Corporate Finance

1. Corporate Finance Class 06 Financial Statement Analysis Daniel Sungyeon Kim Peking University HSBC Business School

2. Class Outline • Financial statement analysis • Ratio analysis • Du Pont Identity • Connection of Balance Sheet & Income Statement • Excel Model 1

3. What Have We Learned so far? • The concept of Free Cash Flow • FCF reflects investment decisions • Adjustments to convert Net Income into Free Cash Flow • Applications of Free Cash Flow • Project Valuation (Capital Budgeting) • Forecast pro-forma Income Statement • Convert pro-forma Net Income to FCF • Discount at proper discount rate

4. Valuation of the Firm • Another application of the FCF concept • Firm valuation • How? • Use the familiar DCF approach • Where to start? • Need to understand the current position of the firm • Ratio analysis

5. The Starting Point • To be able to make accurate forecasts, we must understand… • The operating and financial characteristics of the firm • Cost structure, working capital policies, asset needs, etc. • To understand a firm’s operating and financial characteristics, start by comparing the firm to appropriate benchmarks • What is an appropriate benchmark? • Ratio analysis helps in understanding firm’s cost structure, working capital policies, asset needs, etc. • Understand how a firm’s ratios: • have changed over time (time-series analysis) • compare with competitors’ ratios (cross-sectional analysis)

6. Cross-Sectional Analysis • Compare the firm we analyze to similar firms at the same point in time • Reduces the impact of economy-wide and industry-wide effects • Provides a clear view of the impact of firm-specific characteristics • Difficult to find similar firms • Need to control for numerous factors such as size, age, product mix, financing mix, accounting methods, etc… • No two firms are the same…

7. Time-Series Analysis • Compare the same firm at different points in time • Detects trends in the firm’s characteristics and movements through the product life cycle • However… • No guarantee that we have the correct benchmark • No account for industry effects • A complete analysis should include both cross-sectional and time-series comparisons

8. Limitations to statement analysis • Time-series analysis • Do not blindly assume that ratios will stay constant forever • Watch for changes in product mix or accounting methods • No adjustment for industry conditions • Cross-sectional analysis • Which firms do we compare to? • Based on HISTORICAL data

9. Ratio Analysis • What do we mean by “compare the firm”? • Use financial ratios for comparison → Ratio Analysis • Ratio analysis can helps us… • Understand firm’s operations, cost structure, working capital policies, etc. • Forecast costs, working capital, fixed assets, etc. • Detect strengths and weaknesses in operations and performance • Cannot blindly assume that past ratios will continue to hold in future

10. Ratio Analysis • Financial ratios are tools for analysis • Understand their possible uses • What does a ratio tell us and why? (intended use) • What does a high ratio / low ratio mean? • Know their limitations • How may the ratio be misleading? • Based on historical information

11. The scope of ratio analysis • Ratios based on financial statements • We cover commonly used ratios, the list is not exhaustive • The most important ratios may vary by industry • 4 categories of ratios • Liquidity • Leverage • Asset Use or Efficiency • Profitability

12. Category I: Liquidity • What do they measure? • How well can the firm pay its bills without undue stress • Interpretation? • A high ratio indicates high liquidity, but too high may mean the firm is inefficient • Issues to consider • How liquid are inventory and receivables? • Does the firm have easy access to borrowing?

13. Liquidity ratios • Current ratio = Current Assets / Current liabilities • Quick ratio = (Current assets - inventory) / Current liabilities • Cash ratio = Cash / Current liabilities • Interval measure = Current Assets / Average daily operating costs • Operating Costs = SG&A + COGS – Depreciation • Suppose a firm pays off its suppliers and short term creditors. What happens to its current ratio? • Suppose a firm buys inventory with cash, what happens to its current ratio?

14. Category II: Leverage • What do they measure? • Firm’s long-run ability to meet its obligations • Interpretation • Too high of a ratio could lead to financial distress • Too low of a ratio could indicate the firm is not utilizing all the benefits of debt • Issues to consider • A firm’s level of leverage • A firm’s ability to meet interest payments

15. Leverage ratios EBIT + Depreciation Interest Total Debt Total Equity EBIT Interest LT Debt LT Debt + Total Equity Total Assets Total Equity • Debt/equity ratio = • Long-term debt ratio = • Equity multiplier = • Total debt ratio • Times interest earned ratio = • Cash coverage ratio = Level of leverage Total Assets – Total Equity Total Assets Ability to meet interest payments

16. Category III: Asset use and efficiency • What do they measure? • Firm’s ability to use its assets efficiently to generate sales • Issues to consider • Is the firm maximizing the spread between receivables and payables – working capital management? • Some industries are more asset intensive than others • Some of these ratios vary by industry

17. Asset use and efficiency COGS Inventory 365 days Receivables Turnover Sales Accounts receivable 365 days Inventory Turnover • Inventory Turnover • Days’ Sales in Inventory • Receivables Turnover • Days’ Sales in Receivables • Note: “Days’ sales in inventory” is same as “Inventory days” • Note: “Days’ sales in receivables” is same as “average collection period” Inventory Efficiency A/R Efficiency

18. Asset use and efficiency COGS + SG&A Accounts Payable 365 days Payables Turnover Sales Total Assets Sales Net Fixed Asset • Payables Turnover • Average Payables Period • Fixed Asset Turnover • Total Asset Turnover Payables Turnover Ratios Asset Turnover Ratios

19. Asset Use and Efficiency Ratios • Interpretation of Turnover Ratios • Suppose Sales=$1,500 and Receivables=$250 • Receivables turnover = 1500/250 = 6 times • Days’ sales in receivables = 365/6 = 61 days • …i.e., the firm takes 61 days on average to collect its bills from its customers • Similar intuition behind Days sales in payables, and Days sales in inventory • You can use these ratios (and a sales forecast) to forecast inventories, receivables, fixed assets, etc.

20. Category IV: Profitability • What do they measure? • The firm’s ability to control expenses and generate revenue • Reflect the impact of all other categories of ratios • Margin ratios: • What percentage of sales is profits? • Could also define operating profit margin, gross profit margin, etc. • Return ratios: • What return does firm generate from its assets (or capital)? • Denominator is assets or equity; numerator is a profit item

21. Profitability Ratios Net Income Sales Net Income Total Assets Net Income Total Equity • Profit Margin (PM) • Return on Assets (ROA) • Return on Equity (ROE) • Relationship between profitability ratios and other ratios? (Du Pont identity)

22. Du Pont Identity • ROA and ROE can be decomposed as follows: ROE = Net Profit Margin x Asset Turnover x Equity Multiplier

23. Operating Efficiency Asset Use Efficiency Financial Leverage Interpreting Du Pont Identity • ROE = ROA × Equity Multiplier = Profit Margin × Total Asset Turnover × Equity Multiplier • ROE is determined by: • Operating efficiency (“PM”) • Asset use efficiency (“asset turnover”) • Financial leverage ( “equity multiplier”) • Notice that: • Equity multiplier = 1 + debt-equity ratio

24. Interpreting Du Pont Identity • Du Pont Identity can help in understanding: • Trends in ROE across time, i.e., how ROE changes over a product’s life cycle • Why ROEs differ across firms/ industries • Whether a firm’s ROE is sustainable or not • Note: The 3 components of the ROE decomposition are not independent • If you increase financial leverage, that will have an impact on other components as well • It would be wrong to conclude that a firm can keep increasing its ROE by increasing its financial leverage

25. Du Pont Identity • In-class Exercise • Using Ratio Analysis for K-Mart • Compare K-Mart to Wal-Mart and Target

26. Du Pont Identity • ROE(Wal-Mart) = ? • 52 week high share price = $28.25 • ROE(Target) = ? • 52 week high share price = $8.50 • ROE(K-Mart)= ? • 52 week high share price = $14.25 • Which firm is the market leader? Do you think its ROE is the cause or the result of its leadership position? • The two secondary firms have not performed as well as the leader. In what area(s) have they done particularly poorly?

27. Du Pont Identity • ROE = Profit Margin × Total Asset Turnover × Equity Multiplier • ROE(Wal-Mart) = 3.26% × 2.47 × 2.49 = 20.08% • 52 week high share price = $28.25 • ROE(Target) = 3.43% × 1.89 × 2.99 = 19.39% • 52 week high share price = $8.50 • ROE(K-Mart)= -0.66% × 2.53 × 2.41 = -4.01% • 52 week high share price = $14.25 • What do these ratios tell us about K-Mart?

28. Operating Leverage • So far, we have covered ratios which help us understand firm’s performance in terms of: • Liquidity, Leverage, Asset Use, and Profitability • There are ratios which help us understand the sensitivity of NPV to possible forecast errors • They depend on the firm’s cost structure

29. Operating Leverage • Fixed costs generally magnify forecast errors because they do not change with the level of sales • They make good situations better and bad situations worse • Degree of Operating Leverage • The degree to which % change in the level of sales affects OCF • Depends upon the level of sales Q you start with in determining OCF • % change in OCF  DOL×% change in Q

30. Operating Leverage • Firms with high DOL have higher variability in their ROA than firms with lower DOL • How can DOL help? • DOL tells us the degree to which a firm is committed to fixed costs • There is always some flexibility in production in deciding between fixed and variable costs • DOL Example • We project that a company will sell 20,000 units per year over the next 2 years • The price per unit is $3.00

31. Operating Leverage • DOL Example – continued • Equipment costs are $21,000, depreciated straight-line over 2 years with no salvage value • No increase in NWC • No additional capital outlays for the period of the project • The required return is 15% and tax rate is 15% • There are two scenarios: • Greater Variable Costs: Variable costs are 60% of sales and fixed costs are $3,000 per year • Greater Fixed Costs: Variable costs are 5% of sales, and fixed costs are $36,000 each year

32. Operating Leverage • Same NPV, different DOL Greater Variable Costs Greater Fixed Costs

33. Operating Leverage • What if sales are 5% higher? – High VC Original Forecast Actual Sales

34. Operating Leverage • What if sales are 5% higher? – High FC Original Forecast Actual Sales

35. Multiples Valuation • Although DCF valuation is our primary valuation method, we are going to discuss an alternative method called Multiples Valuation • It is widely used because of its convenience and simplicity • Multiples Valuation is similar to ratio analysis • It tries to estimate market values based on accounting variables such as earnings

36. Multiples Valuation • What is a multiple? • A multiple is a ratio of a market measure to an accounting measure of the firm • Used extensively to value companies and to discuss the relative value of stocks • It is a simple method that gives an intuitively appealing statistic • However, multiples are often misused and severely misunderstood

37. Multiples Valuation • Commonly used Multiples • Earnings Multiples • Price / Earnings per share • Market Value / Operating Cash Flow • Revenue Multiples • Price / Sales per Share

38. Multiples Valuation • Commonly used Multiples • Book Value Multiples • Market Value of Equity / Book Value of Equity • Market Value of Assets / Book Value of Assets • Tobin’s Q → Market Value of Assets / Replacement Value of Assets

39. Multiples Valuation • PE Ratio vs. Market-to-Book Ratio • Both ratios have price or market value in the numerator • But PE ratios are more widely used • Why? Look at the denominators • Earnings per share (EPS) versus Book Value (BV) • BV is more rooted in the past than earnings • Market to Book is more backward looking than PE • Note: Tobin’s Q does not suffer from this problem, but replacement value of assets is difficult to estimate!

40. Multiples Valuation – Applications • Value a firm • Use a multiple (e.g. PE or MB) to identify over-valued or under-valued firms • Most people prefer PE ratio over MB for valuation • Typically compare a firm’s PE with its competitors or industry average • Exit multiple • Estimate the terminal value of a firm in DCF analysis

41. Multiples Valuation – PE Ratio • Variants of PE Ratio • What Earnings to use? • Last year’s (or most recent) Earnings → Trailing PE • Next year’s forecasted Earnings → Forward/Leading PE • What Price to use? • Current price • Average price for the year

42. Multiples Valuation – PE Ratio • Understanding the PE Ratio • Start with a basic DCF: a dividend discount model • P0 = current price, EPS0 = trailing EPS, b = dividend pay-out ratio, re = required rate of return for equity, g = growth rate • Dividing both sides by EPS • PEtrue is the PE ratio based on fundamentals

43. Multiples Valuation – PE Ratio • Estimating PE – Example • Deutsche Bank had an EPS of €46.38 in 2004, and paid out €16.50 as dividends that year • The growth rate in earnings and dividends, in the long term, is expected to be 6% • The required rate of return of equity is 10.7% • Questions: • What is current dividend payout ratio? • What is the PE ratio based on fundamentals? • If the firm trades at a PE of 7, is it over or under-valued?

44. Multiples Valuation – PE Ratio • Understanding the PE Ratio • What factors affect the PE ratio? • Growth rate: All else equal, firms with high g have high PE ratio • Reinvestment: All else equal, firms with high payout (low reinvestment needs) will have high PE ratios • Risk: All else equal, riskier firms have lower PE ratios • Caution: • It is difficult to hold all else equal, because growth rates impact risk and reinvestment needs • PE ratio reflects the aggregate impact of above factors

45. Multiples Valuation – PE Ratio • Impact of growth on PE ratios • Consider the following two airlines: • Airline A has an EPS of $2 and a price of $22 • Airline B has an EPS of $2 and a price of $10.50 • Airline A has g=10% and Airline B has g=5% (Assume b=0.5 and re=15% for both airlines) • Would you say that A is overvalued because it has a PE-ratio of 11 relative to 5.25 for B? • Hint: For each stock, compare its actual PE to its “true” PE

46. Multiples Valuation – PE Ratio • Impact of growth on PE ratios • We have seen that firms with higher growth rates have higher PE ratios • Cannot conclude anything by looking at PE ratio alone • If two firms have different growth rates, we cannot claim either firm is over- or under-valued • To account for differences in growth, investors look at PEG

47. Multiples Valuation – PE Ratio • Impact of growth on PE ratios • If two firms have the same risk but different growth rate, we cannot compare their PE ratios, but we can compare their PEG ratios • What are the PEG ratios for Airlines A and B? Do they have equal PEG ratios? • Not exactly → PEG ratios control for differences in growth only approximately.

48. Multiples Valuation – PE Ratio • Impact of risk on PE ratios • PEG ratios do not take into account the difference in risk profiles of the firms • If two firms have the same growth rate, the high risk firm will trade at lower PEG (or PE) ratio than the low risk firm • Company that looks most under-valued on a PEG ratio basis in a sector may be the riskiest firm in the sector • Therefore, while interpreting multiples… • Pay attention to differences in risk profile • Pay special attention to the capital structure of the firms

49. Multiples Valuation – Exit Multiple • Exit Multiple • Exit multiple uses a comparison multiple like the PE ratio to estimate the terminal value of the firm • Exit multiple offers an alternative, especially when the long-term growth rate is uncertain • Use Exit Multiples when… • Making assumptions about the terminal value of the firm (i.e. the expected growth of the firm forever) is difficult and prone to significant errors

50. Points to Remember • Multiple • Ratio of a market measure to an accounting measure of the firm • PE ratio is the most commonly used multiple • Multiple Valuation • Less rigorous but more convenient alternative to the DCF valuation method • Impact of risk and growth • When interpreting multiples, one must pay attention to differences in growth, risk, etc.