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Debt holders
Interest and Loan repayments
Shareholders
Dividends and cash from Share repurchase
Secondary
BUSINESS ACTIVITIES : All Stocks and Flows for a firm Products & Inputs markets
Customers
Firm OR
Net Operating Assets (NOA)
Capital Markets
C
Net financial Assets (NFA)
Suppliers
OE
Shareholders
Operating activities
Financing activities
F = Net cash flows to debt holders and issuers ; d = Net cash flows to shareholders NFA (net financial assets) = financial assets financial liabilities C= Cash flows from operations; I = cash investment NOA = Net operating assets = operating assets operating liabilities OR = Operating revenue; OE = Operating expense; OI = operating income; NFI = Net financial income
#1 Raise Capital
#2 Invest in Business
#3 Generate Profit
Debt Equity
NOPAT
#4 Reinvest/Return
Operating Operating revenue Operating expense (excluding goodwill, one time items, interest and expected return on plan assets for pensions) Income (loss) on operating associates = Pre-Tax Operating Profit (EBIT) Tax on operations is assumed to be at the statutory rate = NOPAT
Financing Interest income (expense) Dividend income Gain/Loss on financial investments Foreign currency gains (losses) Preferred dividends Pension interest cost Pension expected return on plan assets Implied interest expense on capitalized operating leases = Net Financial Income (Expense) Pretax Tax on financing is assumed to be at the statutory rate = Net Financial Income (Expense)
Other Income (loss) on nonoperating associates Other non-operating income (expense) Minority interest Tax adjustment = Other Income (Expense)
NOPAT + Net Financial Income (Expense) + Other Income (Expense) = Net Income
BALANCE SHEET Operating Assets Operating Liabilities = Net Operating Assets Financial Liabilities Financial Assets = Net Debt Other Assets Other Liabilities = Net Other Assets
Total Assets Total Liabilities and Equity
Operating Liabilities Operating Assets Financial Obligations Shareholders Equity Financial Assets
Shareholders Equity
BALANCE SHEET
GAAP BALANCE SHEET ( Conceptual stock of shareholder value)
Liabilities and Equity Operating liabilities Financial Obligations Common shareholders equity Total claims Rs. OL FO CSE ----------OL + FO + CSE Assets Operating Assets Financial Assets Rs. OA FA ----OA + FA
Total assets
----------------NOA
Issues to resolve: Cash, Long term equity investments, notes receivable (short term And long term), accrued expenses (interest), Deferred tax assets and liabilities, Minority interest, leases, dividends payable
Balance Sheet A traditional balance sheet shows assets (left) and liabilities plus equity (right)
10 5 8 12 50 85
10 60 15
Liabilities Equity
L&E
85
An economic balance sheet shows NOA (left) and invested capital (right)
8 12 50 (10) 60
60 (10) (5) 15 60
Net debt
Equity
(NFE) --------Earnings
Issues to resolve :Income from subsidiary, currency gain or loss, income/ loss from discontinued operations, abnormal gain and losses on extraordinary items Interest on capitalized construction costs, interest income, tax allocation
Income Statement
70 (40) (17) 13
NOPAT
(5) 1 9 Interest exp Interest inc Tax on NFE (5) 1 1 (3) NFE
Tax expense
(4)
NFE
Net income
Net income
Net income
F ------Total Financing Flows d+F (Reflects the thought process of the treasurer Or the CFO and they reflect management Activities)
Cash Flow
5 (2) (3) 2 6 NOPAT Receivables Inventory Payables Depreciation 8 (2) (3) 2 6 (12) FCFO
Capital exp
(12)
Capital exp
Financing
10 (1)
Cash
5 Dividends 1 FCFE
Cash Flow = Income less Delta Balance Sheet Cash flow = Income Statement Balance Sheet
= NOPAT Receivables FCFO Inventory Payables Depreciation Capital exp 8 (2) (3) 2 6 (12) =
NOPAT
2 3 (2) 6 NOA
(3) 10 (5)
NFE
FCFE
Dividends
Net Income
Equity
Equity
RNOA (NOPAT/NOA)
Operating Margin
High
NOPAT Sales
Sales NOA =
NOPAT Margin x
Source: Morgan Stanley Research; Valuing and Measuring a Technological Edge: Finding the FASSTESTSM Companies, October 10, 2000
ROE
NOPAT margin
RNOA
Traditional DuPont Model Net Profit Sales Sales Assets Assets Equity
ROE
OPERATING
Operating Income Operating Profit Margin
+
Financial Expense less G/(L) on Investments
Earnings
RNOA
x
Net Operating Asset Turnover
ROE
Operating Assets less Operating Liabilities
+
FINANCING
Leverage (NFO/Equity)
+
Cash plus Investments less Debt
Equity
Leverage Effect
x
Spread RNOA (NFE/NFO)
Source: Morgan Stanley Research; The Apples to Apples Earnings Monitor Trevor Harris, December 10, 2000
ADJUSTMENTS LIFO PENSIONS AND OPEBs GOODWILL Amortisation, Impairment and unrecorded Indefinite life intangibles Available for sale securities Equity investments Securisation Preferred dividends Leases
VALUE OF OPERATIONS
DCF
DDM
Intrinsic Value Compare and Contrast Cash Flow Models Cash flow models are easy to understand. These models are a form of the familiar NPV analysis. Cash flow is not aligned with focus of forecast: Analysts/ investors typically focus on near-term earnings. Cash flow (and hence most of the value in a cash flow model) typically comes late in the lifecycle. Furthermore, cash flows require a forecast of the balance sheet. Cash flows are volatile: Cash flows are more volatile and less predictable than earnings. They are difficult to forecast. Residual Income Models Focuses predominantly on what we know: Current value book value and near-term residual income are usually the largest component and the terminal value component of value is often the smallest. Returns can be benchmarked. Residual income equals the difference between what the firm earns in a period and what it was expected to earn given its beginning book value. Connects the calculation of intrinsic value directly to the profitability tree, making it possible to uncover how changes in profitability affect residual income and value.
For entity-levels models (DCF and ROIM), consistency between operating and financing drivers is important. Be careful not to miss (or double count) items that dont fall neatly into these categories, like associate income, minority interest, other categories, etc Dont ignore a changing capital structure: WACC should reflect the leverage profile of the company over the forecast period.
REFORMULATED SHAREHOLDERS EQUITY Beginning BV of equity + Net effect of changes in shareholders equity + capital contributions - share repurchase - dividends = Net cash contributions ( negative net dividends) + Effective of operations and nonequity financing + Net income + Other comprehensive income* - Preferred dividends = Comprehensive income available to common shareholders Closing BV of equity *Other Comprehensive income includes translation gains and losses, unrealised gains or losses on available for sale securities, gain or loss on some derivative instruments (fair value hedges and cash flow hedges)
Drivers of Free Cash flows and the Disposition of Free cash 1. Free cash flow = Operating income Change in Net operating Assets C I = OI NOA Free cash flow is also the dividend from operations 2. Free cash flow = Change in net financial assets Net financial income + Net dividends C I = NFA NFI + d 3. Free cash flow = Net financial expenses Change in net financial obligations + net dividends C I = NFE NFO + d
Drivers of Net Operating Assets and Net Indebtedness 1. Net operating assets (end) = Net operating assets (beginning) + operating income Free cash flow NOA t = NOA t-1 + OI t (C t I t)
2. Change in Net operating assets = Operating income Free cash flow NOA = OI t ( C t I t ) 3. Net Financial assets (end) = Net financial assets (begin) + Net financial income + Free cash flow - net dividends NFA t = NFA t-1 + NFI t + ( C t I t ) d t 4. Change in Net Financial Assets = Net income + Free cash flows Net dividends NFA t = NFI t + ( C t I t ) d t
5. Net Financial Obligations (end) = Net financial obligations (beginning) + Net Financial expense Free cash flow + Net dividends NFO t = NFO t -1 + NFE t - (C t I t) + d t
6. Change in Financial Obligations = Net Financial expense Free cash flow + net dividends NFO t = NFE t ( C t I t) + d t
What Generates Value 1. CSE t = CSE t-1 + earnings t net dividends t 2. CSE t = NOA t NFO t
3. NOA t = NOA t-1 + I t + operating accruals 4. NFO t = NFO t-1 ( C t I t) + i t + financing accruals + d t
Level 1
RNOA= OI / NOA =*ROOA + (OLLEV x OLSPRREAD) FLEV= NFO/ CSE SPREAD = RNOA - NBC
Level 2
Level 3
Sales PM
Other items PM
Earnings = Comprehensive income, CSE = Common shareholders equity, OI = Operating Income ( after tax), NOA = Net operating Assets, NFE = Net financial expenses, NFO = Net Financial obligations.
Ratios:
ROCE = Return on equity, RNOA = Return on net operating Assets, ROOA = Return on operating Assets, NBC= Net borrowing cost, OLLEV= Operating liability leverage, OLSPREAD= Operating Liability leverage spread, FLEV= Financial leverage, SPREAD= Operating spread, PM= Operating profit margin, ATO= Asset turnover
Performance Indicators Leverage : pipelines, utilities, hotels Low leverage : business services, printing and publishing and chemicals Low leverage but high operating leverage : business services High financial and operating leverage : airlines, trucking High margins and high turnovers : printing and publishing and chemicals Low turnovers and high margins : pipelines, shipping, utilities and communications High turnovers and low margins : food stores, apparels, retail stores
CHANGE IN ROCE
ROCE RNOA in financing
Level 1
SPREAD =
[RNOA NBC]
FLEV
Core sales PM
Level 3
in core Sales PM drivers in ATO drivers in core other income components in unusual Item components in core NBC drivers
CHANGE IN CSE
CSE
NOA NFO
Sales
1 ATO
Forecasting Checks :UNUSUAL ITEMS Unusual items are those that wont be repeated and also items that appear each Period but cannot be forecasted. Usually listed as extraordinary items. Gross margins may also be impacted by Unusual items ( special order or strike). Examples: ( adjusted for taxes) Special charges Nonrecurring items, assets write downs Changes in estimates, Accounting changes Start up costs expensed ( pre opening costs for Wal Mart, Target, Starbucks) Profit and loss in asset sale, discontinued operations, currency gains and losses Gains from share issues in subsidiaries, Unrealized gains and losses on equity investments Extraordinary operating items Derivative gains and losses (operations)
Issues with Sustainable Earnings Restructuring charges, asset impairments (bleeding back) R&D (Merck & Co) Advertising ( Coco cola) Pensions ( English Electric) Changes in estimates Realised gains and losses (cherry picking : beware of firms with huge investments) Unrealised gains and losses on equity investments Other income (includes interest income)
QUALITY OF EARNINGS Unexplained changes in accounting, especially when performance is poor. Unexplained transactions that boost profits ( e.g. asset sales). Unusual increases in accounts receivable in relation to sales increases. Unusual increases in inventories in relation to sales increases. An increase gap between reported income and cash from operations. An increasing gap between firms reported income and its tax income ( aggressive reporting, e.g. warranty expenses). Unexpected large asset write off (may be due to changed business environment). Qualified audit opinions or changes in independent auditors that are not well justified. Related party transactions or transactions between related entities.
Industry Automobiles Beverages Cellular phones Commercial real estate Computers Fashion clothing Internet commerce Non fashion clothing Pharma Retail
Key economic factors Model design and production efficiency Brand management and production innovation Population covered and churn rates Square footage and occupancy rates Technology path and competition Brand management and design Hits per hour Production efficiency Research and development Retail space and sales per square foot
Key ReOI drivers Sales and margins Sales Sales and ATO Sales and ATO Sales and margins Sales and advertising/sales Sales and ATO Margins Sales Sales and ATO