Chapter 6 on Valuation and Reporting in Organization
- 1. Chapter 6: Analyzing Historical Performance
- 2. Table of content Introduction Importance of past performance analysis Steps of analyzing firm’s historical performance Reorganizing financial statements Measuring and analyzing the firm’s return on invested capital Breakdown the firm’s revenue growth Assessing the firm’s financial health Conclusion
- 3. Forecasting the future financial performance of a company By first understanding its financial past How? This chapter will look at the steps of how we can analyze a company’s past financial performance to help forecast its future performance .
- 4. The importance of historical analysis • To give basis, ideas or precedence for forecasting future performance • To test the company ability to create value over time by analyzing trends in operating and financial metrics and, • To test the company ability to compete effectively within the company’s industry
- 5. Basis for effective historical analysis Objective of an historical analysis is to evaluate a company’s previous performance, its competitive position, and its ability to generate cash in the future Begins by looking at its past financial statements. When looking at these statements: • Try to rearrange the accounting statements, • Go digging for new information in the footnotes, • Try to make sense of the numbers by making informed assumptions
- 6. Basis for effective historical analysis The focus of a historical analysis is 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.
- 7. The steps of analyzing the historical performance of a firm Step 1: Reorganizing financial statements Step 2: Measuring and analyzing the firm’s return on invested capital Step 3: Breakdown the firm’s revenue growth Step 4: Assessing the firm’s financial health
- 8. Step 1: Reorganizing the financial statements To view the company financial performance to reflect its economic performance instead of the accounting performance Reorganize its financial statements to compute the company’s: Net Operating Profit Less Adjusted Taxes or NOPLAT, Invested cash flow and, Free cash flow
- 9. Step 1: Reorganizing the financial statements Reorganize the financial statements by separating the firm operating performance from non-operating items as well as the financing obtained to support the operations Compute Free Cash Flow or FCF, and Return on Invested Capital or ROIC by reorganizing the income statement to compute Net Operating Profit Less Adjusted Taxes or NOPLAT and reorganizing the balance sheet to compute invested capital
- 10. Step 1: Reorganizing the financial statements Reorganize the financial statements by separating the firm operating performance from non-operating items as well as the financing obtained to support the operations. Compute Free Cash Flow or FCF, and Return on Invested Capital or ROIC by reorganizing the balance sheet to compute invested capital reorganizing the income statement to compute Net Operating Profit Less Adjusted Taxes or NOPLAT and
- 11. Reorganizing Balance Sheet to Compute Invested Capital Investor Capital represents the total investor capital required to fund operations (debt and equity) Lets look at a traditional “Accountant Balance Sheet” Total Assets = Liabilities + Equities Based on the diagram: Total Assets (Inventory, NET PP&E, Equity investments) = Liabilities (Accounts Payable + Interest-bearing debt) + Equity (Common Stock + Retained Earnings) 11
- 12. What is Invested Capital? An Economic Balance Sheet An Economic Balance Sheet is the reorganized version of a traditional accounting balance sheet. its formula is as follows: Operating Assets: OA, Operating Liabilities: OL, Nonoperating Assets: NOA, Invested Capital, Debt and its Equivalents: D +DE, Equity and Its Equivalents: E + EE Invested Capital (OA-OL) + NOA = Total Fund Invested = (D + DE) + (E+EE) Invested Capital = (OA-OL) The next diagram will show you how invested capital and total fund invested is calculated 12
- 13. An Economic Balance Sheet 13
- 14. What is Net Operating Profit Less Adjusted Taxes or NOPLAT? NOPLAT represents the total after tax operating income generated by the company’s invested capital available to all investors Invested Capital = includes sources from Debt and Equity and treat them equally NOPLAT = includes profits available to both debts and equity holders
- 15. Reorganizing Income Statement to compute NOPLAT Lets look at a traditional “Accountant’s Income Statement” Net income = Operating Profit (Revenue – Operating Cost – Depreciation) - Interest + Nonoperating income - Taxes 15
- 16. NOPLAT An Economic Income Statement An Economic Income Statement is the reorganized version of a traditional accounting income statement. its formula is as follows: NOPLAT = Operating Profit (Revenue – Operating Costs – Depreciation) – Operating Taxes NOPLAT + After-tax Nonoperating income = Total Income to All Investors The next diagram will show you how NOPLAT and Total Income to All Investors are calculated. 16
- 17. An Economic Income Statement 17
- 18. Other key concepts Return on Invested Capital (ROIC) = NOPLAT / Invested Capital to measure how the company’s core operating performance has changed and how the company compares with its competitors. We will go through them in the next step. For now we will look at FCF. Free Cash Flow (FCF) = NOPLAT + Noncash Operating Expenses – Investments in Invested Capital
- 19. Reorganizing Cash Flow Statement to compute Free Cash Flow Lets look at a traditional “Accountant’s Cash Flow Statement” Cash Flow from Operation = Net Income + Depreciation + Changes in inventory + Changes in Account Payable Cash Flow from Investing = Capital Expenditure + Changes in Equity Investments Cash Flow from financing = Changes in interest-bearing debt + changes in common stock - dividends 19
- 20. A Free Cash Flow Statement 20
- 21. Step 2: Measuring and analyzing the firm’s return on invested capital The next step is to measure and analyze the firm’s return on its invested capital (ROIC) as well as its economic profit. This will help evaluate the company’s ability to create value. ROIC will give the position of the performance of the firm’s core business
- 22. Step 2: Measuring and analyzing the firm’s return on invested capital (ROIC) Having reorganized the balance sheet, the income statement and the cash flow statements, we have a clean measure of total invested capital and its related after tax operating income. ROIC = NOPLAT/ Invested Capital Since ROIC focuses solely on a company’s operation, ROIC is a better analytical tool for understanding the company’s performance than Return on Equity and Return on Assets. ROE mixes operating performance with capital structure whereas Return on Assets is inadequate because the ratio double counts any implicit financing charged by suppliers.
- 23. Step 3: Breakdown the firm’s revenue growth By analyzing historical revenue growth, we can assess the potential for growth going forward The ability to grow cash flows over long periods depends on a company’s ability to organically grow its revenues.
- 24. Step 3: Breakdown the firm’s revenue growth Calculating revenue growth directly from income statement will suffice. But, the year to year revenue growth sometimes can be misleading. Please consider the following three prime culprits affecting revenue growth when evaluating growth. There are: Currency effects Accounting changes Acquisitions
- 25. Currency Changes Consolidate foreign revenues 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
- 26. 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
- 27. Changes In Accounting Policies When a company changes its revenue recognition policies, comparing year-to-year revenue can be misleading.
- 28. Step 4: Assessing the firm’s financial health (Credit Health and Capital Structure) At this point, we have focused on studying the operations of the company and its ability to create value. We have examined the primary drivers of value: return on invested capital, organic revenue growth, and free cash flow. In the final step of historical analysis, we focus on how the company financed its operation. What proportion of invested capital comes from creditors instead of from equity? Is this capital structure sustainable? Can the company survive an industry downturn? In this step, assess the financial health as well as the firm’s capital structure. This will help determine whether the firm has the required financial resources necessary to conduct business as well as undertake
- 29. Step 4: Assessing the firm’s financial health (Credit Health and Capital Structure) In this step, assess the financial health as well as the firm’s capital structure. This will help determine whether the firm has the required financial resources necessary to conduct business as well as undertake both long and short term investments.
- 30. Step 4: Assessing the firm’s financial health (Credit Health and Capital Structure) In this step, assess the financial health, in terms of liquidity and leverage as well as the firm’s capital structure. Liquidity measures the company’s ability to meet short term obligations such as interest expenses, rental payments and required principal payment. Leverage measures the company’s ability to meet obligation over a long term.
- 31. Leverage To better understand the power (and danger) of leverage, consider the relationship between ROE and ROIC Where KD is the cost of debt Equity Debt )kROIC(ROIC Equity Return D
- 32. Leverage The use of leverage magnifies the effect of operating performance. The higher the leverage ratio, the greater the risk. Specifically, with a high leverage ratio, the smallest change in operating performance, can lead to enormous changes in ROE.
- 33. Capital Structure To place the firm’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.
- 34. General Consideration for Historical Analysis 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 are likely to 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
- 35. Questions? Chapter 2. Fundamental Principles of Value Creation 35
Editor's Notes
- #4: In order to forecast the future financial performance of company, it is essential to understand its financial past. How should we begin to understand its past? There are steps to follow for us to analyze the historical financial performance of a company. We will look at each steps in this chapter.
- #5: Firstly, lets look at why it is important to analyze a company past financial performance? It is important because understanding a company’s past will give some ideas or precedence for forecasting its future. By using historical analysis of its past performance, we can test the company ability to create value over time by analyzing its trends in operating and financial metrics and its ability to compete effectively within its industry.
- #6: Now that you understand why we should evaluate a company’s historical and past performance, lets look at how can we effectively evaluate them. We may effectively evaluate a firm previous performance, competitive position, and ability to generate cash in the future by looking at its past financial statements. When looking at its past accounting statements, try rearranging the accounting statements, Go digging for new information in the footnotes, try to make sense of the numbers by making informed assumptions What is the goal or focus while going through the company past accounting statements? The focus will be on the drivers of value which are the return on invested capital (ROIC) and growth. These two drivers drive free cash flow, which is the basis for enterprise value.
- #7: Now that you understand why we should evaluate a company’s historical and past performance, lets look at how can we effectively evaluate them. We may effectively evaluate a firm previous performance, competitive position, and ability to generate cash in the future by looking at its past financial statements. When looking at its past accounting statements, try rearranging the accounting statements, Go digging for new information in the footnotes, try to make sense of the numbers by making informed assumptions What is the goal or focus while going through the company past accounting statements? The focus will be on the drivers of value which are the return on invested capital (ROIC) and growth. These two drivers drive free cash flow, which is the basis for enterprise value.
- #8: There are four steps in conducting effective historical analysis of a company performance. The first step is reorganizing financial statements. The second step is measuring and analyzing the firm’s return on invested capital or ROIC. The third step is analyzing the breakdown the firm’s revenue growth. The final step is assessing the firm’s financial health. We will go through the details of each step next.
- #9: Step 1: Reorganizing the financial statements The objective of this step is to view the company financial performance to reflect its economic performance instead of the accounting performance. To do so we have to reorganize the company financial statements to compute the company’s Net Operating Profit Less Adjusted Taxes or NOPLAT, Invested cash flow and, Free cash flow.
- #10: Step 1: Reorganizing the financial statements Starts by reorganizing the financial statements by separating the company’s operating performance from non-operating items as well as the financing obtained to support the operations. In order to compute the firm’s free cash flow or FCF and return of invested capital, reorganize the income statement to create NOPLAT and reorganize the balance sheet to create invested capital.
- #11: Step 1: Reorganizing the financial statements Starts by reorganizing the financial statements by separating the company’s operating performance from non-operating items as well as the financing obtained to support the operations. In order to compute the firm’s free cash flow or FCF and return of invested capital, reorganize the income statement to create NOPLAT and reorganize the balance sheet to create invested capital. Invested capital represents the total investor capital required to fund operations. Other words all the money available from investor to run the company operation. NOPLAT represents the total after tax operating income (generated by the company’s invested capital) that is available to all financial investors. Return on invested capital and free cash flow both reply on NOPLAT and Invested Capital. ROIC is defined as NOPLAT/Invested Capital FCF is defined as NOPLAT + Noncash Operating Expenses – Investment in Invested Capital
- #12: What is Invested Capital? It represents the total investor capital required to fund operations (all the money in the company regardless whether its from debts or equity) To build an economic balance sheet by separating company operating assets from its non-operating assets and financial structure, we looks at a traditional accountant balance sheet. Balance Sheet Basic Accounting Assets = Liabilities + Equities More Explicit Breakdown Operating Assets = Operating Liabilities + Debt + Equity Economic Balance Sheet Operating Assets – Operating Liabilities = Invested Capital = Debt + Equity
- #13: An Economic Balance Sheet is the reorganized version of a traditional accounting balance sheet. Its formula is a bit different than traditional accountant balance sheet. Its formula is as follows: Invested Capital + Nonoperating Assets = Total Fund Invested = Debt and its Equivalents + Equity and Its Equivalents As you can see, Invested Capital is equal to operating Assets minus operating liabilities. The next slide will show with diagram how invested capital and total fund invested is calculated.
- #14: In this particular diagram under Invested Capital Balance Sheet, the Operating Asset is Inventory and Net Property Plant and Equipment or Net PP&E. The operating liability is Accounts Payable. Invested Capital as represented by the red box is the outcome of operating assets which are Inventory and Net PP&E, minus the operating liabilities which is the accounts payable. As the diagram shows, equity investments are not included in calculating “Invested Capital” because it is a non-operating assets but it is included in calculating Total Funds Invested.
- #15: What is Net Operating Profit Less Adjusted Taxes or NOPLAT? It is the total after tax operating income, generated by the company’s invested capital available to all investors. The concept of Invested capital makes no distinction between debt and equity and treat them as equal sources of fund. The concept of NOPLAT is also similar. It aggregates the operating income generated by invested capital. Unlike net income, NOPLAT includes profit available to both debt holders and equity holders.
- #16: Lets look at a traditional accountant income statement. The formula is Net income is equal to Operating Profit (which is the outcome of Revenue minus Operating Cost minus Depreciation) minus Interest payment plus any other nonoperating income minus finally minus taxes.
- #17: An Economic Income statement is the reorganized version of a traditional income statement. Its formula is a bit different than traditional accountant income statement. Its formula is as follows: NOPLAT is equal to Operating Profit, which is derived from Revenue minus operating costs minus depreciation, minus Operating taxes Whereas the Total Income for All Investors is derived as follows: NOPLAT + After Tax Non Operating Income The next slide will show with diagram how NOPLAT and Total Income to All Investors are calculated.
- #18: In this particular diagram under NOPLAT income statement, the Operating Profit is Revenue minus operating costs minus depreciation. The operating taxes is 70 million which is the tax rate times operating profits. In this case tax rate is 25% and operating profit is 280 million. This is different from the traditional accountant income statement where the taxes are 25% times the Earnings before taxes or 264 millions. So, in this case, NOPLAT is 280 million minus 70 million. NOPLAT is 210 million as represented by the red box. It is the outcome of operating profits 280 million minus the operating taxes of 70 million. As the diagram shows, any income from non-operating assets are excluded from calculating NOPLAT but not Total Income for All Investor. As the diagram shows After-tax interest is 15 million which is the outcome of Interest payment at 20 million minus the taxes on interest payment which is 25% times 20 million or 5 million. Interest payment in this income statement is considered as financial payout to investors not an expense.
- #19: With our newly reorganized financial statements, we can now measure the total investor capital and the after tax operating income generated from those investment. Return on invested capital or ROIC is the ratio of NOPLAT to Invested Capital. The purpose of ROIC is to measure how the company’s core operating performance has changed and how the company compares with its competitors. To value a company’s core operations, we discount projected free cash flow at an appropriate risk-adjusted cost of capital.
- #20: Lets look at a traditional accountant’s cash flow statement The formulas are as follows: First, Cash Flow from operation is equal to net income plus if there is a decrease in inventory or minus if there is an increase in inventory, plus if there is an increase in accounts payable or minus if there is a decrease in accounts payable. Second, Cash Flow from investing is equal to capital expenditure plus if there is a decrease in equity investment or minus if there is an increase in equity investment. Finally, Cash Flow from financing is plus if there is an increase in debt or minus if there is a decrease in debt, plus if there is an increase in common stock or minus if there is a decrease in common stocks, and minus any dividend payments
- #21: In this particular diagram under Free Cash Flow statement, Free Cash Flow or FCF is derived by adding NOPLAT and noncash operating expenses such as depreciation and minus investments in invested capital such as inventory, accounts payable and capital expenditure. So, in this case, FCF is 160 million. NOPLAT is 210 million as represented by the red box. It is the outcome of operating profits 280 million minus the operating taxes of 70 million. As the diagram shows, any income from non-operating assets are excluded from calculating NOPLAT but not Total Income for All Investor. As the diagram shows After-tax interest is 15 million which is the outcome of Interest payment at 20 million minus the taxes on interest payment which is 25% times 20 million or 5 million. Interest payment in this income statement is considered as financial payout to investors not an expense.