FIN 3516

Valuation

Ignacio García de Olalla

 Valuation
Ignacio García de Olalla
Profitability Analysis
 Types of analyses with financial ratios

A ratio analysis usually includes:

Time-series analyis

Cross-sectional analysis

Comparison with the required rate of return

Types of analyses with financial ratios
Measurement of operating profitability

Return on invested capital (ROIC)

Measures the profitability of the operations. The return on invested capital disregards how a firm is financed. It
should be compared with returns from alternative investments with similar risk profile.

A higher ROIC higher value (ceteris paribus)

A higher ROIC access to cheaper credit (ceteris paribus)

The calculations should be based on averages of NOA unless extraordinary issues have occurred at the end of the year.
Measurement of operating profitability

Return on invested capital (ROIC)

Figure 5.2 Return on invested capital for Carlsberg

Is Carlsberg’s ROIC satisfactory? Please account for your answer.
Measurement of operating profitability

When interpreting the return on invested capital is important to address the following issues:

The level of returns:

An estimation of the required rate of return (WACC)

A comparison with competitors (benchmarking)

The development of returns over time:

Stable

Increasing

Decreasing

Fluctuating
Measurement of operating profitability:
assessment of the level of returns.

To estimate the cost of capital (WACC) we need to know:

Net interest-bearing debt (NIBD)
Shareholders’ equity (E)
Interest rate on debt after tax
Shareholders’ required rate of return

NIBD= market value of net interest-bearing debt

MVE= market value of equity
= interest rate on net interest bearing debt
= shareholders’ required rate of return
t= the company’s marginal tax rate
Measurement of operating profitability:
assessment of the level of returns.

Economic Value Added (EVA), or super profit, or economic rents, or above normal profit, or economic profits:

If ROIC>WACC a company creates excess return or economic value added. This means the firm is creating value for its
shareholders.

NOTE: A firm might have a positive accounting profit and not being creating value for its shareholders!!! Why?
Measurement of operating profitability:
assessment of the level of returns.

Figure 5.3 Return on invested capital versus WACC for Carlsberg

Measurement of operating profitability:
assessment of the level of returns.

An alternative method: cross-sectional analysis.

We compare the firm’s performance with its competitors’.

Important issues regarding comparability must be taken into account.

Figure 5.4 Comparison of the return on invested capital for Carlsberg and Heineken
Measurement of operating profitability:
assessment of trends in financial ratios.

How does the ratio develop over time?

It is usually done relatively to other comparable firms.

For listed firms, we can infer what are the market’s expectations regarding the future profitability.
Remember that stock prices are forward looking!

Where g= growth in EVA

MVE>BVE if ROIC>WACC.

If g and WACC are both constant, then:

Is the market’s expectation correct?

 Alternative interpretations of ROIC

Often, high and positive developments in the return on invested capital is viewed as positive, as it signals increasing
value creation

However, there are circumstances with alternative interpretations. For example, ROIC is affected by:
Differences in accounting policies (lectures 13 & 14)

The average age of assets

Differences in operating risks

Products’ lifecycle.
Alternative interpretations of ROIC:
The average age of assets.

Example:

· A company purchases a new machine by the end of year 0 for £10,000. The machine is the company’s only asset
· The economic lifetime of the machine is 5 years and the salvage value is 0 by the end of year 5
· The cost of capital equals 10 percent
· The yearly net cash flows are 2,638. For simplicity, all cash flows fall by the end of each year
· The company’s only source of financing is equity. This implies that ROIC equals ROE
· All cash surplus is paid as dividend
· Taxes are ignored. Depreciation is the only expense (beyond the expenses that have already been deducted from
the net cash flows).

· What is the internal rate of return?

· What is the return on invested capital?
 Alternative interpretations of ROIC:
The average age of assets.

· What is the internal rate of return?

The IRR shows what investors can expect to earn on average each year during the entire lifetime of a project. To
calculate it, we need to estimate the cash flows.

What is the return on invested capital?

ROIC is the accounting equivalent to the IRR. While IRR is based on predictions, ROIC is based on realised figures.

Where
NCF is the net cash flow per period from the project
is the initional invested capital in the project
 Alternative interpretations of ROIC:
The average age of assets.

1 2 3 4 5 6
(1-2) (4begin-2) (3/5begin)
Year Net Depreciation Net Book value Market value ROIC=ROE
cash flows income end (equity) end (equity)
0 10000,0 10000,0
1 2638 1638,0 1000 8362,0 8362,0 10,0%
2 2638 1801,8 836 6560,2 6560,2 10,0%
3 2638 1982,0 656 4578,2 4578,2 10,0%
4 2638 2180,2 458 2398,0 2398,0 10,0%
5 2638 2398,2 240 0,0 0,0 10,0%

1 2 3 4 5 6
(1-2) (4begin-2) (3/5begin)
Year Net Depreciation Net Book value Market value ROIC=ROE
cash flows income end (equity) end (equity)
0 10000 10000,0
1 2638 2000 638 8000 8362,0 6,4%
2 2638 2000 638 6000 6560,2 8,0%
3 2638 2000 638 4000 4578,2 10,6%
4 2638 2000 638 2000 2398,0 16,0%
5 2638 2000 638 0 0,0 31,9%
 Alternative interpretations of ROIC:
The average age of assets.

• What is the internal rate of return?

The internal rate of return is 10%

• What is the return on invested capital?

The ROIC increases with the passage of time because the cash flows remain constant but the invested capital
diminishes every year.

At the beginning of a project, ROIC is typically below the true return IRR, while the opposite is true at the end of the
project.

This is relevant for start-ups and firms under liquidation. Other firms will find that different projects «cancel» each
other out, so ROIC is a good estimate of the underlying IRR.
 Alternative interpretations of ROIC:
Differences in operating risks.

A firm might have a high ROIC because it operates in an industry with more systematic risk

Firms should be compared with firms of similar risk profiles.

A ROIC that is satisfactory in an industry, might not be satisfactory in another industry.

Where
Alternative interpretations of ROIC:
Product lifecycle.

Figure 5.6 Return on invested capital at different stages of the product lifecycle
 Alternative interpretations of ROIC:
Product lifecycle.

This is also applicable to the business as a whole, not only the product

It does not make much sense to directly compare firms in very different stages of their lifecycles (even in the same
industry).

However, it might be useful to study the profitability of firms later in their lifecycles, to infer what can be expected
in the future.
 Decomposition of ROIC

ROIC does not explain whether profitability is driven by a better revenue and expense relation or an improved capital
utilisation. It is necessary to decompose the ratio into

(a) The profit margin (revenue/expense relation), PM

(b) The turnover rate of invested capital (capital utilisation), ATO

Profit margin after tax is defined as:

Profit margin before tax is defined as:

The profit margin describes the revenue and expense relation and expresses, operating income as a percentage of net
revenue.
 Decomposition of ROIC

• The turnover rate is defined as:

The turnover rate expresses a company’s ability to utilise invested capital. It expresses how many kroner a firm
generates for each invested krone in operations.

Which industries/types of firms are likely to be centred around ‘A’ in the figure?
Which industries/types of firms are likely to be centred around ‘B’ in the figure?
 Decomposition of ROIC

Heavy investment companies, like pharmaceutical companies, are located in area ‘A’
Companies with a high proportion of fixed costs, and often low turnover rates

To attract capital to the industry, it is necessary to generate higher profit margins to compensate for the low
turnover rate

The higher profit is achieved usually because of some special product properties that are difficult to imitate, or
competitive advantages leading to a reduction in the intensity of competition in the industry.

Companies that offer standard services (commodities) often operate in area ‘B’
Companies are affected by significant competition

Fierce competition lead an upper limit to the profit margin

Price is typically the most important parameter, as the products or services do not differ significantly among
competitors

To attract capital for such undertakings, they need to generate high turnover rates. A high turnover rate is achieved
by tight costs control throughout the value chain, while invested capital is held at a minimum.
Decomposition of ROIC

Figure 5.8 Comparison of profit margin of Heineken and Carlsberg

Decomposition of ROIC

Figure 5.9 Comparison of turnover rate for Heineken and Carlsberg

 Analysis of profit margin and turnover rate of invested capital

An analysis of the profit margin and turnover rate of capital helps to explain whether the revenue/expense relation and
the capital utilisation efficiency have improved

The analysis of the two ratios is, however, vague in their description of why the ratios have evolved as they have

In order to deepen our understanding of the evolution of the profit margin and asset turnover, it is necessary to
decompose the two ratios further. This can be done in two ways:

Indexing (trend analysis)

Common-size analysis.
 Analysis of profit margin and turnover rate of invested capital

Indexing is a suitable method to quickly identify trends in various revenue and expense items .

Table 5.6 Trend analysis of Carlsberg’s revenue and operating expenses

 Analysis of profit margin and turnover rate of invested capital

Index numbers show the trend in important operating items, but do not show the relative size of each item. Common-size
analysis scales each item as a percentage of revenue.

Table 5.7 Common-size analysis of Carlsberg’s revenue and operating expenses

Analysis of profit margin and turnover rate of invested capital

Table 5.8 Trend analysis of invested capital for Carlsberg and Heineken, respectively
Analysis of profit margin and turnover rate of invested capital

Table 5.8 Trend analysis of invested capital for Carlsberg and Heineken, respectively
Analysis of profit margin and turnover rate of invested capital: Indexing and common-size analysis of invested capital

To evaluate the relative importance of each item, rather than its trend, a variation of common size analysis is used.

We calculate the number of days in hand for each item making up invested capital.

Days on hand express the number of days that an accounting item is consuming cash
Analysis of profit margin and turnover rate of invested capital:
Indexing and common-size analysis of invested capital

Table 5.9 Days on hand of invested capital for Carlsberg and Heineken, respectively
Analysis of profit margin and turnover rate of invested capital:
Indexing and common-size analysis of invested capital

Table 5.9 Days on hand of invested capital for Carlsberg and Heineken, respectively (Continued)
Structure of a profitability analysis – expanded Du Pont model
• Is it possible to decompose the financial ratios describing the operating
profitability any further?

The firm’s competitive edge

Market growth The information disclosed in
Market size
the annual report does not
Revenue typically allow for a more
Market share
Production detailed analysis of the
Price profitability at the following
Profit Margin Marketing
levels:
Distribution
Administration • Location
Amortisation and • Product (group)
ROIC depreciation • Customer (group)
Non-current assets

Inventories
Receivables
Turnover rate
Invested capital Operating cash
EVA
Operating liabilities

Financial leverage

WACC Creditors’ required rate of return

Investors’ required rate of return

Return on Equity

Return on equity (ROE) measures the profitability taking into account returns earned on operations plus the effect of
financial leverage:

ROE measures the owners’ accounting return on their investments in the company.

ROE is affected by:

Operating profitability
Net borrowing interest after tax
Financial leverage
Return on Equity

ROE can be decomposed as follows:

NIBD
Return on equity = ROIC + (ROIC - NBC) x
BVE
where

ROIC = Return on invested capital after tax

BVE = Book value of equity
NIBD = (Book value of) net interest bearing debt
NBC = Net borrowing cost after tax in percent

Net financial expenses after tax

NBC = × 100
Net interest bearing debt

If ROIC>NBC, an increase in financial leverage will improve ROE. The reverse is also true.

ROIC-NBC is often referred to as the interest margin or spread.

Return on Equity

Return on invested capital, ROIC = 10%

Net borrowing costs, NBC = 6-14%
Financial leverage, NIBD/BVE = 0-5
Return on Equity

Minority interest:
Return on Equity

We can evaluate the value creation for the shareholders by the residual income:

) x BVE

Note that we do not compare ROE with WACC but with the owners’ required rate of return (cost of equity)
Return on Equity

Figure 5.11 Structure of profitability analysis

Return on Equity

Table 5.10 The decomposition of ROE for Carlsberg and Heineken

• Carlsberg's ROE is significantly lower than Heineken’s in the first four years
(Years 1, 2 and 3 not shown)
• A decomposition of ROE shows that the higher return in Heineken can be
attributed to a higher ROIC
• If Heineken had adopted a financial leverage similar to Carlsberg in year 4 to year 7 it would have experienced a
significantly higher ROE than it actually realised
• In year 8, Heineken’s ROE is suffering due to a sharp decline in ROIC.