INVESTMENT BANKING
LESSON 14 DETERMINING THE STRENGTH OF
A COMPANY’S RETURN ON EQUITY
Investment Banking (2nd edition) Beijing Language and Culture University
Press, 2013
Investment Banking for Dummies, Matthew Krantz, Robert R.
Johnson,Wiley & Sons, 2014
WHAT’S IN THE NEWS OR
WHAT’S THERE TO LEARN?
SHANGHAI OPENS FIRST PRIVATE
BANK!
VOCABULARY REVIEW – WHAT DO THESE
WORDS MEAN?
Present value and discount rate
Discounted free cash flow
Discounted free cash flow model
Free cash flows (FCF)
Weighted average cost of capital (WACC)
Capital expenditures
VOCABULARY REVIEW – WHAT DO THESE
WORDS MEAN?
What is present value? The value of any
asset is the present value of all future cash
flows given a certain rate of return.
What is the discount rate? The rate that
puts future cash sum in today’s dollars.
What does discounted free cash flow mean?
time value of money; present value of cash
flows; future value of cash flows; cash flow
analysis
VOCABULARY REVIEW – WHAT DO THESE
WORDS MEAN?
What does the discounted free cash flow
model tell you? the value of a company is equal
to the value of all future free cash flows
discounted at the weighted average cost of
capital (WACC).
What is free cash flow (FCF)? The amount of
cash flow form operations after paying for
capital expenditures. It is the money the
company has left to pay it’s investors after it
meets all it’s obligations (payments)
VOCABULARY REVIEW – WHAT DO THESE
WORDS MEAN?
Which of the following assets are capital
expenditures?
Office supplies
rent
Building or plant
utilities
Insurance
truck
office furniture
equipment
company car
What is weighted average cost of capital
(WACC)? Simply, the cost of funding for a
company. The cost of capital.
A. INTRODUCTION
B. IMPORTANCE OF RETURN OF EQUITY
(ROE) AND OTHER PROFITABILITY RATIOS
1. Gross Profit Margin
2. Operating Profit Margin
3. Net Profit Margin
C. HOW DOES ROE GUIDE IB ACTIVITIES
D. THE DUPONT ANALYSIS
1. Three-factor DuPont Method
The breakdown of ROE
a. Net Profit margin
b. Total Asset Turnover
c. Leverage
D. THE DuPONT ANALYSIS
2. Five-factor DuPont Method
The Breakdown of Net Profit Margin
a. Operating Profit Margin
b. The Effect of Non-operating
items
c. The Tax Effect
E. INTERPRETING THE RESULTS
How do IB judge how well a company is
performing? For publicly held companies, it
is how well is the stock doing. Has the stock
risen or fallen recently? But how does the IB
evaluate a privately held company?
Trend analysis – Using ratios to compare
against other companies in the same
industry. Looking at past data and then
projecting or making estimations for the
future growth of a company.
Lesson 10 focused on the key ratios. Do
you remember what some of them are?
What does an IB and a company want to
measure?
1.
2.
3.
4.
In this lesson, we will focus on the
ratio that is considered the most
important to investors, management
and IB – Return on Equity (ROE).
Making money for owners is the goal of
most businesses, since they provide
risky capital. Owners expect to be
rewarded. What are the things that
drive rising stock prices and happy
investors?
WHAT IS RETURN ON EQUITY (ROE)?
ROE measures how well a company is
producing a return on the money supplied
by stockholders.
Return on equity =
𝑵𝒆𝒕 𝑰𝒏𝒄𝒐𝒎𝒆
𝑺𝒉𝒂𝒓𝒆𝒉𝒐𝒍𝒅𝒆𝒓′ 𝒔 𝑬𝒒𝒖𝒊𝒕𝒚
When a company earns money, it can do 2
things:
1. Reinvest in the company
2. Pay out earnings as dividends to investors
IB must estimate the long-term growth of
the company:
Long-term growth=ROE x (1-Dividend payout rate)
in earnings
The dividend payout rate is a % of net income the
firm pays out in dividends.
For example, if a firm earns $100 million & pays out
$25 million in dividends the payout rate is 25%.
If the same firm has an ROE of 20% then:
Long term growth rate = 20% x (1-0.25) = 15%
The higher the dividend payout rate, the lower the
future growth. Some companies pay out a large
amount in dividends and others pay no dividends and
reinvest to provide for future growth.
REAL WORLD EXAMPLE: Warren Buffett’s Berkshire
Hatthaway Co. has never paid a dividend but
shareholders are pleased with an average 19.7%
annual return over the last 45 years.
Later we will look at Coca-Cola and it’s profitability
but the next chart show Coca Cola’s return over the
past 10 years.
Table 14-1
Return on Equity for Coca-Cola
Year
Return on Equity Year Return on Equity
2012
2011
2010
2009
2008
27.4%
27.1%
37.8%
27.5%
28.4%
2007
2006
2005
2004
2003
27.5%
30.8%
29.6%
30.3%
30.8%
Pros and Cons of ROE versus other
Profitability measures – We will also look at:
Gross profit margin
Operating profit margin
Net profit margin
For an example we will break down perhaps
the most recognized company in the world –
Coca-Cola (ticker symbol: KO)
Coca-Cola & Pepsico are 2 very well run
companies that really are simple. They both
are known around the world.
Coca-Cola has been ranked the #1 brand in
the world. Pepsico ranked 22nd.
Both companies have the same ROE but get it
in different ways. Pepsi’s net profit margin is
half of Cokes, but it’s asset turnover is twice
as high and Pepsi is more highly leveraged,
with more debt than Coke.
What do you see when looking at Pepsi
and Coke? There is more than one way
to see good results as a company.
Coke has a business model that relies on
higher net profit margin, lower asset
turnover and lower debt than Pepsi. The
good news for Coke is that they can take
on more debt if they want to grow their
returns. Pepsi cannot take on more
debt.
What do you see when looking at Pepsi and
Coke? There is more than one way to see
good results as a company.
Coke has a business model that relies on
higher net profit margin, lower asset
turnover (not as effective using assets) and
lower debt than Pepsi. The good news for
Coke is that they can take on more debt if
they want to grow their returns. Pepsi
cannot take on more debt.
Coke has wider net profit margins & would
do better than Pepsi if there was a “COLA
WAR”! Pepsi’s net profit margin is thin and
does not have a great margin of safety as
Coke does.
Pepsi does well in using its assets. Coke could
do better and see more dollars from its
assets. Both companies are selling at 21 and
20 times earnings. The Dow Jones average is
17 times earnings so you can see both
companies are doing well.
Coke and Pepsi are too big to be taken over.
But by doing the DuPont analysis IB can help
them to be better acquisition candidates.
Companies must focus on having a higher
ROE. THIS IS THE MOST IMPORTANT
MEASURE FOR COMPANIES LOOKING TO BE
ACQUIRED BY OTHER FIRMS OR TO GO
PUBLIC THEMSELVES. Investors look at ROE
so management must do so as well. But, it’s
also in how they got there and not achieved
by high levels of debt.