



Reorganise the financial statements to reflect
economic, instead of accounting, performance.
Measure and analyse the company’s return on
invested capital (ROIC) and economic profit to
evaluate the company’s ability to create value
Break down revenue growth into four
components: organic revenue growth, currency
effects, acquisitions and accounting changes
Assess the company’s financial health and capital
structure to determine whether it has the
financial resources to conduct business and
make short-and long-term investments


Separate operating performance from nonoperating items and the financing obtained to
support the business.
ROIC and Free Cash Flow (FCF) are
independent of leverage and focus solely on
the operating performance of the business.

OA +NOA = OL + (D +DE) + (E + EE)
◦
◦
◦
◦
◦
◦
◦
OA = Operating assets
NOA = Non-operating assets
OL = Operating liabilities
D = Debt
DE = Debt equivalent
E = Equity
EE =Equity equivalents


Invested Capital +NOA =
Total Funds Invested = (D+DE) + (E + EE)
Invested capital = OA – OL

ACCOUNTANT’S BALANCE SHEET
Previous year
Current
year
Liabilities and Equity
Share capital
50
50
Retained earnings
115
200
Interest-bearing debt
225
200
Accounts payable
125
150
Total liabilities and equity
515
600
300
350
15
25
Inventory
200
225
Total assets
515
600
Assets
Net PPE
Equity investments

INVESTED CAPITAL
Net PP&E
Previous year
300
Current year
350
Inventory
Accounts payable
Operating working capital
Invested capital
Equity investments
Total funds invested
200
(125)
75
375
15
390
225
(150)
75
425
25
450
Share capital
Retained earnings
Interest-bearing debt
Total funds invested
50
115
225
390
50
200
200
450




Interest is not subtracted from operating profit.
It is considered a payment to company’s financial
investors.
Exclude any non-operating income, gains, or
losses generated from assets excluded from
invested capital.
Effects of interest expense and non-operating
income are removed from taxes.
◦ Start with reported taxes, add back the tax shield caused
by interest expense, and remove taxes paid for nonoperating income.


Model all financing cost (including interest
and tax shield) in the cost of capital.
Taxes on non-operating income should be
netted against operating income.

ACCOUNTANT’S INCOME STATEMENT
Revenue
Operating cost
Depreciation
Operating profit
Interest
Non-operating income
Earnings before taxes (EBT)
Taxes
Net profit
Current year
1,000
(700)
(20)
280
(20)
4
264
(66)
198

NOPLAT
Revenue
Operating cost
Depreciation
Operating profit
Operating taxes (assume 25%)
NOPLAT
After tax non-operating income
Total income to all investors
Reconciliation with net profit
Net profit
After tax interest
Total income to all investors
Current year
1,000
(700)
(20)
280
(70)
210
3
213
198
15
213


ROIC = (NOPLAT/Invested Capital)
ROIC is used to measure how the company’s
core operating performance has changed and
how the company compares with its
competitors, without the effects of financial
structure and non-operating items distorting
the analysis.


FCF = NOPLAT + Non-Cash Expenses –
Investments in Invested Capital
Cash flow from non-operating assets should
be evaluated separately from core operations

ACCOUNTANT’S CASH FLOW
Current year
Net income
198
Depreciation
20
Decrease (increase) in inventory
(25)
Increase (decrease) in accounts payable
25
Cash flow from operations
218
Capital expenditures
(70)
Decrease (increase) in equity investments
(10)
Cash flow from investing
(80)
Increase (decrease) in interest-bearing debt
(25)
Increase (decrease) in common stock
0
Dividends
(113)
Cash flow from financing
(138)

FREE CASH FLOW
NOPLAT
Depreciation
Current year
210
20
Gross cash flow
230
Decrease (Increase) in inventory
(25)
Increase (Decrease) in accounts payable
25
Capital expenditures
(70)
Gross investment
(70)
Free cash Flow
160
After tax non-0perating income
Decrease (increase) in equity investments
3
(10)
Cash flow available to investors
153
After tax interest expense
15
Decrease (increase) in interest-bearing debt
25
Decrease (increase) in share capital
0
Dividends
113
Cash flow available to investors
153

Specifically excess cash and marketable
securities are excluded.
◦ Excess cash represents temporary imbalances in the
company’s cash position.

Operating liabilities should not be considered
as a form of financing.
◦ Assumption that operating liabilities are a form of
financing is inconsistent with the definition of
NOPLAT.

The book value of net property, plant and
equipment is always included in the operating
assets.

Adjust reported goodwill upwards to
recapture historical amortisation and
impairments.
◦ To maintain consistency, amortisation and
impairments are not deducted from revenues to
determine NOPLAT.

An unrecorded goodwill should be added to
recorded goodwill.


Operating lease
Expensed investments: advertising, and
research and development

Excess cash and marketable securities.
◦ To asses the minimum cash needed to support
operations, look for a minimum clustering of cash
to revenue across the industry.


Illiquid investments, non-consolidated
subsidiaries and other equity investments.
Pre-paid and intangible pension assets




Unfunded retirement liabilities
Operating lease
Reserves for plan decommissioning
Reserve for restructuring

Deferred tax liability
◦ To be consistent use cash taxes to compute
NOPLAT




Earnings before interest, tax, and amortisation of
goodwill (EBITA) is the starting point
Exclude non-operating incomes, gains and losses
Adjust income for hidden assets
Consider operating cash taxes on EBITA
◦ Use marginal tax rate to eliminate tax effect
◦ Use cash taxes actually paid
◦ Subtracting the increase in deferred taxes lead to cash
taxes

Reconcile net income to NOPLAT to ensure that
the reorganisation is complete

It represents the cash available for investment
and investor payout, without having to sell nonoperating assets or raise additional capital.
◦ Gross cash flow has two components: NOPLAT and Noncash operating expenses.

The two most common non-operating expenses
are depreciation and employee stock option.
◦ ESOPs represent value being transferred from
shareholders to company employees.
◦ If ESOPs are added back to NOPLAT, those must be
valued separately.
◦ If they are not added back, there is no need to value
them separately.


Change in operating working capital
Net capital expenditure
◦ It is estimated by taking the change in the net PP&E
plus depreciation.
◦ Change in the gross PP&E should not be considered
as gross investment because when assets are
retired gross PP&E is reduced without any cash flow
implication.

Change in capitalised operating leases

Investment in acquired intangibles and goodwill
◦ For acquired intangible assets, where cumulative
amortisation has been added back, investment is
estimated by computing the change in net acquired
intangibles.
◦ For intangibles that are being amortised, the method
that is being used for estimating net investment in PP&E
is used.


Change in other long-term operating assets, net
of long-term liabilities.
Non-cash increase should be adjusted (e.g.
exchange difference, and change in fair value)


Reinvestment ratio =
Gross investment/Gross cash flow
If the ratio is rising without a corresponding
increase in growth, examine:
◦ Whether the company’s investments are taking
longer to blossom than expected; or
◦ Whether the company is adding capital in efficiently



ROIC = NOPLAT/Average Invested Capital
When ROIC is used to measure historical
performance for company’s shareholders,
ROIC should be measured with goodwill.
ROIC excluding goodwill measures the
company’s internal performance and is useful
for comparing operating performance across
companies and for analysing trends.

Economic profit =
Invested capital × (ROIC – WACC)
◦ Invested capital is measured at the beginning of the
year.


Economic profit measures the one-year
performance on historical book value.
The change in market value measures
changing expectations about future economic
profits.


ROIC =
(1 – Cash tax rate) × (EBITA/Revenues) ×
(Revenues/ Average invested capital)

Components of ROIC
Pre-tax
ROIC
25.5
Operating
margin
11.0
ROIC
Gross margin
31.8
SG&A/Revenues
19.1
31.8
Depn /Revenues
1.7
18.2
Cash tax
rate
28.6
Average
capital turns
2.3
Op WC /Revenues
4.2
FA /Revenues
38.9



Compare historical value drivers with drivers
of other companies in the same industry
What are the sources of competitive
advantage?
Is the competitive advantage sustainable?

Convert every line item to some type of ratio,
for example:
◦ Operating ratios
◦ Each line item in the balance sheet as a percentage
of revenue



If, available, analyse the operating data.
By evaluating operating drivers, one can
better assess the sustainability of financial
spreads among competitors.
Example: Airlines industry
◦
◦
◦
◦
(Labour expense/Revenue) =
(Labour expense/Total employees) ×
(Total employees/Available seat miles flown ) ×
(Available seat miles flown /Revenue)




Value of a company is driven by ROIC, WACC
and growth
Growth is defined as growth in cash flows
Assuming profit margins and reinvestment
rates stabilise to a long-term level, long-term
growth in cash flows will be directly ties to
long-term growth in revenues.
By analysing historical revenue growth, one
can assess the potential for growth going
forward.

IBM: Revenue Growth analysis (Per cent)
[Ref: Valuation Mc Kinsey Exhibit 7.16]
2001
2002 2003
Organic revenue growth
0.5
(1.8)
(2.6)
Acquisition
0.5
2.1
5.4
Divestiture
0
(3.3)
0
Currency effects
(3.9)
(2.5)
7.0
Reported revenue growth
(2.9)
(5.5)
9.8



Revenues earned in different currencies are
translated in the reporting currency.
Reported revenue is affected by the
weakening or strengthening o currencies
against the reporting currency during the
reporting period.
Thus a rise in revenue may not reflect
increased pricing power or greater quantities
sold, but just a depreciation of the company’s
home currency.



Revenues = (Revenue/Unit) × Units
Revenue per unit does not represent the price
If revenue per unit is rising, the change could
be due to rising prices or due to the change
in the product mix from low-priced to highpriced items

Revenue Growth Analysis: Retail Chain (Per
cent) (Ref: Valuation, McKinsey, Exhibit 7.19
Number of
transactions
per store
(3.7)
Revenue
11.3
Revenue
per store
(0.1)
Dollar per
transaction
3.7
11
90.1)
Number of
stores
11.4
Square feet per
store
4.2
Number of
transactions per
square foot
4.2


New store development is an investment
choice, where as same-store sales growth
reflects store-by-store operating
performance.
New stores require large capital investments,
where as comparable (that is, year-to-year
sale store sales) requires little incremental
capital.
◦ Higher revenue and less capital leads to higher
ROIC


Interest coverage ratio
EBIT/Interest or EBIDTA/Interest
◦ (EBITA/Interest) measures the company’s ability to
repay interest without having to cut expenditures
intended to replace depreciating equipment.

EBITDAR/(Interest + Rental Expense)
◦ Important for companies engaged in industries like
retailing business

ROE =
ROIC + [ROIC – (1 – T) kd] × (D/E)
◦ ROE is a direct function of its ROIC, its spread of
ROIC over its after-tax cost of debt, and bookbased debt-equity ratio

To assess leverage, measure company’s
(market) debt-to-equity ratio over time and
against peers.

Look back as far as possible (at least 10 years)
◦ This allows to determine whether the company and
industry tend to revert to some normal level of
performance, and whether short-term trends are likely
to be permanent.

Disaggregate value drivers, both ROIC and
revenue growth
◦ If possible, link operational performance measures with
each key value driver.

If there is any radical change in performance,
identify the source.
◦ Determine whether the change is temporary or
permanent, or merely an accounting effect.

Value the operating leases: Capitalise the asset
value on the balance sheet, and the implied debt
as liability
◦ Rental Expenset =
Asset Valuet - 1× [kd + (1/Asset Life)]
◦ Asset Valuet – 1 =
[Rental Expenset ] ÷ [kd + (1/Asset Life)]

Break down the rental expenses into two
components: interest expense and depreciation
◦ Implied interest payment should be added back to EBITA
and taxes should be adjusted to remove the interest tax
shield

Capitalising R&D expense:
◦ Choose an amortisation period, for example 10
years; use product and industry characteristics to
guide your choice

Unlike ROIC, FCF does not change when
expenses are capitalised