Financial Statement Analysis

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					Financial Statement Analysis

                               1   January 13
  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       
                                                                   2   January 13
  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 
                                                                 3   January 13
  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  
                                                                  4   January 13
  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      
                                                                            5   January 13
Income Statement

                   6   January 13
  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
  •   NOPLAT is computed by EBIT less adjusted taxes, where taxes are computed
      through adjusting income taxes.    
                                                                         7   January 13
  Standard Computation of EBITDA
                                       8   January 13
  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.  
                                                                  9   January 13
  Simplified Income Statement

  •   Sales
      -     COGS
  •   =     Gross Margin                      There is a debate about how to handle
      -     SG&A                              other income from non-consolidated
      -     Other Expenses                    subsidiary companies.

  •   +     Other Income
                                              One school of thought (McKinsey) is that
  •   =     EBITDA
                                              they should be valued separately since
  •   -     Depreciation and Amortization     they will have different cost of capital etc.

  •   =     EBIT
                                              In this case, do not include in EBITDA
  •   -     Interest Expense (income)         and remove the asset balance from the
                                              invested capital. Must be consistent
  •   =     EBT
      -     Income Taxes
  •   -     Minority Interest
  •   =     Net Income

  NOPLAT = EBIT x (1-tax rate)
  NOPLAT = Net Income + Interest Expense x (1-tax)       
                                                                                        10 January 13
  Analysis of Income Statement – Computation of EBITDA,
  Minority Interest, Preferred Dividends, Exploration Expense
                                                      11   January 13
  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    
                                                 12 January 13
  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
                                                                          13 January 13
  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
          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  
                                                                   14 January 13
Cash Flow Statement

                      15   January 13
  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   
                                                                        16 January 13
  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            
                                                                                    17 January 13
  Cash Flow Statement Example
                                       18 January 13
  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
  • 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  
                                                                  19 January 13
  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
          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   
                                                                     20 January 13
  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  
                                                              21 January 13
  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     
                                                                      22 January 13
  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   
                                                                     23 January 13
  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                                       Some argue that free cash flow
                                                                         should not include non-operating
           Less: Tax Shield on Interest                                 items. Here the non-consolidated
  •   From the income statement, the formula is:                         companies are treated in a similar
                                                                         manner as liquid investments
           EBITDA
           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             
                                                                                            24 January 13
  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      
                                                                         25 January 13
                                       One could make adjustments for
  Free Cash Flow Example               dividends payable, interest payable and
                                       other items in the working capital

                                                    In actual situations,
                                                    must adjust the free
                                                    cash flow for deferred
                                                                 26 January 13
Balance Sheet

                27   January 13
  Balance Sheet Adjustments

  •   When analysing the balance sheet, various items should be adjusted and grouped
          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
          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    
                                                                          28 January 13
  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. 
                                                                 29 January 13
  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  
                                                               30 January 13
Financial Ratio Analysis

                           31   January 13
  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  
                                                                           32 January 13
  IRR Mathematics and IRR Exercise

  • IRR is simply rate of return                         Why we raise to a
                                                         power with two year
          Example: Invest 100 and receive 120 in 1 year case
          IRR = 120/100 = 120% - 100% = 20%
                                                           FV = PV (1+r) (1+r)
  • If the cash flow is over two years
                                                           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% 
                                                                 33 January 13
  Financial Ratio Analysis

  •   Purpose :
        Evaluate relation between two or more economically important items (one is
         the starting point for further analysis)
        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
  •   Show components of numerator and denominator in rows above the ratio
                                                                      34 January 13
  General Discussion of Financial Ratios

  •   Financial Ratios Often Compares Income Statement or Cash Flow with Balance
          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    
                                                                          35 January 13
  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.

  •   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
                                                                          36 January 13
Ratios that Measure Management

                            37   January 13
  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    
                                                                    38 January 13
  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
                                                               39 January 13
  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. 
                                                                 40 January 13
   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
                                                                   41 January 13
  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
                   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         
                                                                                      42 January 13
  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   
                                                                       43 January 13
  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 long-
      term 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.    
                                                                        44 January 13
  Exxon Mobil Return on Capital Employed – Where are they
  making expenditures
                                                   45 January 13
  Exxon Mobil Return on Capital

  Return on average capital employed                                        2005                  2004                2003
                                                                 -millions of dollars
   Net income                                                    $ 36,130.00            $   25,330.00          $ 21,510.00
   Financing costs -after tax
       Third-party debt                                                    (1.00)              (137.00)             (69.00)
       ExxonMobil share of equity companies                              (144.00)              (185.00)            (172.00)
       All other financing costs – net -1                                (295.00)                54.00            1,775.00

              Total financing costs                                      (440.00)              (268.00)           1,534.00

   Earnings excluding financing costs                            $    36,570.00         $   25,598.00          $ 19,976.00

   Average capital employed                                      $ 116,961.00           $ 107,339.00           $ 95,373.00

   Return on average capital employed – corporate total                    31.30                 23.80               20.90

                                                          “All other financing costs – net” in 2003 includes

                                                          interest income (after tax) associated with the
                                                          settlement of a U.S. tax dispute.                       
                                                                                                                     46 January 13
  Example of ROIC Calculation - AES
                                        47 January 13
  Illustration of Invested Capital Computation
                                                 48 January 13
  ROE and ROIC – Note how to compute growth rates from ROE
  and Retention
                                                 49 January 13
  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.    
                                                                          50 January 13
  Relationship Between Various Ratios and DuPont Analysis

          Profitability                              Asset Utilization
                                                Working Capital/ Sales
Gross Margin = Gross profit/ Sales              Plus:
Less: Operating costs/ Sales                    Long-term capital/ Sales
Equals EBIT Margin (EBIT/ 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 )   
                                                                    51 January 13
  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     
                                                                         52 January 13
  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. 
                                                                  53 January 13
  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    
                                                                        54 January 13
  Illustration of EV Ratios and Computation of Market Value of
  Balance Sheet Components
                                                      55 January 13
  Investment Banker Analysis of Comparable Multiples
                                                   56 January 13
  Investment Banker Analysis of Multiples
                                            57 January 13
  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  
                                                                58 January 13
Risk Assessment of Debt and Analysis of
           Credit Spreads

                                 59   January 13
    Liquidity and Solvency

            Credit worthiness: Ability to honor credit obligations
                              (downside risk)

               Liquidity                                 Solvency
Ability to meet short-term obligations     Ability to meet long-term
 Focus:                                    obligations
• Current Financial                             Focus:
   conditions                              • Long-term financial
• Current cash flows                          conditions
• Liquidity of assets                      • Long-term cash flows
                                           • Extended profitability   
                                                                      60 January 13
  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    
                                                                       61 January 13

  •   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)     
                                                                            62 January 13
  Banks or Rating Agencies Value Debt with Risk Classification

         Map of Internal Ratings to Public Rating Agencies
              Credit                                  Corresponding
             Ratings    Code       Meaning               Moody's
                 1       A       Exceptional               Aaa
                 2       B         Excellent               Aa1
                 3       C          Strong               Aa2/Aa3
                 4       D           Good                A1/A2/A3
                 5       E       Satisfactory         Baa1/Baa2/Baa3
                 6       F        Adequate                 Ba1
                 7       G        Watch List             Ba2/Ba3
                 8       H          Weak                    B1
                 9       I       Substandard              B2/B3
                10       L         Doubtful               Caa - O
                         N      In Elimination
                         S     In Consolidation
                         Z   Pending Classification    
                                                                       63 January 13
  S&P Ratio Definitions
                                         64 January 13
  S&P Benchmarks
                                      65 January 13
   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
                                                                66 January 13
               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         1.4–2.0 2.0–3.0             3.0–4.5        >4.5

                                          Key Industry Characteristics And Drivers Of Credit Risk
               Credit risk impact: High (H); Medium (M); Low (L)
                                                                                                          Regulatory/Gov      Energy
Risk factor                        Cyclicality      Competition     Capital intensity Technology risk        ernment         sensitivity
Industry                               H                H                   H               L                  M/H               H
Airlines (U.S.)                        H                H                   H               M                   M                H
Autos*                                 H                H                   H               M                   M                M
Auto suppliers*                        H                H                  M                H                   L               L/M
High technology*                       H                H                   H               M                  M/H               H
Mining*                                H                H                   H               L                   M                L
Chemicals (bulk)*                      H                H                   H               L                   M                H
Hotels*                                H                H                   H               L                   L                M
Shipping*                              H                H                   H               L                   L                M
Competitive power*                     H                H                  M                L                   H                H
Telecoms (Europe)                      M                H                   H               H                   H                L

                                                                                                                                           67 January 13
  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
                                              68 January 13
  Default Rates and Credit Spreads
                                         69 January 13
                      Credit Spreads

                              Increase of 5%          Credit Crisis
                                               70 January 13
         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

 11.0%                                                                                                         10.5%               10.5%
                                                                                                                                             10.3% 10.3%
                                                                                                                                                                                    10.1% 10.0% 10.0% 10.0% 10.0% 9.8%
                                                                                                      9.8%                                                                                                                                 9.3%
 10.0%                                                                                       9.6%
                                                                                    9.0%                                                                                                                                                            8.8%
  9.0%                                                           8.5%
                                      7.7%     7.7%
  7.0%    6.2%
% 6.0%
  4.0%                                                                                                                                                                                                                                                       3.77%*


















       Note: *Long run annual default rate is 3.77%                          
                                                                                                                                                                                                                  71 January 13
  Updated Transition Matrix
                                         72 January 13
  Probability of Default

  • This chart shows rating migrations and the probability of default for
    alternative loans. Note the increase in default probability with longer
                                                                  73 January 13
  Bond Ratings and Historic Credit Spreads
                                             74 January 13
  Credit Spreads for Utility Debt
                                          75 January 13
  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.    
                                                                       76 January 13
    Credit Spread on Debt Facilities

    • The spread on a loan is directly related to the probability of default and
      the loss, given default.

    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).   
                                                                    77 January 13
    Expected Loss Can Be Broken Down Into Three Components

                          Borrower Risk                              Facility Risk Related

  EXPECTED                 Probability of                Loss Severity               Loan Equivalent
    LOSS                      Default              x    Given Default           x        Exposure
                                 (PD)                      (Severity)                   (Exposure)
      $$                          %                             %                             $$

                         What is the probability       If default occurs, how       If default occurs, how
                          of the counterparty            much of this do we         much exposure do we
                              defaulting?                  expect to lose?              expect to have?

The focus of grading tools is on modeling PD       
                                                                                      78 January 13
  Comparison of PD x LGD with Precise Formula
  Case 1: No LGD and One Year

  • .
                                                79 January 13
  Comparison of PD x LGD with Precise Formula
  Case 2: LGD and Multiple Years

  • .
           Years                        5              BB                5
           Risk Free Rate 1            5%                                7
           Prob Default 1           20.8%              PD           20.80%
           Loss Given Default 1       80%

        Alternative Computations of Credit Spread
            Credit Spread 1        3.88%
            PD x LGD 1            16.64%

                                  Opening              Closing      Value
           Risk Free                  100               127.63      127.63

                                              Prob    Closing       Value
           Risky - No Default         100        0.95    153.01     145.36

           Risky - Default            100       0.05        30.60     1.53

           Total Value                                              146.89    FALSE

        Credit Spread Formula
           With LGD
                                            cs = ((1+rf)/((1-pd)+pd*(1-lgd))-rf)^(1/years)-1                  
                                                                                               80 January 13
  Default Rates by Industry
                                         81 January 13
  Recovery Rates
                                      82 January 13
Mathematical Credit Analysis

                               83   January 13
  General Payoff Graphs from Holding Investments with Future
  Uncertain Returns

                   Stock Payoff versus Price if Purchased or Sold Stock at $40

                                                            Ending Stock Price
                  -10 0    10     20     30     40     50      60      70        80
                                Purchase at $40          Sell Stock Short        
                                                                                  84 January 13
  Payoff Graphs from Call Option – Payoffs when Conditions

                             Call Option Payoff Patterns

                         0        20                40          60             80
                   -10                                               Ending Value
                   -20              Bought call          Sold Call
                                                                           85 January 13
  Payoff Graphs from Buying Put Option – Returns are realized
  to buyer when the value declines
                                                    86 January 13
  Payoff Graphs from Selling Put Option – Value Changes with
  Value Decreases

                             Put Option Payoff Pattern from
                            Selling Put -- Lender Perspective

                     -5 0      20        40       60    80      100    120
                 -10                                   Ending Firm Value
                                                                           87 January 13
  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).   
                                                              88 January 13
         Payoff to
         claimholders                                                  At maturity date T, the
                                                                       debt-holders receive
                                                                       face value of bond F
                                                                       as long as the value of
                   Value of the company and                            the firm V(T) exceeds
                   changes in value to equity and                      F and V(T) otherwise.
                   debt investors
                                                                       They get F - Max[F -
                                                                       V(T), 0]: The payoff of
                                Nominal Debt                           riskless debt minus the
                                                                       payoff of a put on V(T)
                                                              Equity   with exercise price F.

           F                                                           Equity holders get
                                                                       Max[V(T) - F, 0], the
                                                                       payoff of a call on the


                                    Value of Firm in Time T
                                                                       89 January 13
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.
                                                                       90 January 13
  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

          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 re-
           payments and no dividend payments
          APR is not violated      
                                                                         91 January 13
  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
  • We will derive the loss rates endogenously, together with the default
  • 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
                                                                  92 January 13
  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.         
                                                                                    93 January 13
        Default Occurs at Maturity of Debt if V(T)<F

                Asset Value

E (VT )  V0 e T                                                       2
                                                       VT  V0 exp{[   ]T   T ZT }



                                                     Probability of default

                              T                                                     Time  
                                                                                         94 January 13
  Resources and Contacts

  • My contacts
          Ed Bodmer
          Phone: +001-630-886-2754
          E-mail:
  • Other Sources
          Financial Library – project finance case studies including Eurotunnel
           and Dabhol
          Financial Library – Monte Carlo simulation analysis  
                                                                 95 January 13

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