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Analyzing Historical Performance

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Title: Analyzing Historical Performance Description: Version 1.1 11/5/2005 Last modified by: Chunlin Liu Created Date: 5/12/2004 9:19:46 PM Document presentation format – PowerPoint PPT presentation

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Title: Analyzing Historical Performance


1
  • Analyzing Historical Performance

2
The Importance of Historical Analysis
  • Understanding a companys past is essential for
    forecasting its future. Using historical
    analysis, we can test a companys ability to
  • create value over time by analyzing trends in
    operating and financial metrics
  • compete effectively within the companys industry
  • In this presentation, we will examine how to
    effectively evaluate a companys 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.

3
Evaluating Historical Performance
To analyze a companys historical performance, we
proceed in four steps
Reorganize the companys financial
statements First convert the companys 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 Profit Return on
invested capital (ROIC) measures the economic
performance of a companys core business. ROIC
is independent of financial structure and can be
disaggregated into measures examining
profitability and capital efficiency. Analyze
Revenue Growth Break down revenue growth into its
four components organic revenue growth, currency
effects, acquisitions, and accounting
changes. Evaluate credit health and financial
structure Assess the companys 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.
4
The Problems with Traditional Financial Analysis
Why do we need to reorganize the companys
financial statements?
  • 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.

5
Modern Financial Analysis
  • To prevent non-operating items and capital
    structure from distorting the companys 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

FCF NOPLAT Net Increase in Invested capital
6
Reorganizing the Balance Sheet An Example
  • Lets rearrange the accountants balance sheet
    into invested capital and total funds invested
    for a simple hypothetical company (i.e. a company
    with only few line items).

Economic Balance Sheet
Accountants Balance Sheet
Prior year
Current year
Prior year
Current year
Assets
Inventory
200
225
Operating liabilities are netted
against operating assets
Inventory
200
225
Accounts payable
(125)
(150)
Net PPE
300
350
Operating working capital
75
75
Equity investments
15
25
Total assets
515
600
Net PPE
300
350
Invested capital
375
425
Non-operating assets are not included in invested
capital.
Liabilities and equity
Equity investments
15
25
Accounts payable
125
150
Total funds invested
390
450
Interest-bearing debt
225
200
Common stock
50
50
Retained earnings
115
200
Total funds invested
Note the redundancy of total funds invested
Total liabilities and equity
515
600
200
225
Interest-bearing debt
50
50
Common stock
200
115
Retained earnings
450
390
Total funds invested
7
Reorganizing the Income Statement NOPLAT
  • 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.

8
Reorganizing the Income Statement NOPLAT
  • NOPLAT includes only operating-based income.
    Unlike net income, interest expense and
    non-operating income is excluded from NOPLAT.

Accountants income statement
NOPLAT
Revenues
Revenues
1,000
1,000
Operating costs
Operating costs
(700)
(700)
Depreciation
Depreciation
(20)
(20)
Operating profit
Operating profit
280
280
Taxes are calculated on operating profits
Operating taxes
(70)
Interest
(20)
NOPLAT
210
Nonoperating income
4
Do not include income from any asset excluded
from invested capital as part of NOPLAT
Earnings before taxes (EBT)
264
A/T nonoperating income
3
3
Total income to all investors
213
213
Taxes
(66)
Net income
198
Reconciliation with net income
Net income
198
Treat interest as a financial payout
to investors, not an expense
After-tax interest
15
Total income to all investors
213
Assumes a flat tax of 25 on all income
9
Calculating NOPLAT Top-Down Approach
  • To build NOPLAT, start with revenues and subtract
    traditional operating expenses, such as COGS,
    SGA, and depreciation.

NOPLAT
Revenues
1,000
Operating costs
(700)
Depreciation
(20)
Operating profit
280
  • 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
(70)
NOPLAT
210
  • To compute operating taxes, proceed in two steps
  • Compute operating taxes by adjusting reported
    taxes for non-operating items
  • Adjust reported taxes by the increase in net
    deferred tax liabilities.

10
Calculating NOPLAT Advanced Issues
  • Capitalizing RD
  • If a company has significant long-term RD, do
    not subtract the annual RD expense. Instead,
    capitalize RD on the balance sheet and subtract
    an annualized amortization of this capitalized
    RD.
  • 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.

11
Evaluating Historical Performance
To analyze a companys historical performance, we
proceed in four steps
Reorganize the companys financial
statements First convert the companys 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 Profit Return on
invested capital (ROIC) measures the economic
performance of a companys core business. ROIC
is independent of financial structure and can be
disaggregated into measures examining
profitability and capital efficiency. Analyze
Revenue Growth Break down revenue growth into its
four components organic revenue growth, currency
effects, acquisitions, and accounting
changes. Evaluate credit health and financial
structure Assess the companys 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.
12
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

ROIC Home Depot vs. Lowes
Home Depots outperforms Lowes when measured by
ROIC.
13
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

Economic Profit Invested Capital x (ROIC-WACC)
2002
2001
2003
Return on invested capital (ROIC)
15.0
16.8
19.4
Weighted average cost of capital (WACC)
10.1
9.0
9.3
Home Depot earned 2.6 billion more than
expected based on the companys risk profile
Economic spread
4.9
7.9
10.1
21,379
x Invested capital
23,635
26,185
Economic profit
1,048
1,857
2,645
14
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
ROIC
x
x
(1 - Cash Tax Rate)

Revenues
Invested Capital
Profit Margin
Capital Efficiency
  • As the formula demonstrates, a companys ROIC is
    driven by its ability to (1) maximize
    profitability, (2) optimize capital efficiency,
    or (3) minimize taxes

This equation can be organized into a tree
15
Understanding Value Creation Decomposing ROIC
  • Home Depot benefits from a more efficient use of
    capital and a better cash tax rate.

Gross margin
31.8
  • This capital efficiency comes primarily from
    fixed assets, which in turn come from more
    revenues per dollar of store investment

31.2
Operating margin
11.0
SGA/ revenues
19.1
10.7
18.0
Depreciation/ revenues
1.7
Pre-tax ROIC
25.5
2.5
Home Depot
20.5
Operating working capital/ revenues
4.2
ROIC
18.2
Average capital turns
2.3
4.6
13.9
Cash tax rate
28.6
Fixed assets/ revenues
38.9
1.9
Lowes
32.5
47.4
16
Evaluating Historical Performance
To analyze a companys historical performance, we
proceed in four steps
Reorganize the companys financial
statements First convert the companys 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 Profit Return on
invested capital (ROIC) measures the economic
performance of a companys core business. ROIC
is independent of financial structure and can be
disaggregated into measures examining
profitability and capital efficiency. Analyze
Revenue Growth Break down revenue growth into its
four components organic revenue growth, currency
effects, acquisitions, and accounting
changes. Evaluate credit health and financial
structure Assess the companys 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.
17
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
    companys 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
  • Currency Changes. Foreign revenues must be
    consolidated into domestic financial statements.
    If foreign currencies are rising in value
    relative to the companys home currency, this
    translation, at better rates, will lead to higher
    revenue.
  • 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
  • Changes in accounting policies. When a company
    changes its revenue recognition policies,
    comparing year-to-year revenue can be misleading.

18
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?

IBM purchased two companies Rational Software
and PwCC
IBM Revenue Growth
2001
2002
2003
Organic revenue growth
0.5
(1.8)
(2.6)
Nearly 7 of IBM growth caused by the weakening
dollar.
Acquisitions
0.5
2.1
5.4
Divestitures
0.0
(3.3)
0.0
Currency effects
(2.5)
(3.9)
7.0
Reported revenue growth
(2.9)
(5.5)
9.8
19
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.

IBM Annual Report, Page 51
Had currencies remained at their prior year
levels, IBM revenue would have been 83.5
billion, rather than the 89.1 billion reported.
20
Analyzing Revenue Growth MA
  • 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
IBM reported 2002 revenue
81,186.0
Ten months of Rational Software
2/21/2003
689.8
10/12
574.8
Nine months of PwCC revenue
10/1/2002
5,200.0
9/12
3,900.0
IBM adjusted 2002 revenue
85,660.8
Rational was a publicly traded company, so
revenues are exact. PwCC was private and
estimated using Hoovers data.
Three months of PwCC data was included in IBMs
2002 financials. Therefore, we must add the
remaining nine months, to make 2002 2003
consistent.
Compute growth by comparing 2003 to this number
21
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.

Total System Services, Annual Report, page F-7
Reimbursable Expenses As a result of the
Financial Accounting Standards Boards (FASBs)
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.

22
Understanding Value Creation Decomposing Growth
  • Once revenues have been disaggregated, analyze
    revenue growth from an operational perspective.
    The most standard decomposition is

Square feet per store
4.2
2.7
Number of transactions per store
(3.7)
0.2
Revenue per store
(0.1)
Number of transactions per square foot
(7.6)
4.4
Dollars per transaction
3.7
Home Depot
(2.5)
Revenue
11.3
4.2
16.4
  • Growth trees can be built using advanced versions
    of the decomposition formula presented above.
  • How is Home Depot driving revenue growth?

Lowes
Number of stores
11.4
11.5
23
Evaluating Historical Performance
To analyze a companys historical performance, we
proceed in four steps
Reorganize the companys financial
statements First convert the companys 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 Profit Return on
invested capital (ROIC) measures the economic
performance of a companys core business. ROIC
is independent of financial structure and can be
disaggregated into measures examining
profitability and capital efficiency. Analyze
Revenue Growth Break down revenue growth into its
four components organic revenue growth, currency
effects, acquisitions, and accounting
changes. Evaluate credit health and financial
structure Assess the companys 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.
24
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 companys
    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.

25
Credit Health and Capital Structure - Liquidity
  • The interest coverage ratio measures a companys
    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.

Interest Coverage at Home Depot
Home Depot ( Million)
2003
EBITA
6,847
EBITDA
7,922
EBITDAR
8,492
Interest
62
Rental expense
570
Interest plus rental expense
632
EBITA/Interest
110.4
EBITDA/Interest
127.8
EBITDAR/Interest plus rental
13.4
R stands for rental expense
26
Credit Health and Capital Structure - Leverage
  • To better understand the power (and danger) of
    leverage, consider the relationship between ROE
    and ROIC.
  • 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.

27
Typical Leverage Ratios Across Industries
Median Debt-to-Equity, 2003
  • To place the companys 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.

In percent
Note Market value of debt proxied by book
value. Enterprise value proxied by book value of
debt plus market value of equity
28
Closing Thoughts
  • Understanding a companys past is essential for
    forecasting its future. Through historical
    analysis, we can test a firms ability to create
    value
  • over time by analyzing trends in operating and
    financial metrics, and
  • as compared to other companies within the firms
    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.
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