Analyzing Historical Performance

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					Analyzing Historical Performance
              The Importance of Historical Analysis

• Understanding a company’s past is essential for forecasting its future. Using historical
  analysis, we can test a company’s ability to

     • create value over time by analyzing trends in operating and financial metrics

     • compete effectively within the company’s industry

• In this presentation, we will examine how to effectively evaluate a company’s previous
  performance, competitive position, and ability to generate cash in the future by:

     • rearranging the accounting statements,

     • digging for new information in the footnotes,

     • making informed assumptions where needed

• A good historical analysis will focus on the drivers of value: return on invested capital
  (ROIC) and growth. ROIC and growth drive free cash flow, which is the basis for
  enterprise value.



                                                                                              1
                 Evaluating Historical Performance
To analyze a company’s historical performance, we proceed in four steps:

               Reorganize the company’s financial statements
               First convert the company’s financial statements to reflect economic, rather than
Step 1:
               accounting performance, creating such new terms as net operating profit less
               adjusted taxes (NOPLAT), invested capital, and free cash flow.


               Analyze ROIC & Economic Profit
Step 2:        Return on invested capital (ROIC) measures the economic performance of a
               company’s core business. ROIC is independent of financial structure and can be
               disaggregated into measures examining profitability and capital efficiency.


               Analyze Revenue Growth
Step 3:        Break down revenue growth into its four components: organic revenue growth,
               currency effects, acquisitions, and accounting changes.


               Evaluate credit health and financial structure
               Assess the company’s liquidity and evaluate its capital structure in order to
Step 4:
               determine whether the company has the financial resources to conduct business
               and make short and long-term investments.


                                                                                                   2
     The Problems with Traditional Financial Analysis

  Why do we need to reorganize the company’s financial statements?

• Traditional measures of performance, such as ROE and ROA, include non-operating
  items and financial structure that impair their usefulness.

    • ROE mixes operating performance with capital structure, making peer group
      analysis and trend analysis less meaningful. ROE rises with leverage if ROIC is
      greater than the after-tax cost of debt.

                          Return                         Debt
                                  ROIC  (ROIC  k D )
                          Equity                        Equity
    • ROA measures the numerator and denominator inconsistently (even when profit
      is computed on a pre-interest basis).

    • To ground our historical analysis, we need to separate operating performance
      from non-operating items and the financing to support the business.




                                                                                        3
                           Modern Financial Analysis

• To prevent non-operating items and capital structure from distorting the company’s
  operating performance, we must reorganize the financial statements. We will create
  two new terms:

     • NOPLAT. The income statement will be reorganized to create net operating profit less
       adjusted taxes (NOPLAT). NOPLAT represents the after-tax operating profit available to all
       financial investors.

     • Invested Capital. The balance sheet will be reorganized to create invested capital.
       Invested capital equals the total capital required to fund operations, regardless of type (debt
       or equity).

• By reorganizing the income statement and balance sheet, we can develop
  performance metrics that are focused on core operations:

                                               NOPLAT
                                 ROIC 
                                           Invested Capital

                    FCF = NOPLAT – Net Increase in Invested capital


                                                                                                         4
           Reorganizing the Balance Sheet: An Example
• Let’s rearrange the accountant’s balance sheet into invested capital and total funds
  invested for a simple hypothetical company (i.e. a company with only few line items).


      Accountant’s Balance Sheet                       Economic Balance Sheet

                               Prior   Current                           Prior    Current
Assets                         year    year                              year     year
Inventory                       20      22       Inventory                 200    225       Operating liabilities
Net PP&E                        30 0    35 5     Accounts payable         (125)   (150)     are netted against
                                                                                            operating assets
Equity investments              15 0    25 0     Operating working capital 75      75
Total assets                    51      60
                                   5       0     Net PP&E                 300     350
                                                 Invested capital         375     425
Liabilities and equity                                                                      Non-operating assets
Accounts payable                12      15       Equity investments        15      25       are not included in
Interest-bearing debt           22 5    20 0     Total funds invested     390     450       invested capital.
Common stock                    50 5    50 0
Retained earnings              115      20       Total funds invested
                                                                                                  Note the
Total liabilities and equity    51      60 0     Interest-bearing debt    225     200
                                   5       0                                                   redundancy of
                                                 Common stock              50      50
                                                                                                 total funds
                                                 Retained earnings        115     200             invested
                                                 Total funds invested     390     450



                                                                                                                5
      Reorganizing the Income Statement: NOPLAT

• Net Operating Profit Less Adjusted Taxes (NOPLAT) is after-tax
  operating profit available to all investors

    • NOPLAT equals revenues minus operating costs, less any taxes that
      would have been paid if the firm held only core assets and were financed
      only with equity.

    • Unlike net income, NOPLAT includes profits available to both debt
      holders and equity holders

• In order to calculate ROIC and free cash flow properly, NOPLAT should
  be defined consistently with invested capital.

    • For instance, if a non-operating asset is excluded from invested capital,
      any income from that assets should be excluded from NOPLAT.




                                                                                  6
           Reorganizing the Income Statement: NOPLAT
• NOPLAT includes only operating-based income. Unlike net income, interest
  expense and non-operating income is excluded from NOPLAT.

Accountant’s income statement                         NOPLAT

Revenues                      1,000    Revenues                        1,000
Operating costs               (700)    Operating costs                 (700)
Depreciation                    (20)   Depreciation                      (20)
Operating profit               280     Operating profit                 280
                                                                                    Taxes are
                                       Operating taxes                  (70)      calculated on
Interest                       (20)                                              operating profits
                                       NOPLAT                           210
Nonoperating income              4
Earnings before taxes (EBT)    264                                                  Do not include
                                       A/T nonoperating income*           3       income from any
                                       Total income to all investors    213     asset excluded from
 Taxes*                        (66)                                              invested capital as
 Net income                    198                                                 part of NOPLAT
                                       Reconciliation with net income
                                       Net income                     198        Treat interest as a
                                       After-tax interest*               15      financial payout to
                                       Total income to all investors    213       investors, not an
* Assumes a flat tax of 25%
                                                                                      expense
  on all income



                                                                                                       7
          Calculating NOPLAT – Top-Down Approach
• To build NOPLAT, start with revenues and subtract traditional operating expenses,
  such as COGS, SG&A, and depreciation.

                                           NOPLAT
                            Revenues                  1,000              Do not subtract
                            Operating costs            (700)                goodwill
                            Depreciation                (20)              amortization
                            Operating profit            280

• From this number, subtract operating taxes. Operating taxes are the cash taxes that
  would have been paid, if the company held only core assets finance entirely with
  equity.
                            Operating taxes             (70)
                            NOPLAT                      210


• To compute operating taxes, proceed in two steps:
     1.   Compute operating taxes by adjusting reported taxes for non-operating items
     2.   Adjust reported taxes by the increase in net deferred tax liabilities.


                                                                                           8
           Calculating NOPLAT – Advanced Issues

Capitalizing R&D
• If a company has significant long-term R&D, do not subtract the annual R&D
  expense. Instead, capitalize R&D on the balance sheet and subtract an
  annualized amortization of this capitalized R&D.


Capitalizing Operating Leases
• If a company has significant operating leases, capitalized the operating lease on
  the balance sheet and add back lease-based interest to operating profit. Convert
  the remaining rental expense to depreciation.


Excluding Recognized Pension Gains & Losses.
• Pension gains & losses booked on the income statement are usually hidden within
  cost of goods sold. Remove any recognized gains or losses from NOPLAT.
  Unrecognized gains do not flow through the income statement, so no change is
  required for unrecognized gains.



                                                                                      9
                 Evaluating Historical Performance
To analyze a company’s historical performance, we proceed in four steps:

               Reorganize the company’s financial statements
               First convert the company’s financial statements to reflect economic, rather than
Step 1:
               accounting performance, creating such new terms as net operating profit less
               adjusted taxes (NOPLAT), invested capital, and free cash flow.


               Analyze ROIC & Economic Profit
Step 2:        Return on invested capital (ROIC) measures the economic performance of a
               company’s core business. ROIC is independent of financial structure and can be
               disaggregated into measures examining profitability and capital efficiency.


               Analyze Revenue Growth
Step 3:        Break down revenue growth into its four components: organic revenue growth,
               currency effects, acquisitions, and accounting changes.


               Evaluate credit health and financial structure
               Assess the company’s liquidity and evaluate its capital structure in order to
Step 4:
               determine whether the company has the financial resources to conduct business
               and make short and long-term investments.


                                                                                                   10
     Using ROIC to Compare Operating Performance


• Having reorganized the financial
  statements, we now have a clean
  measure of total invested capital        ROIC: Home Depot vs. Lowes
  and its related after-tax operating
                                                                           18.2
  income.                                               16.0
                                         14.3                                     13.9
• To measure historical operating                              12.8
                                                10.3
  performance, compute return on
  investment by comparing NOPLAT
  to invested capital:


                   NOPLAT                   2001            2002              2003
     ROIC =
               Invested Capital            Home Depot (%)      Lowe's %)




           Home Depot’s outperforms Lowes when measured by ROIC.


                                                                                         11
        Measuring Value Creation: Economic Profit

• Home Depot ROIC improved between 2001 and 2003, but is the company using its
  investors funds more effectively than could be expected in the capital markets?

• To answer this question, we examine economic profit, defined as follows:


               Economic Profit = Invested Capital x (ROIC-WACC)


                                 2001        2002         2003
      Return on invested
      capital (ROIC)            15.0%       16.8%       19.4%

      Weighted average
                                10.1%        9.0%         9.3%
      cost of capital (WACC)
                                                                        Home Depot
      Economic spread            4.9%        7.9%       10.1%            earned $2.6
                                                                        billion more
      x Invested capital        21,37        23,63       26,18        than “expected”
                                    9            5           5          based on the
      Economic profit           1,048        1,857       2,645         company’s risk
                                                                            profile


                                                                                    12
   Understanding Value Creation: Decomposing ROIC

• Compared to both its weighted average cost of capital, and that of its rival Lowes,
  Home Depot has been earning a superior return on invested capital.

     • But what is driving this superior performance?

     • Can these advantages be sustained?

• To better understand ROIC, we can decompose the ratio as follows:


                                              EBITA            Revenues
            ROIC = (1 - Cash Tax Rate) x                x
                                            Revenues        Invested Capital


                                          Profit Margin     Capital Efficiency

• As the formula demonstrates, a company’s ROIC is driven by its ability to (1)
  maximize profitability, (2) optimize capital efficiency, or (3) minimize taxes

                                     This equation can be organized into a tree…

                                                                                        13
     Understanding Value Creation: Decomposing ROIC

 Home Depot benefits from a more efficient use of capital
  and a better cash tax rate.                                                       31.8
                                                                    Gross
                                                                    margin
 This capital efficiency comes                                                     31.2

  primarily from fixed assets, which in
                                                             11.0                   19.1
  turn come from more revenues per             Operating            SG&A/
  dollar of store investment…                  margin               revenues*
                                                             10.7                   18.0


                                                                                    1.7
                                                                    Depreciation/
                                      25.5
                           Pre-tax                                  revenues
                                                                                    2.5
                           ROIC
        Home Depot                    20.5
                                                                    Operating       4.2
                18.2                                                working
                                                                    capital/
       ROIC                                                  2.3    revenues        4.6
                                               Average
                13.9                           capital
                                      28.6     turns         1.9                    38.9
          Lowe’s                                                    Fixed
                           Cash tax
                                                                    assets/
                           rate
                                      32.5                          revenues        47.4



                                                                                           14
                 Evaluating Historical Performance
To analyze a company’s historical performance, we proceed in four steps:

               Reorganize the company’s financial statements
               First convert the company’s financial statements to reflect economic, rather than
Step 1:
               accounting performance, creating such new terms as net operating profit less
               adjusted taxes (NOPLAT), invested capital, and free cash flow.


               Analyze ROIC & Economic Profit
Step 2:        Return on invested capital (ROIC) measures the economic performance of a
               company’s core business. ROIC is independent of financial structure and can be
               disaggregated into measures examining profitability and capital efficiency.


               Analyze Revenue Growth
Step 3:        Break down revenue growth into its four components: organic revenue growth,
               currency effects, acquisitions, and accounting changes.


               Evaluate credit health and financial structure
               Assess the company’s liquidity and evaluate its capital structure in order to
Step 4:
               determine whether the company has the financial resources to conduct business
               and make short and long-term investments.


                                                                                                   15
                      Analyzing Revenue Growth
• The value of a company is driven by return on invested capital, the weighted average
   cost of capital, and growth. And the ability to grow cashflows over the long-term
   depends on a company’s ability to organically grow its revenues.

• Calculating revenue growth directly from the income statement will suffice for most
   companies. The year-to-year revenue growth numbers sometimes can be misleading,
   however. The three prime culprits affecting revenue growth are:

     1. Currency Changes. Foreign revenues must be consolidated into domestic
        financial statements. If foreign currencies are rising in value relative to the
        company’s home currency, this translation, at better rates, will lead to higher
        revenue.

     2. Mergers and Acquisitions. When one company purchases another, the
        bidding company may not restate historical financial statements. This will bias
        one-year growth rates upwards

     3. Changes in accounting policies. When a company changes its revenue
        recognition policies, comparing year-to-year revenue can be misleading.


                                                                                          16
                Organic Growth vs. Reported Growth
• To demonstrate how misleading year-to-year revenue growth figures can be, consider
   the following example from IBM.

• When IBM reported its first rise in reported revenues in three years in 2003, it became
   the subject of a Fortune magazine cover story. “Things appear to be straightening out
   dramatically,” reported Fortune. “Last year Palmisano's company grew for the first
   time since 2000, posting a 10% revenue jump.”

• But where is this revenue growth coming from?
                                                               IBM purchased
                                                               two companies:
                     IBM Revenue Growth                       Rational Software
                                                                 and PwCC
                                  2001     2002      2003
      Organic revenue growth     0.5%    (1.8)%    (2.6)%

      Acquisitions                 0.5      2.1       5.4
                                                                    Nearly 7% of IBM
      Divestitures                 0.0      (3.3      0.0           growth caused by
                                               )
      Currency effects           (3.9)      (2.5      7.0            the weakening
                                               )                         dollar.
      Reported revenue growth   (2.9)%   (5.5)%     9.8%



                                                                                        17
      Analyzing Revenue Growth: Currency Changes
• Companies with extensive foreign business will report revenues using both current, as
   well as constant exchange rates (CER).

• For instance, IBM reports a “year-to-year revenue change” of 9.8%, but a “year-to-
   year change constant currency” of only 2.8%.

                              IBM Annual Report, Page 51




             Had currencies remained at their prior year levels, IBM revenue
           would have been $83.5 billion, rather than the $89.1 billion reported.

                                                                                       18
                     Analyzing Revenue Growth: M&A
• Growth through acquisition may have very different ROIC characteristics than growth
   through internal investments (this due to the sizable premiums a company must pay
   to acquire another company).

• The bidder will often only include partial-year revenues from the target after the
   acquisition is completed. To remain consistent, reconstructed prior years must only
   include partial year revenue as well:

                                                            Estimated
                                        Transaction         2002             Partial year         Revenue
                                        date                revenue          adjustment           adjustments
  IBM reported 2002 revenue                                                                       81,186.0
  Ten months of Rational Software       2/21/200            689.8            10/12                  574.8
                                        3
  Nine months of PwCC revenue           10/1/200            5,200.           9/12                  3,900.0
                                        2                   0
  IBM adjusted 2002 revenue                                                                       85,660.8

                                 Rational was a publicly     Three months of PwCC data was            Compute growth by
                                   traded company, so        included in IBM’s 2002 financials.       comparing 2003 to
                               revenues are exact. PwCC         Therefore, we must add the               this number
                                was private and estimated     remaining nine months, to make
                                  using Hoover’s data.            2002 & 2003 consistent.


                                                                                                                   19
    Analyzing Revenue Growth: Accounting Changes
• Each year the Financial Accounting Standards Board (U.S.) and International
   Accounting Standards Board (Europe) make recommendations concerning the
   financial treatment of certain business transactions.

• Consider EITF 01-14 from the Financial Accounting Standards Board, which concerns
   reimbursable expenses.

     – Prior to 2002, U.S. companies accounted for reimbursable expenses by ignoring
       the expense entirely. Starting in 2003, U.S. companies can recognize the
       reimbursement as revenue and the outlay as an expense.

     – This “new” revenue will artificially increase year-to-year comparisons.


                                 Total System Services, Annual Report, page F-7
     Reimbursable Expenses

     As a result of the Financial Accounting Standards Board‟s (FASB‟s) Emerging Issues Task Force 01-14 (EITF 01-14),
     formerly known as Staff Announcement Topic D-103, “Income Statement Characterization of Reimbursements
     Received for „Out-of-Pocket‟ Expenses Incurred,” the Company has included reimbursements received for outof-
     pocket expenses as revenue. Historically, TSYS had not reflected such reimbursements in its consolidated statements
     of income.
                                                            …
                                                                                                                           20
  Understanding Value Creation: Decomposing Growth
                                                                                     Home Depot (%)
• Once revenues have been disaggregated, analyze revenue
                                                                                     Lowe’s (%)
  growth from an operational perspective. The most standard
  decomposition is:                                                                       4.2%
                                                                            Square feet
                             Revenue                                        per store
                Revenues            x Units                                              2.7%
                              Unit

                                                     Number of      (3.7)
                                                     transactions
                                                     per store      0.2
                                           (0.1)
                              Revenue
                              per store                                                   (7.6)%
                                               4.4                          Number of
                                                                    3.7     transactions per
      Home Depot                                     Dollars per
                                                                            square foot (2.5)%
                                                     transaction
                11.3%                                               4.2
      Revenue
                16.4%
                                                     • Growth trees can be built using advanced
         Lowe’s                                        versions of the decomposition formula
                                           11.4        presented above.
                              Number of
                              stores
                                           11.5
                                                     • How is Home Depot driving revenue growth?


                                                                                                      21
                 Evaluating Historical Performance
To analyze a company’s historical performance, we proceed in four steps:

               Reorganize the company’s financial statements
               First convert the company’s financial statements to reflect economic, rather than
Step 1:
               accounting performance, creating such new terms as net operating profit less
               adjusted taxes (NOPLAT), invested capital, and free cash flow.


               Analyze ROIC & Economic Profit
Step 2:        Return on invested capital (ROIC) measures the economic performance of a
               company’s core business. ROIC is independent of financial structure and can be
               disaggregated into measures examining profitability and capital efficiency.


               Analyze Revenue Growth
Step 3:        Break down revenue growth into its four components: organic revenue growth,
               currency effects, acquisitions, and accounting changes.


               Evaluate credit health and financial structure
               Assess the company’s liquidity and evaluate its capital structure in order to
Step 4:
               determine whether the company has the financial resources to conduct business
               and make short and long-term investments.


                                                                                                   22
                Credit Health and Capital Structure

• In the final step of historical analysis, we focus on how the company has financed its
  operations. We ask:

     • How is the company financed, i.e. what proportion of invested capital comes from
       creditors versus equityholders?

     • Is this capital structure sustainable?

     • Can the company survive an industry downturn?

• To assess the aggressiveness of a company’s capital structure, we examine

     • Liquidity – the ability to meet short-term obligations. We measure liquidity by
       examining the interest coverage ratio.

     • Leverage – the ability to meet long-term obligations. Leverage is measured
       by computing the market-based debt-to-value ratio.




                                                                                           23
       Credit Health and Capital Structure - Liquidity


• The interest coverage ratio measures a
                                             Interest Coverage at Home Depot
  company’s ability to meet short-term
  obligations:
                                                Home Depot ($ Million)          2003
                                                EBITA                           6,847
                       EBITDA (or EBITA)
   Interest Coverage 
                         Interest Expense       EBITDA                          7,922

                                                EBITDAR*                        8,492
• EBITDA / interest measures the ability
                                                Interest                          62
  to meet short-term financial
  commitments using both profits, as well       Rental expense                   570

  as depreciation dollars earmarked for         Interest plus rental expense     632

  replacement capital.                          EBITA/Interest                  110.4

• EBITA / interest measures the ability to      EBITDA/Interest                 127.8
  pay interest without having to cut            EBITDAR/Interest plus rental     13.4
  expenditures intended to replace
  depreciating equipment.
                                                * R stands for rental expense



                                                                                        24
         Credit Health and Capital Structure - Leverage

• To better understand the power (and
  danger) of leverage, consider the                                    The Effect of Financial Leverage
  relationship between ROE and ROIC.                                        on Operating Returns



                                                                                     25.0%             2.0x
      Return                         Debt
              ROIC  (ROIC  k D )
      Equity                        Equity
                                                                                     15.0%                            1.0x

• The use of leverage magnifies the




                                             Return on Equity
  effect of operating performance.                                                    5.0%


   • The higher the leverage ratio                              -25%   -15%          -5%          5%            15%          25%
                                                                                      -5.0%
     (IC/E), the greater the risk.

   • Specifically, with a high leverage                                             -15.0%

     ratio (a very steep line), the
     smallest change in operating                                                   -25.0%

     performance, can lead to                                                 Operating Profit / Total Assets


     enormous changes in ROE.


                                                                                                                                   25
                  Typical Leverage Ratios Across Industries



                                                 Median Debt-to-Equity, 2003
• To place the company’s                                      In percent
  current capital structure in
                                  Information technology     0%
  the proper context, compare
                                  Healthcare                  4%
  its capital structure with
                                  Aerospace and defence            14%
  those of similar companies.
                                  Industrial machinery              15%
• Industries with heavy fixed                                        18%
                                  Consumer discretionary
  investment in tangible assets
                                  Consumer staples                         23%
  tend to have higher debt
                                  Oil and gas                               28%
  levels.
                                  Chemicals, paper, metals                       35%
• High-growth industries,         Telecommunications                               43%
  especially those with           Airlines                                             49%
  intangible investments, tend    Utilities                                                              89%
  to use very little debt.
                                  Note: Market value of debt proxied by book value. Enterprise value proxied
                                        by book value of debt plus market value of equity


                                                                                                         26
                             Closing Thoughts

• Understanding a company’s past is essential for forecasting its future. Through
  historical analysis, we can test a firm’s ability to create value…

     • over time by analyzing trends in operating and financial metrics, and

     • as compared to other companies within the firm’s industry

• When analyzing historical performance, keep the following in mind:

     • Look back as far as possible (at least 10 years). Long term horizons will allow
       you to evaluate company and industry trends and whether short-term trends will
       likely be permanent

     • Disaggregate value drivers, both ROIC and revenue growth, as far back as
       possible. If possible, link operational performance measures with each key value
       driver.

     • Identify the source, when there are radical changes in performance. Determine
       whether the change is temporary or permanent, or merely an accounting effect.


                                                                                          27

				
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