Financial Analysis and
Valuation
Analyzing Financial Performance
Decomposing ROIC
Evaluating Historical Performance
To analyze a company’s historical performance, we proceed in three steps:
Slides 2−10
Step 1
Slides 11−19
Step 2
Slides 20−25
Step 3
Analyze ROIC and Economic Profit
Return on invested capital (ROIC) measures the economic performance of a company’s 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 company’s 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.
2
Using ROIC to Compare Operating Performance
• To measure historical operating
performance, compute ROIC by
comparing NOPAT to invested
capital:
UPS and FedEx: Return on Invested Capital 1
percent
20
15
NOPAT
ROIC =
Invested Capital
UPS
10
FedEx
5
• The ROIC of UPS was 5-12% higher than that of
FedEx from 2004-2013. Thus despite similar
revenue levels, the enterprise value of UPS traded
at roughly double that of FedEx.
0
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
1
ROIC measured with goodwill and acquired intangibles. Goodwill and acquired intangibles
do not meaningfully affect ROIC for either company.
3
ROIC With or Without Goodwill?
• Compute ROIC both with and without
goodwill and acquired intangibles,
because each ratio analyzes different
things.
• To measure aggregate value creation for the
company’s shareholders, measure ROIC with
goodwill.
Ecolab Inc.: Return on Invested Capital
percent
ROIC without goodwill and acquired intangibles
37.5
ROIC with goodwill and acquired intangibles
36.6
19.8
33.8
17.3
30.1
10.8
• ROIC excluding goodwill measures the
underlying operating performance of the
company and its businesses and is used to
compare performance against peers and to
analyze trends.
8.4
2010
2011
2012
2013
2010
2011
2012
2013
Note: This presentation sometimes shortens goodwill and acquired intangibles to goodwill.
4
Understanding Value Creation: Decomposing ROIC
• In 2013, FedEx’s ROIC (6.2%) trailed UPS’s ROIC (16.9%) by over 10 percentage points.
• But what is driving this difference in performance?
• Can the deficit be closed?
• To better understand ROIC, we can decompose the ratio as follows:
ROIC = (1 - Operating Tax Rate) x
EBITA
Revenues
x
Revenues Invested Capital
Profit Margin
Capital Efficiency
• As the formula demonstrates, a company’s 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 …
5
Understanding Value Creation: Decomposing ROIC
percent
Compensation and benefits /
revenues1
UPS
52.2
FedEx
36.6
Purchased transportation /
revenues
Operating margin
Pretax ROIC
UPS
28.2
FedEx
10.5
UPS
12.6
UPS
13.5
FedEx
9.8
FedEx
17.6
Fuel / revenues
UPS
7.3
FedEx
10.0
Depreciation / revenues
ROIC without goodwill
ROIC with goodwill
UPS
16.9
FedEx
6.2
UPS
18.9
FedEx
6.9
12.1
FedEx
11.5
3.0
FedEx
5.6
Other expenses / revenues1
Operating cash tax rate
UPS
32.8
FedEx
34.6
Revenues / invested capital
Goodwill as a percent of capital
UPS
UPS
UPS
11.4
FedEx
20.4
Operating working capital/revenues
UPS
2.24
UPS
3.0
FedEx
1.07
FedEx
3.4
Fixed assets/revenues
UPS
41.6
FedEx
89.7
6
1
Compensation and benefits have been adjusted for nonoperating expenses, such as nonoperating pension expense. Other expenses have been adjusted for operating leases.
Understanding Value Creation: Decomposing ROIC
• Margin Perspective:
• UPS’s operating margin was 12.6% versus 9.8% for Lowe’s.
• Do they have the same business model?
• Their business mixes are different, e.g. the ratio of overnight to ground-based
deliveries. Thus UPS’s primary cost driver is its own labor force, while FedEx’s
primary drivers are purchased transportation, fuel, depreciation, and “other” expenses
such as landing fees and rental expense.
• Capital efficiency derives primarily from the efficiency of fixed assets.
• UPS’s capital turnover (2.24) is more than double FedEx’s 1.07.
7
Understanding Value Creation: Line Item Analysis
UPS and FedEx: Operating Current Assets in Days
 To complete a thorough analysis, each tree branch
should examined separately over time and across
competitors.
Number of days in revenues
UPS
Operating cash
Accounts receivable, net
Other current assets
Operating current assets
Accounts payable 1
Accrued wages and withholdings 2
Self-insurance reserves
Other current liabilities
Operating current liabilities
Working capital days3
FedEx
2011
7
43
8
58
2012
7
41
7
55
2013
7
43
6
56
2011
7
40
8
56
2012
7
42
6
55
2013
7
44
6
57
82
81
89
43
50
52
25
5
10
122
26
5
10
122
29
5
9
132
37
6
9
95
37
7
9
103
28
6
10
96
15
12
11
13
10
15
1
Days in accounts payable computed using fuel and other expenses, rather than revenues.
2
Days in accrued wages and withholdings computed using compensation and benefits, rather than revenues.
3
Days in working capital computed using revenue, not as the difference between assets and liability days
 For operating current assets and liabilities, we can
convert each line item into “days,” using the following
formula:
Balance Sheet Account
Days  365 
Revenues (or COGS)
UPS is better able to delay
payment to suppliers with
82-89 accounts payable
days to FedEx’s 43-52.
8
Understanding Value Creation: Nonfinancial Metrics
• In an external analysis, ratios are often confined to financial performance.
• If you are working inside a company, however, or if the company releases operating data, you should link operating
drivers directly to return on invested capital. For instance, how can we use data about employees and miles flown
for airlines?
United Airlines and JetBlue: Financial and Operating Statistics
$ million
United Airlines
JetBlue
Revenues
Aircraft fuel and related taxes
Salaries and related costs
Other operating expenses
Operating (loss) profit
2011
37,119
(12,375)
(7,652)
(14,663)
2,429
2012
37,160
(13,138)
(7,945)
(14,703)
1,374
2013
38,287
(12,345)
(8,625)
(15,538)
1,779
2011
4,504
(1,664)
(947)
(1,571)
322
2012
4,982
(1,806)
(1,044)
(1,756)
376
2013
5,441
(1,899)
(1,135)
(1,979)
428
Operating statistics
Enmployees (full-time equivalents)
Available seat-miles (millions)
87,000
219,437
88,000
216,330
87,000
213,007
12,133
37,232
12,460
40,075
12,952
42,824
9
Nonfinancial Metrics: Building an Equation
• To better understand labor expenses, we disaggregate labor expenses to revenue using the
following equation:
How much labor cost is incurred per available seat-mile (ASM) flown?
Labor Expenses
Revenue
=
Labor Expenses
×
Total Employees
Cost Structure
×
Total Employees
ASMs Flown
Productivity
ASMs Flown
×
Revenue
×
Price
Average Salary per
Productivity of Each Full-Time
# Miles Needed to
Full-Time
Employee (# Employees to Fly One
Be Flown to
Employee
Billion Available Seat-Miles)
Generate $1
• Note how each term’s denominator cancels the next term’s numerator, leaving us with the original ratio.
10
Nonfinancial Metrics: Analyzing the Data
• It appears that United Airlines and JetBlue
have similar labor costs per dollar of
revenue, 22.5 cents and 20.9 cents
respectively. This statistic is misleading. It
costs United Airlines $40.50 per thousand
ASMs to JetBlue’s $26.50. That cost per
ASM is offset by United Airlines’ ability to
charge 41.5% more per ASM than JetBlue.
Operational Drivers of Labor Expenses to Revenues, 2013
percent
Aircraft fuel/revenues
United
32.2
JetBlue
34.9
Labor expenses / employee 2
Labor expenes/ 1000 ASMs
Operating margin
United
• Analysis leads to questions. For example,
what causes the difference in productivity
(ASM/employee)? Different route
structures? Levels of service?
JetBlue
4.6
Labor expenses/revenues
United
22.5
JetBlue
20.9
7.9
Other costs/revenues
United
40.6
JetBlue
36.4
Profit and Loss Statement
United
40.5
JetBlue
26.5
1
United
99.1
JetBlue
87.6
Millions of ASMs / employee
Revenues/1000 ASMs1
United
179.7
JetBlue
127.1
United
2.4
JetBlue
3.3
Key Performance Indicators
1
Available seat-miles (ASMs) are the standard unit of measure for the U.S. airline industry. Labor expense and revenue ratios measured in cents per mile.
2
Labor expenses per employee measured in $ thousands
11
Evaluating Historical Performance
To analyze a company’s historical performance, we proceed in three steps:
Slides 2−10
Step 1
Slides 11−19
Step 2
Slides 20−25
Step 3
Analyze ROIC and Economic Profit
Return on invested capital (ROIC) measures the economic performance of a company’s 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 company’s 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
Analyzing Revenue Growth
•
The value of a company is driven by return on invested capital, the weighted average cost of capital, and growth. The
ability to grow cash flows over the long term depends on a company’s ability to grow its revenues organically.
•
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:
1. Currency changes. Foreign revenues must be consolidated into domestic financial statements. If foreign currencies are rising in
value relative to the company’s home currency, this translation, at better rates, will lead to higher revenue.
2. Mergers and acquisitions. When one company purchases another, the bidding company may not restate historical financial
statements. This will bias one-year growth rates upward.
3. Changes in accounting policies. When a company change its revenue recognition policies, comparing year-to-year revenues
can be misleading.
13
Organic Growth vs. Reported Growth
Compass and Sodexo: Revenue Growth Analysis
•
•
Compass (based in the United Kingdom)
and Sodexo (based in France) are global
providers of canteen services in businesses,
schools, and sporting venues.
In 2013, Sodexo’s revenue growth rate,
0.9%, trailed Compass’ by 3.0%.The
difference in growth rates is dramatic and
misleading. While currency effects (Pounds
Sterling vs Euro) impacted both, only
Sodexo was seriously effected by one-time
items. Thus Sodexo’s organic growth rate,
2.9%, only trails Compass’ by 1.4%.
percent
Compass
Sodexo
2011
2012
2013
2011
2012
2013
Organic revenue growth
5.4
5.4
4.3
5.2
4.5
2.9
Temporary revenue 1
0.0
0.0
0.0
0.0
2.0
(1.8)
Currency effects
0.2
(1.1)
(0.6)
0.2
2.7
(0.6)
Portfolio changes
3.8
2.5
0.2
0.0
4.4
0.4
Reported revenue growth
9.4
6.8
3.9
5.4
13.6
0.9
1
Effect of one-time items such as 2012 Oiympic games and 53rd week in United States
14
Analyzing Revenue Growth: Currency Changes
• The exhibit below reports the revenue
breakout by geography for Compass and
Sodexo.
Compass and Sodexo: Effect of Currencies on Revenue Growth
percent
Revenue by geography
Effect of currency changes on revenue growth
5.1
Rest of world
United Kingdom
17
17
3.7
13
2.8
12
• The companies have similar geographic
mixes, with roughly 40 percent of revenues
coming from North America. Since each
company translates U.S. dollars into a
different currency, exchange rates will affect
each company quite differently.
1.0
Compass
Europe
North America
26
40
36
2006
2007
2008
39
-5.1
Sodexo
Compass translates U.S. dollars from its North
American business into British pounds. Given the
weakening of the pound against the U.S. dollar
($2.04 per pound in 2007 versus $1.78 per pound in
2008), Compass reported an increase in revenues of
5.1 percent attributable to the weakening pound.
-6.7
Compass
Sodexo
15
Analyzing Revenue Growth: Currency Changes
•
Companies with extensive foreign business will report revenues using both current and constant exchange rates (CER).
•
For instance, IBM reported a year-to-year revenue change of 9.8 percent in 2003, but a year-to-year constant currency
change of only 2.8 percent.
IBM 2003 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.
16
Analyzing Revenue Growth: M&A
• Stripping the effect of acquisitions from reported revenues is difficult. Unless an acquisition
is deemed material by the company’s accountants, company filings do not need to detail
or even report the acquisition.
1. For larger acquisitions, a company will report pro forma statements that recast
historical financials as though the acquisition were completed at the beginning of the
fiscal year. Revenue growth then should be calculated using the pro forma revenue
numbers
2. If the target company publicly reports its own financial data, you can construct pro
forma statements manually by combining revenue of the acquirer and the target for
the prior year. But beware: The bidder will include partial-year revenues from the
target for the period after the acquisition is completed.
17
Analyzing Revenue Growth: M&A
• Consider the hypothetical purchase
of a target company in the seventh
month of year 3.
• Both the parent company and the
target are growing organically at 10
percent per year. Consolidated
revenue growth, however, is
reported at 22.8 percent in year 3
and 18.2 percent in year 4.
Effect of Acquisitions on Revenue Growth
$ million
Year
Revenue by company
2
3
4
5
Parent company
100.0
110.0
121.0
133.1
146.4
Target company
20.0
22.0
24.2
26.6
29.3
110.0
121.0
133.1
146.4
14.1
26.6
29.3
110.0
135.1
159.7
175.7
Consolidated revenue growth
10.0
22.8
18.2
10.0
Organic growth
10.0
10.0
10.0
10.0
Consolidated revenues
Revenue from parent
100.0
Revenue from target
Consolidated revenues
• To create an internally consistent
comparison for years 3 and 4, adjust
the prior year’s consolidated
revenues to match the current year’s
composition.
1
Growth rates
1
1
100.0
(percent)
Only consolidated revenues are reported in a company's annual report.
18
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 IFRS 15, effective January 2017, from the International Accounting Standards Board, which concerns
revenue from contracts with customers.
• The International Accounting Standards Board feels that revenue Standards do not offer adequate guidance on a number of
important topics. Thus economically similar transactions are accounted for differently.
• The Standard establishes a five-step process to determine the timing and magnitude of revenue recognition.
• Some companies may see one-time increases or drops in revenue as recognition is delayed or accelerated.
International Accounting Standards Board, IFRS 15 Feedback Statement, page 3
IFRS 15 addresses those deficiencies by specifying a comprehensive and robust framework for the recognition, measurement and disclosure of
revenue. In particular, IFRS 15:
• improves the comparability of revenue from contracts with customers;
• reduces the need for interpretive guidance to be developed on a case-by-case basis to address emerging revenue recognition issues;
and
• provides more useful information through improved disclosure requirements.
19
Understanding Value Creation: Decomposing Growth
• Once revenues have been disaggregated, analyze revenue growth from an operational perspective. The most standard decomposition is:
Home Depot and Lowe’s: Revenue Growth Analysis
percent
Square feet/store
Transactions/store
Revenues/store
Organic Revenue Growth
Home Depot
Lowe's
1
5.4
5.3
Home Depot
Lowe's
Home Depot
1.7
Lowe's
2.2
5.1
5.0
Number of stores
Home Depot
0.3
Lowe's
0.3
Dollars/transaction
Home Depot
3.4
Lowe's
2.7
Home Depot
0.1
Lowe's
-0.1
Transactions / square foot
Home Depot
1.5
Revenues 
Revenue
 Units
Unit
• Growth trees can be built using advanced versions
of the decomposition formula presented above.
• How is Home Depot driving revenue growth?
Lowe's
2.4
Excluding Lowe's purchase of 72 Orchard Supply Hardware Stores in September 2013
20
Evaluating Historical Performance
To analyze a company’s historical performance, we proceed in three steps:
Slides 2−10
Step 1
Slides 11−19
Step 2
Slides 20−25
Step 3
Analyze ROIC and Economic Profit
Return on invested capital (ROIC) measures the economic performance of a company’s 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 company’s 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.
21
Credit Health and Capital Structure
• In the final step of historical analysis, focus on how the company has financed its operations. Ask:
• How is the company financed? That is, what proportion of invested capital (IC) comes from creditors versus equity
holders?
• Is this capital structure sustainable?
• Can the company survive an industry downturn?
• To assess the aggressiveness of a company’s capital structure, 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.
22
Credit Health and Capital Structure—Liquidity
Home Depot and FedEx : Measuring Coverage
• The interest coverage ratio measures a company’s
ability to meet short-term obligations:
Interest Coverage 
EBITDA (or EBITA)
Interest Expense
• EBITDA/interest measures the ability to meet shortterm financial commitments using 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.
$ million
FedEx
UPS
EBITA
EBITDA
2011
7,008
8,768
2012
7,125
8,955
2013
6,973
8,820
2011
4,410
6,505
2012
4,254
6,613
2013
4,447
7,011
EBITDAR1
9,397
9,574
9,395
8,733
8,866
9,362
Interest
Rental expense
Interest plus rental expense
348
629
977
393
619
1,012
380
575
955
52
2,228
2,280
82
2,253
2,335
160
2,351
2,511
Coverage ratios
EBITA/interest
EBITDA/interest
EBITDAR/interest plus rental expense
20.1
25.2
9.6
18.1
22.8
9.5
18.3
23.2
9.8
84.8
125.1
3.8
51.9
80.6
3.8
27.8
43.8
3.7
2.4
1.9
2.4
2.3
1.8
3.0
2.4
1.9
2.6
5.0
3.4
3.2
5.9
3.8
3.3
6.3
4.0
3.4
Debt multiples
Debt-to-EBITD
Debt-to-EBITDA
Debt and Leases-to-EBITDAR
1
Earnings before interest, taxes, depreciation, amortization, and rental expense
23
Credit Health and Capital Structure—Liquidity
• EBITDA interest coverage (times interest earned) is the most widely used ratio for large companies with
access to public capital markets.
Yield to Maturity 1
by Ratings Class, 2009
Interest Coverage Ratio
Three -Year (2005 −2007) Medians
9.10
9.44
26.5
7.07
22.2
19.8
17.0
17.2
16.2
4.68
4.75
5.05
4.20
4.44
4.83
5.33
AAA
AA+
AA
AA −
A+
A
A−
6.09
6.19
BBB+
BBB
3.31
10.5
AAA
•
AA
A
BBB
BB
B
CCC
1 Monthly
BBB − BB+
BB
average of yields.
Although interest coverage is the primary driver of a company’s rating, it is not the only driver. Other drivers include
capital intensity, debt to value, among others.
24
Credit Health and Capital Structure—Leverage
• To better understand the power (and danger)
of leverage, consider the relationship between
return on equity (ROE) and ROIC.
Effect of Financial Leverage
on Operating Returns
Return
Debt
 ROIC  (ROIC  k d )
Equity
Equity
• The use of leverage magnifies the effect of
operating performance.
• The higher the leverage ratio (lC/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.
2.0x
25%
15%
1.0x
5%
Return on Equity
−25%
−15%
−5%
−5%
5%
15%
25%
−15%
−25%
Operating Profit/Invested Capital (ROIC)
25
Median Leverage Ratios Across Industries
Median Debt to Value by Industry1
• To place the company’s current capital
structure in the proper context, compare its
capital structure with those of similar
companies.
percent
2003
Internet
0.1
Software
0.0
Health care equipment
63.1
58.5
3.8
36.8
Beverages
• Industries with heavy fixed investment in
tangible assets tend to have higher debt levels.
29.1
Household products
24.0
26.0
Chemicals
Airlines
1
21.1
24.0
17.2
Gas utilities
Paper and forest
29.5
13.0
Tobacco
• High-growth industries, especially those with
intangible investments, tend to use very little
debt.
2008
41.7
…
42.2
33.2
9.7
4.1
0.2
S&P 1500 classified by GICS industry. Debt to value measured using market values.
Note: Market value of debt proxied by book value. Enterprise value proxied by book value of
debt plus market value of equity.
26