Analyzing Historical Performance
The Importance of Historical Analysis
• Understanding a company’s past is essential for forecasting its future. Using historical
analysis, we can test a company’s ability to
• create value over time by analyzing trends in operating and financial metrics
• compete effectively within the company’s industry
• In this presentation, we will examine how to effectively evaluate a company’s 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.
1
Evaluating Historical Performance
To analyze a company’s historical performance, we proceed in four steps:
Reorganize the company’s financial statements
Step 1:
First convert the company’s 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
Step 2:
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
Step 3:
Break down revenue growth into its four components: organic revenue growth,
currency effects, acquisitions, and accounting changes.
Evaluate credit health and financial structure
Step 4:
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
The Problems with Traditional Financial Analysis
Why do we need to reorganize the company’s 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.
Return
Debt
 ROIC  (ROIC  k D )
Equity
Equity
• 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.
3
Modern Financial Analysis
• To prevent non-operating items and capital structure from distorting the company’s
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:
ROIC 
NOPLAT
Invested Capital
FCF = NOPLAT – Net Increase in Invested capital
4
Reorganizing the Balance Sheet: An Example
• Let’s rearrange the accountant’s 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
Accountant’s Balance Sheet
Assets
Inventory
Net PP&E
Equity investments
Total assets
Liabilities and equity
Accounts payable
Interest-bearing debt
Common stock
Retained earnings
Total liabilities and equity
Prior
year
200
300
15
515
125
225
50
115
515
Prior
year
Current
year
225
350
25
600
150
200
50
200
600
Current
year
Inventory
200
Accounts payable
(125)
Operating working capital 75
225
(150)
75
Net PP&E
Invested capital
350
425
Equity investments
Total funds invested
300
375
15
390
25
450
225
50
115
390
200
50
200
450
Total funds invested
Interest-bearing debt
Common stock
Retained earnings
Total funds invested
Operating liabilities
are netted against
operating assets
Non-operating assets
are not included in
invested capital.
Note the
redundancy of
total funds
invested
5
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.
6
Reorganizing the Income Statement: NOPLAT
• NOPLAT includes only operating-based income. Unlike net income, interest
expense and non-operating income is excluded from NOPLAT.
Accountant’s income statement
Revenues
Operating costs
1,000
(700)
NOPLAT
Revenues
Operating costs
Depreciation
(20)
Depreciation
Operating profit
280
Operating profit
Interest
Nonoperating income
Earnings before taxes (EBT)
(20)
4
264
(66)
Net income
198
280
(70)
NOPLAT
210
A/T nonoperating income*
3
213
Reconciliation with net income
Net income
198
After-tax interest*
* Assumes a flat tax of 25%
on all income
(700)
(20)
Operating taxes
Total income to all investors
Taxes*
1,000
Total income to all investors
15
213
Taxes are
calculated on
operating profits
Do not include
income from any
asset excluded from
invested capital as
part of NOPLAT
Treat interest as a
financial payout to
investors, not an
expense
7
Calculating NOPLAT – Top-Down Approach
• To build NOPLAT, start with revenues and subtract traditional operating expenses,
such as COGS, SG&A, and depreciation.
NOPLAT
Revenues
1,000
Operating costs
(700)
(20)
Depreciation
Operating profit
Do not subtract
goodwill
amortization
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:
1.
Compute operating taxes by adjusting reported taxes for non-operating items
2.
Adjust reported taxes by the increase in net deferred tax liabilities.
8
Calculating NOPLAT – Advanced Issues
Capitalizing R&D
• If a company has significant long-term R&D, do not subtract the annual R&D
expense. Instead, capitalize R&D on the balance sheet and subtract an
annualized amortization of this capitalized R&D.
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.
9
Evaluating Historical Performance
To analyze a company’s historical performance, we proceed in four steps:
Reorganize the company’s financial statements
Step 1:
First convert the company’s 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
Step 2:
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
Step 3:
Break down revenue growth into its four components: organic revenue growth,
currency effects, acquisitions, and accounting changes.
Evaluate credit health and financial structure
Step 4:
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.
10
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 =
NOPLAT
Invested Capital
ROIC: Home Depot vs. Lowes
18.2
16.0
14.3
12.8
13.9
10.3
2001
Home Depot (%)
2002
2003
Lowe's %)
Home Depot’s outperforms Lowes when measured by ROIC.
11
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)
Return on invested
capital (ROIC)
2001
2002
2003
15.0%
16.8%
19.4%
Weighted average
cost of capital (WACC)
10.1%
9.0%
9.3%
Economic spread
4.9%
7.9%
10.1%
x Invested capital
21,37
9
1,048
23,63
5
1,857
26,18
5
2,645
Economic profit
Home Depot
earned $2.6
billion more
than “expected”
based on the
company’s risk
profile
12
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
ROIC = (1 - Cash Tax Rate) x
Revenues
x
Revenues
Profit Margin
Invested Capital
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…
13
Understanding Value Creation: Decomposing ROIC
 Home Depot benefits from a more efficient use of capital
and a better cash tax rate.
 This capital efficiency comes
primarily from fixed assets, which in
turn come from more revenues per
dollar of store investment…
31.8
Gross
margin
31.2
11.0
Operating
margin
19.1
SG&A/
revenues*
10.7
18.0
1.7
Depreciation/
revenues
25.5
Pre-tax
ROIC
Home Depot
2.5
20.5
18.2
ROIC
13.9
Lowe’s
28.6
Cash tax
rate
32.5
Average
capital
turns
2.3
1.9
Operating
working
capital/
revenues
4.2
Fixed
assets/
revenues
38.9
4.6
47.4
14
Evaluating Historical Performance
To analyze a company’s historical performance, we proceed in four steps:
Reorganize the company’s financial statements
Step 1:
First convert the company’s 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
Step 2:
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
Step 3:
Break down revenue growth into its four components: organic revenue growth,
currency effects, acquisitions, and accounting changes.
Evaluate credit health and financial structure
Step 4:
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.
15
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 company’s 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:
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 upwards
3. Changes in accounting policies. When a company changes its revenue
recognition policies, comparing year-to-year revenue can be misleading.
16
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 Revenue Growth
2001
2002
2003
0.5%
(1.8)%
(2.6)%
Acquisitions
0.5
2.1
5.4
Divestitures
0.0
(3.3
)
(2.5
)
(5.5)%
0.0
Organic revenue growth
Currency effects
Reported revenue growth
(3.9)
(2.9)%
7.0
9.8%
IBM purchased
two companies:
Rational Software
and PwCC
Nearly 7% of IBM
growth caused by
the weakening
dollar.
17
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-toyear 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.
18
Analyzing Revenue Growth: M&A
• 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:
Transaction
date
Estimated
2002
revenue
Partial year
adjustment
IBM reported 2002 revenue
81,186.0
Ten months of Rational Software
Nine months of PwCC revenue
IBM adjusted 2002 revenue
Revenue
adjustments
2/21/200
3
10/1/200
2
Rational was a publicly
traded company, so
revenues are exact. PwCC
was private and estimated
using Hoover’s data.
689.8
10/12
5,200.
0
9/12
Three months of PwCC data was
included in IBM’s 2002 financials.
Therefore, we must add the
remaining nine months, to make
2002 & 2003 consistent.
574.8
3,900.0
85,660.8
Compute growth by
comparing 2003 to
this number
19
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 Board’s (FASB’s) 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 outofpocket expenses as revenue. Historically, TSYS had not reflected such reimbursements in its consolidated statements
of income.
…
20
Understanding Value Creation: Decomposing Growth
Home Depot (%)
Lowe’s (%)
• Once revenues have been disaggregated, analyze revenue
growth from an operational perspective. The most standard
decomposition is:
Revenues 
4.2%
Square feet
per store
Revenue
x Units
Unit
2.7%
(0.1)
Number of
transactions
per store
(3.7)
0.2
Revenue
per store
4.4
Home Depot
3.7
Dollars per
transaction
11.3%
(7.6)%
Number of
transactions per
square foot (2.5)%
4.2
Revenue
16.4%
Lowe’s
11.4
• Growth trees can be built using advanced
versions of the decomposition formula
presented above.
11.5
• How is Home Depot driving revenue growth?
Number of
stores
21
Evaluating Historical Performance
To analyze a company’s historical performance, we proceed in four steps:
Reorganize the company’s financial statements
Step 1:
First convert the company’s 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
Step 2:
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
Step 3:
Break down revenue growth into its four components: organic revenue growth,
currency effects, acquisitions, and accounting changes.
Evaluate credit health and financial structure
Step 4:
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.
22
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 company’s 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.
23
Credit Health and Capital Structure - Liquidity
• The interest coverage ratio measures a
company’s ability to meet short-term
obligations:
EBITDA (or EBITA)
Interest Coverage 
Interest Expense
• 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
24
Credit Health and Capital Structure - Leverage
• To better understand the power (and
danger) of leverage, consider the
relationship between ROE and ROIC.
The Effect of Financial Leverage
on Operating Returns
2.0x
25.0%
Return
Debt
 ROIC  (ROIC  k D )
Equity
Equity
• 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.
Return on Equity
15.0%
1.0x
5.0%
-25%
-15%
-5%
-5.0%
5%
15%
25%
-15.0%
-25.0%
Operating Profit / Total Assets
25
Typical Leverage Ratios Across Industries
• To place the company’s
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.
Median Debt-to-Equity, 2003
In percent
Information technology
Healthcare
Aerospace and defence
Industrial machinery
Consumer discretionary
Consumer staples
Oil and gas
Chemicals, paper, metals
Telecommunications
Airlines
Utilities
0%
4%
14%
15%
18%
23%
28%
35%
43%
49%
89%
Note: Market value of debt proxied by book value. Enterprise value proxied
by book value of debt plus market value of equity
26
Closing Thoughts
• Understanding a company’s past is essential for forecasting its future. Through
historical analysis, we can test a firm’s ability to create value…
• over time by analyzing trends in operating and financial metrics, and
• as compared to other companies within the firm’s 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.
27