Class Note for SCH-MGMT 797 at UMass(5)
Class Note for SCH-MGMT 797 at UMass(5)
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Date Created: 02/06/15
I ge efiberg School ofManagement SCHMGMT 797AA Financial Statement Analysis Notes for fifth day of class Chapters 11 and 12 Ray Pfeiffer July 17 2005 Note an C17 ten 11 and 12 Rape er age7 Administrative items Music Today Questions Why do we need to focus on ROCE and change in CSE Understanding the effects of leverage Decomposing RNOA to identify pro tability and efficiency Analyzing earnings growth Analyzing changes in financing Analyzing growth in CSE For Tomorrow Suggested homework E112 E115 E118 E122 E121O A simplification of the valuation models and simple forecasting Studymchapters 13714 come to with questions Reminder Valuation Models and Other Key Information Co iexi We need it underxm d wmi re ex Value ir ae m 2h aeprexe i a dpaxi bemme we 1mm i0 predz fztmre Valuer Se ni we remember ae Valualio ModeI mi WePd it me d d tl m ae Maxi impeda i driven tfmue V0E 130 PVResid1mlEamings To figure out Value for a company therefore we need to be able to forecast residual earnings Residual earnings RE Eamt 9E 1Bt71ROCE pE 1Bt71 Nate an Cba ten 77 and 72124 P ei er a 22 ARE Change due to change in the spread between ROCE and 1quot plus change due to change in common equity ARE1 AROCE costofcapitalijJ Eo ACSE1XROCE costofcapiml1 Therefore to do the forecasting we begin by understanding what determines preyml zmdpzm residual earnings chapter 11 and changes in residual earnings chapter 12 Decomposing RE the effects of leverage Example Suppose we each own tishirt businesses we each invest 10000 in our businesses so CSE100 and we have no debt NFO 0 Suppose I sell tishirts that cost 5 for 20 each So do you Assume we have no other costs Assume also that we both pay out all profits to ourselves as dividends each period Also assume that in steadyistate we maintain operating assets equal to the total capital we raise That means we each have a margin of 75 1520 If we each sell 100 tishirts in a given period we each have a return on common equity ROCE of 15 150010000 Now suppose I borrow an additional 10000 which enables me to double my output of tishirts I will now make 3000 200 tishirts 15 profit per tishirt ignoring interest costs on the borrowed money but my common equity stays the same 10000 so my ROCE is now 30 3000 10000 In short I was able to increase my ROCE relative to you simply by expanding my leverage Note My financial leverage is 100 1000010000 My RNOA is 300020000 or 15 So my ROCE can be decomposed as RNOA FLEVSPREAD or 15 10015 7 0 30 Your financial leverage is 0 and your RNOA is 15001000015 So your ROCE can be decomposed as 15 015 15 Note that if we add borrowing cost to my example say at 10 interest then my income goes from 3000 to 2000 So my RNOA remains 300020000 15 but ROCE is now 20 200010000 because of the 1000 of net financial expense interest ROCE can be decomposed as 15 10015710 20 I still have a higher ROCE than you do because I have positive leverage effects that is my rate of return on operations RNOA is greater than my net borrowing cost NBC In other words I have positive spread So shouldn t every business increase its leverage It depends on the sign of the spread Suppose I have to borrow money at 18 instead of 10 because of my riskiness i and indeed if I have borrowed 100 of equity a prospective lender may well consider me to be a very high credit risk What changes Nate an Cba ten 77 and 72124 P ei er a e 3 RNOA is still 15 But earnings are now 1200 OI 7 NFE 3000 7 1800 and so ROCE is now 12 You can see the effects ofleverage directly from the decomposition ROCE RNOA FLEVSPREAD 15 10015 7 18 12 So leverage is only advantageous in a ROCE sense if the SPREAD is positive ddling Me 179m ifevemgefor ambJzk Residual earnings RE Eamt pE 1B1 ROCE pE 1Br1 Derivation from box 111 ROCE Comprehensive income CSE Comprehensive income is composed of OI and NFE CI OI 7 NFE OI is generated by NOA and NFE is generated by NFO in particular OI RNOANOA and NFE NBCNFO So putting this together we can write ROCE NOARNOA CSE 7 NFONBCCSE 7 that is ROCE is a weighted average of return on net operating assets and net borrowing cost where the weights are based on NOA and NFO as a proportion of total CSE Some rearranging yields NFO CSE ROCE RNOA XRNOANBC or ROCE RNOA FLEVSPREAD Note that this expression clearly divides ROCE into operating and nancing sources and in particular we can think of ROCE having three sources operating pro tability RNOA leverage FLEV and operating spread SPREAD See gure 111 page 350 for the schematic for levels 173 Tbe E em of Operdlmg Liabiz UVemge RNOA can be thought of as the return on operating assets if there were no operating liabilities plus or minus a premium based on operating liability leverage RNOA ROOA OLLEVX OLYPREAD where OI Implicitinterest after tax and Opera ngassets ROOA Level 2 Nate an Cba ten 77 and 72124 P ei er 4 e4 OLLEV NOA OLYPREAD ROOA Short term borrowing rate after tax Tbe E m zimen d Leverage ROCE RNOA FLEVX SPREAD where PLEVNFOCSE and SPREAD RNOA NBC We can combine these two sources to get an expression for ROCE ROCE ROOA RNOA ROOA ROCE RNOA The second term represents the increment for operating liability leverage and the last term represents the increment for nancial leverage We would want to know the sources of pro tability for our target rm These computations help to isolate those sources and help us to think about forecasting from where pro tability will come in the future See Table 112 page 358 for an illustration with Nike and Reebok Notes 1 Now we see why it is usefulnecessary to reformulate the nancial statements i we need to have clean measures of all of the components of ROCE in order to conduct this analysis 2 Penman points out important contrasts with popularlyeused measures ROA and Debt Equity and those used in this framework RNOA and NFO The former de nitions confuse operating and nancing activities and tend not to reflect comprehensive income Look at Elll to get the hang of the above Focus on perdling pro tability What drives RNOA Remember ROCE RNOA FLEVXSPREAD OI after tax J39ae 541 But RNOA PMXATO where PM NOA and ATO This sort of ratio analysis is known as the DhPonl model Nate an Cba ten 77 and 72124 P ei er a 25 Look at Table 113 for an illustration of how different rms generate ROCE with combinations of FLEV OLLEV RNOA PM and ATO We can use these observations to try to pinpoint where a target rm is generating its RNOA with an eye toward forecasting future RNOA Level 3 Focus on the drivers of pro t margin and the drivers of turnover Pro t margin comes from core activities and other activities We can examine the profitability of each line of the reformulated income statement to learn more The Sales PM is equal to the gross margin ratio 7 expense ratios Gross Admin exp Selling expense RampD Operating taxes Sales Sales Sales Sales Sales SaleIPM The pro t margin from other parts of the income statement can be analyzed as follows Subsidiary income Other equity income Special items Other G L Sales Sales Sales Sales quototherquot PM Similarly we can analyze the components of ATO although arithmetically we have to invert it to get something that adds together to get a common denominator 1 Caxb AR Inventog39 AP Pandonliab m Am Sale Kale Sale Jule Kale This analysis will enable us to pinpoint the dollars of sales per dollar of investments in speci c net operating assets Notes 1 Typically we use average values of balance sheet items when doing ratio analysis 2 There are other types of analysis commonly done on some balance sheet accounts such as Days in AR Days in inventory etc See table 114 page 364 for an illustration based on Nike and Reebok L flbJ What drive Operdlmg Spread Nate an Cba ten 77 and 72124 P ei er a e 6 Operating spread is RNOA 7 NBC We already analyzed RNOA So what drives NBC NBC But we can analyze this further by looking at the components of both the numerator and denominator What we do is break down the interest income and interest expense from each source and add them together NBC FO x Int a zrtm WIFO FA x Intz ertnx MFA m NFO FO NFO FA Again use average values for balance sheet numbers in this computation Putting it All Together Executing this sort of analysis helps us to clearly pinpoint the sources of profitability in the past and present for the company we are analyzing That information is vital in helping us try to forecast future pro tability residual earnings and investment book values Moving from Analysis of Pro tability to Analysis of Growth chapter 12 Remember from the start of class Since RE ROCEI Costofcapit11BH then ARE1 AROCE costofcapitallXCJ39Eo ACSE1XROCE costofcapiml1 We focus therefore on 3 things 1 Changes in return on common equity Growth in stockholders equity 3 Separating sustainable versus nonisustainable components of earnings Analysis of Changes in Profitability See figure 121 page 389 for the schematic diagram of levels 173 of the analysis process Level 7 Analyze changes in RNOA Focus on distinguishing core and unusual parts of RNOA CoreOIfromsales CoreotherOI UI RNOA NOA NOA NOA Nate an vaz ten 77 and 72124 P ei er a e 7 Note the difference between lmmllog low quality and rmmlmzbleperwdnenl high quality earnings Exhibit 121 page 390 provides a suggested further reformulation of the operating income part of the income statement More informally we can consider speci c potentially troubling issues Restructuring charges Unrealized gains and losses on investments Research and development discretionary Advertising also discretionary Pension expense income Changes in estimates Gains and losses look in the statement of cash ows Income taxes look at the tax footnote Other income OPOHF P eP NB Take a look at E121 which asks the student to compute core operating income and core PM Which components of that company s income statement would you forecast to continue and which are unlikely to repeat Level 2 Pinpoint the causes of changes in RNOA ARNOA APM x prior ATO AATO given PM changes in other income and unusual items ARNOAAcoresalesPMtxAm1AAT0xcoresa1esPMtAMJ A U1 NOA NOA Computing these components helps to identify where the changes originate so that we can then decide whether those changes are likely to be permanent or transitory Level 3 Analyze the specific causes of changes in PM ATO other income and unusual items Compute and analyze the changes in individual PM and ATO to identify which forces appear to be at work and likely to influence future RNOA Comlder operallng leverage different from operating liability leverage If you have the ability as an analyst to clearly distinguish fixed and variable costs such that you can compute the contribution margin for the target rm then the following relationships can be helpful in analyzing changes in operating income Nate an Cba ten 77 and 72124 P ei er a e 8 Contribution margin Operating income OLEV and 39VoACore OI OLE VX ACore sales Point out to students that they did this sort of analysis in their managerial cost accounting class and for a review they can look at E128 which considers the effects of operating leverage for USAir Analyzing Changes in Financing Level 7 Compute changes in nancial leverage FLEV and the operating spread SPREAD AROCEtARNOAt ASPREADIXFLEVH APLEKXJPREAD This relationship helps to identify the effects of financing but also the source of the effects i either changes in the spread RNOA 7 NBC or changes in the financial leverage NFOCSE Level 2 Explain the changes in net borrowing cost NBC NFENFO Spread consists of RNOA which has already been analyzed above and NBC So we look here for reasons why NBC has changed We do this by first separating core financial expenses from unusual financial expenses and analyzing them separately Level 3 Explain any changes in leverage N FO CSE Penman says that FLEV does not tend to change much but you need to be aware of any such changes since they feed directly into changes in ROCE as well Penman cautions against changes in ROCE caused by additional leverage Analyzing Growth in Shareholders Equity Remember that ARE1 AROCE costofcapitaIIXCSEO ACJ39EIXROCE costof capital1 We ve analyzed the rst term looking for changes in ROCE but we can also have changes in RE caused by changes in investment changes in CSE Sales are the main engine of growth But sales growth requires NOA growth and NOA growth requires additional capital Existing shareholder value is maximized if the additional capital can come from debt rather than equity Nate an Cba ten 77 and 72124 P ei er a e 9 In other words changes in CSE have three causes 1 Growth in sales 2 Change in the net operating assets that support the growth in sales and 3 change in the amount of net debt in place of equity that is used to nance the change in NOA 1H ACSE ASaIe X ATO gtlt Kale NFO ATO This relation helps us to identify the sources of changes in shareholder investment so that we can analyze where these changes are coming from again with an eye toward forecasting what is going to happen in the future Look at E129 which analyzes the growth in equity for a hypothetical rm Putting it all Together All of these component analyses help to give a clear picture of the past and present causes for changes in ROCE and changes in shareholders investment ACSE These changes can yield important insights about the past and present that can be useful for making forecasts Summary 1 You made a connection between the valuation framework and the key variables necessary for implementing valuation 2 You discovered a set of tools relationships and ratios to analyze the past and present conditions and results of a rm i both pro tability and residual earnings growth 3 You thought about the idea of sustainable versus transitory earnings Next Next we work under the premise that perhaps nancing activities do not contribute to value and then develop a modified valuation model that is based solely on operations Then we move on to a method of forecasting that is based directly on current nancial statements
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