Section 5
Analysis of
Profitability, Leverage and Growth
‘General Motors is not in the business of making
automobiles. General Motors is in the business of making
money.’ --Alfred P. Sloan
Learning objectives
After studying this chapter, you will understand
• The concept of the value creation of the firm
• How value creation is related to accounting profitability
of the firm
• How to decompose profitability measures to trace the
drivers of the value of the firm
• The role of business and financial risk in the profitability
of the firm
• The link between market and accounting rates of returns
2
It’s all about value creation
• The ultimate goal of the firm is to maximize the value of its
equity
• Can we link managerial decisions to the value creation of
the firm?
• Finance and accounting research has produced many
approaches for this
• One approach is the concept of Economic Value Added
– Also known as ’Economic Profit’, ’Excess Profit’ etc.
3
When does a firm create value?
Value creation
Are we as profitable
as we are supposed
to be?
Investors’ required
rate of return
How profitable are
we supposed to be?
4
Actual
performance
How profitable are
we in reality?
How to measure value creation?
Value creation
- Economic Value Added
or other similar concepts
Investors’ required
rate of return
- Cost of capital, WACC
- Capital structure
5
Actual performance
- Return on invested
capital, ROIC
When does a firm create value?
• A firm creates value for only, if its profitability is greater
than its cost of capital
• This leads us to the following statements:
(1) EVA > 0, if ROIC > WACC
(2) EVA = 0, if ROIC = WACC
(3) EVA < 0, if ROIC < WACC
• The management of the firm should
– maximize ROIC via its components
– mimimize WACC via its components
• What are the components ROIC of WACC that managers
should affect?
6
Example: Value creation and
managerial decions
• Given the definition of EVA, a firm can create value by:
– Maximizing earnings (profits)
– Minimizing the amount of Invested capital
– Minimizing the cost of capital, WACC
Earnings
300
InvestedCapital
2 500
- InvestedCapital × WACC (10%) = - 250
= EVA
50
• How do firms pay attention to this in reality?
7
Weighted Average Cost of Capital,
WACC
• Rate of return required by investors
– Equity investors Cost of equity
– Debt investors Cost of debt
• Investors define the required rate of return for a firm
based on their assessment of the risk of the firm
• Interest payments are tax deductable
Reduces the cost of debt capital
8
The WACC formula
E
D
WACC =
× RE +
× R D , where
E+D
E+D
E is the value of equity
D is the value of debt
R E is the cost of equity capital
R D is the after tax cost of debt capital
9
WACC of Kone
Risk-free
rate
of return
4,5 %

Betacoefficient
0,82

Risk
Preemium
4,5 %
Capital Structure:
• Market values vs. book values?
• Long-term target of the capital
structure?
• Debt or net debt?
Cost of
= Equity 
Capital
8,19 %
Capital
Structure
Equity:
1724
1724 + 𝟐𝟕𝟒
= 𝟎, 𝟖𝟔𝟑
+
1 – Tax rate
24,5%

Cost of new
borrowing
4,0 %
10
Cost of

= Debt
Capital
3,02 %
Debt:
274
1724 + 𝟐𝟕𝟒
= 𝟎, 𝟏𝟑𝟕
=
WACC
7,5 %
Decomposing EVA
EVA = (ROIC-WACC) × InvestedCapital
= ROIC×InvestedCapital - WACC×InvestedCapital
= (NOPAT/Inv.Capital)×Inv.Capital - WACC×Inv.Capital
= NOPAT - WACC×InvestedCapital
Operational performance
Cost of financing
 EVA is the part of earnings that remains after paying all
financing cost to debt and equity investors
11
Return on invested capital, ROIC
• Note that ROIC is very important!
• Financial assets and liabilities are typically close to
market values, but operating assets and liabilities are
not
• ROICt =
NOPATt
(INVESTED CAPITALt +INVESTED CAPITALt−1 )/2
Invested capital:
• Closing or beginning balance
sheet?
• Or their average?
12
Case: ROIC and EVA of Kone, 2013
ROIC2013
NOPAT2013
=
(INVESTEDCAPITAL2013 + INVESTEDCAPITAL2012 )/2
=
720,8
(1120,0+994,6)/2
=
720,8
1057,3
Invested Capital:
• Closing or beginning
balance sheet?
• Or their average?
= 𝟔𝟖, 𝟐%
EVA2013 = ROIC2013 − WACC × INVESTEDCAPITAL2012/13
= 0,68 − 0,075 × 1057,3 MEUR
= 𝟔𝟒𝟎 𝐌𝐄𝐔𝐑
13
Case: Reported ROCE of Kone, 2013
• On Page 45 of its financial report, Kone reports its Return
on Capital Employed (ROCE):
ROCE2013
(NET INCOME + FINANCIAL EXPENSES)2013
=
= 𝟑𝟔, 𝟑%
(EQUITY + INTEREST_BEARING DEBT)2013/2012
• This number differs from our ROIC, because
– Numerator is the reported income rather than NOPAT
– Denominator includes the financial assets (the main issue)
• Note that financial ratios can be calculated in many ways
– ROI, ROIC, RONA, ROCE, ROA, ROTA…
– Sometimes ROCE even refers to Return on Common Equity!
14
More on decomposing EVA
EVA
WACC
Cost of equity
Re = Rf+ß×RP
Cost of debt
Rd
Capital
structure
This is what
we have
discussed
so far…
ROIC
Invested capital
turnover rate
Profit margin
Revenues
Costs
Domestic vs.
foreign
Production
Market share
and growth
Marketing,
administration
15
Working
capital
Long-term
capital
…but there is
still a lot to be
discussed.
More on decomposing EVA
• Value creation is embedded in every decision a firm
makes every day
• Firm-level ROIC can be decomposed based on any
aspect relevant to business:
– Firm-level ROIC can decomposed to project-level ROICs
ROIC and its components need to be considered in every
investment decision
– Firm-level ROIC can be decomposed to customer-level ROICs
ROIC and its components need to be considered in every
customer decision
16
Decomposing ROIC
• ROIC as such does not explain whether profitability (and
value creation) is driven by
– High margins or
– An effective use of invested capital
• We can address this issue by decomposing ROIC into
the profit margin and the turnover rate of invested capital:
ROIC =
NOPAT
REVENUES
×
REVENUES INVESTED CAPITAL
Profit
Margin
(PM)
Invested Capital
Turnover rate
(ICTO)
17
This is also called as
’Asset Turnover Rate’ (ATO).
You can clearly see why…
Decomposing ROIC: Profit margin
• NOPAT/REVENUES is known as a profit margin
• High profit margin indicates
– Strong pricing power and/or
– Good cost control
• Other profit margins can also be calculated in a similar
way
– EBITDA/REVENUES
– EBIT/REVENUES
• Interpretations are similar to NOPAT/REVENUE, but
different levels in I/S allow focusing on different cost items
18
Decomposing ROIC:
Turnover of rate of invested capital
• REVENUES/INVESTED CAPITAL is known as a turnover
rate of invested capital
– Also known as ‘Asset turnover rate’ (ATO)
• High turnover rate of invested capital implies an effective
use of capital received from both equity and debt holders
19
Example: Components of ROIC
ROIC
Our firm
22.5% (= 15%×1.5)
Profit margin
Our firm
Competitor
15%
11%
20
Competitor
30.8% (= 11%×2.8)
Invested capital
turnover rate
Our firm
Competitor
1.5
2.8
Example: Components of ROIC
• Our competitor is more profitable than we are (and can
therefore create more value), but why?
• Our profit margin (15%) is actually greater than that of
our competitor (11%)
– We are good at marketing/pricing/production etc.
• The problem is that our Invested capital turnover rate is
low, if compared to the competitor (1,5 vs. 1,8)
– We have poor working capital management, and/or
– We do not use wisely long-term capital obtained from investors
21
Example: Cargotec, Interim report Q2/2015
22
Decomposing ROIC to identify
differentiation vs. cost leadership strategy
Profit Margin
8%
×
Firm B (Apple Inc.)
All firms on this curve
earn the same ROA
6%
Firm A (Lenovo)
2%
×
1
2
3
4
Asset Turnover
23
5
Decomposing ROIC
24
Example: ROIC decomposition of US firms
Case: Components of ROIC of Kone
ROIC2013 = PROFIT MARGIN2013 × INVESTED CAPITAL TURNOVER RATE2013
=
NOPAT2013
REVENUE2013
×
REVENUE2013 (INVESTEDCAPITAL2013 + INVESTEDCAPITAL2012 )/2
720,8 6932,6
=
×
6932,6 1057,3
= 0,10397 × 6,5569
= 0,6817
= 𝟔𝟖, 𝟐%
26
Case: Components of ROIC of Kone over
time
8 000,0
7 000,0
6 000,0
5 000,0
4 000,0
3 000,0
2 000,0
1 000,0
0,0
2009
NOPAT
2010
2011
2012
2013
Net revenue
Invested capital
27
Case: EVA and stock price of Kone over
time
28
Profit margins of the US and European
listed companies as of Sep 1, 2014
US
Europe
What can you learn from this
figure as an equity investor?
29
Source: Thomson Reuters
Profit margin decomposition
• Profit margin can be decomposed further to trace the
profit margin drivers (time subscripts omitted):
NOPAT
PROFIT MARGIN =
REVENUES
REVENUES − COSTS
=
REVENUES
=
REVENUES − MATERIALS & SERVICES − WAGES & SALARIES
REVENUES
−OTHER COSTS − DEPRECIATIONS − TAXES − OTHER ITEMS
REVENUES
30
Case: Profit margin decomposition, Kone
REVENUES − MATERIALS & SERVICES − WAGES & SALARIES
PROFIT MARGIN =
REVENUES
−OTHER COSTS − DEPRECIATIONS − TAXES − OTHER ITEMS
REVENUES
Numbers are from
the analytical I/S of
Kone
3416,4 1983,8 584,8
78,5
233,9
=1−
−
−
−
−
6932,6 6932,6 6932,6 6932,6 6932,6
−85,6
−
6932,6
= 1 − 49,28% − 28,62% − 8,44% − 1,13% − 3,37% + 1,23%
= 𝟏𝟎, 𝟒𝟎%
31
Example: Kemira, Interim report Q2/2015
32
Example: Kemira, Interim report Q2/2015
33
Example: EBITDA bridge of Outotec,
Interim report Q2/2015
34
Invested Capital Turnover decomposition
• Invested Capital Turnover rate can be decomposed
further to trace the asset turnover drivers:
1
InvCapital

InvCapitalTurnover REVENUES
PPE
Cash
AccountsReceivables Inventories




...
REVENUES REVENUES
REVENUES
REVENUES
AccountsPayables FinancialAssets


...
REVENUES
REVENUES
35
Return on equity (ROE)
• ROIC measures operating profitability
• Return on equity (ROE) measures the profitability
taking into account returns earned on operations and
the effect of financial leverage:
NOPATt − NET FINANCIAL COSTSt
ROEt =
(EQUITYt + EQUITYt−1 )/2
Remember that
NOPAT excludes
financial items.
=
NET EARNINGSt
(EQUITYt + EQUITYt−1 )/2
36
Case: ROE of Kone, 2013
ROE2013 =
NOPAT2013 − NET FINANCIAL COSTS2013
(EQUITY2013 + EQUITY2012 )/2
720,8 − (−4,4)
=
(1833,7 + 1724,6)/2
725,2
=
1779,2
= 0,408
= 𝟒𝟏%
37
Case: Reported ROE of Kone, 2013
• On Page 45 of its financial report, Kone reports that its
ROE based on the reported Net Income is 40,1%
• It is calculated as follows:
ROE2013,𝑅𝑒𝑝𝑜𝑟𝑡𝑒𝑑
Remember that Net
Income includes
financial items.
713,1
=
(1833,7 + 1724,6)/2
713,1
=
1779,2
= 0,4008
= 𝟒𝟎, 𝟏%
38
Link between ROIC and ROE
• There is an important link between ROIC and ROE
(time subscripts omitted):
ROE = ROIC + SPREAD × FLEV
= ROIC + ROIC − NBC ×
NIBD
,
EQUITY
where
NET BORROWING COSTS AFTER TAX
NBC =
, and
NIBD
NIBD = NET INTERESTBEARING DEBT
39
Impact of financial leverage on ROE
Net
Income
High degree
of financial
leverage
Low degree
of financial
leverage
Year
40
Case: ROE, ROIC and leverage of Kone
NBC2013
4,4
4,4
=
=
= 0,0061 = 0,61%
729,8 + 713,7 721,8
2
ROE2013 = ROIC2013 + SPREAD2013 × FLEV2013
Numbers are from
the analytical I/S
and balance sheet
= 0,6817 + 0,6817 − 0,0061 ×
= 0,6817 − 0,2741
= 0,408
= 41%
41
−721,8
1779,1
ROE and the cost of equity capital
• Note that:
E
D
WACC =
× RE +
× RD
(E + D)
(E + D)
D
→ R E = WACC + (WACC − R D ) ×
E
The famous Modigliani and
Miller proposition
• Hence, we have market- and accounting-based returns:
Market rate of returns
D
R E = WACC + (WACC − R D ) ×
E
ROE = ROIC + ROIC − NBC ×
Accounting rate of returns
NIBD
EQUITY
42
Market leverage (should be…)
Book leverage
Yes, we can decompose also ROE…
• We can decompose ROE like we decomposed ROIC
• This decomposition is known as the DuPont identity
(time subscripts omitted):
NET INCOME
REVENUES
INVESTED CAPITAL
ROE =
×
×
REVENUES
INVESTED CAPITAL
EQUITY
Profit
Margin
Invested Capital
Turnover rate
43
Financial
Leverage
Residual income
• Residual income (RI) is a concept similar to EVA
– Residual income: based on ROE and the cost of equity
– EVA: based on ROIC and WACC
EVA = ROIC − WACC × INVESTED CAPITAL
RI = ROE − R E × EQUITY
• RI focuses on the value creation directly from equity
owners’ perspective
– Especially useful in equity valuation models
44
Case: Residual income of Kone
RI2013 = ROE2013 − COST OF EQUITY2013 × (EQUITY2013 + EQUITY2012 )/2
RI2013 = 0,41 − 0,0819 × 1779,2 MEUR
= 584 MEUR
45
Big picture of profitability analysis
RI
Cost of equity
Re
Risk free rate
Risk premium
ROE
NBC
ROIC
Book leverage
ROE = ROIC + ROIC − NBC ×
Profit margin
Turnover rate
of invested
capital
46
NIBD
EQUITY
Financial leverage
• Financial leverage referes to the debt-equity mix
–
High degree of financial leverage (more debt) increases the risk
of the firm
•
–
•
Interest payments need to be paid even in the recession period
Increased financial risk increases the volatility of earnings
Measures of financial leverage include
–
Gearing (Net Debt)
–
Equity ratio (Equity to Total Capital)
–
Debt to Sales
47
Gearing
• NIBD/EQUITY –ratio we have already is called as
Gearing –ratio
• Net Interest-bearing Debt in numerator
– Interest-bearing debt minus financial assets
– A firm can pay back its debt by using financial assets
– ’Debt does not create financial risk, if it can be paid back
anytime’
• Equity in denominator
• Gearing can be calculated using
– Average of the opening and closing balance sheet items or
– Closing balance sheet items
48
Equity ratio
• A direct measure of the debt-equity mix of the firm
• Usually, it is calculated as follows (without time subscipts):
EQUITY
EQUITY
EQUITY RATIO =
=
DEBT + EQUITY TOTAL ASSETS
• The Finnish practice (YTN) is to deduct advanced
payments from total assets
49
Case: Equity ratio of Kone, 2013
EQUITY RATIO2013
EQUITY
=
TOTAL ASSETS
=
1724,6
= 𝟑𝟐, 𝟑%
5343,3
And the Finnish practice:
EQUITY RATIO2013
EQUITY
=
TOTAL ASSETS − ADVANCED PAYMENTS
1724,6
=
= 𝟒𝟑, 𝟕%
5343,3 − 1397,5
50
Kone reports this
number on Page 45 in
its Financial Report
Debt-to-sales ratio
• Combines I/S and B/S items
• Is calculated as follows (without time subscipts):
DEBT
DEBT TO SALES RATIO =
SALES
• The Finnish practice (YTN) is to deduct advanced
payments from debt
51
Case: Debt-to-Sales ratio of Kone
DEBT TO SALES RATIO2013
DEBT CURRENT AND NONCURRENT LIABILITIES
=
=
SALES
SALES
261,9 + 3217,4
=
6932,6
= 𝟓𝟎, 𝟐%
And the Finnish practice:
DEBT TO SALES RATIO2013 =
=
DEBT − ADVANCED PAYMENTS
SALES
261,9 + 3217,4 − 1397,5
6932,6
= 𝟑𝟎, 𝟎%
52
Analysis of growth
• Growth of the firm must create value
• Not all growth creates value
– Acquisition of other firms that have low profitability, low margins
etc.
– Acquisition of other firms at a too high price
– Capital expenditures with too low net present value
• Indicators of value-creating growth
–
–
–
–
EPS, DPS, BPS growth
Revenues and earnings growth,
Even EVA growth, but…
Margins remain stable or even grow, but do not decline
53
Case: Growth rates of Kone
54
Value creation at different organizational
levels
Cost of equity
Financial
decisions
Firm level
Cost of
capital
Cost of debt
Capital struct.
Business
area
level
Investment
decisions
Working cap.
Fixed assets
Cash
flows
Customers
Process
level
Operative
decisions
Products
etc.
55
E
V
A
When does a firm destroy value?
• Well, if ROIC < WACC… But when does this occur?
• Top executives think that equity capital is inexpensive or
even free of charge!
 WACC is seriously underestimated, EVA looks great…
• Middle level executives think that it is not their responsibility
to think about value creation
Poor working capital management
Poor investment decisions
Poor cost control
• Blue collar staff have not even heard about value creation…
Poor cost control, produt quality
56
Summary
• Value creation is an important framework for analyzing
the financial performance of the firm
• A firm creates value, if its net operating profit after taxes
is greater than its cost of capital
• We can decompose profitability measures like ROIC
and ROE to trace the key drivers of profitability, and
consequently, the sources of value creation
• Financial leverage can be used to boost ROE, but at the
time, risks increase
• Profitability analysis should be brought to all
organizational levels of the firm
57