F402/F560
Corporate Valuation and Strategy
Part 2: Basic Corporate Performance Measures
Readings in The Quest for Value:
Chapter 3, pp. 68-76 and 83-95
The Economics of the Business
Market value is driven by the economics of the business.
- Cash is invested (by debtholders and equityholders) in assets to operate
the business.
- The assets are used to generate sales revenue.
- Operating expenses and income taxes are subtracted from sales
revenue.
- The resulting after-tax operating profit represents the cash return to
the investors.
Return on Capital
Paraphrasing Stewart:
Managers add value to their company only if they earn rates of return on
capital which exceed the returns offered by other, equally risky
businesses.
If they do not, then capital has been misallocated or mismanaged.
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Invested Capital is the sum of all cash invested in the operations of the
business. It is equal to the net operating assets (net of NIBCLs, see below):
Current assets + PP&E – current operating liabilities.
Why are current operating liabilities netted out?
Return on invested capital (ROIC) is the after-tax, cash-on-cash yield earned
in operating the business with those operating assets. It is the after-tax cash
profits divided by the amount of capital employed in the business:
NOPAT
Beginning Operating Capital
An important distinction among items on financial statements:
1. Operating invested capital and operating cash return
2. Financial invested capital and financial cash return
A third category: nonperating accounts, such as extraordinary or
nonrecurring items.
Companies should be valued on the economics of the business, i.e., the
results of operations: operating cash return on operating invested capital.
Keep operating items and financial items separate (though they must
balance).
Maintains comparability among firms.
Eliminates distortions caused by different financial structures.
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Measuring Capital (in Economic Terms)
Capital is the sum of all cash contributed to the business by all investors
(debtholders and equityholders).
Capital
= cash invested in the operations of the business for purposes of
earning a return
= (debt + equity) in the business,
where “debt” means interest-bearing borrowings, not things which
have no interest cost.
= (net working capital + net fixed assets) in the business
= operating invested capital
The amount of invested capital can be computed from the accounting
balance sheet.
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Total assets
Deduct financial assets (e.g., cash and marketable securities)
Deduct non-interest-bearing current liabilities (NIBCLs)
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Example:
Assets
Inventory
Accounts receivable
Total current assets
Property, plant & equipment
Total assets
6,000
3,000
9,000
11,000
20,000
Liabilities and equity
Accounts payable
Debt
Equity
Total liabilities and equity
2,000
6,000
12,000
20,000
Operating capital - operating approach
Net working capital
7,000
PP&E
11,000
Operating capital
18,000
Operating capital - financing approach
Debt
6,000
Equity
12,000
Operating capital
18,000
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Measuring Return on Capital (in Economic Terms)
The cash returns in the business are the funds available for distribution to
debtholders and equityholders.
Cash returns are the profits derived from the operations of the
business, after taxes and before financing costs.
Net operating profit after tax
=
NOPAT
=
Sales revenue
– operating expenses
– taxes on just the operating profits
NOPAT does not include financing cash flows. They must be reversed.
In other words, the effects of financing items in the income statement
(such as interest expense) must be removed.
NOPAT = Net income + interest expense after tax
+ other nonoperating expenses after tax
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Example:
Sales revenue
Costs
Gross profit
Interest expense
PBT
Tax
Net income
Add back interest
Subtract tax savings from interest
NOPAT
Firm A
100
(80)
20
0
20
(8)
12
Firm B
100
(80)
20
(9)
11
(4.4)
6.6
0
0
12
9
(3.6)
12
Assets
100
100
Liabilities
Equity
Total liabilities and equity
0
100
100
90
10
100
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IDENTIFYING OPERATING ITEMS
IN FINANCIAL STATEMENTS
Objective: Determine the operating return on the operating invested capital
in the business.
Whether an item should be categorized as an operating item depends on
the answers to these questions:
Is this item used in – or does it result from – the normal, everyday
running of the base business? If yes, it’s part of operating invested
capital.
Does this item represent cash from the investors, invested in the
business with the expectation of earning a return, or income or
expense associated with such an item? If yes, it’s part of financial
invested capital.
If the answer is no to both, then the item is an unusual, extraordinary
or nonrecurring item. It should be excluded from the calculations of
operating and financial returns.
Operating items:
Inventory
PP&E
Accounts payable
Cost of goods sold
Rent
Depreciation
Financial items:
Debt, short-term or long-term
Interest expense (or income?)
Treasury stock
Deferred taxes
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Nonoperating or extraordinary items:
Short-term invested cash
Restructuring charges
Extraordinary income or expense
Charges for changes to accounting practices
The boss’ condo in Ft. Meyers
To compute operating return on operating invested capital, reverse the
effects of financial and nonoperating items from the income statement:
Add back financial and nonoperating deductions (then increase taxes, due
to loss of tax shield).
Subtract financial and nonoperating income (then decrease taxes, due to
removal of taxable income).
On the balance sheet, include “Other assets” net of “Other liabilities” as
part of operating invested capital.
Any liability with an explicit interest cost or other explicit rate of return
should be included as part of financial invested capital.
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NOPAT, FINANCING APPROACH
Start with Net Income (at the bottom of the income statement).
Reverse financing items, after tax, to arrive at an after-tax operating profit
number.
 Use marginal tax rate (40%).
Add changes in deferred taxes, to arrive at cash operating profit after tax
(NOPAT).
See Abercrombie & Fitch example on the following pages.
NOPAT, OPERATING APPROACH
Start with Total Revenue (at the top of the income statement).
Add and subtract only operating items, leaving out any financial income or
expense, to arrive at an operating profit number before tax (NOPBT).
Subtract the accounting Provision for Income Tax.
Reverse tax effects of financing or nonperating items (only the tax effects, not
the items themselves) to arrive at an after-tax operating profit number.
 Use marginal tax rate (40%).
Add changes in deferred taxes, to arrive at cash operating profit after tax
(NOPAT).
See Abercrombie & Fitch example on the following pages.
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OPERATING NOPAT: CASH TAXES ON NOPBT
Actual cash taxes on operating NOPBT can be approximated by adjusting the
accounting provision for taxes (shown on income statement) to account for two
things:
1. Reverse tax effects of nonoperating income statement items.
2. Adjust for any changes in the deferred tax accounts on the balance sheet,
to arrive at an estimate of cash taxes actually paid.
 Reduce the taxes by the amount of increase in deferred tax
liability.
 Increase taxes by the amount of increase in deferred tax asset.
Reverse tax effects means:
Cash taxes are higher by the amount of any tax shield from
nonoperating deductions.
Cash taxes are lower by the amount of any taxes paid on
nonoperating income.
Tax rate: Always use the marginal tax rate for making these
line-item adjustments:
Use 40% at present.
Adjust for changes in deferred taxes means:
If deferred tax liability went up, then the amount of the increase
represents taxes computed by the accountants which were not
actually paid. Therefore, there is no cash outlay for the amount
of the increased liability. This is equivalent to a cash inflow.
If deferred tax liability went down, then the amount of the
decrease represents additional taxes paid on calculated taxes
from previous years. This is equivalent to a cash outflow.
Deferred tax assets have the opposite effect; increase in
deferred tax assets is an outflow; decrease is an inflow.
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Basic example:
Year ending
2002
2003
Deferred tax liability
Sales
Costs and expenses
Interest expense
Profit before tax
Provision for taxes
Net income
Cash taxes on NOPBT
Accounting taxes
Tax shield from interest
Change in deferred tax
Cash taxes
1,200
1,500
25,000
(16,000)
(2,000)
7,000
(2,170)
4,830
(2,170)
(800)
300
(2,670)
See Abercrombie & Fitch example on the following pages.
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ABERCROMBIE & FITCH
CONSOLIDATED STATEMENTS OF NET INCOME
(Thousands, except per share amounts)
2007
(Year ending Feb. 2, 2008)
NET SALES
Cost of Goods Sold
GROSS PROFIT
3,749,847
(1,238,480)
2,511,367
Stores and Distribution Expense
Marketing, General & Administrative Expense
Other Operating Income, Net
OPERATING INCOME
(1,386,846)
(395,758)
11,734
740,497
Interest Income, Net
INCOME BEFORE INCOME TAXES
18,828
759,325
Provision for Income Taxes
NET INCOME
ABERCROMBIE & FITCH
CONSOLIDATED BALANCE SHEETS
(Thousands, except share amounts)
ASSETS
Deferred Income Taxes
(283,628)
475,697
February 3, February 2,
2007
2008
33,170
36,128
LIABILITIES AND SHAREHOLDERS’ EQUITY
Deferred Income Taxes
30,394
22,491
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ABERCROMBIE & FITCH
NOPAT (financial)
NET INCOME
Interest Income reversed
Marginal tax on interest income reversed
475,697
(18,828)
7,531
Change in deferred taxes:
Asset
Liability
Financial NOPAT
(2,958)
(7,903)
453,539
NOPAT (operating)
NET SALES
Cost of Goods Sold
Stores and Distribution Expense
Marketing, General & Administrative Expense
Other Operating Income, Net
Provision for Income Taxes
Reverse tax effects of nonoperating items:
Interest Income, Net
Change in deferred taxes:
Asset
Liability
Operating NOPAT
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3,749,847
(1,238,480)
(1,386,846)
(395,758)
11,734
(283,628)
7,531
(2,958)
(7,903)
453,539
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