital. The balance sheet will be reorganized to create invested capital.

Invested capital equals the total capital required to fund operations, regardless of type

(debt or equity).

• By reorganizing the income statement and balance sheet, we can develop

performance metrics that are focused on core operations:

CapitalInvested

NOPLATROIC

FCF = NOPLAT – Net Increase in Invested capital

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Reorganizing the Balance Sheet: An Example

Operating liabilitiesare netted againstoperating assets

Non-operating assetsare not included ininvested capital.

Accountant’s Balance Sheet Economic Balance Sheet

Assets Prior year

Currentyear

Prioryear

Currentyear

Liabilities and equity

Total funds invested

Inventory

Net PP&E

Equity investments

Total assets

200

300

15

515

225

350

25

600

Inventory

Accounts payable

Operating working capital

200

(125)75

225

(150)

75

Invested capital 375

Net PP&E 300

350425

Equity investments

Total funds invested

15

390

25

450

20050

200450

22550

115390

Interest-bearing debt

Common stock

Retained earnings

Total funds invested

Accounts payable

Interest-bearing debt

Common stock

Retained earnings

Total liabilities and equity

125

225

50

115

515

150

200

50

200

600 Note the redundancy of

total funds invested

• Let’s rearrange the accountant’s balance sheet into invested capital and total funds

invested for a simple hypothetical company (i.e. a company with only few line items).

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• Net Operating Profit Less Adjusted Taxes (NOPLAT) is after-tax

operating profit available to all investors

• NOPLAT equals revenues minus operating costs, less any taxes that

would have been paid if the firm held only core assets and were financed

only with equity.

• Unlike net income, NOPLAT includes profits available to both debt

holders and equity holders

• In order to calculate ROIC and free cash flow properly, NOPLAT should

be defined consistently with invested capital.

• For instance, if a non-operating asset is excluded from invested capital,

any income from that assets should be excluded from NOPLAT.

Reorganizing the Income Statement: NOPLAT

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Reorganizing the Income Statement: NOPLAT

NOPLAT

Taxes are calculated on

operating profits

Revenues 1,000

Operating costs

Depreciation

Operating profit

(700)

(20)

280

Revenues 1,000Operating costs

Depreciation

Operating profit

(700)

(20)

280

Interest

Nonoperating income

Earnings before taxes (EBT)

(20)

4

264

Taxes*

Net income

(66)

198

* Assumes a flat tax of 25% on all income

Operating taxes

NOPLAT

(70)

210

A/T nonoperating income*

Total income to all investors

3

213

Reconciliation with net income

Net income

After-tax interest*

Total income to all investors

198

15

213

Do not include income from any

asset excluded from invested capital as

part of NOPLAT

Treat interest as afinancial payout toinvestors, not an

expense

3

213

Accountant’s income statement

• NOPLAT includes only operating-based income. Unlike net income, interest expense and non-operating income is excluded from NOPLAT.

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Calculating NOPLAT – Top-Down Approach

• To build NOPLAT, start with revenues and subtract traditional operating expenses,

such as COGS, SG&A, and depreciation.

NOPLAT

Revenues 1,000Operating costs

Depreciation

Operating profit

(700)

(20)

280

Do not subtract goodwill

amortization

• From this number, subtract operating taxes. Operating taxes are the cash taxes that

would have been paid, if the company held only core assets finance entirely with

equity.

Operating taxes

NOPLAT

(70)

210

• To compute operating taxes, proceed in two steps:

1. Compute operating taxes by adjusting reported taxes for non-operating items

2. Adjust reported taxes by the increase in net deferred tax liabilities.

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Calculating NOPLAT – Advanced Issues

Capitalizing R&D

• If a company has significant long-term R&D, do not subtract the annual R&D

expense. Instead, capitalize R&D on the balance sheet and subtract an annualized

amortization of this capitalized R&D.

Capitalizing Operating Leases

• If a company has significant operating leases, capitalized the operating lease on

the balance sheet and add back lease-based interest to operating profit. Convert

the remaining rental expense to depreciation.

Excluding Recognized Pension Gains & Losses.

• Pension gains & losses booked on the income statement are usually hidden within

cost of goods sold. Remove any recognized gains or losses from NOPLAT.

Unrecognized gains do not flow through the income statement, so no change is

required for unrecognized gains.

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Evaluating Historical Performance

To analyze a company’s historical performance, we proceed in four steps:

Reorganize the company’s financial statementsFirst convert the company’s financial statements to reflect economic, rather than

accounting performance, creating such new terms as net operating profit less

adjusted taxes (NOPLAT), invested capital, and free cash flow.

Analyze ROIC & Economic ProfitReturn on invested capital (ROIC) measures the economic performance of a

company’s core business. ROIC is independent of financial structure and can be

disaggregated into measures examining profitability and capital efficiency.

Analyze Revenue GrowthBreak down revenue growth into its four components: organic revenue growth,

currency effects, acquisitions, and accounting changes.

Evaluate credit health and financial structureAssess the company’s liquidity and evaluate its capital structure in order to

determine whether the company has the financial resources to conduct business

and make short and long-term investments.

Step 1:

Step 2:

Step 3:

Step 4:

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Using ROIC to Compare Operating Performance

• Having reorganized the financial

statements, we now have a clean

measure of total invested capital

and its related after-tax operating

income.

• To measure historical operating

performance, compute return on

investment by comparing NOPLAT

to invested capital:

NOPLATInvested Capital

ROIC =

18.2

14.316.0

13.912.8

10.3

2001 2002 2003

Home Depot (%) Lowe's %)

ROIC: Home Depot vs. Lowes

Home Depot’s outperforms Lowes when measured by ROIC.

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Measuring Value Creation: Economic Profit

• Home Depot ROIC improved between 2001 and 2003, but is the company using its

investors funds more effectively than could be expected in the capital markets?

• To answer this question, we examine economic profit, defined as follows:

20022001 2003Return on invested capital (ROIC)

Weighted average cost of capital (WACC)

15.0%

10.1%

16.8%

9.0%

19.4%

9.3%

Economic spread

x Invested capital

Economic profit

4.9%

21,379

1,048

7.9%

23,635

1,857

10.1%

26,185

2,645

Economic Profit = Invested Capital x (ROIC-WACC)

Home Depot earned $2.6 billion more

than “expected” based on the

company’s risk profile

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Understanding Value Creation: Decomposing ROIC

• Compared to both its weighted average cost of capital, and that of its rival Lowes,

Home Depot has been earning a superior return on invested capital.

• But what is driving this superior performance?

• Can these advantages be sustained?

• To better understand ROIC, we can decompose the ratio as follows:

EBITA Revenues

Revenues Invested CapitalROIC x x(1 - Cash Tax Rate)=

• As the formula demonstrates, a company’s ROIC is driven by its ability to (1)

maximize profitability, (2) optimize capital efficiency, or (3) minimize taxes

Profit Margin Capital Efficiency

This equation can be organized into a tree…

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Understanding Value Creation: Decomposing ROIC

Home Depot benefits from a more efficient use of capital

and a better cash tax rate.

ROIC

18.2

13.9

Pre-tax ROIC

25.5

20.5

Cash tax rate

28.6

32.5

Averagecapital turns

2.3

1.9

Operating margin

11.0

10.7

Grossmargin

31.8

31.2

SG&A/revenues*

19.1

18.0

Depreciation/revenues

1.7

2.5

Operating working capital/revenues

4.2

4.6

Fixed assets/revenues

38.9

47.4

Home Depot

Lowe’s

This capital efficiency comes

primarily from fixed assets, which in

turn come from more revenues per

dollar of store investment…

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Evaluating Historical Performance

To analyze a company’s historical performance, we proceed in four steps:

Reorganize the company’s financial statementsFirst convert the company’s financial statements to reflect economic, rather than

accounting performance, creating such new terms as net operating profit less

adjusted taxes (NOPLAT), invested capital, and free cash flow.

Analyze ROIC & Economic ProfitReturn on invested capital (ROIC) measures the economic performance of a

company’s core business. ROIC is independent of financial structure and can be

disaggregated into measures examining profitability and capital efficiency.

Analyze Revenue GrowthBreak down revenue growth into its four components: organic revenue growth,

currency effects, acquisitions, and accounting changes.

Evaluate credit health and financial structureAssess the company’s liquidity and evaluate its capital structure in order to

determine whether the company has the financial resources to conduct business

and make short and long-term investments.

Step 1:

Step 2:

Step 3:

Step 4:

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Analyzing Revenue Growth

• The value of a company is driven by return on invested capital, the weighted average

cost of capital, and growth. And the ability to grow cashflows over the long-term

depends on a company’s ability to organically grow its revenues.

• Calculating revenue growth directly from the income statement will suffice for most

companies. The year-to-year revenue growth numbers sometimes can be misleading,

however. The three prime culprits affecting revenue growth are:

1. Currency Changes. Foreign revenues must be consolidated into domestic

financial statements. If foreign currencies are rising in value relative to the

company’s home currency, this translation, at better rates, will lead to higher

revenue.

2. Mergers and Acquisitions. When one company purchases another, the

bidding company may not restate historical financial statements. This will bias

one-year growth rates upwards

3. Changes in accounting policies. When a company changes its revenue

recognition policies, comparing year-to-year revenue can be misleading.

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Organic Growth vs. Reported Growth

• To demonstrate how misleading year-to-year revenue growth figures can be, consider

the following example from IBM.

• When IBM reported its first rise in reported revenues in three years in 2003, it became

the subject of a Fortune magazine cover story. “Things appear to be straightening out

dramatically,” reported Fortune. “Last year Palmisano's company grew for the first

time since 2000, posting a 10% revenue jump.”

• But where is this revenue growth coming from?

2001

2002

2003Organic revenue growth

Acquisitions

Divestitures

Currency effects

Reported revenue growth

0.5%

0.5

0.0

(2.9)%

(1.8)%

2.1

(3.3)

(2.5)

(5.5)%

(2.6)%

5.4

0.0

(3.9)

7.0

9.8%

IBM Revenue Growth

IBM purchased two companies:

Rational Software and PwCC

Nearly 7% of IBM growth caused by

the weakening dollar.

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Analyzing Revenue Growth: Currency Changes

• Companies with extensive foreign business will report revenues using both current, as

well as constant exchange rates (CER).

• For instance, IBM reports a “year-to-year revenue change” of 9.8%, but a “year-to-

year change constant currency” of only 2.8%.

Had currencies remained at their prior year levels, IBM revenue

would have been $83.5 billion, rather than the $89.1 billion reported.

IBM Annual Report, Page 51

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Analyzing Revenue Growth: M&A

• Growth through acquisition may have very different ROIC characteristics than growth

through internal investments (this due to the sizable premiums a company must pay

to acquire another company).

• The bidder will often only include partial-year revenues from the target after the

acquisition is completed. To remain consistent, reconstructed prior years must only

include partial year revenue as well:

Estimated 2002 revenue

Partial year adjustment

Transaction date

Revenue adjustments

IBM reported 2002 revenue

Ten months of Rational Software

Nine months of PwCC revenue

IBM adjusted 2002 revenue

2/21/200310/1/2002

689.8

5,200.0

10/129/12

81,186.0

574.8

3,900.0

85,660.8

Rational was a publicly

traded company, so

revenues are exact. PwCC

was private and estimated

using Hoover’s data.

Three months of PwCC data was

included in IBM’s 2002 financials.

Therefore, we must add the

remaining nine months, to make

2002 & 2003 consistent.

Compute growth by

comparing 2003 to

this number

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Analyzing Revenue Growth: Accounting Changes

• Each year the Financial Accounting Standards Board (U.S.) and International

Accounting Standards Board (Europe) make recommendations concerning the

financial treatment of certain business transactions.

• Consider EITF 01-14 from the Financial Accounting Standards Board, which concerns

reimbursable expenses.

– Prior to 2002, U.S. companies accounted for reimbursable expenses by ignoring

the expense entirely. Starting in 2003, U.S. companies can recognize the

reimbursement as revenue and the outlay as an expense.

– This “new” revenue will artificially increase year-to-year comparisons.

Reimbursable Expenses

As a result of the Financial Accounting Standards Board’s (FASB’s) Emerging Issues Task Force 01-14 (EITF 01-14),

formerly known as Staff Announcement Topic D-103, “Income Statement Characterization of Reimbursements

Received for ‘Out-of-Pocket’ Expenses Incurred,” the Company has included reimbursements received for outof-

pocket expenses as revenue. Historically, TSYS had not reflected such reimbursements in its consolidated statements

of income.

Total System Services, Annual Report, page F-7

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Understanding Value Creation: Decomposing Growth

• Once revenues have been disaggregated, analyze revenue

growth from an operational perspective. The most standard

decomposition is:

Revenue

11.3%

16.4%

Revenueper store

(0.1)

4.4

Number of stores

11.4

11.5

Dollars pertransaction

3.7

4.2

Number oftransactions per store

(3.7)

0.2

Number of transactions persquare foot

(7.6)%

(2.5)%

Square feet per store

4.2%

2.7%

Home Depot

Lowe’s

Home Depot (%)Lowe’s (%)

UnitsxUnit

RevenueRevenues

• Growth trees can be built using advanced

versions of the decomposition formula

presented above.

• How is Home Depot driving revenue growth?

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Evaluating Historical Performance

To analyze a company’s historical performance, we proceed in four steps:

Reorganize the company’s financial statementsFirst convert the company’s financial statements to reflect economic, rather than

accounting performance, creating such new terms as net operating profit less

adjusted taxes (NOPLAT), invested capital, and free cash flow.

Analyze ROIC & Economic ProfitReturn on invested capital (ROIC) measures the economic performance of a

company’s core business. ROIC is independent of financial structure and can be

disaggregated into measures examining profitability and capital efficiency.

Analyze Revenue GrowthBreak down revenue growth into its four components: organic revenue growth,

currency effects, acquisitions, and accounting changes.

Evaluate credit health and financial structureAssess the company’s liquidity and evaluate its capital structure in order to

determine whether the company has the financial resources to conduct business

and make short and long-term investments.

Step 1:

Step 2:

Step 3:

Step 4:

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Credit Health and Capital Structure

• In the final step of historical analysis, we focus on how the company has financed its

operations. We ask:

• How is the company financed, i.e. what proportion of invested capital comes from

creditors versus equityholders?

• Is this capital structure sustainable?

• Can the company survive an industry downturn?

• To assess the aggressiveness of a company’s capital structure, we examine

• Liquidity – the ability to meet short-term obligations. We measure liquidity by

examining the interest coverage ratio.

• Leverage – the ability to meet long-term obligations. Leverage is measured by

computing the market-based debt-to-value ratio.

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Credit Health and Capital Structure - Liquidity

• The interest coverage ratio measures a

company’s ability to meet short-term

obligations:

• EBITDA / interest measures the ability

to meet short-term financial

commitments using both profits, as well

as depreciation dollars earmarked for

replacement capital.

• EBITA / interest measures the ability to

pay interest without having to cut

expenditures intended to replace

depreciating equipment.

Home Depot ($ Million)

EBITA 6,847

EBITDA 7,922

EBITDAR* 8,492

Interest 62

Rental expense 570

Interest plus rental expense 632

EBITA/Interest

EBITDA/Interest 127.8

EBITDAR/Interest plus rental 13.4

110.4

2003

ExpenseInterest

EBITA)(or EBITDA CoverageInterest

Interest Coverage at Home Depot

* R stands for rental expense

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Credit Health and Capital Structure - Leverage

• To better understand the power (and

danger) of leverage, consider the

relationship between ROE and ROIC.

The Effect of Financial Leverage on Operating Returns

-25.0%

-15.0%

-5.0%

5.0%

15.0%

25.0%

-25% -15% -5% 5% 15% 25%

Operating Profit / Total Assets

Re

turn

on

Eq

uit

y

1.0x

2.0x

Equity

Debt)kROIC( ROIC

Equity

ReturnD

• The use of leverage magnifies the

effect of operating performance.

• The higher the leverage ratio

(IC/E), the greater the risk.

• Specifically, with a high leverage

ratio (a very steep line), the

smallest change in operating

performance, can lead to

enormous changes in ROE.

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Typical Leverage Ratios Across Industries

Note:Market value of debt proxied by book value. Enterprise value proxied by book value of debt plus market value of equity

28%

35%

43%

49%

89%

23%

18%

15%

14%

4%

0%Information technology

Healthcare

Aerospace and defence

Industrial machinery

Consumer discretionary

Consumer staples

Oil and gas

Chemicals, paper, metals

Telecommunications

Airlines

Utilities

Median Debt-to-Equity, 2003In percent• To place the company’s

current capital structure in

the proper context, compare

its capital structure with

those of similar companies.

• Industries with heavy fixed

investment in tangible assets

tend to have higher debt

levels.

• High-growth industries,

especially those with

intangible investments, tend

to use very little debt.

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Closing Thoughts

• Understanding a company’s past is essential for forecasting its future. Through

historical analysis, we can test a firm’s ability to create value…

• over time by analyzing trends in operating and financial metrics, and

• as compared to other companies within the firm’s industry

• When analyzing historical performance, keep the following in mind:

• Look back as far as possible (at least 10 years). Long term horizons will allow

you to evaluate company and industry trends and whether short-term trends will

likely be permanent

• Disaggregate value drivers, both ROIC and revenue growth, as far back as

possible. If possible, link operational performance measures with each key value

driver.

• Identify the source, when there are radical changes in performance. Determine

whether the change is temporary or permanent, or merely an accounting effect.