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Corporate Finance

Corporate Finance. Class 06 Financial Statement Analysis Daniel Sungyeon Kim Peking University HSBC Business School. Class Outline. Financial statement analysis Ratio analysis Du Pont Identity Connection of Balance Sheet & Income Statement Excel Model 1. What Have We Learned so far?.

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Corporate Finance

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  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.

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