Financial Statement Analysis
1
March 16
Financial Statement Analysis Contents
•
Overview and objective of financial statement analysis
•
Review and Re-formatting Statements for Financial Analysis
 Income Statement – EBITDA and NOPLAT
 Cash Flow Statement - Free Cash Flow and Equity Cash Flow
•
Financial ratio analysis
 Management Performance
 Valuation
 Credit Analysis
 Financial Model Drivers
•
Reference Slides
 Financial Ratio Calculations
 Discussion of Economic Profit
www.edbodmer.com
edbodmer@aol.com
2
March 16
Financial Statement Analysis - Introduction
• Financial Statement Analysis should tell a story about the company –
How profitable is the company, what are the trends, how much risk is
there etc.
• You should be comfortable in reading various different financial
statements to be effective at financial modeling and financial analysis.
• Financial statement analysis is also important in:
 Assessing management performance of a company and whether
projections of improvement or sustainability are reasonable.
 Assessing the value of a company from historic performance.
 Assessing the reasonableness of financial projections provided by a
company or the validity of earnings projections
 Assessing whether the financial structure of a company is of
investment grade quality
www.edbodmer.com
edbodmer@aol.com
3
March 16
Objectives of Financial Statement Analysis
• Financial statement analysis is like detective work – How can we use
information in financial statements to make assessments of various
issues. The financials should paint a picture of what has happened to
the company:
 How can we quickly review the income statement, balance sheet
and cash flow statement to determine how the stock market value of
a company compares to inherent value.
 How can we look the financial statements and assess risks
associated with a company and whether the company has sufficient
cash flow to pay off debt.
 Finance and valuation are about projecting the future -- how can
financial statement analysis be used in making projections.
 The problem in any financial analysis and valuation is that
measuring risk is very difficult
www.edbodmer.com
edbodmer@aol.com
4
March 16
Double Counting and Judgments in Financial Ratio Analysis
•
In analyzing financial statements judgments must be made in computing key data
such as EBITDA and in developing financial ratios.
•
Examples
 Whether or not to include Other Income in EBITDA
o If other income not in EBITDA, then should not add non-consolidated
subsidiary companies in invested capital
 Exploration Expenses taken out of EBITDA
o Make consistent between companies with different accounting policies
 Goodwill (ROIC with or without goodwill depending on analysis issue)
 Minority Interest (if include or exclude do for both income and balance)
o Total of minority interest is in EBITDA, therefore must include
financing of minority interest in invested capital
•
A key principle is that the financial data and the financial ratios are consistent and
logical – work through simple examples
www.edbodmer.com
edbodmer@aol.com
5
March 16
Income Statement
6
March 16
Income Statement
•
Review trends in EBITDA, EBIT, EBT and Net Income and explain what is
happening to the company
•
EBITDA includes operating earnings and other income, but it does not include
foreign exchange gains or losses, minority interest, extraordinary income or
interest income.
 EBITDA is a rough proxy for free cash flow
 EBITDA is not generally shown on Income Statement
 Potential Adjustments for items such as exploration expense
 Compare EBIT to Net Assets and Net Capital
•
Ratio of EBITDA to Revenues should be shown for historic and projected periods
•
EBITDA is related to un-levered cash flow while Net Income and EPS are after
leverage
•
NOPLAT is computed by EBIT less adjusted taxes, where taxes are computed
through adjusting income taxes.
www.edbodmer.com
edbodmer@aol.com
7
March 16
Standard Computation of EBITDA
www.edbodmer.com
edbodmer@aol.com
8
March 16
Problems with EBITDA
• EBITDA is useful in its simplicity, and can be a good reference for
comparison of debt and value, but it has weaknesses:
 EBIT is more important than DA, because must use cash for
replacing depreciation and amoritsation
 In credit analysis, EBITDA works better for low rated credits than
high rated credits. (Moody’s)
 EBITDA is a better measure for companies with long-lived assets
 EBITDA can be manipulated through accounting policies (operating
expenses versus capital expenditures)
 EBITDA ignores changes in working capital, does not consider
required re-investment, says nothing about the quality of earnings,
and it ignores unique attributes of industries.
www.edbodmer.com
edbodmer@aol.com
9
March 16
Simplified Income Statement
•
Sales
COGS
•
=
-
Gross Margin
SG&A
Other Expenses
•
+
Other Income
•
=
EBITDA
•
-
Depreciation and Amortization
•
=
EBIT
•
-
Interest Expense (income)
•
=
-
EBT
Income Taxes
•
-
Minority Interest
•
=
Net Income
There is a debate about how to handle
other income from non-consolidated
subsidiary companies.
One school of thought (McKinsey) is that
they should be valued separately since
they will have different cost of capital etc.
In this case, do not include in EBITDA
and remove the asset balance from the
invested capital. Must be consistent
NOPLAT = EBIT x (1-tax rate)
NOPLAT = Net Income + Interest Expense x (1-tax)
www.edbodmer.com
edbodmer@aol.com
10
March 16
Analysis of Income Statement – Computation of EBITDA,
Minority Interest, Preferred Dividends, Exploration Expense
www.edbodmer.com
edbodmer@aol.com
11
March 16
Income Statement Analysis
•
Example of Adjustments to EBITDA
 Exploration Expenses (EBITDAX)
 Rental and Lease Payments (EBITDR)
•
EBITDA Computation
 Top Down – move other income
 Bottom-up (Indirect)
•
EBITDA Notes
 Interest Income out of EBITDA
 Interest Expense not in EBITDA
 Understand Non-cash Expenses
o Deferred Mining Costs
o Equity Income
o Minority Interest
www.edbodmer.com
edbodmer@aol.com
12
March 16
Discounted Cash Flow Analysis – Real World Example
•
Credit Suisse First Boston estimated the present value of the stand-alone,
Unlevered, after-tax free cash flows that Texaco could produce over calendar
years 2001 through 2004 and that Chevron could produce over the same period.
The analysis was based on estimates of the managements of Texaco and
Chevron adjusted, as reviewed by or discussed with Texaco management, to
reflect, among other things, differing assumptions about future oil and gas prices.
•
Ranges of estimated terminal values were calculated by multiplying estimated
calendar year 2004 earnings before interest, taxes, depreciation, amortization and
exploration expense, commonly referred to as EBITDAX, by terminal EBITDAX
multiples of 6.5x to 7.5x in the case of both Texaco and Chevron.
•
The estimated un-levered after-tax free cash flows and estimated terminal values
were then discounted to present value using discount rates of 9.0 percent to
10.0 percent.
•
That analysis indicated an implied exchange ratio reference range of 0.56x to
0.80x.
www.edbodmer.com
edbodmer@aol.com
13
March 16
Employee Stock Options
• One can debate the treatment of employee stock options for EBITDA,
free cash flow and valuation.
• Think of options as giving stock to employees
 If the treatment has changed over the years and it is a significant
expense, make adjustments to current or prior statements for
consistency.
 Think of options as giving free shares to employees. The value of
existing shareholders is diluted.
o One can argue that this is two things
 First, employees are compensated and the cash should be
accounted for
 Second, invested capital is increased and the new equity
should be included in the capital base
www.edbodmer.com
edbodmer@aol.com
14
March 16
Cash Flow Statement
15
March 16
Cash Flow Statement
•
Modern Cash Flow Statement has separation between
 Operations
 Capital expenditures (to maintain and grow operations) and
 Financing
•
Operating Cash Flow
 Add back items from the income statement that do not use cash
(depreciation, dry hole costs etc)
•
Analyze how much cash flow the company generated and how it raised funds or
disposed funds
•
Use Cash Flow statement as a basis to compute free cash flow although cash flow
not presented on the statement
•
Problem: Interest Expense – related to financing and not operations – is in
the Net Income and is included in Cash From Operations
www.edbodmer.com
edbodmer@aol.com
16
March 16
Cash Flow Statement
•
A. Operating Cash Flows
•
1) Net Income including interest expense, interest income and taxes
•
2) Depreciation
•
3) Deferred Taxes
•
4) Working Capital Changes
•
5) Minority Interest on Income Statement and Other Items
•
B. Investing Cash Flows
•
1) Capital Expenditure and Asset Purchases
•
3) Sale of Property, Plant, & Equipment
•
4) Inter-Corporate Investment
•
C. Financing Cash Flows
•
1) Dividend Payments
•
3) Proceeds from Equity or Debt Issuance
•
4) Equity Repurchased
•
5) Debt Principal Payments
www.edbodmer.com
edbodmer@aol.com
17
March 16
Cash Flow Statement Example
www.edbodmer.com
edbodmer@aol.com
18
March 16
The Notion of Free Cash Flow
• In practice the term cash flow has many uses. For example, operating
cash flow is net income plus depreciation.
• Free cash flow is the cash flow that is available to investors – FREE of
obligations such as capital expenditures and taxes -- to both debt and
equity investors – after re-investing in plant, and financing and paying
taxes.
• Accountants define cash flow from operations as net income plus
depreciation and other non-cash items less changes in working capital.
However, this cash flow is not available for distribution to equity holders
and debt holders. The free cash flow must account for capital
expenditures, repayments of debt, deferred items and other factors.
• Free cash flow consists of
 Cash flow to equity holders
 Cash flow to debt holders
www.edbodmer.com
edbodmer@aol.com
19
March 16
Theoretical Context – Miller and Modigliani
• Theory that changed finance in 1958
 Value assets on fundamental operating characteristics such as the
capacity utilisation, the cost and the efficiency of assets and not the
manner in which assets are financed – debt versus equity or the
manner in which assets are hedged.
 This has led to the discounted cash flow model that underlies most
valuations
 The proof was based on a simple arbitrage idea that you could buy
stock in a company that has no debt and then borrow against the
stock. This will yield the same results as if the company borrowed
money instead of you.
 The implication of this is that project finance is irrelevant
www.edbodmer.com
edbodmer@aol.com
20
March 16
Fundamental Distinction in Financial Analysis – Free Cash
Flow and Equity Cash Flow
• Free Cash flow that is independent from financing
 Valuation
 Performance in managing assets
 Claims on free cash flow
 Cash flow to pay debt obligations
 Comparisons unbiased by capital structure policy
• Equity cash flow
 Valuation of equity securities
 Performance for shareholders
www.edbodmer.com
edbodmer@aol.com
21
March 16
Importance of Free Cash Flow
•
Alternative Definitions, but one correct concept
 Free Cash Flow Is Also Known As Unleveraged Cash Flow
 Unleveraged Cash Flow Is Not Distorted By The Capital Structure
 Free Cash Flow should not change when the capital structure changes
 Free Cash Flow should be the same as equity cash flow if no debt is
outstanding and not cash balances are built up.
•
Free Cash Flow in Valuation
 PV of Free Cash Flow Defines Enterprise Value
 The Relevant Discount Rate Is The Unlevered Discount Rate or the
Weighted Average Cost of Capital
 IRR on Free Cash Flow is the Project IRR
 Free Cash Flow in Economic Value
 FCF – Carrying Charge = Economic Profit
www.edbodmer.com
edbodmer@aol.com
22
March 16
Cash Flow Statement in Financial Model
•
Analysis in Cash Flow Statements
 Compute Cash Flow before Financing
o Operating Cash Flow minus Capital Expenditures
o Use Cash Flow Before Financing in Deriving Free Cash Flow
 Equity Cash Flow
o Dividends less Cash Investments
o Cash Flow Before Financing less Maturities plus New Debt Issues
 Last Line on Cash Flow Statement Includes
o Change in Cash Balance
o Change in Short-term Debt or Overdrafts
o Beginning Balance + Change = Ending Cash
o Beginning Balance of STD + Change = Ending Short-term Debt
www.edbodmer.com
edbodmer@aol.com
23
March 16
Free Cash Flow Formulas
•
Free cash flow can be computed from the income statement or from the cash flow statement.
•
From the cash flow statement, the formula is:
 Cash Before Financing
 Plus: Interest Expense
 Less: Tax Shield on Interest
•
From the income statement, the formula is:
 EBITDA
Some argue that free cash flow
should not include non-operating
items. Here the non-consolidated
companies are treated in a similar
manner as liquid investments
 Less: Taxes on EBIT
 Less: Working Capital Investment
 Less: Capital Expenditures
•
From Net Income
 Net Income
 Add: Net of Tax Interest
 Add Depreciation, Deferred Taxes and Other Non-Cash Changes
 Less: Changes in Working Capital
 Less: Capital Expenditures
www.edbodmer.com
edbodmer@aol.com
24
March 16
Free Cash Flow from NOPLAT
•
Free cash flow can be computed using the notion of net operating profit less
adjusted tax as follows (assuming no extraordinary income)
•
Step 1: Compute NOPLAT
 Net Income
 Plus Net Interest after Tax
 Plus Deferred tax
 Equals NOPLAT
•
Step 2: Compute Free Cash Flow
 NOPLAT
 Plus: Depreciation
 Less: Change in Working Capital
 Less: Capital Expenditures
 Equals Free Cash Flow
www.edbodmer.com
edbodmer@aol.com
25
March 16
Free Cash Flow Example
One could make adjustments for
dividends payable, interest payable and
other items in the working capital
analysis.
In actual situations,
must adjust the free
cash flow for deferred
tax
www.edbodmer.com
edbodmer@aol.com
26
March 16
Balance Sheet
27
March 16
Balance Sheet Adjustments
•
When analysing the balance sheet, various items should be adjusted and grouped
together:
 Net Debt
o Total short and long term debt minus liquid investments held and
surplus cash
 Cash Bucket
o For modelling, subtract short-term debt from surplus cash and liquid
investments
 Surplus Cash
o Include temporary investments and also include long-term investments
 Current Assets and Current Liabilities
o Separate the surplus cash from current assets and the debt from
current liabilities and relate remaining working capital items to revenue
and expense items
www.edbodmer.com
edbodmer@aol.com
28
March 16
Balance Sheet Issues
• Treat surplus cash as negative debt and debt as negative cash
 Rule of thumb – cash is 2% of revenues
 Example – when developing a basic cash flow model, group the
cash and the debt as one account and then separate this account
on the balance sheet.
 Unfunded pension expenses should be treated like debt – they
involve a fixed obligation and they can be replaced with debt when
they are funded.
 Deferred taxes depend on the way deferred taxes are modelled for
cash flow purposes. If you model future changes in deferred taxes
and take account of these in projections, do not put deferred taxes
as a component of equity.
www.edbodmer.com
edbodmer@aol.com
29
March 16
Problems with Equity Balance
• Would like the return on equity and the return on invested capital to
measure equity invested by shareholders for return on investment and
return on equity
 Problems with using equity balance on the balance sheet to
measure equity investment
o Write-offs of plant
o Accumulated Other Comprehensive Income
o Goodwill
o Re-structuring losses
o Employee Stock options
 Can make adjustments to equity balance
www.edbodmer.com
edbodmer@aol.com
30
March 16
Financial Ratio Analysis
31
March 16
Tension between Equity Analysis and Asset Analysis
•
Free Cash Flow
•
Equity Cash Flow
•
Project IRR
•
Equity IRR
•
ROIC (ROCE)
•
ROE
•
WACC
•
Cost of Equity
•
Enterprise Value
•
Market Capitalisation
•
EV/EBITDA
•
P/E
•
Market to Replacement Cost
•
Market to Book Ratio
EV = Σ Value of Business Units = Debt + Equity Value
In ratio analysis, cash = negative debt
www.edbodmer.com
edbodmer@aol.com
32
March 16
IRR Mathematics and IRR Exercise
Why we raise to a
power with two year
 Example: Invest 100 and receive 120 in 1 year case
• IRR is simply rate of return
 IRR = 120/100 = 120% - 100% = 20%
• If the cash flow is over two years
FV = PV (1+r) (1+r)
FV = PV (1+r)2
 IRR = -100 , 60 , 60  13.07%
FV/PV = (1+r)2
 Modified IRR with 5% Re-investment
(FV/PV)^(1/2) = (1+r)
 60 receives 5% in year two  60 x (1.05) = 63 (FV/PV)^(1/2) – 1 = r
 Plus final 60 = 123
 MIRR = (123/100)^(1/2) - 1 = 10.9%
www.edbodmer.com
edbodmer@aol.com
33
March 16
Financial Ratio Analysis
•
Purpose :
 Evaluate relation between two or more economically important items (one is
the starting point for further analysis)
Cautions:
 Accounting analysis is important (deferred taxes etc.)
•
Interpretation is key
 What does the P/E mean
 Is an interest coverage of 3.5 good
 Why is the ROIC low
 Should we use MB, PE or EV/EBITDA
•
Document financial ratios (numerator and denominator) with footnotes and
comments
•
Show components of numerator and denominator in rows above the ratio
calculation
www.edbodmer.com
edbodmer@aol.com
34
March 16
General Discussion of Financial Ratios
•
Financial Ratios Often Compares Income Statement or Cash Flow with Balance
Sheet
 In developing ratios, understand why the formula is developed (e.g. other
income and other investments in return on invested capital)
•
There is Not Necessarily One Single Correct Formula
 For example, pre-tax or after-tax return on assets.
 Keep the numerator consistent with the denominator
•
Financial Ratios should be evaluated in the context of benchmarks
 Credit ratios and bond rating standards
 Returns and cost of capital
 Operating ratios and history
www.edbodmer.com
edbodmer@aol.com
35
March 16
Classes of Financial Ratios
•
Management Performance
 Ratios that measure the historic economic performance of management and
evaluate whether the economic performance can be maintained (e.g. ROIC)
•
Valuation
 Ratios that are used to give an indication of the value of the company (e.g.
P/E)
•
Credit Analysis
 Ratios that gauge the credit quality and liquidity of the company (e.g.
Interest coverage and current ratio)
•
Model Evaluation
 Ratios used to evaluate the assumptions and mechanics of financial
forecasts
www.edbodmer.com
edbodmer@aol.com
36
March 16
Ratios that Measure Management
Performance
37
March 16
Class 1: Financial Indicators of Management Performance
•
Evaluate Whether Management is Doing a Good Job with Investor Funds (Not if
the company is appropriately valued)
 Return on Invested Capital
 Return on Assets
 Return on Equity
 Market/Book Ratio
 Market Value/Replacement Cost
•
Key Issue
 Evaluate relative to risk
o ROE versus Cost of Equity
o ROIC versus WACC
www.edbodmer.com
edbodmer@aol.com
38
March 16
ROIC, WACC and Growth
• ROIC is before interest and the return covers both debt and equity
financing – EBIT is before interest and investment includes both debt and
equity investment
• WACC is the blended average of debt and equity required returns
• ROIC versus WACC measures the ability to make true economic profit
• Once have economic profit, should grow the business as much as
possible.
www.edbodmer.com
edbodmer@aol.com
39
March 16
Basic Economic Principles, ROIC and Financial Analysis
• When you measure value, you are gauging the ability of a firm to realize
economic profit. For example, when you compare the equity IRR with the
equity cost of capital.
• When you assess assumptions in a financial forecast, you must assess
whether economic profit implicit in the assumptions can in fact be
realized. For example, if the financial forecast has a very high ROE, is
that reasonable.
• When you interpret financial statistics, you are gauging the strategy of the
company in terms of whether economic profit is being realized. In
reviewing the return on invested capital, does this demonstrate that the
company has the potential to earn economic profit.
www.edbodmer.com
edbodmer@aol.com
40
March 16
Return on Invested Capital Analysis
• ROIC is not distorted by the leverage of the company
• ROIC can be used to gauge economic profit and whether the company
should grow operations
• ROIC can be used to assess the reasonableness of projections
 For example, if ROIC is very high and the company is in a
competitive business with few barriers to entry, the forecast is
probably not realistic.
• ROIC can be computed on a division basis EBIT and allocation of capital
to divisions from net assets to gauge the profit of parts of the company
• ROIC comes from sustainable competitive advantage and high market
share
www.edbodmer.com
edbodmer@aol.com
41
March 16
Formula for Return on Invested Capital
•
The return in invested capital formula can be for a division or an entire corporation. It is after
tax and after depreciation. Cash balances should be excluded from the denominator and
interest income from the numerator. Goodwill and goodwill amortization should be excluded.
•
Formula:
 ROIC = EBITAT/Invested Capital
 Where:
o EBITAT: Earnings before Interest Taxes and Goodwill Amortization less taxes on
EBITAT
o Taxes on EBITAT: Cash Income Taxes Less Tax on Interest Expense and
Interest Income and Tax on Non-operating Income
o Invested Capital less cash balance
•
Adjustments
 Other Assets
 Cash Balances
 Goodwill
 Other
www.edbodmer.com
edbodmer@aol.com
42
March 16
Issues in Management Performance Evaluation
•
Basic Formula: ROIC versus WACC
 How to compute ROIC
o NOPLAT/Average Invested Capital
o May or may not include goodwill – If goodwill is not included, compute
NOPLAT without subtracting goodwill write-off and subtract net
goodwill from invested capital
o Reduce the invested capital by surplus cash balances
o Some don’t include other income – then the invested capital should be
reduced by other investments
o Can compute with ratios
 EBIT Margin x (1-t) * Asset Turn
 Asset Turn = Sales/Assets; EBIT Margin = EBIT/Sales
 ROCE vs ROIC
o ROCE is generally computed in an indirect way by starting with net
income, and adding net of tax interest and adding minorities
www.edbodmer.com
edbodmer@aol.com
43
March 16
Exxon Mobil Return on Average Capital Employed
•
Return on average capital employed (ROCE) is a performance measure ratio.
From the perspective of the business segments, ROCE is annual business
segment earnings divided by average business segment capital employed
(average of beginning and end-of-year amounts).
•
These segment earnings include ExxonMobil’s share of segment earnings of
equity companies, consistent with our capital employed definition, and exclude
the cost of financing.
•
The corporation’s total ROCE is net income excluding the after-tax cost of
financing, divided by total corporate average capital employed. The corporation
has consistently applied its ROCE definition for many years and views it as the
best measure of historical capital productivity in our capital intensive longterm industry, both to evaluate management’s performance and to
demonstrate to shareholders that capital has been used wisely over the long
term. Additional measures, which tend to be more cash flow based, are used for
future investment decisions.
www.edbodmer.com
edbodmer@aol.com
44
March 16
Exxon Mobil Return on Capital Employed – Where are they
making expenditures
www.edbodmer.com
edbodmer@aol.com
45
March 16
Exxon Mobil Return on Capital
2005
-millions of dollars
$ 36,130.00
Return on average capital employed
Net income
Financing costs -after tax
Third-party debt
ExxonMobil share of equity companies
All other financing costs – net -1
Total financing costs
25,330.00
$ 21,510.00
(1.00)
(144.00)
(295.00)
(137.00)
(185.00)
54.00
(69.00)
(172.00)
1,775.00
(440.00)
(268.00)
1,534.00
$ 19,976.00
$ 116,961.00
$ 107,339.00
$ 95,373.00
31.30
23.80
20.90
$
Average capital employed
36,570.00
Return on average capital employed – corporate total
www.edbodmer.com
$
2003
25,598.00
Earnings excluding financing costs
(1)
2004
$
“All other financing costs – net” in 2003 includes
interest income (after tax) associated with the
settlement of a U.S. tax dispute.
edbodmer@aol.com
46
March 16
Example of ROIC Calculation - AES
www.edbodmer.com
edbodmer@aol.com
47
March 16
Illustration of Invested Capital Computation
www.edbodmer.com
edbodmer@aol.com
48
March 16
ROE and ROIC – Note how to compute growth rates from ROE
and Retention
www.edbodmer.com
edbodmer@aol.com
49
March 16
Example of Return on Capital Employed (Return on Invested Capital)
in Financial Analysis
• The argument has been made that the best measure to evaluate management
performance that is not distorted by leverage (as in the case of ROE) or has the
problems of ROA is the return on invested capital. An example of use of this ratio is
in the Exxon Mobile Merger:
 J.P. Morgan reviewed and analyzed the return on capital employed
("ROCE") of both Exxon and Mobil since 1993. J.P. Morgan observed that
Exxon's ROCE has consistently been 2-3% above that of Mobil.
J.P. Morgan's analysis indicated that if Mobil were to be merged with
Exxon, the combined entity's capital productivity would eventually be
higher than the pro forma capital productivity of Exxon and Mobil.
 J.P. Morgan indicated that it would be reasonable to assume that the
benefits of this capital productivity increase would occur within three years of
the closing of the merger.
www.edbodmer.com
edbodmer@aol.com
50
March 16
Relationship Between Various Ratios and DuPont Analysis
Asset Utilization
Profitability
Gross Margin = Gross profit/ Sales
Less: Operating costs/ Sales
Equals EBIT Margin (EBIT/ Sales)
Working Capital/ Sales
Plus:
Long-term capital/ Sales
Equals:Capital employed/ Sales
1 divided by Capital Employed/ Sales
Equals: Asset Turnover
(Sales/ Capital Employed)
Multiplied by
ROCE(EBIT/ Capital Employed )
Multiplied by (1 minus Tax Rate)
ROCE(EBIT after Tax/ Capital Employed )
www.edbodmer.com
edbodmer@aol.com
51
March 16
Class 2: Financial Indicators of Market Value
•
Financial Ratios can be used to analyze whether the valuation of a company is
appropriate. Analysts should understand the drivers of different ratios. Valuation
Ratios include:
 Universal Financial Ratios
o Price to Earnings Ratio
o Enterprise Value/EBITDA
o PEG (P/E to Earnings Growth) Ratio
o Market to Book Ratio
 Industry Specific Financial Ratios
o Value/Reserve
o Value/Customer
o Value/Plane Seat
www.edbodmer.com
edbodmer@aol.com
52
March 16
Valuation Ratios and Benchmarks
• Valuation ratios measure the stock market value of a company relative to
some accounting measure such as EPS, EBITDA, Book Value/Share or
growth in EPS
• The ratios can be used as benchmarks in valuing non-traded companies
by using industry average valuation ratios.
• Example to value non-traded company:
 Value of company = EPS of Company x Industry Average P/E Ratio
• Valuation ratios will be further discussed in the portion of the course
where corporate models are used to value companies.
www.edbodmer.com
edbodmer@aol.com
53
March 16
P/E Ratio
•
The P/E Ratio is the most prominent valuation ratio. It is affected by estimated
earnings growth, the ability of a company to earn economic profits and the growth
in profitable operations.
•
Formula:
 Share Price/Earnings per Share
•
Issues
 Trailing Twelve Months and Forward Twelve Months – Generally use
forward EPS
 Formula: (1-g/r)/(k-g)
•
Problems
 Affected by earnings adjustments
 Causes too much focus on EPS
 Distortions created by financing
www.edbodmer.com
edbodmer@aol.com
54
March 16
Illustration of EV Ratios and Computation of Market Value of
Balance Sheet Components
www.edbodmer.com
edbodmer@aol.com
55
March 16
Investment Banker Analysis of Comparable Multiples
www.edbodmer.com
edbodmer@aol.com
56
March 16
Investment Banker Analysis of Multiples
www.edbodmer.com
edbodmer@aol.com
57
March 16
Use of PE in Valuation
• The long-run P/E ratio is often used in valuation. This process involves:
 Project EPS
 Compute Stable EPS
 Compute P/E Ratio using formula
o P/E = (1-g/r)/(k-g)
o g – growth in EPS or Net Income
o r – rate of return earned on equity
o k – cost of equity capital
 Related Formula for terminal value with NOPLAT (EBITAT)
o (1-g/ROIC)/(WACC – g)
 The formula demonstrates where value really comes from
www.edbodmer.com
edbodmer@aol.com
58
March 16
Risk Assessment of Debt and Analysis of
Credit Spreads
59
March 16
Liquidity and Solvency
Credit worthiness: Ability to honor credit obligations
(downside risk)
Liquidity
Solvency
Ability to meet short-term obligations
Focus:
• Current Financial
conditions
Ability to meet long-term
obligations
Focus:
• Current cash flows
• Long-term financial
conditions
• Liquidity of assets
• Long-term cash flows
• Extended profitability
www.edbodmer.com
edbodmer@aol.com
60
March 16
Solvency Ratios
•
Ratios are the center of traditional credit analysis that assesses whether a
company can re-pay loans. These ratios should be compared to benchmarks.
 Solvency
o Debt Payback Ratios
 Funds from Operations to Total Debt
 Debt to EBITDA
o Leverage Ratios
 Debt to Capital (Include Short-term Debt)
 Market Debt to Market Capital
o Payment Ratios
 Interest Coverage
 Debt Service Coverage [Cash Flow/(Interest + Principal)]
o Capital Investment Coverage
 Operating Cash Flow/Capital Expenditures
www.edbodmer.com
edbodmer@aol.com
61
March 16
Liquidity
•
Current Ratio
 Current Assets to Current Liabilities
 Current Assets less Inventory to Current Liabilities
•
Model Working Capital
 Current Assets less Cash and Temporary Securities minus Current liabilities
less Short-term Debt
•
Liquidity Assessment
 Debt Profile (Maturities)
 Bank Lines (Availability, amount, maturity, covenants, triggers)
 Off Balance Sheet Obligations (Guarantees, support, take-or-pay contracts,
contingent liabilities)
 Alternative Sources of Liquidity (Asset sales, dividend flexibility, capital
spending flexibility)
www.edbodmer.com
edbodmer@aol.com
62
March 16
Banks or Rating Agencies Value Debt with Risk Classification
Systems
Map of Internal Ratings to Public Rating Agencies
Internal
Credit
Ratings
1
2
3
4
5
6
7
8
9
10
www.edbodmer.com
Code
Meaning
A
Exceptional
B
Excellent
C
Strong
D
Good
E
Satisfactory
F
Adequate
G
Watch List
H
Weak
I
Substandard
L
Doubtful
N
In Elimination
S
In Consolidation
Z
Pending Classification
Corresponding
Moody's
Aaa
Aa1
Aa2/Aa3
A1/A2/A3
Baa1/Baa2/Baa3
Ba1
Ba2/Ba3
B1
B2/B3
Caa - O
edbodmer@aol.com
63
March 16
S&P Ratio Definitions
www.edbodmer.com
edbodmer@aol.com
64
March 16
S&P Benchmarks
www.edbodmer.com
edbodmer@aol.com
65
March 16
Example of Using Ratios to Gauge Credit Rating
• The credit ratios are shown next to the achieved ratios. Concentrate on
Funds from operations ratios.
Note that based on business
profile scores published by
S&P
www.edbodmer.com
edbodmer@aol.com
66
March 16
Credit Rating Standards and Business Risk
Business Risk/Financial Risk
—Financial risk profile—
Business risk profile
Minimal Modest Intermediate Aggressive Highly leveraged
Excellent
AAA
AA
A
BBB
BB
Strong
AA
A
A-
BBB-
BB-
Satisfactory
A
BBB+
BBB
BB+
B+
Weak
BBB
BBB-
BB+
BB-
B
Vulnerable
BB
B+
B+
B
B-
Financial risk indicative ratios*
Minimal Modest Intermediate Aggressive Highly leveraged
Cash flow (Funds from operations/Debt) (%) Over 60
45–60
30–45
15–30
Below 15
Debt leverage (Total debt/Capital) (%)
Below 25 25–35
35–45
45–55
Over 55
Debt/EBITDA (x)
<1.4
3.0–4.5
>4.5
1.4–2.0 2.0–3.0
Key Industry Characteristics And Drivers Of Credit Risk
Credit risk impact: High (H); Medium (M); Low (L)
Risk factor
Industry
Airlines (U.S.)
Autos*
Auto suppliers*
High technology*
Mining*
Chemicals (bulk)*
Hotels*
Shipping*
Competitive power*
Telecoms (Europe)
Cyclicality
H
H
H
H
H
H
H
H
H
H
M
www.edbodmer.com
Competition
H
H
H
H
H
H
H
H
H
H
H
Capital intensity Technology risk
H
L
H
M
H
M
M
H
H
M
H
L
H
L
H
L
H
L
M
L
H
H
Regulatory/Gov
ernment
M/H
M
M
L
M/H
M
M
L
L
H
H
Energy
sensitivity
H
H
M
L/M
H
L
H
M
M
H
L
edbodmer@aol.com
67
March 16
Debt Capacity and Interest Cover
• Despite theory of
probability of default and
loss given default, the
basic technique to
establish bond ratings
continues to be cover
ratios,\.
www.edbodmer.com
edbodmer@aol.com
68
March 16
Default Rates and Credit Spreads
www.edbodmer.com
edbodmer@aol.com
69
March 16
Credit Spreads
Increase of 5%
www.edbodmer.com
Credit Crisis
edbodmer@aol.com
70
March 16
Moody’s Forecast of Default Rates
Defaults versus Long-term Average
Moody's Speculative Grade Trailing 12-Month Default Rates
Actual Jan. 2000 to Aug. 2002 / Forecasted Sept. 2002 to Feb. 2003
12.0%
11.0%
10.5%
9.6%
10.0%
9.0%
8.5%
7.7%
8.0%
7.0%
7.7%
8.8%
10.7%
10.5%
10.3% 10.3%
10.5%
10.3%
9.8%
10.1% 10.0% 10.0% 10.0% 10.0% 9.8%
9.3%
9.0%
8.8%
7.9%
7.1%
6.7%
6.2%
% 6.0%
5.0%
4.0%
3.77%*
3.0%
2.0%
1.0%
www.edbodmer.com
Note: *Long run annual default rate is 3.77%
Months
edbodmer@aol.com
71
March 16
Feb-03
Jan-03
Dec-02
Nov-02
Oct-02
Sep-02
Aug-02
Jul-02
Jun-02
May-02
Apr-02
Mar-02
Feb-02
Jan-02
Dec-01
Nov-01
Oct-01
Sep-01
Aug-01
Jul-01
Jun-01
May-01
Apr-01
Mar-01
Feb-01
Jan-01
0.0%
Updated Transition Matrix
www.edbodmer.com
edbodmer@aol.com
72
March 16
Probability of Default
• This chart shows rating migrations and the probability of default for
alternative loans. Note the increase in default probability with longer
loans.
www.edbodmer.com
edbodmer@aol.com
73
March 16
Bond Ratings and Historic Credit Spreads
www.edbodmer.com
edbodmer@aol.com
74
March 16
Credit Spreads for Utility Debt
www.edbodmer.com
edbodmer@aol.com
75
March 16
DSCR Criteria in Different Industries in Project Finance
•
Electric Power:
1.3-1.4
•
Resources:
1.5-2.0
•
Telecoms:
1.5-2.0
•
Infrastructure:
1.2-1.6
•
Minimum ratio could dip to 1.5
•
At a minimum, investment-grade merchant projects probably will have to exceed a
2.0x annual DSCR through debt maturity, but also show steadily increasing ratios.
Even with 2.0x coverage levels, Standard & Poor's will need to be satisfied that
the scenarios behind such forecasts are defensible. Hence, Standard & Poor's
may rely on more conservative scenarios when determining its rating levels.
•
For more traditional contract revenue driven projects, minimum base case
coverage levels should exceed 1.3x to 1.5x levels for investment-grade.
www.edbodmer.com
edbodmer@aol.com
76
March 16
Credit Spread on Debt Facilities
• The spread on a loan is directly related to the probability of default and
the loss, given default.
S
The Credit Triangle
S = P (1-R)
P

R
The credit spread (s) can be characterized as the default probability (P)
times the loss in the event of a default (R).
www.edbodmer.com
edbodmer@aol.com
77
March 16
Expected Loss Can Be Broken Down Into Three Components
Borrower Risk
EXPECTED
LOSS
$$
=
Probability of
Default
Facility Risk Related
Loss Severity
x
Given Default
Loan Equivalent
Exposure
x
(PD)
(Severity)
(Exposure)
%
%
$$
What is the probability
of the counterparty
defaulting?
If default occurs, how
much of this do we
expect to lose?
If default occurs, how
much exposure do we
expect to have?
The focus of grading tools is on modeling PD
www.edbodmer.com
edbodmer@aol.com
78
March 16
Comparison of PD x LGD with Precise Formula
Case 1: No LGD and One Year
• .
www.edbodmer.com
edbodmer@aol.com
79
March 16
Comparison of PD x LGD with Precise Formula
Case 2: LGD and Multiple Years
• .
Assumptions
Years
Risk Free Rate 1
Prob Default 1
Loss Given Default 1
5
5%
20.8%
80%
BB
5
7
20.80%
PD
Alternative Computations of Credit Spread
Credit Spread 1
3.88%
PD x LGD 1
16.64%
Proof
Opening
100
Closing
127.63
Value
127.63
Risky - No Default
100
Prob
Closing
0.95
153.01
Value
145.36
Risky - Default
100
Risk Free
Total Value
0.05
30.60
1.53
146.89
FALSE
Credit Spread Formula
With LGD
cs = ((1+rf)/((1-pd)+pd*(1-lgd))-rf)^(1/years)-1
www.edbodmer.com
edbodmer@aol.com
80
March 16
Default Rates by Industry
www.edbodmer.com
edbodmer@aol.com
81
March 16
Recovery Rates
www.edbodmer.com
edbodmer@aol.com
82
March 16
Mathematical Credit Analysis
83
March 16
General Payoff Graphs from Holding Investments with Future
Uncertain Returns
Stock Payoff versus Price if Purchased or Sold Stock at $40
50
40
30
Payoff
20
10
Ending Stock Price
0
-10 0
10
20
30
40
50
60
70
80
-20
-30
-40
-50
www.edbodmer.com
Purchase at $40
Sell Stock Short
edbodmer@aol.com
84
March 16
Payoff Graphs from Call Option – Payoffs when Conditions
Improve
Call Option Payoff Patterns
40
30
Payoff
20
10
0
-10
-20
0
20
Bought call
40
60
80
Ending Value
Sold Call
-30
-40
www.edbodmer.com
edbodmer@aol.com
85
March 16
Payoff Graphs from Buying Put Option – Returns are realized
to buyer when the value declines
www.edbodmer.com
edbodmer@aol.com
86
March 16
Payoff Graphs from Selling Put Option – Value Changes with
Value Decreases
Put Option Payoff Pattern from
Selling Put -- Lender Perspective
10
5
Payoff
0
-5 0
20
40
60
-10
80
100
120
Ending Firm Value
-15
-20
-25
-30
-35
-40
www.edbodmer.com
edbodmer@aol.com
87
March 16
The Black-Scholes/Merton Approach
•
Consider a firm with equity and one debt issue.
•
The debt issue matures at date T and has principal F.
•
It is a zero coupon bond for simplicity.
•
Value of the firm is V(t).
•
Value of equity is E(t).
•
Current value of debt is D(t).
www.edbodmer.com
edbodmer@aol.com
88
March 16
Payoff to
claimholders
At maturity date T, the
debt-holders receive
face value of bond F
as long as the value of
the firm V(T) exceeds
F and V(T) otherwise.
Value of the company and
changes in value to equity and
debt investors
Nominal Debt
Repayment
Equity
F
They get F - Max[F V(T), 0]: The payoff of
riskless debt minus the
payoff of a put on V(T)
with exercise price F.
Equity holders get
Max[V(T) - F, 0], the
payoff of a call on the
firm.
Debt
Value of Firm in Time T
www.edbodmer.com
V(T)
edbodmer@aol.com
89
March 16
Payoff to
debt holders
Credit spread is the payoff from selling
a put option
A1
B
A2
Assets
The payoffs to the bond holders are limited to the amount lent B
at best.
www.edbodmer.com
edbodmer@aol.com
90
March 16
Merton’s Model
•
Merton’s model regards the equity as an option on the assets of the firm
•
In a simple situation the equity value is
max(VT -D, 0)
where VT is the value of the firm and D is the debt repayment required
Assumptions
 Markets are frictionless, there is no difference between borrowing and
lending rates
 Market value of the assets of a company follow Brownian Motion Process
with constant volatility
 No cash flow payouts during the life of the debt contract – no debt repayments and no dividend payments
 APR is not violated
www.edbodmer.com
edbodmer@aol.com
91
March 16
Merton‘s Structural Model (1974)
• Assumes a simple capital structure with all debt represented by one zero
coupon bond – problem in project finance because of amortization of
bonds.
• We will derive the loss rates endogenously, together with the default
probability
• Risky asset V, equity S, one zero bond B maturing at T and face value
(incl. Accrued interest) F
• Default risk on the loan to the firm is tantamount to the firm‘s assets VT
falling below the obligations to the debt holders F
• Credit risk exists as long as probability (V<F)>0
• This naturally implies that at t=0, B0<Fe-rT; yT>rf, where πT=yT-rf is the
default spread which compensates the bond holder for taking the default
risk
www.edbodmer.com
edbodmer@aol.com
92
March 16
Merton Model Propositions
•
Face value of zero coupon debt is strike price
•
Can use the Black-Scholes model with equity as a call or debt as a put option to directly
measure the value of risky debt
•
Can use to compute the required yield on a risky bond:
 PV of Debt = Face x (1+y)^t
 or
 (1+y)^t = PV/Face
 (1+y) = (PV/Face)^(1/t)
 y = (PV/Face)^(1/t) – 1
 With continual compounding = - Ln(PV/Face)/t
•
Computation of the yield allows computation of the required credit spread and computation of
debt value
•
Borrower always holds a valuable default or repayment option. If things go well repayment
takes place, borrower pays interest and principal keeps the remaining upside, If things go bad,
limited liability allows the borrower to default and walk away losing his/her equity.
www.edbodmer.com
edbodmer@aol.com
93
March 16
Default Occurs at Maturity of Debt if V(T)<F
Asset Value
E (VT )  V0 e T
2
VT  V0 exp{[   ]T   T ZT }
2
VT
V0
F
Probability of default
T
www.edbodmer.com
Time
edbodmer@aol.com
94
March 16
Resources and Contacts
• My contacts
 Ed Bodmer
 Phone: +001-630-886-2754
 E-mail: edbodmer@aol.com
• Other Sources
 Financial Library – project finance case studies including Eurotunnel
and Dabhol
 Financial Library – Monte Carlo simulation analysis
www.edbodmer.com
edbodmer@aol.com
95
March 16