143 valuation securities analysis chap1-4

Chapter 1: Introduction

Valuation and securities analysis is a further unit offered on theEconomics, Management, Finance and the Social Sciences (EMFSS) suite ofprogrammes. It is a subject that provide insights and understanding ofsecurity analysis and valuation from both theoretical and empiricalperspectives. It is aimed at students who are interested in equity research,corporate finance and fund management.

We jointly teach a more advanced unit at LSE where it is offered as an MSccourse. Our MSc course is based on an economics framework and draws onarticles published in the financial analysis and financial economicliteratures to address issues related to the use of information in securityanalysis, fundamental and technical analysis, and efficient market research.Students in our course are furthermore provided with an opportunity toapply their skills in a corporate valuation project. The Ryanair case studyused throughout this subject guide is mostly taken from one of the projectsproduced by a group of our students (K. Fernbach, M. Mangelsdorf, L. Mellor, L. H. Semionova and A. Shahsavarani) at the end of their courseat LSE.

We hope that you enjoy studying this unit.

Aims and objectives of this unitThis unit is aimed at students who are interested in equity research,corporate finance and fund management. It is designed to provide you withthe tools, drawn from accounting, finance, economics and strategy, requiredto:

• analyse the performance of securities

• value securities

• assess returns on active investment strategies.

Furthermore, it provides empirical evidence on returns to fundamental andtechnical analysis.

Learning outcomesOn completion of this unit, you should:

• be able to analyse the performance of securities and understand theequity research published by financial analysts

• have gained the knowledge in valuation technologies required incorporate finance

• be able to read and critically assess valuation reports

• have gained insights into fund management

• appreciate the difficulties associated with assessing abnormal returnsto fundamental and technical analysis.

How to use this subject guideThe aim of this subject guide is to help you to interpret the syllabus. Itoutlines what you are expected to know for each area of the syllabus andsuggests relevant readings to help you to understand the material.


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Unlike many of the units available on the external programme there areonly two set textbooks which you must read for this unit. Much of theinformation you need to learn and understand is contained in examplesand activities within the subject guide itself.

We would recommend that you work through the guide in chapter order.First read through a whole chapter to get an overview of the material to becovered. Subsequently re-read the chapter and follow up the suggestionsfor reading in the essential reading or further reading. Then you need toengage in the activities identified.

At the end of each chapter you will find a checklist of your learningoutcomes – this is a list of the main points that you should understand onceyou have covered the material in the guide and the associated readings.

Having said this, it is important that you appreciate that different topics arenot self-contained. There is a degree of overlap between them and you areguided in this by the cross-referencing between different chapters. In termsof studying this subject, the chapters of this guide are designed as self-contained units of study, but for examination purposes you need to have anunderstanding of the subject as a whole.

Structure of the guideThis subject covers three broad topics: financial analysis, securitiesvaluation and returns to fundamental and technical analysis.

• Chapter 1 serves as a foundation to understanding.

• Chapter 2 introduces the framework used for securities analysis andvaluation, and outlines the structure and articulation of the financialstatements. It aims to enable you to produce reformulated financialstatements to be used for valuation purposes.

• Chapter 3 introduces the tools required to assess the performance of afirm from the point of view of its shareholders.

• Chapter 4 explains a firm’s bottom-line performance through ananalysis of financial leverage and business performance.

• Chapter 5 covers strategic and accounting analysis.

• Chapter 6 projects the financial analysis in the future. It is all aboutforecasting.

• Chapter 7 covers the set of valuation methods. It builds on theforecasting techniques introduced in Chapter 6.

• Chapter 8 discusses implications of financial analysis for pricemultiples (price-to-earnings and price-to-book ratios).

• Chapter 9 covers the link between financial information and stockprices.

• Chapter 10 provides some application of valuation methods describedin Chapter 7, as regard Internet stocks and merger and acquisitions(M&A).

• Chapter 11 reviews empirical evidence on the returns to fundamentalanalysis.

• Chapter 12 reviews empirical evidence on the returns to technicalanalysis.

143 Valuation and securities analysis

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Essential readingYou should purchase:

Palepu, K., V. Bernard and P. Healy Business analysis and valuation. (Mason,Ohio: South-Western College Publishing, 2004) third edition [ISBN 0324118945].

Penman, S. Financial statement analysis and security valuation. (Boston, Mass.:McGraw-Hill, 2007) third edition [ISBN 0071254323 (pbk)].

Each chapter of the subject guide begins by identifying the appropriatechapters from these textbooks. In instances where these textbooks areinadequate or simply do not cover a particular topic, we haverecommended additional or supplementary reading.

Essential journal articles available in the online libraryIt is essential that you support your learning by reading as widely aspossible and by thinking about how these principles apply in the real world.To help you read extensively, all external students have free access to theUniversity of London online library where you will find either the full textor an abstract of many of the journal articles listed in this subject guide.You will need to have a username and password to access this resource.Details can be found in your Handbook or online at:www.external.ull.ac.uk/index.asp?id=lse

DeBondt, W. and R. Thaler ‘Does the stock market overreact?’, Journal ofFinance (40), 1985, pp. 793–805.

Fama, E. and K. French ‘The cross-section of expected stock returns’, Journalof Finance 47 (2), 1992, pp. 427−65.

Jegadeesh, N. and S. Titman ‘Returns to buying winners and selling losers:Implications for stock market efficiency’, Journal of Finance 48 (1), 1993,pp. 65−91.

Jorion, P. and E. Talmor ‘Value relevance of financial and non financialinformation in emerging industries: the changing role of web traffic data’,SSRN Working Paper, November 2001.

Lakonishok, J., A. Shleifer and R.W. Vishny ‘Contrarian investment,extrapolation, and risk’, Journal of Finance 49 (5), 1994, pp. 1541−78.

Lev, B. and R. Thiagarajan ‘Fundamental information analysis’, Journal ofAccounting Research 31 (2), 1993, pp. 190−215.

Sloan, R.G. ‘Do stock prices fully reflect information in accruals and cash flowsabout future earnings’, Accounting Review 71 (3), 1996, pp. 289−315.

Teoh, S.H., I. Welch and T.J. Wong ‘Earnings management and the long-runmarket performance of initial public offerings’, Journal of Finance 53 (6),1998, pp. 1935−74.

Trueman, B., M.H.F. Wong, and X. Zhang ‘The eyeballs have it: Searching forthe value in internet stocks’, Journal of Accounting Research 38(Supplement), 2000, pp. 137−62.

Finally, it should be noted that this subject builds on previous knowledgeand understanding you will have gained in studying for the prerequisiteunits if you are studying this unit as part of a BSc degree.

Further readingA full bibliography of the further reading is provided below.


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BooksBarker, R. Determining value. Valuation models and financial statements.

(Harlow: Pearson Education Limited, 2001) [ISBN 027363979X], Chapter 9.

Copeland, T., T. Koller and J. Murrin Valuation. Measuring and managing thevalue of companies. (New York: John Wiley and Sons, 2000) third edition[ISBN 0471361917], Chapter 8.

Damodaran, A. Investment valuation. Tools and techniques for determining thevalue of any asset. (New York: John Wiley and Sons, 2002) second edition[ISBN 0471414883], Chapters 23 and 25.

Grinblatt, M., and S. Titman Financial markets and corporate strategy. (Boston, Mass.: McGraw-Hill, 2002) second (international) edition [ISBN 0072294345].

JournalsBernard, V. and J. Thomas ‘Evidence that stock prices do not fully reflect

implications of current earnings for future earnings’, Journal of Accountingand Economics (13), 1990, pp. 305−41.

Bradley, M., A. Desai and E. Kim ‘The rationale behind interfirm tender offers:Information or synergy?’, Journal of Financial Economics 11, 1983, pp.183−206.

�OLL Brock, W., J. Lakonishok and B. LeBaron ‘Simple technical trading rulesand stochastic properties of stock returns’, Journal of Finance 47 (5), 1992,pp 1731−64.

Core, J.E., R.G. Wayne and A. Van Burskirk ‘Market valuations in the neweconomy: an investigation of what has changed’, Journal of Accounting andEconomics 34 (1), 2003, pp. 43−67.

Francis, J., P. Olsson and D. Oswald ‘Comparing the accuracy andexplainability of dividends, free cash flow and abnormal earnings equityvaluation models’, Working Paper, University of Chicago, 1997.

Hand, J.R.M., ‘The role of book income, web traffic, and supply and demandin the pricing of US internet stocks’, European Finance Review 5, 2001, pp.295−317.

Healy, P., S. Myers and C. Howe ‘R&D accounting and the trade-off betweenrelevance and objectivity’, Journal of Accounting Research 40, 2002, pp.677−710.

Healy, P.M., K.G. Palepu and R.S. Ruback ‘Does corporate performanceimprove after mergers?’, Journal of Financial Economics 31, 1992, pp. 135−75.

�OLL Jarrell, G., J. Brickley and J. Netter ‘The market for corporate control:the empirical evidence since 1980’, Journal of Economic Perspectives 2 (1),1988, pp. 49−68.

Jegadeesh, N. and S. Titman ‘Profitability of momentum strategies: anevaluation of alternative explanations’, Journal of Finance 56 (2), 2001,pp. 699−720.

Jensen, M.C. and R.S. Ruback ‘The market for corporate control: the scientificevidence’, Journal of Financial Economics 11, 1983, pp. 5−50.

Jorion, P. and E. Talmor ‘Value relevance of financial and non financialinformation in emerging industries: the changing role of web traffic data’,Working Paper, November 2001.

Keating, E.K., T.Z. Lys and R.P. Magee ‘Internet downturn: Finding valuationfactors in spring 2000’, Journal of Accounting and Economics 34 (1–3),2003, pp. 189−236.

Kothari, S.P. ‘Capital markets research in accounting’, Journal of Accountingand Economics (31), 2001, section 4.3.

�OLL Lang, L.H.P. and R.M. Stulz ‘Tobin’s q, corporate diversification, and firmperformance’, Journal of Political Economy 102 (6), 1994, pp. 1248−80.


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Nissim, D., and S. Penman ‘Ratio analysis and equity valuation: from researchto practice’, Review of Accounting Studies (6), 2001, pp. 109−54.

�OLL Penman, S.H. and T. Sougiannis ‘A comparison of dividend, cash flow,and earnings approaches to equity valuation’, Contemporary AccountingResearch 15 (3), 1998, pp. 343−83.

Teoh, S.H., T.J. Wong and G.R. Rao ‘Are earnings during initial public offeringsopportunistic?’, Review of Accounting Studies (3), 1998, pp. 97–122.

Truman, B., M.H.F. Wong and X. Zhang ‘The eyeballs have it: Searching for thevalue in internet stocks’, Journal of Accounting Research 38 (Supplement),2000, pp. 137−62.

Works citedFor certain topics, we will also list journal articles or texts as supplementaryreferences to the additional reading. It is not essential that you read thismaterial, but it may be helpful if you wish to further understand some ofthe topics in this subject guide. A full bibliography of the cited references isprovided below:

Akerlof, G. ‘The market for lemons: Quality uncertainty and the marketmechanism’, Quarterly Journal of Economics, (84), 1970, pp. 488–500.

Ali, A. and P. Zarowin ‘The role of earnings level in annual earnings-returnsstudies’, Journal of Accounting Research 30, 1992, pp. 286−96.

Ball, R. and P. Brown ‘An empirical evaluation of accounting income numbers’,Journal of Accounting Research 6, 1968, pp. 159−78.

Ball, R. and R. Watts ‘Some time series properties of accounting income’,Journal of Finance 27(3), 1972, pp. 663−81.

Basu, S. ‘The conservatism principle and the asymmetry timeliness ofearnings’, Journal of Accounting and Economics (24), 1997, pp. 3−37.

Beaver, W., R. Lambert and D. Morse ‘The information content of securityprices’, Journal of Accounting and Economics (2), 1980, pp. 3−28.

Bernard, V. and J. Thomas ‘Post-earnings-announcement drift: Delayed priceresponse or risk premium?’, Journal of Accounting Research (27), 1989, pp. 1−36.

Bernard, V. and J. Thomas ‘Evidence that stock prices do not fully reflectimplications of current earnings for future earnings’, Journal of Accountingand Economics (13), 1990, pp. 305−41.

Bernstein, L. Analysis of financial statements. (Homewood, Ill.: Business OneIrwin) fourth edition [ISBN 1556239300].

Brown, L.P. and M. Rozeff ‘Univariate time-series models of quarterlyaccounting earnings per share: A proposed model’, Journal of AccountingResearch (17), 1979, pp. 179−89.

Collins, D., E. Maydew and I. Weiss ‘Changes in the value-relevance ofearnings and book values over the past forty years’, Journal of Accountingand Economics (24), 1997, pp. 39−67.

Comment, R. and G.A. Jarrell ‘Corporate focus and stock returns’, Journal ofFinancial Economics 37, 1995, pp. 67−87.

Damodaran, A. Investment valuation. (Chichester: Wiley, 1996) [ISBN0471751219], Chapter 9.

Dechow, P. ‘Accounting earnings and cash flows as measures of firmperformance: the role of accounting accruals’, Journal of Accounting andEconomics (18), 1994, pp. 3−42.

DeLong, J.B., A. Shleifer, L.H. Summers and R.J. Waldmann ‘Positive feedbackinvestment strategies and destabilising rational speculation’, Journal ofFinance (45), 1990, pp. 379−95.

Demers, E.A., and B. Lev ‘A rude awakening: Internet shakeout in 2000’,Review of Accounting Studies, 6 (2/3), 2001, pp. 331–59.

Easton, P. and M. Zmijewski ‘Cross-sectional variation in the stock marketresponse to accounting earnings announcements’, Journal of Accountingand Economics (11), 1989, pp. 117, 141.


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Easton, P., T. Harris and J. Ohlson ‘Aggregate accounting earnings can explainmost of security returns: the case of long-event windows’, Journal ofAccounting and Economics (15), 1992, pp. 119−42.

Eckbo, B.E. ‘Horizontal mergers, collusion, and stockholder wealth’, Journal ofFinancial Economics 11, 1983, pp. 241−73.

Fama, E. ‘Efficient capital markets: II’, Journal of Finance (46), 1991, pp. 1575–618.

Fama, E. and M. Blume ‘Filter rules and stock market trading profits’, Journalof Business (39), 1966, pp. 226−41.

Fama, E. and K. French ‘The cross-section of expected stock returns’, Journalof Finance (47), 1992, pp. 427−65.

Fama, E.F. and K.R. French ‘Forecasting profitability and earnings’, Journal ofBusiness 73 (2), 2000, pp. 161−75.

Foster, G. ‘Quarterly accounting data: Time series properties and predictive-ability results’, The Accounting Review (52), 1977, pp. 1−21.

Franks, J., R. Harris, R. and C. Mayer ‘Means of payment in takeovers: Resultsfor the UK and US’, CEPR Discussion Paper no. 200, 1987. London Centrefor Economic Policy Research, www.cepr.org/pubs/dps/DP200.asp

Freeman, R.N., J.A. Ohlson and S.H. Penman ‘Book rate-of-return andprediction of earnings changes: an empirical investigation’, Journal ofAccounting Research 20 (2), 1982, pp. 639−53.

Gordon, M. The investment, financing and valuation of the corporation.(Homewood, Ill.: Irwin, 1962).

Kormendi, R., and R. Lipe ‘Earnings innovation, earnings persistence and stockreturns’, Journal of Business (60), 1987, pp. 323−45.

Kothari, S. and R. Sloan ‘Information in prices about future earnings:Implications for earnings response coefficients’, Journal of Accounting andEconomics (15), 1992, pp. 143−71.

Lakonishok, J., A. Shleifer and R.W. Vishny ‘Contrarian investment,extrapolation, and risk’, Journal of Finance (49), 1994, pp. 1541−78.

Lev, B. ‘On the usefulness of earnings and earnings research: Lessons anddirections from two decades of empirical research’, Journal of AccountingResearch (27), 1989, pp. 153−201.

Lev, B. and R. Thiagarajan ‘Fundamental information analysis’, Journal ofAccounting Research 31 (2), 1993, pp. 190–215.

Liu, J., D. Nissim, D and J. Thomas ‘Equity valuation using multiples’, Journalof Accounting Research (40), 2002, pp. 135−72.

Lo, A. and A.C. MacKinlay ‘When are contrarian profits due to stock marketoverreaction?, Review of Financial Studies (3), 1990, pp. 175−208.

Lundholm, R. and T. O’Keefe ‘Reconciling value estimates from the discountedcash flow value model and the residual income model’, Working Paper,University of Michigan Business School, 2000.

Miller, M.H. and F. Modigliani ‘Dividend policy, growth, and the valuation ofshares’, Journal of Business 34 (4), 1961, pp. 411−33.

Morck, R., A. Shleifer and R.W Vishny ‘Do managerial objectives drive badacquisitions?’, Journal of Finance XLV (1), 1990, pp. 31−48.

Myers, S. and N. Majluf ‘Corporate financing and investment decisions whenfirms have information that investors do not have’, Journal of FinancialEconomics (13), 1984, pp. 187–221.

Ofek, E. and M. Richardson ‘The valuation and market rationality of internetstock prices’, Oxford Review of Economic Policy 18 (3), 2002, pp. 265−87.

O’Hanlon, J. and K. Peasnell ‘Wall Street’s contribution to managementaccounting: the Stern Stewart EVA financial management system’,Management Accounting Research 9, 1998, pp. 421−44.

Ou, J. and S. Penman ‘Financial statement analysis and the prediction of stockreturns’, Journal of Accounting and Economics, 11 (4), 1989, pp. 295−329.

Penman, S. ‘An evaluation of accounting rate-of-return’, Journal of Accounting,Auditing and Finance (Spring), 1991, pp. 233−55.


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Penman. S. ‘The articulation of price-earnings ratios and the evaluation ofgrowth’, Journal of Accounting Research (34), 1996, pp. 235−59.

Porter, M. Competitive strategy. (New York: The Free Press, 1980) [ISBN0684841487].

Porter, M. Competitive advantage: Creating and sustaining superior performance.(New York: The Free Press, 1985) [ISBN 0684841460].

Poterba, J. and L. Summers ‘Mean reversion in stock prices: Evidence andimplications’, Journal of Financial Economics (22), 1988, pp. 27−59.

Rajgopal, S., S. Kotha and M. Venkatachalam ‘The relevance of web traffic forstock prices of internet firms’, Working Paper, October 2000.

Ramakrishnan, R. and R. Thomas ‘Valuation of permanent, transitory, andprice-irrelevant components of reported earnings’, Journal of Accounting,Auditing, and Finance 13 (3), 1998, pp. 301–36.

Rappaport, A. and M.L. Sirower ‘Stock or cash? The trade-offs for buyers andsellers in mergers and acquisitions’, Harvard Business Review 77 (6), 1999,pp. 147−58.

Ritter, J. ‘The long-run performance of initial public offerings’, Journal ofFinance (46), 1991, pp. 327.

Sharpe, W.F. ‘Capital asset prices: A theory of market equilibrium underconditions of risk’, Journal of Finance 19 (3), 1964, pp. 425–42.

Watts, R.L. and R.W. Leftwich ‘The time series of annual accounting earnings’,Journal of Accounting Research (Autumn) 1977, pp. 253−71.

Williams, J.B. The theory of investment value. (Harvard University Press, 1938).

Examination structureImportant: the information and advice given in the following section arebased on the examination structure used at the time this guide was written.Please note that subject guides may be used for several years. Because ofthis we strongly advise you always to check both the current Regulations forrelevant information about the examination, and the current Examiners’reports where you should be advised of any forthcoming changes. Youshould also carefully check the rubric/instructions on the paper youactually sit and follow those instructions.

The examination paper for this unit is three hours in duration and youare expected to answer four questions, from a choice of 10. The Examinerattempts to ensure that all of the topics covered in the syllabus and subjectguide are examined. Some questions could cover more than one topic fromthe syllabus since the different topics are not self-contained. A sampleexamination paper appears in an appendix to this guide, along with asample Examiners’ report.

The Examiners’ reports contain valuable information about how to approachthe examination and so you are strongly advised to read them carefully.Past examination papers and the associated reports are valuable resourceswhen preparing for the examination.

Examination adviceYou should ensure that all four questions are answered, allowing anapproximately equal amount of time for each question, and attempting allparts or aspects of a question. Pay attention to the breakdown of marksassociated with the different parts of each question. Some questions maycontain both numerical and essay-based parts. Examples of these types ofquestions (or parts of questions) are provided at the end of each chapter ofthis subject guide.


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Answers with a clear structure and which show a good understanding ofthe material and originality in the approach will be likely to achieve a goodmark. Conversely, answers that simply repeat the subject guide material ina relevant way may be given a pass at best. In this regard, please usematerial only when relevant to the question. Answers that include a largeamount of irrelevant material are likely to be marked down.

SyllabusThis subject covers three broad topics: financial analysis, securitiesvaluation and returns to fundamental and technical analysis.

IntroductionThe analysis framework and financial statements

Introduction to the analysis framework using financial statements. Thesetting: investors, firms, securities and financial markets. The frameworkfor analysis. Business strategy analysis. Industry analysis. Competitivestrategy analysis. Sources of competitive advantage. Achieving andsustaining competitive advantage. Accounting analysis. Financial analysis.Prospective analysis.

Introduction to stylised financial statements. Stylised profit and loss, balancesheet and cash flow statements. Accounting relations governing the stylisedfinancial statements.

Part One: The framework for analysisFinancial analysis: performance evaluation

Concept of comprehensive earnings. Earnings and stock returns. Bottom-line profitability. Cost of equity capital. Concept of residual earnings.Accounting rates of return and stock rates of return.

Financial analysis: the determinants of performance

Business profitability. Economic value added. Link between business andbottom-line profitability. Determinants of business profitability. Businessprofitability and free cash flows.

Accounting and strategy analysis

Overview of the institutional setting. Industry analysis. Corporate strategyanalysis. Sources of competitive advantage. Accounting analysis. Factorsinfluencing accounting quality. Assessing the quality of accounting

Prospective performance evaluation and valuation

Forecasting: simple forecasting and full information forecasting. Empiricalevidence on the behaviour of accounting rates of return, residual earnings,economic value added, financial leverage. A full-information forecastingtemplate.

Part Two: Securities valuationSecurities valuation

Introduction to valuation methods based on dividends, free cash flows,residual earnings and economic value added. Inferences on valuationaccuracy. Comparison of valuation methods: empirical evidence.


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Implications for price-to-earnings and price-to-book ratios

Determinants of price-to-book ratios. Residual earnings growth.Determinants of price-to-earnings ratios. Empirical evidence. Strategictaxonomy. Implications of strategic taxonomy for price-to-book and price-to-earnings ratios. Empirical evidence on the joint distribution of price-to-book and price-to-earnings ratios.

Financial information and stock prices

Usefulness of earnings to investors: the empirical evidence from capitalmarkets research. Earnings response coefficients. Competing hypotheses toexplain the earnings response conundrum. Fundamental informationanalysis and stock prices.

Applications

Internet stock. Financial measures vs usage measures in the valuation ofInternet stocks. A time trend analysis of the relative importance of financialvs usage measures.

Mergers and acquisitions. Motivation for mergers and acquisitions. Strategicand financial analysis of mergers and acquisitions. Acquisition pricing.Accounting issues. Acquisition financing. Acquisition outcome.

Part Three: Empirical evidence on returns to fundamental andtechnical analysis

Returns to fundamental analysis

Contrarian strategies. Implications of current earnings for future earnings. Dostock prices fully reflect information in accruals and cash flows about futureearnings? Earnings management and the long run performance of IPOs.

Returns to technical analysis

Contrarian strategies. Momentum strategies. Reconciliation of empiricalevidence.

List of abbreviationsAE Abnormal Earnings

AEG Abnormal Earnings Growth

AOI Abnormal Operating Income

ARNOA Abnormal Return on Net Operating Assets

AROCE Abnormal ROCE

AT Asset Turnover

ATO Operating Asset Turnover

C Cash flow from operations

CAPEX Capital Expenditures

CAPM Capital Asset Pricing Model

CE Comprehensive Earnings

CSE Common Shareholders’ Equity

DCF Discounted Cash Flow

DCFE Discounted Cash Flow to Equity

DDM Dividend Discount Method

EBILAT Earnings Before Interest Less Adjusted Taxes

EVA Economic Value Added


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FA Financial Assets

FCF Free Cash Flow

FCFE Free Cash Flow to Equity-holders

FE Financial Expenses

FLEV Financial Leverage

FO Financial Obligations

FR Financial Revenues

GAAP General Accepted Accounting Principles

GGM Gordon Growth Method

I Cash investments in operations

IE Interest Expenses

IFRS International Financial Reporting Standards

IPO Initial Public Offering

NBC Net Borrowing Costs

NFA Net Financial Assets

NFE Net Financial Expenses

NFO Net Financial Obligations

NI Net Income

NOA Net Operating Assets

NOPLAT Net Operating Profits Less Adjusted Taxes

OA Operating Assets

OE Operating Expenses

OI Operating Income

OL Operating Liabilities

OLL Operating Liability Leverage

OR Operating Revenues

PB Price-to-Book ratio

PCFO Price-to-Cash-Flow ratio

PE Price-to-Earnings ratio

PM Profit Margin

PS Price-to-Sales ratio

PVED Present Value of Expected Dividends

PVFCF Present Value of Expected Free Cash Flows

PVFCFE Present Value of Free Cash Flows to Equity-holders

ReOI Residual Operating Income

RNOA Return on Net Operating Asset

ROA Return on Assets

ROCE Return on Common Equity

ROS Return on Sales

SAR Stock Abnormal Return

SARR Stock Abnormal Rate of Return

SR Stock Return

TA Total Assets

WACC Weighted Average Cost of Capital


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Chapter 2: The analysis framework andfinancial statements

Aim of the chapterThis unit provides an economic framework for business analysis andvaluation. The aim of this chapter is to introduce both the analysisframework and the stylised financial statements supporting the analysis.The chapter first explains the role played by capital markets, and securitiesanalysis and valuation in an economy. It then outlines the key steps used inthe analysis framework and how they relate to each other. It finally showshow to reformulate financial statements into the stylised ones used toperform the analysis and explains how the components of the reformulatedfinancial statement relate to each other (under the so-called accountingrelations). For each statement we will first introduce the form/contentaccording to the US GAAP, and then explain the template needed for itsreformulation to highlight operating and financing activities. We will alsoprovide a practical application to an airline company, Ryanair plc.

Learning objectivesBy the end of this chapter, and the relevant readings and activities, you willbe able to:

• understand the role of capital markets in the economy

• appreciate how securities analysis can create value in the capitalmarkets

• identify the five steps involved in securities analysis and valuation

• appreciate how these steps relate to each other

• explain how financial statements are used in securities analysis andvaluation

• explain how financial statements can be reformulated, and preparereformulated statements

• identify what assets and liabilities typically fall into operating andfinancing categories, and explain why

• explain the problems associated with the GAAP statement of cash flow,and make the adjustments needed to identify operating, financing andinvesting activities

• explain the differences between direct and indirect calculations of cashflow from operations

• explain how free cash flow can be calculated from reformulatedincome statements and balance sheets, and do this calculation

• explain how the components of the financial statement relate to eachother (under the so-called accounting relations).

Chapter 2: The analysis framework and financial statements

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Essential readingPalepu, K., V. Bernard and P. Healy Business analysis and valuation. (Mason,

Ohio: South-Western College Publishing, 2003), Chapter 1.Penman, S. Financial statement analysis and security valuation. (Boston, Mass.:

McGraw-Hill, 2007) third edition [ISBN 0071254323 (pbk)], Chapters 7,8, 9 and 10.

Works citedAkerlof, G. ‘The market for lemons: Quality uncertainty and the market

mechanism’, Quarterly Journal of Economics, (84), 1970, pp. 488–500.Myers, S. and N. Majluf ‘Corporate financing and investment decisions when

firms have information that investors do not have’, Journal of FinancialEconomics (13), 1984, pp. 187–221.

Capital markets and the role of valuation and securitiesanalysis

One of the main challenges in any economy is to allocate savings byinvestors to entrepreneurs with good investment opportunities. A goodmatch is valuable as it results in a higher wealth shared in the economy.The matching process is, however, fraught with potential difficulties,coming in the form of both information asymmetries and incentiveproblems. As a result of both information asymmetries and incentiveproblems, capital markets may break down as investors may be unwillingto provide any financing to the entrepreneurs (Akerlof, 1970).Furthermore, even if capital markets do not break down, investors may endup financing some projects with negative net present values and someentrepreneurs endowed with positive net present value projects may electnot to invest in them (Myers and Majluf, 1984).

The market for lemonsThe market for lemons (Akerlof, 1970) can be illustrated in the followingexample. Consider an economy consisting of two types of firms, either‘good’ or ‘bad’, with the fundamental (true) value of a ‘good’ firm being£10m and the fundamental (true) value of a ‘bad’ firm being worth £2m.These firms are currently privately owned by entrepreneurs. Eachentrepreneur, who has private information and knows the true worth of hisfirm, is considering selling his firm to a group of competing potentialinvestors in an initial public offering (IPO). The potential investors do notknow the true worth of any of the firms but know that half of the firms are‘bad’ and half of the firms are ‘good’.

Each entrepreneur has the option to go through an IPO but will only do soif he expects that potential investors will bid either the true value of hisfirm or more. Potential investors are only getting any value from buying afirm if the price paid for the firm is less than or equal to the true value ofthe firm. In a competitive market, potential investors hence bid theirexpectation of true worth of the firm.

Let us first assume that the potential investors believe that all theentrepreneurs are selling their firms through IPOs. The potential investorswill hence bid the ex ante expectation of any firm’s true worth, that is, £6m(50% £10m + 50% £2m). Given the potential investors’ bidding strategies,the entrepreneurs with the good firms are not willing to go though IPOs. In


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equilibrium, only the entrepreneurs endowed with bad firms are willing tosell their firms and the potential investors hence bid the true value of the‘bad’ firms, that is, £2m.

Information asymmetry between the entrepreneurs and potential investorshence leads to a market breakdown. In a setting characterised by acontinuum of types of firms, only the worst type of firm goes through an IPO.

Distortions in investment decisionsAsymmetry of information between managers and investors can lead todistorted investment decisions (Myers and Majluf, 1984). Consider aneconomy consisting of a population of firms differing in both the quality(intrinsic value) of their assets in place and the quality (net present value) oftheir investment projects. Any investment project has to be financed throughan issue of equity. Assume also that the managers of any firm are betterinformed about both the quality of their firm’s assets in place and the qualityof their firm’s investment project than are outsiders. Furthermore, assumethat managers act in the interest of their firm’s existing shareholders.

Only managers know whether the equity of their firm is over- orunderpriced though and this creates an opportunity for them to exploit themarket in order for existing shareholders to profit. The existence ofinformation asymmetries thus implies that the market can mispricecorporate equity: some firms’ equity may be overpriced and others will beunderpriced.

In this setting, managers may raise equity for two reasons. They may wishto invest in a positive net present value investment, which would result inan increase in the value of the firm’s equity. Alternatively, they may wish toissue overpriced equity, which would result in a transfer of wealth from thenew to the old shareholders. Given rational expectations, the financialmarket correctly recognises both incentives to raise equity. In equilibrium,managers of low-quality firms, that is, managers of firms with assets inplace whose true worth is low enough (and are hence overvalued), raiseequity in order to take projects with a small but negative net present value.The benefit to the existing shareholders resulting from issuing overvaluedequity exceeds the cost resulting from taking the negative net present valueproject. Similarly, managers of high-quality firms, that is, managers of firmswith assets in place whose true worth is high enough (and are henceundervalued), abstain from raising equity and hence taking projects with asmall but positive net present value. The dilution to the existingshareholders resulting from issuing undervalued equity exceeds the benefitresulting from the positive net present value generated by taking theproject. The presence of information asymmetries between managers andshareholders hence leads to distortions in investments.

The role of valuation and securities analysisAs shown in the previous sub-sections, information asymmetries in capitalmarkets can lead to a breakdown of the capital markets. When capitalmarkets do not break down, information asymmetries can generatedistorted investment decisions. Valuation and securities analysis plays animportant role in any economy by reducing asymmetries of information.Valuation and securities analysis can lead to more active capital markets,better valuation in capital markets, better investments by firms and ahigher wealth shared in the economy.


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Introduction to the valuation and securities analysis frameworkA firm’s managers are responsible for acquiring physical and financialresources from the firm’s environment and using them to create value forthe firm’s investors. Intuitively, value is created when the firm earns areturn on its investment in excess of the cost of capital. The longer theperiod over which the firm is able to enjoy superior performance, thehigher the firm’s intrinsic value. The excess of a firm’s return on commonequity over its cost of equity capital may be due to a superior performancein the product markets. The superior performance in the product marketsreflects both the attractiveness of the industry and the success of the firm’scompetitive and corporate strategies. Alternatively, the excess of the firm’sreturn on common equity over its cost of equity capital could be generatedby successful financial engineering. Finally, it could be due to accountingdistortions. Sustainability of performance through time, and hence value, isshown to depend on the source of performance.

This chapter introduces a framework for securities analysis and valuation.This framework consists of five key steps:

• a strategy analysis

• an accounting analysis

• a financial analysis

• a prospective analysis

• a valuation.

Step 1: Strategy analysis

The purpose of the strategy analysis is to assess the company’s profitpotential at a qualitative level through an industry analysis, competitivestrategy analysis and corporate strategy analysis:

• The industry analysis is used to assess the profitability of each of theindustries in which the company is competing. The profitability of anyindustry is shown to depend on the degree of actual and potentialcompetition among firms and the relative bargaining power of both theindustry’s suppliers and buyers. The degree of actual and potentialcompetition is in turn shown to depend on the degree of rivalry amongexisting firms within the industry, the threat of new entrants into theindustry and the threat of substitute products from other industries.

• The competitive strategy analysis is used in order to determine themanner in which the company is competing in each of the industriesin which it is competing. In order to build a sustainable competitiveadvantage, the company could adopt either a cost leadership strategyor a differentiation strategy. Cost leadership enables the company tosupply the same product or service at a lower cost than itscompetitors. Differentiation may enable the company to supply aunique product or service at a lower cost than the price premiumcustomers are willing to pay.

• The corporate strategy analysis is used in order to assess the way inwhich the company is creating and exploiting synergies across theindustries in which it is competing.

The strategy analysis is an essential step in the securities analysis andvaluation framework as it provides a foundation for subsequent analysis. Itfurthermore enables analysts to ground the subsequent financial andprospective analysis in business reality.


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Step 2: Accounting analysis

The purpose of accounting analysis is to evaluate the degree to which afirm’s accounting captures the underlying economic reality. An accountinganalysis normally consists of the following:

• An analysis of the operating assets and liabilities used in the firm’sindustry. In this context, an analyst will consider the main ‘economic’operating asset and liabilities and check how these assets andliabilities are captured in the financial statements.

• An analysis of the key success factors and risks identified in thestrategy analysis. In this context, an analyst will assess the accountingpolicies and estimates the firm uses to measure its key success factorsand risks.

• A ‘red flags’ analysis. In this context, an analyst will look for red flagspointing towards earnings management. These red flags are also usedby auditors in order to allocate effort when looking for misstatements.

An accounting analysis enables an analyst to assess the degree of distortionin a firm’s financial statements and possibly undo any accountingdistortions by recasting the firm’s accounting numbers. The accountinganalysis is an essential step in the securities analysis and valuationframework as it improves the reliability of inferences made from thefinancial analysis.

Step 3: Financial analysis

The purpose of a financial analysis is to evaluate a firm’s performance andassess its sustainability. A financial analysis may assess the firm’sperformance either from the point of view of its shareholders (bottom-lineperformance) or from the point of view of all claimholders in the capitalstructure (business performance). It allows an analyst to determinewhether any abnormal performance, as far as shareholders are concerned,is generated by abnormal performance in the product markets or financialengineering. It enables the analyst to explain any abnormal performance inthe product markets through an abnormal asset turnover or margin. Finally,it helps to explain the dynamics of free cash flows.

A financial analysis may involve comparison of a firm’s performance withthe firm’s relevant cost of capital. It may also involve either a cross-sectional analysis or a time-series analysis:

• in a cross-sectional analysis, analysts compare the firm’s performancewith peers’ performance in the same industry

• in a time-series analysis, analysts examine the firm’s relativeperformance over time to determine whether it is improving ordeteriorating.

The financial analysis is an essential step in the securities analysis andvaluation framework as it improves an analyst’s understanding of a firm’scurrent performance and future prospects.

Step 4: Prospective analysis

The purpose of a prospective analysis is to forecast the future flows, such asdividends, free cash flows, abnormal earnings or abnormal operatingincome, which are used in the valuation step. These flows are not forecastdirectly by any analyst. Instead, in any prospective analysis, the analystforecasts future financial statements, such as balance sheets and incomestatements, over a number of years. The set of projected financial statementsthen generates a set of projected flows used in the valuation step.


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The set of projected financial statements implies some levels ofperformance and growth, which must be consistent with the output of thefinancial analysis. The prospective analysis is an essential step in thesecurities analysis and valuation framework as it generates the input to thevaluation step.

Step 5: Valuation

The purpose of a valuation is to determine the intrinsic (fundamental)value of a firm’s equity or a firm’s net operating assets (enterprise value).This subject guide will consider both accounting-based valuation methods,such as the abnormal earnings method and the abnormal operating incomemethod, and cash flow-based valuation methods, such as the dividenddiscount method, the discounted cash flow to equity-holders method andthe discounted cash flow method. Any valuation includes the present valueof some flow in the future, where the flow could be a dividend, cash flowto equity-holders, free cash flow, abnormal earnings or abnormal operatingincome. The future consists of an explicit forecasting period, in which theanalyst takes the present value of some flow generated by the set ofprojected financial statements from the prospective analysis, and a post-horizon period, in which the analyst makes some simplifying assumptionabout the flow’s growth.

The five steps used in valuation and securities analysis and introduced inthis chapter will be covered in more detail in subsequent chapters. Theremaining part of this chapter introduces the stylised financial statementsused in valuation and securities analysis.

Introduction to stylised financial statementsIn this section we focus our attention on financial statements, which can bedescribed as a lens that provides a picture of the business. The threeprimary financial statements required by the accounting rules atinternational level are the balance sheet, the income statement and thecash flow statement. (According to the US rules, firms must produce afourth statement, known as statement of shareholders’ equity, thatreconciles beginning and ending shareholders’ equity, whereas according tointernational rules, firms have simply to produce an explanation of changesin shareholders’ equity.)

In the US, the Financial Accounting Standards Board (FASB) establishes thewidely accepted set of rules, standards and procedures for reportingfinancial information that is known as GAAP (General Accepted AccountingPrinciples). Other countries have similar requirements: namely, theInternational Accounting Standard Board (IASB) develops financialreporting standards (known as International Financial Reporting Standards,IFRS) with international application. Note that US-listed firms must alsofile an annual 10-K report and a quarterly 10-K report with the Securitiesand Exchange Commission (SEC). Throughout this guide the reference willbe to the US GAAP.

Activity 2.1

Please visit the web sites of FASB (www.fasb.org) and IASB (www.iasb.org) to have aview of the activity of these accounting bodies. Then download the PricewaterhouseCoopers’ document available atwww.pwc.com/extweb/pwcpublications.nsf/docid/5A95FDDA0969EBFF8025705F00434F9B and read pages 4–10 to have a view of the main similarities and differences betweenIFRS and US GAAP.


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Although reported financial statements are useful tools, they do not providean appropriate picture of the business for valuation purposes. Therefore,the first step of any valuation is to reformulate the financial statements in away that better aligns the reported stocks and flows with the businessactivities that generate value. The aim is to produce stylised statementsclearly highlighting operating and financing activities. These samestatements are then used to apply valuation models, as illustrated in thenext chapters.

Financing activities involve raising cash from the capital market, where theinvestors become claimants on the value generated by the firm. Theseclaimants can be both debt-holders and shareholders. Operating activitiescombines assets with inputs of the production process (like labour andmaterials) to produce products and services, which in turn will be sold tocustomers to obtain cash. If successful, the excess of cash generated byoperating activities can be reinvested in assets to be employed inoperations, or to be returned to claimants. Investing activities use the cashraised from financing activities and generated in operations to acquire(physical and intellectual) assets to be used in operations. Given the natureof investing activities, it is common to refer to the operating and investingactivities together as operating activities. Therefore in the rest of the subjectguide we will refer to operating activities (that include investing activities)and financing activities.

The aim of this chapter is to answer the following questions. How areGAAP financial statements organised? How are operating and financingassets/liabilities/income/cash flows identified in the financial statements?How are the financial statements reformulated to separate operating andfinancing activities? To do so, for each statement we will first introduce theform (i.e. the way in which the financial statement is organised) andcontent (i.e. the way in which line items in the financial statement aremeasured) according to the US GAAP. We will then explain the templateneeded for the reformulation of financial statements. We will also provide apractical application to an airline company. (Note that throughout thesubject guide you will need to use your pre-existing technical knowledgeabout financial statements, with a view to be able to prepare them in auseful way for financial statement analysis and valuation.)

Stylised income statementThe GAAP income statement (known as profit and loss statement in theUK) indicates the sources of net income, which represents the bottom-linemeasure of value added to shareholders’ equity during a period of time.These sources are classified as revenues (value coming from sales) andexpenses (value used to earn the revenues). The typical form of a GAAPincome statement is represented in Figure 2.1.

Figure 2.1 GAAP income statement

Net revenues

– Cost of goods sold

= Gross margin

– Operating expenses

= Operating income (also referred to as earnings before interests and taxes, EBIT)

– Net interest expenses

= Income before taxes


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– Taxes

= Income after taxes

+/– Extraordinary items

= Net income

– Preferred dividends

= Net income available to common shareholders

Activity 2.2

Go to Ryanair’s web site at:

� www.ryanair.com/site/EN/about.php?page=Invest&sec=reports.Here download the financial statements (balance sheet, income statement and cash flowstatement) for the company for the years 1999–2005. It is very important that youdownload these statements because we will refer to Ryanair – the leader in the low-costsector of the European airline industry – throughout this guide, so that you will be ableto see a complete analysis of this firm carried out, which in turn can be used as atemplate to develop a concrete analysis and valuation of any firm.

For equity valuation, however, analysts need to reformulate the GAAPincome statement by distinguishing operating and financing activities. The distinction between these two types of activity is important becauseoperating activities are typically the source of value generation, and it isthese operating activities that we will particularly focus on when weanalyse firms. (Note that the reformulated income statement also includes‘dirty-surplus’ items removed from common equity to produce a statementof comprehensive earnings, as we will extensively explain in Chapter 3.)

Operating activities combine net operating assets (such as property, plantand equipment) with inputs from suppliers (of labour, materials and so on)to produce products and services, which in turn will be sold to customers.Thus operating activities involve trading with suppliers (and thus imply theoccurrence of operating expenses) and trading with customers (and thusdetermine the obtainment of operating revenues). Financing activitiesinstead relate to the trading in capital markets, or rather to the transactionsbetween the firm and the two categories of claimants (shareholders anddebt-holders). Trading with debt-holders (namely bondholders, banks andother creditors) involves the payment of interests (financial expenses) andthe repayments of principal for the cash borrowed from these creditors: inthis case the firm has financial obligations (also known as financialliabilities). Alternatively, the firm can also buy financial assets from debtissuers (governments, banks or other firms). This represents a financingactivity (of a lending nature instead of a borrowing nature), and involvesthe receipt of interests (financial revenues) and the repayments of principalto the firm: in this case the firm holds financial assets.

Operating income (OI) represents the results of operating activities, and itis obtained as the difference between operating revenues and operatingexpenses. Net financial expense (NFE) instead represents the result offinancing activities when financial expense is greater than financial revenue(in the opposite case the amount is called net financial income). Operatingincome is combined with net financial expense to give a measure of totalvalue added to shareholders, known as net income (NI) or comprehensiveearnings (CE) (for an investigation of the differences between net incomeand comprehensive earnings, please refer to Chapter 3). Figure 2.2 showsthe typical content of a stylised income statement.


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Figure 2.2 Reformulated income statement

Operating revenue OR

Operating expense (OE)

Operating income OI

Financial expense FE

Financial revenue FR

Net financial expense (NFE)

Net income NI

The reformulation of the GAAP income statement is required mainlybecause the reported operating income and the reported net financialexpenses are typically incomplete; hence the adjustments. The first step ofthe reformulation requires you to distinguish between operating incomethat comes from sales and operating income that does not come from sales.Note that in the reformulation the lack of disclosure is often a problem (seefor example, the little explanation provided in the financial statements for alarge expense item like selling, administrative and general expenses).

A typical problem in the reformulation concerns tax allocation, or ratherthe allocation of the one single income tax number reported in the financialstatements to the two components of income (operating and financing).This requires first the calculation of the tax shield, which is the tax benefitof deducting interest expense on debt for tax purposes and allocating it tooperating income. Formally, this after-tax net interest expense can becalculated as:

After-tax net interest expense = Net interest expense – Tax benefit =Net interest expense × (1 – tax rate) (2.1)

The tax rate typically used in this calculation is the margin tax rate (i.e. thehighest rate at which income is taxed), but the effective tax rate (which istax expense divided by net income before tax in the income statement) canalso be used.

Without the tax benefit of debt, the taxes on operating income would behigher; therefore the tax benefit has to be added back to the taxes onoperating income, as shown below.

Tax on operating income = Reported tax expense + Tax benefit =Reported tax expense + (Net interest expense × Tax rate) (2.2)

Activity 2.3*

Go back to the income statement of Ryanair downloaded for Activity 2.2. Calculate thetax on operating income from sales for each year in the period 1999–2005.

(*The solution to this activity can be found at the end of the subject guide.)

Another typical issue in the reformulation concerns extraordinary items.Some have to be considered operating items (e.g. abnormal gains andlosses in extraordinary items and income from discontinued operations),while others (e.g. gain and losses from debts retirement) are financingitems.


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Activity 2.4

Go back to the income statement of Ryanair downloaded for Activity 2.2. Prepare thereformulated income statement for the years 1999–2005. Then compare your answerwith the reformulated income statement provided here below.

Above you can find the reformulated income statement of Ryanair for theyears 1999–2005: from this template you can have a view of the classificationof the typical items found in the income statement of any company.

Stylised balance sheetThe GAAP balance sheet represents the assets, liabilities and shareholders’equity of a given firm, as shown in Figure 2.3. With reference to a givenpoint in time, it shows the resources (assets) the firm controls and how ithas financed these assets. Assets are investments that are expected togenerate future economic benefits. Liabilities are obligations to the firm’sclaimants other than owners. Shareholders’ (stockholders’) equity is theclaim by the owners. Both assets and liabilities are classified into current(i.e. duration less than one year) and long-term categories.


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RYANAIR AIRLINES Reformulated Income Statements

DESCRIPTION 1999 2000 2001 2002 2003 2004 2005 Euro 000 Euro 000 Euro 000 Euro 000 Euro 000 Euro 000 Euro 000Operating Income from Sales

Revenues 295759 370137 487405 624050 842508 1074224 1336586Cost of Sales 177309 251862 344582 448761 564411 790493 987475Gross Margin 118450 118275 142823 175289 278097 283731 349111

Amortisation of Goodwill 2342 2125Administrative Expenses 24602 34220 28812 12356 14623 16141 19622Other Operating Expenses 25986 0 0 0 0 0 0Total Operating Expenses from Sales 50588 34220 28812 12356 14623 18483 21747

Operating Income from Sales (before tax) 67862 84055 114011 162933 263474 265248 327364Tax on Operating Income from Sales 16455 16115 17076 20552 25015 25365 32199Operating Income from Sales (after tax) 51407 67940 96935 142381 238459 239883 295165

Other Operating Expenses (after tax)Foreign Exchange Losses (Gains) -297 -1029 -1305 -826 -548 -2911 2101Buzz Reorganization Costs and Aircraft Rentals 14753Other Non-Recurrent Operating Expenses -906 -731 -42 -446 25 8 -43Other Comprehensive Operating Income (CI) 0 0 0 0 0 0 0Total Other Operating Expenses (after tax) -1202 -1760 -1347 -1272 -523 11850 2058

Total Operating Income (after tax) 52609 69700 98282 143652 238982 228033 293107

Net Financing ExpenseInterest Expense 237 3781 11962 19609 30886 47564 57499Interest Income 6610 7498 19666 27548 31363 23891 28342Net Financing Expense (before tax) -6373 -3717 -7704 -7939 -477 23673 29157Tax Effect 1510 899 1503 1216 61 -2251 -2791Net Financing Expense (after tax) -4863 -2818 -6201 -6723 -416 21422 26366

Comprehensive Income 57472 72518 104483 150375 239398 206611 266741Net Income 57472 72518 104483 150375 239398 206611 266741

Figure 2.3 GAAP balance sheet

Once again for equity analysis, the published balance sheets are betterreformulated by dividing into operating and financing activities (both for theasset and liability side). Firms often issue debt (financial obligations) and holddebt (financial assets) at the same time. The stock of net debt-holding can thusalternatively be net financial assets (if financial assets are greater thanfinancial liabilities), or net financial obligations (in the opposite case). Firmsalso invest in operating assets (such as land, factories, inventories) and useoperating liabilities (such as accounts payable) to produce goods for sales.

Positive operating stocks are known as operating assets (OA), while negativeoperating stocks are called operating liabilities (OL). Their differencerepresents net operating assets (NOA). Financing stocks can also be eitherfinancial assets (FA) or financial obligations (FO). Their difference can beeither negative (and thus generate net financial obligations, NFO) or positive(and thus be known as net financial assets, NFA). The common shareholders’equity (CSE) can be considered as an investment in net operating assets andnet financial assets. (Note that common shareholders are known as ordinaryshareholders in the UK.) A typical reformulated balance sheet is shown inFigure 2.4.

Figure 2.4 Reformulated balance sheet

Activity 2.5

Go back to the GAAP balance sheet statement you downloaded for Activity 2.2. Then classifyall the items in the statement according to the categories identified in Figure 2.4.

In distinguishing between operating and financing activities, several issuesarise:

• Cash and cash equivalents. Working cash (also called operating cash) is thecash needed to carry out normal business and thus represents an operatingasset. However, cash equivalents (i.e. investments with less than threemonths’ maturity) and cash invested in short-term securities are financialassets. Usually operating cash and cash equivalents are reported together,


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Net operating assets Net financial obligations and equity

Operating assets (OA) Financial obligations FO

Operating liabilities (OL) Financial assets (FA)

Net financial obligations NFO

Common shareholders’ equity CSE

Net operating assets NOA NFO + CSE

Assets Liabilities and equity

Current assets: Current liabilities:

Cash and cash equivalents Accounts payable

Short-term investments Total current liabilities

Accounts receivable Long-term debt

Inventories

Total current assets Shareholders’ equity:

Property, plant and equipment (net) Preferred stocks

Investments Common stocks

Total assets Retained earnings

Total shareholders’ equity

Total liabilities and shareholders’ equity

so analysts need some hypothesis/calculation to isolate the amount ofoperating cash. The amount of operating cash is very much related tothe actual business of the firm. A procedure often used is to calculate itas a percentage of sales: for most industrial companies this percentageis between 1 per cent and 2 per cent.

• Leases. Leases that are capitalised, known as capital leases, representin substance purchases of an asset; therefore in the reformulatedbalance sheet statement the lease asset is treated as an operatingasset and the lease obligation as a financial obligation. Leases that donot represent a purchase, called operating leases, do not appear inthe balance sheet (just the rent payments are included in the incomestatement as an expense).

• Preferred stocks. These represent a financial obligation from thepoint of view of a common shareholder.

• Minority interests. These represent an equity sharing in the results ofthe consolidated operations, and not a financial obligation. Thereforethey should be included as a separate line item in the commonshareholders’ equity.

Activity 2.6

Go back to the balance sheet statement of Ryanair downloaded for Activity 2.2.Prepare the reformulated balance sheet statement for the years 1999–2005. Thencompare your answer with the reformulated balance sheet provided below.

Here you can find the reformulated balance sheet statement of Ryanair forthe years 1999–2005, which gives the classification of typical items foundin the balance sheet of any company.


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RYANAIR AIRLINES Reformulated Balance Sheet Statements

DESCRIPTION 1999 2000 2001 2002 2003 2004 2005Euro 000 Euro 000 Euro 000 Euro 000 Euro 000 Euro 000 Euro 000

Net Operating Assets

Operating Assets

Operating Cash 2958 3701 4874 6241 8425 10742 13366Accounts Receivable 18475 21974 8695 10331 14970 14932 20644Inventories 12917 13933 15975 17125 22788 26440 28069

Prepaid Expenses and Other Current Assets 6306 6478 12235 4918 9357 14640 19495Total Operating Current Assets 40656 46086 41779 38615 55540 66754 81574

Property, Plant, and Equipment 203493 315032 613591 951806 1352361 1576526 2092283Other Operating Assets 53 0 0 0 0 44499 30449Total Operating Assets 244202 361118 655370 990421 1407901 1687779 2204306

Operating Liabilities

Accounts Payable 30764 22861 29998 46779 61604 67936 92118Income Taxes Payable 33558 18581 8830 6563 9789 9764 17534Other Current Operating Liabilities 44414 88864 130576 210545 241539 328444 418653Total Current Operating Liabilities 108736 130306 169404 263887 312932 406144 528305

Provision for Risk and Charges 0 0 0 0 0 6522 7236Deferred Income Taxes 11277 15279 30122 49317 67833 87670 105509Other Operating Liabilities 0 0 0 18086 5673 30047 18444Total Operating Liabilities 120013 145585 199526 331290 386438 530383 659494

Net financial ObligationsCash Equivalents 155637 351547 621846 893035 1051793 1246608 1600277Other Current Financial Assets 0 0 0 6117 7013 4611 5117Current Portion of Long-Term Debt 5658 13347 33072 44305 64607 80682 128935Capital Leases 408 74 1 0 0 0 114861Long-Term Debt 22797 112338 374755 511703 773934 872645 1178999

-126774 -225788 -214018 -343144 -220265 -297892 -182599

Commons Stockholders’ Equity 250963 441321 669862 1002274 1241728 1455288 1727411

Stylised statement of cash flowsThe statement of cash flows shows how the firm generates and uses cash.The GAAP statement of cash flows classifies cash flows into three sections(see Figure 2.5): cash flows from operating activities (cash generated fromselling goods/services minus cash used to pay the cost of inputs andoperations), cash flows used in investing activities (cash paid for capitalexpenditure and cash spent in buying assets less cash received from sellingassets) and cash flows from financing activities (cash raised from or paid tothe firm’s claimants – debt-holders and shareholders). The total cash flowsfrom these sections provide the change in cash and cash equivalents (notethat this amount has to be equal to the difference in the cash balancebetween the ending and beginning balance sheet). The difference betweencash flows from operations and cash flows used in investment activitiesprovides a sort of measure of free cash flow (FCF), the cash flow associatedto operating activities.

Firms use two formats for the statement of cash flows: the direct methodand the indirect method. The key difference between the two formats is theway in which they represent cash flow from operations. Under the directmethod, cash from operations is calculated by subtracting from the list ofthe separate sources of operating cash inflows (e.g. cash from sales, cashfrom rents, cash from interest) the list of sources of operating cash outflows(e.g. cash paid to suppliers, cash paid to employees, cash paid for interest,cash paid for income taxes). The direct method is used by only a smallnumber of firms in practice. Under the indirect method, cash fromoperations is calculated as the net income including changes in net workingcapital items (i.e. accounts receivable, inventories and accounts payable)plus adjustments for non-cash revenues and expenses (such asdepreciation, amortisation and deferred income taxes).

Figure 2.5 GAAP statement of cash flows

Cash flow in operating activities

– Cash flow used in investing activities

+ Cash flow from financing activities

= Change in cash and cash equivalents

The GAAP statement of cash flows seems to distinguish between the flowsfrom operating activities and from financing activities. However, itsomehow confuses the two categories. Here we analyse a number ofdeficiencies.

• Change in cash and cash equivalents. The GAAP statement of cashflows aims at explaining the change in cash and cash equivalents.Change in operating cash (as defined in the section ‘Accountingrelations on the form of stylised financial statements’ below) should beincluded in cash investment (and thus concurs with the formation offree cash flow), whereas the change in cash equivalents is aninvestment of excess cash in financial assets (and thus has to beincluded in the debt financing section).

• Net cash interest and tax on net interest. The GAAP reported cashflow from operations includes cash interest payments and receipts forfinancing activities (this happens because in the calculation of cashflows from operations the starting line is net income and notoperating income). However, they should be included in the financingflows. Analogously the reported cash flow from operations include alltax cash flows (also the ones paid on financing activities, such asinterest income and expense). Tax cash flows related to financing


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activities should be separated. The reported cash flow from operationshas to be corrected accordingly.

• Transactions in financial assets. The GAAP reported cash flow frominvesting includes investments and disinvestments in financial assets(such as short-term marketable securities and long-term debtsecurities). However, these investments should be included in thefinancing section because they represent a disposition of free cashflow (and not a reduction of free cash flow). Similarly, thedisinvestments of financial assets should be classified as financingflows rather than investing flows: they satisfy a free cash flowshortfall, they do not create it. Therefore the reported cash flow frominvesting has to be corrected accordingly.

Overall, how do we calculate the components of FCF (cash flows fromoperations and cash investments in operations) starting from the GAAPstatement of cash flow? For the calculation of cash flow from operations,the GAAP reported cash flow from operations has to be corrected asregards net cash interest and tax on net interest. Formally, this can bewritten as:

Cash flow from operations = Reported cash flow from operations + After-tax net interest payments (2.3)As for the calculation of cash investments in operations, the GAAP reportedcash flow from investing has to be corrected as regards transactions infinancial assets, as shown below:

Cash investments in operations = Reported cash flow from investing – Netinvestment in interest-bearing instruments (2.4)

A summary of the adjustments of the GAAP statement of cash flow –necessary because some operating and financing cash flows aremisclassified – is shown in Figure 2.6.

Figure 2.6 Adjusting GAAP statement of cash flows

GAAP reported cash from operating activities

+ Net cash interest outflow (after tax)

– GAAP reported cash used in investing activities

+ Purchase of financial assets

– Sale of financial assets

– Increase in operating cash

= Free cash flow

GAAP reported cash from financing activities

+ Net cash interest outflow (after tax)

+ Purchase of financial assets

– Sale of financial assets

+ Increase in cash equivalents

= Financing cash flow

Activity 2.7

Go back to the statement of cash flows of Ryanair downloaded for Activity 2.2. Preparethe reformulated statement of cash flows for the years 1999–2005. Keep your answer –it will be needed in Chapter 7.


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The above adjustments are quite complex. Nevertheless, the analyst canproduce a reformulated statement (without adjusting the GAAP statement ofcash flows) by recalling all the cash flows to/from product and input marketson the one hand, and capital markets on the other hand. On the operatingside, the cash flows involved in the purchase of operating assets to producegoods for sales are cash investments. The cash inflows from selling productsand services less cash outflows from paying wages, rents, invoices and so onare the so-called cash flow from operations. On the financing side, the cashflows to and from the debt-holders (summarised in the net debt financingflow) relate to the payment/receipt of interests and the repayments ofprincipal to/from the firm for the cash lent to/borrowed from these creditors.The cash flows to and from the shareholders (summarised in the net cashflow to shareholders) involve the payment of dividends and repurchases ofstocks in exchange of the contribution to the firm from the shareholders.

The cash flows associated to operating activities are cash from operationsand cash investments in operations. By comparing these operating flows,the analyst gets a measure known as free cash flow (FCF). The FCF thenequals the cash paid for financing activities, which is given as the sum ofthe net cash flows paid to debt-holders (or issuers) and shareholders.Figure 2.7 summarises the four flows and represents a typical reformulatedstatement of cash flows.

Figure 2.7 Reformulated statement of cash flows

Cash flow from operations

– Cash investments in operations

= Free cash flow from operating activitiesCash paid to debt-holders and issuers

+ Cash paid to shareholders

= Cash paid for financing activities

Note that the value of FCF can be obtained in a more straightforward wayfrom the reformulated balance sheet and reformulated income statement(without the need to produce a full reformulated statement of cash flows),as we will explain in section ‘Business profitability and free cash flows’ inChapter 4 (p.61).

Accounting relations governing the stylised financialstatements

Accounting relations indicate how the financial statements and theircomponents relate to each other, and also what drives each component.The understanding of these relations is essential because they provide astructure for fundamental analysis, which is the object of this guide, andcan be simply defined as a method based on analysing information on thefirm, and forecasting payoffs to get an intrinsic value based on thoseforecasts. As one of the tasks of fundamental analysis is to correct for themissing values in the financial statements, the full comprehension ofaccounting relations is essential.

Note that in the following sections we will mainly refer to accountingrelations that govern reformulated financial statements, but when neededwe will also recall relations related to the GAAP statements.


25

Accounting relations on the form of stylised financial statementsAccounting relations that govern how different components relate to eachother are said to govern the form of financial statements. Under theframework of a stylised balance sheet, the main balance sheet equationrelates the net stocks for operating and financing activities to each other. Inparticular, shareholders’ equity can be seen as an investment in net operatingassets and net financial assets. Formally this can be written as:

Common shareholders’ equity = Net operating assets + Net financial assetsCSE = NOA + NFA (2.5)

where net operating assets (NOA) is the difference between operating assets(OA) and operating liabilities (OL); and net financial assets (NFA) is thedifference between financial assets (FA) and financial obligations (FO).

However, the investment in net financial assets can be negative. When netfinancial assets is negative (and it is named net financial obligations),equation (2.5) becomes:

Common shareholders’ equity = Net operating assets + Net financialobligationsCSE = NOA + NFO (2.6)Note that the last two relations restate the well-known balance-sheetequation used for GAAP balance sheets, which indicates that shareholders’equity is the residual claim on the assets after subtracting liability claims. Thisimplies that shareholders’ equity is always equal to the difference betweenassets and liabilities, or rather:

Shareholders’ equity = Assets – Liabilities (2.7)

With reference to the stylised statement of cash flows, the well-known cash-conservation equation (or the sources and uses of cash equation) relates thefour cash-flow components to each other by stating that the sources of cashmust be equal to its uses. Formally this can be expressed as follows:

Cash from operations – Cash investments in operations = Net dividends toshareholders + Net payments to debt-holders and issuersC – I = d + F (2.8)The left-hand side (C – I) represents the free cash flow (FCF). The right-handside (d + F) represents the net cash flows paid to debt-holders (or issuers)and shareholders. If operations generates more cash than is used ininvestments, FCF is positive and it is used either to buy bonds (F) or paydividends (d). If operations produce less cash than needed for newinvestments, FCF is negative and it requires that a firm either issues bonds(negative F) or issues shares (negative d) to satisfy the cash shortfall. In doingso, the firm has to cover any net dividend it wants to pay and any net interestcash flow (i). This can be summarised in the treasurer’s rule, which is:

If C – I – i > d, the firm has to lend or buy back its own debt;

If C – I – i < d, the firm has to borrow or reduce its own debt.

Accounting relations on the drivers of each component of reformulatedfinancial statements

The reformulated statement of cash flows and the reformulated incomestatement are statements of flows over a period, while the reformulatedbalance sheet is a statement of the stocks at the end of a period. The flowsand the changes in stocks are linked by some accounting relations, whichdescribe what drives, or determines, each component. Below we analysethese relations.


26

The drivers of free cash flow can either relate to its sources or to its uses

To see how the FCF is generated, or rather what are the sources of FCF, wecan refer to the following equation:

FCF = Operating income – Change in net operating assets = OI – ΔNOA(2.9)

That is, operations generate operating income, and FCF is the part ofoperating income remaining after reinvesting some of it in NOA. (If theinvestment in NOA is higher than the operating income, the FCF isnegative. This implies that an infusion of cash is required.)

Alternatively, by focusing on the disposition of FCF, the uses of FCF can beformalised in two different ways according to the presence of net financialobligations or net financial assets.

If the firm has net financial obligations, FCF can be written as follows:

FCF = Net financial expenses – Change in net financial obligations + Net dividends = NFE – ΔNFO + d (2.10)

This implies that FCF is used to pay for the net financial expenses, toreduce net borrowing and to pay net dividends.

If the firm has net financial assets, FCF can be written as follows:

FCF = Change in net financial assets – Net financial income + Net dividends = ΔNFA – NFI + d (2.11)

FCF and net financial income increase net financial assets and are also usedto pay net dividends.

The drivers of dividends

Dividends, or rather the cash flow paid out to shareholders, can also beexplained on the basis of several operating and financial components of thefinancial statements. If the firm has financial obligations, by reordering theFCF equation (2.10), we identify the following drivers of dividends:

Net dividends = FCF – Net financial expenses + Change in net financialobligations = FCF – NFE + ΔNFO (2.12)

This means that dividends are generated from free cash flow after payingnet interest expenses, but also by increasing borrowing. This accountingrelation explains why dividends are not a good indicator of valuegeneration in the short term: the firm can borrow in order to pay outdividends.

Conversely, if the firm has financial assets, by reordering equation (2.11),the drivers of dividends become:

Net dividends = FCF – Change in net financial assets + Net financialincome = FCF – ΔNFA + NFI (2.13)

This relation implies that dividends are paid out of free cash flow and netfinancial income and by selling financial assets: financial assets are sold topay dividends if free cash flow is insufficient to pay dividends.

The drivers of net operating assets and net financial obligations

The changes in the balance sheet components can also be explained on thebasis of the FCF accounting relation. By rearranging equation (2.9), we areable to identify the drivers of net operating assets (at the end of the year).Formally, this can be written as:


27

Net operating assets (end) = Net operating assets (beginning) + Operatingincome – Free cash flow = NOAt–1+ OIt – FCFt (2.14)

The value added from operations (represented by operating income)increases the net operating assets, whereas the free cash flow reduces netoperating assets as cash is taken from operations and invested in netfinancial assets.

Activity 2.8

Correspondingly identify the drivers of net financial obligations by rearranging equation(2.10).

Activity 2.9

Go to the SEC web site (www.sec.gov) and download the financial statements ofMicrosoft Corp. for the years 2001 and 2002 (go to ‘EDGAR FILERS’, then to ‘FILINGS(EDGAR)’, and to ‘Search for company filings’. Finally go to ‘Companies and other filers’and write down ‘Microsoft Corp’. Now produce reformulated balance sheet and incomestatements. Then compare your answer with the reformulated financial statements inPenman (2007, pp. 288 and 297).

Chapter summaryThis unit provides an economic framework for securities analysis andvaluation. This chapter introduced both the analysis framework and thestylised financial statements supporting the analysis.

In the first part of the chapter, we outlined the role played by capitalmarkets in the economy. Capital markets were characterised byasymmetries of information between firms’ managers or entrepreneursand potential investors. These asymmetries of information could lead todistortions in investments by firms as well as to a breakdown in thecapital markets. We hence argued that securities analysis and valuationcould play an important role in the economy by reducing theseasymmetries of information. We then outlined the key steps used in theanalysis framework and how they relate to each other.

In the second part of this chapter we showed that misclassification in thefinancial statements can lead to erroneous financial statement analysisand erroneous valuations. This explains why analysts must reformulatefinancial statements before proceeding with valuations. Indeed, as weproceed with financial analysis and valuation, we will work withreformulated statements, not published GAAP statements. We have shownhow to produce reformulated financial statements clearly highlightingoperating and financing activities (both with regard to stylised statementsand to an application to an airline company). In particular, reformulatedbalance sheets must distinguish between operating and financial assetsand liabilities; reformulated income statements have to distinguishoperating and financing income; and reformulated cash flow statementsisolate free cash flow and make it equal to financing cash flows.

Accounting relations are another important tool for analysts because theybasically enable analysts to get at the drivers of the main items in thereformulated financial statements. In particular, we have described theways in which analysts can use accounting relations to understand howfinancial statements, and their components, relate to each other, and alsowhat drives each component. This understanding is essential to have astructure for fundamental analysis, as developed in the next chapters.


28


29

Key terms

A reminder of your learning outcomesHaving completed this chapter, and the relevant readings and activities, youshould now be able to:

• understand the role of capital markets in the economy

• appreciate how securities analysis can create value in the capitalmarkets

• identify the five steps involved in securities analysis and valuation

• appreciate how these steps relate to each other

accounting analysis

accounting relations

assets

balance sheet

balance sheet equation

capital leases

cash conservation equation

cash equivalents

cash flows from operations

cash flows from financing activities

cash flow in operating activities

cash flow statement

cash investments in operations

cash flows used in investingactivities

common shareholders’ equity (CSE)

comprehensive earnings (CE)

direct method

earnings

expenses

financial analysis

financial assets (FA)

financial expenses (FE)

financial obligations (FO)

financial revenue (FR)

financing activities

free cash flow (FCF)

fundamental analysis

General Accepted AccountingPrinciples (GAAP)

income statement

initial public offering (IPO)

indirect method

International Financial ReportingStandards (IFRS)

investing activities

liabilities

minority interest

net financial expense (NFE)

net financial assets (NFA)

net financial obligations (NF)

net operating assets (NOA)

net income (NI)

net profit

operating activities

operating assets (OA)

operating cash

operating expenses (OE)

operating income (OI)

operating leases

operating liabilities (OL)

operating revenues (OR)

ordinary shareholders

preferred stocks

profit and loss statement

prospective analysis

revenues

shareholders’ equity

statement of cash flows

stylised statements

stockholders’ equity

strategy analysis

tax allocation

tax shield

treasurer’s rule

• explain how financial statements are used in securities analysis andvaluation

• explain how financial statements can be reformulated, and preparereformulated statements

• identify what assets and liabilities typically fall into operating andfinancing categories, and explain why

• explain the problems associated with the GAAP statement of cash flow,and make the adjustments needed to identify operating, financing andinvesting activities

• explain the differences between direct and indirect calculations of cashflow from operations

• understand how free cash flow can be calculated from reformulatedincome statements and balance sheets, and do this calculation

• explain how the components of the financial statement relate to eachother (under the so-called accounting relations).

Sample examination questions1. How can valuation and securities analysis create value in the

economy?

2. What are the five steps involved in securities and valuation analysis?How do they relate to each other?

3. What are the main adjustments of the GAAP statement of cash flowsneeded to separate operating, financing and investing activities? Whyare these adjustments needed?

4. By investing in short-term marketable securities to absorb excess cash,the firm reduces its reported cash flow after investing activitiesprepared according to the GAAP. What is wrong in this picture?

5. Explain the main accounting relations on the drivers of the followingcomponents of the reformulated financial statements: free cash flow,dividends and net operating assets.


30

Part 1: The framework for analysis

Part 1: The framework for analysis

31

Notes


32

Chapter 3: Financial analysis: performance evaluation

33

Chapter 3: Financial analysis:performance evaluation

Aim of the chapterThe aim of this chapter is to provide tools in order to assess theperformance of a firm from the point of view of a shareholder. We willintroduce accounting-based measures, such as a firm’s return on commonequity and abnormal earnings, used to assess performance and providebenchmarks to compare these measures with. We will provide intuition forthe use of these accounting-based performance measures and discuss theirlimitations. We will introduce market-based measures of performance, suchas stock return and stock rates of return. We will then explain the linkbetween accounting-based and market-based measures of performance.Finally, we will explain how a firm’s stock price obtaining in an efficientmarket reflects the firm’s expected future performance.


• assess the performance of a firm, as far as a shareholder is concerned,using accounting tools

• assess the performance of a firm, as far as a shareholder is concerned,using market-based performance measures

• understand why accounting-based performance measures may differfrom market-based performance measures

• appreciate the limitations of the accounting-based performance measures

• appreciate the limitations of market-based measures

• understand how a firm’s fundamental value is related to the firm’sexpected future performance

• understand why a firm’s fundamental value of equity may differ fromits book value of equity.

Essential readingPenman, S. Financial statement analysis and security valuation. (Boston, Mass.:

McGraw-Hill, 2007) third edition [ISBN 0071254323 (pbk)], Chapter 5.

Further readingPalepu, K., V. Bernard and P. Healy Business analysis and valuation. (Mason,

Ohio: South-Western College Publishing, 2004) third edition [ISBN 0324118945], Chapter 4.

Nissim, D. and S. Penman ‘Ratio analysis and equity valuation: from researchto practice’, Review of Accounting Studies (6), 2001, pp. 109−54.

Works citedGrinblatt, M. and S. Titman Financial markets and corporate strategy. (Boston,

Mass.: McGraw-Hill, International Edition, 2002) [ISBN 0071123415].Healy, P., S. Myers, and C. Howe ‘R&D accounting and the trade-off between

relevance and objectivity’, Journal of Accounting Research 40, 2002, pp.677−710.

IntroductionIn the previous chapter we introduced the analysis framework used invaluation and securities analysis. In this context, we highlighted the mainsteps involved: strategy analysis, financial analysis, accounting analysis andprospective analysis. This chapter introduces the tools required to performa financial analysis and assess the performance of a firm from the point ofview of a shareholder. It considers both accounting-based and market-basedmeasures of performance. It explains the link between accounting-basedand market-based measures of performance. It explains the limitations ofboth classes of performance measures. It shows how a firm’s stock priceobtaining in an efficient market reflects the firm’s expected futureperformance. Determinants of performance, as far as shareholders areconcerned, are analysed in the next chapter.

This chapter is organised as follows. We first introduce accounting-basedmeasures of performance. We then cover market-based measures ofperformance and show how these measures are related to the accounting-based measures. We then show the link between a firm’s intrinsic value ofequity and the firm’s expected future performance.

Accounting-based measures of performanceThis section introduces in turn the following accounting-based measures ofa firm’s performance as far as a shareholder is concerned: comprehensiveearnings (CE), the return on common equity (ROCE), the abnormal returnon common equity (AROCE), and abnormal earnings (AE).

Comprehensive earningsInvesting in a firm’s shares is a risky proposition. As a reward, shareholdersare entitled to earnings. Earnings capture the net economic resourcesgenerated by the firm for its shareholders during some period. Earningsfurthermore result from the inter-temporal allocation of cash flows(revenue and expenditure).

We will first focus on a measure of earnings, comprehensive earnings,accruing to shareholders.

SFAC (Statement of Financial Accounting Concepts) 6 definescomprehensive earnings as ‘the change in common equity...fromtransactions...from non-owner sources. It includes all changes in commonequity during a period except those resulting from investments by commonequity owners and distribution to common equity owners.’

More formally, the comprehensive earnings (CE) generated over someperiod are given by:

CE = CSE(EP) – CSE(BP) + ND (3.1)

where CSE(EP) and CSE(BP), respectively, denote the commonshareholders’ equity, a balance sheet item, also referred to as the bookvalue of equity, obtaining at the end and at the beginning of the period;and ND denotes the net dividends, that is, the dividends in excess of anyproceeds from issues of shares.

Consider a savings account. According to SFAC 6, earnings on your savingsaccount are equal to the change in the savings balance over the periodadjusted for any contribution or withdrawal. The concept of comprehensiveearnings is hence quite intuitive.


34

Using Ryanair as an example, we derive comprehensive earnings generatedin each of the last five financial years in Table 3.1. Ryanair did not pay anycash dividend during this period but did issue shares. Comprehensiveearnings were hence lower than the increase in the book value of equity.We also compare comprehensive earnings with net income and do not findany discrepancy.

Table 3.1 Derivation of comprehensive earnings (CE) at Ryanair

When evaluating performance, financial analysts tend to distinguishbetween recurrent and non-recurrent (also referred to as transitory)components of comprehensive earnings, as non-recurrent components ofcomprehensive earnings reflect one-off events and do not have anyimplications for future earnings.

In general, comprehensive earnings, as calculated in equation (3.1), aredifferent from the net income reported in an income statement. Anydiscrepancy between comprehensive earnings and net income comes fromdirty-surplus accounting, that is, net economic resources consumed orearned during the period, recognised in common stockholders’ equity (CSE,balance sheet) but unrecognised in net income (income statement).

Dirty-surplus accounting components tend to be quite significant incontinental Europe. They are less common in countries such as the UK orthe USA. Recent international accounting standards are, however,consistent with clean-surplus accounting as they do not introducediscrepancies between comprehensive earnings and net income. But, evenin the UK or the USA, there are still accounting standards which are notconsistent with clean-surplus accounting. Revaluation gains and losses, forinstance, do bypass income in both countries.

Activity 3.1*

Consider R&D Inc., a biotech start-up. This firm:

• incurs expenditure in R&D of $50 at the beginning of its first year of activity

• has an opening book value of equity of $1,000

• generates comprehensive earnings (before any R&D expenses) of $205 in year 1and $221 in year 2, at the end of which it is liquidated

• pays $155 in cash dividends at the end of the first year.Calculate the comprehensive earnings generated by R&D Inc. for its shareholders in eachyear of activity, assuming that the firm expenses research and development as incurred(in the year in which the expenditure is incurred).


2001 2002 2003 2004 2005

( 000) ( 000) ( 000) ( 000) ( 000)

CSE(EP) 669898 1002274 1241728 1455288 1727411

CSE(BP) 441357 669898 1002274 1241728 1455288

ND –124058 –182001 –6 –6949 –5382

CE 104483 150375 239398 206611 266741

NI 104483 150375 239398 206611 266741


35

Comprehensive earnings can hence be thought of as the payoff accruing toshareholders, as measured by accounting, for holding a firm’s shares.However, it would be useful to relate this payoff to the investment that wasmade. Hence we will introduce in the next section a measure of bottom-line profitability.

Bottom-line profitabilityIn order to assess bottom-line performance, that is, performance as far asshareholders are concerned, analysts tend to use an accounting-basedprofitability ratio: the return on common equity (ROCE). A firm’sROCE can be defined at the ratio of the shareholders’ payoff, as measuredby accountants, that is, the stock return, over the shareholders’ investment,as measured by accountants, that is, the book value of equity:

(3.2)

Financial analysts sometimes also define ROCE by considering the averageof CSE at the beginning of the period (BP) and CSE at the end of theperiod (EP):

(3.3)ROCE is a comprehensive indicator of a firm’s performance because itprovides an indication of how well managers are employing the fundsinvested by the firm’s shareholders to generate returns. A naturalbenchmark for a firm’s ROCE is the firm’s cost of equity capital. You maythink of the firm’s cost of equity capital as the opportunity cost of ashareholder or as the rate of return required by a shareholder tocompensate her or him for the investment’s risk. In the long run, one wouldexpect the value of a firm’s equity to be determined by the deviation of thefirm’s ROCE from its cost of equity capital, also referred to as theabnormal return on common equity (AROCE):

AROCE = ROCE – rE (3.4)

The cost of equity capital can be estimated either empirically or from anasset pricing model. In the context of securities analysis and valuation, themost widely used asset pricing model is the capital asset pricing model(CAPM). The CAPM states that any security’s expected return is equal tothe risk-free rate plus a risk premium depending on the security’ssystematic risk:rE = rF + βE [E(rM) – rF] (3.5)

where rF denotes the risk-free rate

βE denotes the systematic risk of the security

E(rM) denotes the expected return of the market portfolio.

A thorough analysis of a security’s cost of equity capital can be found eitherin the 24 Principles of Banking and Finance subject guide or inGrinblatt and Titman (2002, Chapter 5).

As an application, let us estimate the cost of equity capital of Ryanair. Theyield on medium-term government bonds (10 years) is about 4.25 per cent.The excess of the average return on stocks over government bonds is about4.2 per cent. The beta of Ryanair’s equity is 1.11. It hence follows that: rE= 4.25% + 1.11*4.2% = 8.9%.

[ ])()(2

1 EPCSEBPCSECEROCE+

=

)(BPCSECEROCE =


36

Deviations of a firm’s return on common equity from its cost of equitycapital, that is, non-nil abnormal returns on common equity, may arise forthe following reasons. The firm may be in an attractive industry and itsstrategic position may enable it to generate supernormal economic profitsat least over the short run. The firm may be at some competitivedisadvantage at least in the short run, leading to subnormal profitability.Alternatively, the firm may be very skilled (or underskilled) in financialengineering and may be able to generate supernormal (subnormal)economic profits. Finally, the accounting used may be biased in the sensethat it fails to capture the underlying business reality. If accounting isbiased, the firm’s abnormal return on common equity is likely to bedistorted and may hence not reflect any abnormal economic profitability.

When assessing a firm’s performance, analysts may also compare the firm’scurrent return on common equity with competitors’ performance (cross-sectional analysis) and with the firm’s own past performance (time-seriesanalysis). Cross-sectional analysis and time-series analysis are discussed inmore details in the next chapter.

Table 3.2 ROCE (BP) in the airline industry

As an example, we derive the return on common equity (ROCE) generatedby Ryanair in each of the last financial years for which financialinformation is available, using the book value of equity as of the beginningof the financial year. As shown in Table 3.2, Ryanair’s ROCE exceeds its costof equity capital by some margin. Ryanair has also outperformed its rival,EasyJet, and the leading American low-cost airline, Southwest, over the lastthree financial years for which financial information was available for thethree airlines.

Activity 3.2*

Calculate the return on common equity for R&D Inc. in each year of activity.


Abnormal earningsFinancial analysts also assess a firm’s performance, as far as shareholdersare concerned, through abnormal earnings. Abnormal (or residual)earnings can be defined as the ‘actual’ comprehensive earnings generatedby the firm in excess of the firm’s ‘normal’ (comprehensive) earnings, whichcan be thought as a charge for the use of equity capital. The firm’s normalearnings are the comprehensive earnings required for equity to be earningat the cost of equity capital. More formally, normal earnings are defined asthe product of the book value of equity (as of the beginning of the period),and the cost of equity capital. The firm’s abnormal earnings can hence bederived as:

(3.6) )(BPCSErCEAE E−=

2001 2002 2003 2004 2005

(%) (%) (%) (%) (%)

Ryanair 23.7 22.4 23.9 16.7 18.3

EasyJet 54.3 13.2 3.3 2.0

Southwest 13.9 8.1 11.5 12.0


37

Activity 3.3*

Calculate the abnormal earnings generated by R&D Inc. in each year of activity assumingthat the cost of equity capital is equal to 10 per cent.


Abnormal earnings can also be rewritten as a product of the abnormalreturn on common equity and the book value of equity as of the beginningof the period:

(3.7)Three different situations can occur:

1. AE = 0 ↔ ROCE = rE: The firm shows a ‘normal rate of return’ oncommon shareholders’ equity

2. AE > 0 ↔ ROCE > rE: If accounting is unbiased, the firm is creatingeconomic value (economic rents) for its shareholders

3. AE < 0 ↔ ROCE < rE: If accounting is unbiased, the firm isdestroying economic value for its shareholders.

Activity 3.4

The bulk chemical industry is very competitive. Consider a firm in this industry whichdoes not have any comparative advantage. Assuming that the accounting used by thisfirm is unbiased, what is your best estimate of the firm’s future abnormal earnings. Why?

Non-nil abnormal earnings may arise for the following reasons. The firm maybe in an attractive industry and its strategic position may enable it togenerate returns on common equity in excess of its cost of equity capital atleast over the short run. The firm may be at some competitive disadvantageat least in the short run, leading to subnormal abnormal profitability.Alternatively, the firm may be very skilled (or underskilled) in financialengineering and may be able to generate supernormal (subnormal) economicprofits. In any event, if accounting is unbiased, positive abnormal earningscapture the economic rent accruing to shareholders generated either in theproduct markets or in the financial markets. Finally, the accounting used maybe biased in the sense that it fails to capture the underlying business reality. Ifaccounting is biased, the firm’s comprehensive earnings and book value ofequity are likely to be distorted and hence may not reflect any economicvalue created or destroyed for the firm’s shareholders.

Information on percentiles of ROCE, along with percentiles of annualgrowth in the book value of equity, for NYSE and AMEX firms, as reportedby Penman (2007), can be found in Table 3.3. Over the 1963–97 period, themedian ROCE is 12.2 per cent, with variations from –21.5 per cent at thefifth percentile to 31 per cent at the 95th percentile. Similarly, the mediangrowth in the book value of equity is 9 per cent, with variations from –18per cent at the fifth percentile to 50.5 per cent at the 95th percentile.

Table 3.3 Percentiles of annual growth

Percentile ROCE (%) CSE growth (%)95 31.0 50.590 24.5 33.275 17.6 17.350 12.2 9.025 6.3 2.710 –4.8 –6.95 –21.5 –18.0

)(*)()(* BPCSErROCEBPCSEAROCEAE E−==


38

As an example, Table 3.4 shows the abnormal earnings generated by Ryanairin each of the last financial years for which financial information is availableassuming a cost of equity capital rE equal to 7.6 per cent over the period.

Table 3.4 Derivation of abnormal earnings (AE) at Ryanair

Assuming that accounting is unbiased, Ryanair has hence been generatingeconomic value for its shareholders over the past five years.

Market-based measures of performanceThis section introduces the following market-based measures of a firm’sperformance as far as shareholders are concerned: the stock return (SR),the stock rate of return (SRR), the stock abnormal rate of return (SARR)and the stock abnormal return (SAR).

Stock returnConsider the actual return of a share, SR, experienced in the capitalmarkets over some period. This payoff, also referred to as stock return ormarket value added, can be defined as the sum of the change in the marketvalue of equity and net dividend paid over the period:

SR = MV(EP) – MV(BP) + ND(3.8)

Substituting the net dividend ND from (3.1) into (3.8) leads to:

SR = CE + [MV(EP) – CSE(EP)] – [MV(BP) – CSE(BP)](3.9)

The return on a share, as experienced in the capital markets over someperiod, is hence equal to comprehensive earnings plus the change inpremium of the market value of equity over the book value of equity overthe period.

In general, there is no reason for the premium of market over book toremain constant over any period. The payoff to a firm’s shareholders, asmeasured by accounting, comprehensive earnings, hence tends to differfrom the one experienced in the capital markets, the stock return.

Activity 3.5*

Calculate the stock return for R&D Inc. in each year of activity assuming that:

• the market value of equity at the beginning of the first year is $1,150

• the market value of equity at the end of the first year is $1,110

• the market value of equity at the end of the second year is $1,221.(*The solution to this activity can be found at the end of the subject guide.)

2001 2002 2003 2004 2005

( 000) ( 000) ( 000) ( 000) ( 000)

CE 104483 150375 239398 206611 266741

CSE(BY) 441357 669898 1002274 1241728 1455288

AE 70807 99262 162824 111867 155703


39

Stock rate of returnConsider the actual rate of return, SRR, experienced by a share in thecapital markets over some period. This rate of return, also referred to asstock rate of return, can be defined as the ratio of the payoff SR over themarket value of equity obtaining at the beginning of the period:

(3.10)


(3.11)

The stock rate of return experienced in the capital markets, SRR, is henceequal to the rate of return calculated by accountants, ROCE, multiplied bythe book-to-market ratio obtaining at the beginning of the period, plus thechange in the premium of the market value of equity over the book valueof equity over the period deflated by the market value of equity obtainingat the beginning of the period.

In general, the SRR experienced in the capital markets over a period differsfrom the measure of bottom-line profitability ROCE derived by accountants.The relationship between SRR and ROCE furthermore depends both on thesign of the current premium of market over book and the sign of thechange in premium.

Consider a special case in which the current premium of the market valueof equity over the book value of equity is nil and there is no change in thepremium over the period: MV(EP) = CSE(EP) = MV(BP) = CSE(BP). Inthis case, it follows from (3.11) that the SRR is equal to the ROCE. Incontrast, with a constant positive premium, the SRR is strictly lower thanthe ROCE. Finally, with a premium increasing from zero, the SRR strictlyexceeds the ROCE.

Activity 3.6*

Calculate the stock rate of return (SRR) for R&D Inc. in each year of activity.


In the spirit of the AROCE for accounting-based performance measures, wecan also consider the abnormal rate of return, SARR, experienced by theshare in the capital markets over some period. This abnormal rate ofreturn, also referred to as the stock abnormal rate of return, can bedefined as:

SARR = SRR – rE (3.12)

Intuitively, the stock abnormal rate of return captures the extent to whichthe actual rate of return experienced by a stock in the capital marketsexceeds or falls short of the rate of return required by investors tocompensate them for the risk associated with their investment. In general,as the stock rate of return experienced in the capital markets over anyperiod differs from the return on common equity derived by accountants,the stock abnormal rate of return also differs from the abnormal return oncommon equity.

Activity 3.7*

Calculate the stock abnormal rate of return (SARR) for R&D Inc. in each year of activity.


)(

)]()([)]()([

MV(BP)

CSE(BP)

BPMVBPCSEBPMVEPCSEEPMVROCESRR −−−

+=

)(

)()(

BPMVNDBPMVEPMVSRR +−

=


40

In the interest of concision, but in an abuse of language, a firm’s stock rateof return is also referred to in many textbooks as the (stock’s) return.Similarly, a firm’s abnormal stock rate of return is often referred to as the(stock’s) abnormal return. Subsequent chapters in this guide will follow thesame approach.

Stock abnormal returnConsider the abnormal return, SAR, experienced by a share in the capitalmarkets over some period. This abnormal return, also referred to as stockabnormal return or abnormal market value added, can be defined as:

SAR = SR – rEMV(BP) (3.13)

Intuitively, the stock abnormal return captures the excess of stock return (ormarket value added of the firm’s equity) over the one required by investorsto compensate them for the risk involved with their investment.

Activity 3.8*

Calculate the stock abnormal return (SAR) for R&D Inc. in each year of activity.



SAR = AE + [MV(EP) – CSE(EP)] – (1 + rE)[MV(BP) – CSE(BP)] (3.14)

The abnormal payoff obtained from investing in any share over someperiod, as experienced in the capital markets, SAR, is hence related to theabnormal payoff derived by accountants, AE. In general, however, they aredifferent.

Accounting-based versus market-based performancemeasures

In the previous sections, when assessing the performance of a firm from thepoint of view of its shareholders, we introduced both market-based andaccounting-based performance measures: the stock return andcomprehensive earnings, the stock rate of return and return on commonequity, the stock abnormal rate of return and abnormal return on commonequity, and the stock abnormal return and abnormal earnings. Both types ofperformance measures are related. Although related, measures ofperformance as derived by accountants are different from measures ofperformance as experienced in the capital markets. The main reason forthis discrepancy comes from the rules used in order to recognise the neteconomic resources gained or consumed in any period.

Accountants use very restrictive rules based on the realisation, thematching and the conservatism principles. As explained by Palepu et al.(2004):

Revenues are economic resources earned during a time period.Revenue recognition is governed by the realization principlewhich proposes that revenues should be recognized when (a)the firm has provided all, or substantially all, the goods orservices to be delivered to the customer and (b) the customerhas paid cash or is expected to pay cash with a reasonabledegree of certainty.


41

Similarly:

Expenses are economic resources used up in a time period.Expense recognition is governed by the matching and theconservatism principles. Under these principles, expenses are(a) costs directly associated with revenues recognized in thesame period, or (b) costs associated with benefits that areconsumed in this time period, or (c) resources whose futurebenefits are not reasonably certain.

More intuitively, revenue is only recognised when the firm makes a sale toa customer. Accounting then matches the expenses incurred in gainingrevenue against the revenue. Earnings can then be derived as the resultingdifference between revenue and expenses.

In efficient markets, stock prices reflect the present value of all neteconomic resources to be generated in the future for shareholders. In otherwords, stock prices are anticipatory. As a result of both anticipatory stockprices and the set of restrictive rules used by accountants, stock prices tendto lead earnings. In other words, the information content from economictransactions and news tends to get impounded in stock prices before it isrecognised by accounting. As an example, consider the following release ofinformation by governors of central banks: ‘interest rates are bound toincrease in Europe in the next financial year’. This event has no impact onthe comprehensive earnings (the return on common equity, abnormalreturn on common equity or abnormal earnings) generated by Ryanair inthe current financial year. Higher interest rates in the future will, however,lead to lower demand for travel and a higher cost of equity capital. Thepresent value of the net economic resources generated in the future forRyanair’s shareholders is hence lower after the information release. Inefficient markets, the information release will hence have an adverse effecton Ryanair’s stock return (as well as on its stock rate of return, stockabnormal rate of return, or stock abnormal return) over the currentfinancial year.

The fact that stock prices are anticipatory, and hence volatile, implies thatmarket-based measures of performance may, in some instances, be lessuseful than accounting-based measures of performance. Assessing andrewarding risk-averse managers on the basis of noisy stock prices, which donot capture accurately the consequences of managers’ actions, can forinstance be sub-optimal. In other situations, when assessing theperformance of a portfolio of stocks, market-based measures ofperformance are more appropriate (as illustrated in Chapters 10 and 11 ofthis subject guide).

Present value of abnormal earningsIn 24 Principles of Banking and Finance, it has already beenestablished that the intrinsic (or fundamental) value of a firm’s equity canbe calculated as the present value of the firm’s expected future netdividends (PVED):

(3.15)

with Vt* denoting the intrinsic value of the firm’s equity at date t

Et*(NDt+i) denoting the net dividend expected at date t + i as of date t.

Given (3.15), it can be shown that the intrinsic value of the firm’s equity isalso equal to the sum of the current book value of equity and the presentvalue of all future expected abnormal earnings (PVAE):

∑+

+∞=

=

+=i

iiitt

t

rNDEVE1

*

)1(

)(


42

(3.16)

In efficient markets, the market value of a firm’s equity is equal to theintrinsic value of the firm’s equity. According to (3.16), the premium of themarket value of equity over the book value of equity is hence equal to thepresent value of all future expected abnormal earnings. A proof of (3.16)can be found in the Appendix.

Let us first consider a special case: a firm without any comparativeadvantage in a very competitive industry. If accounting is unbiased, futureexpected abnormal earnings are expected to be nil and, in efficientmarkets, the market value of such a firm’s equity is equal to its book value(nil premium of market over book). Let us then consider a firm with somecomparative advantage in a more attractive industry, at least in the shortterm. For the latter firm, if accounting is unbiased, future expectedabnormal earnings are strictly positive (at least in the short term). Inefficient markets, the market value of such a firm’s equity hence strictlyexceeds its book value (positive premium of market over book). Otherthings being equal, the stronger the firm’s comparative advantage and thelonger the time interval over which the firm is able to sustain somecomparative advantage, the higher the market value of equity, and hence,the higher the premium of market over book.

Accounting choices, accounting-based performancemeasures and valuation

Financial statements, such as balance sheet and income statements, arebased on accrual accounting as opposed to cash accounting. Theaccounting-based measures of performance introduced in this chapter arehence not cash-flow based. Assessing a firm’s performance on the basis ofcash flows would, however, discourage investment in the form of capitalexpenditure and increases in working capital.

Accounting choices affect the recognition of revenue and expenses in theincome statement and, hence, the valuation of assets and liabilities in thebalance sheet statement. Accounting-based measures of performance, suchas comprehensive earnings, return on common equity and abnormalearnings, are hence affected by accounting choices too.

Healy et al. (2002) illustrate the effect of accounting choices in the contextof research and development through a simulation. As summarised byPenman (2007):

In this experiment, a pharmaceutical firm spends each year a setamount for basic research and development on a number of drugswith a set probability of success. If the research is successful, thefirm moves to preclinical testing and clinical trials, again with a setprobability of a successful outcome. Successful drugs are launchedcommercially with estimated revenues, production costs, andmarketing costs. All estimates, including the probability of R&Dsuccess, are based on experience in the drug industry, lending thema certain realism.

R&D may be accounted for by using the expensing method, the full costingmethod or the successful efforts method. The expensing method expensesR&D expenditure whenever incurred. The full costing method capitalisesR&D expenditure and amortises it straight-line over a period of 10 yearsfollowing the commercial launch. The successful efforts method capitalises

∑+

+∞=

=

++=i

iiitt

tt

rAEECSEVE1

*

)1(

)(


43

R&D expenditure, writes off R&D expenditure for drugs failing to reach thenext stage of development, and amortises R&D for successful drugs over aperiod of 10 years following the commercial launch.

Average ROCE over many trials in the simulation are provided in Table 3.5.These results were generated for a representative firm starting its R&Dprogramme in year 1 with the first revenue being generated in year 14after a long development period.

A steady state is reached from year 26. Even in this steady state, theaverage ROCE generated when using the most conservative accountingmethod, that is, the expensing method, is nearly twice the average ROCEgenerated when using the least conservative accounting method.

Table 3.5 ROCE (%) from a simulated R&D programme

This experiment calls for caution when using AROCE or AE in order toassess the performance of any firm from the point of view of itsshareholders. A meaningful interpretation is only possible if accounting isunbiased. If accounting is biased, it may be possible to remove the bias bymaking adjustments. Alternatively, one may evaluate performance over alonger period, which tends to attenuate the effects of bias in accounting onreported performance.

Activity 3.9*

Calculate the return on common equity for R&D Inc. in each year of activity assumingthat the firm capitalises and amortises research and development expenditure on astraight-line basis (e.g. $25 in each period).


Whereas accounting-based measures of performance are affected byaccounting choices, the intrinsic valuation of a firm’s equity obtained fromthe PVAE is not affected by the accounting choices made by analysts. Theintuition behind this result is as follows. Given consistent underlying data,both the PVED and PVAE provide the same valuation outcomes. Thevaluation outcome of the PVED is independent of accounting choices. Thevaluation outcome of the PVAE is hence also independent of accountingchoices.

Activity 3.10*

Calculate the intrinsic value of R&D Inc. using the PVAE using the following scenarios:

1. The firm expenses research and development as incurred (in the year in whichthe expenditure is incurred).

2. The firm capitalises and amortises research and development expenditure on astraight-line basis (e.g. $25 in each period).


Year Expensing method Full costingmethod

Successful effortsmethod

14 –92.3 –3.4 –15.2

20 8.1 10.7 11.0

26 54.8 27.8 39.6

32 54.0 26.4 39.3


44

Activity 3.11*

Show that the intrinsic value of the equity of R&D Inc. is the same whether estimatedwith the PVED or with the PVAE.


Chapter summaryThis chapter has provided the tools required to assess a firm’s performancefrom the point of view of its shareholders. It introduced accounting-basedperformance measures, such as the return on common equity (andabnormal return on common equity) as well as abnormal earnings. It hasshown how these accounting-based performance measures are affected bythe accounting choices made by managers. It provided economicinterpretations whenever these performance measures are derived usingunbiased accounting. It introduced market-based measures of performancesuch as the stock rate of return (and stock abnormal rate of return) as wellas the stock abnormal return. It showed how these market-basedperformance measures are related to and differ from the accounting-basedperformance measures. Furthermore it has shown how the fundamentalvalue of a firm’s equity and hence the market value of the firm’s equity inefficient markets reflect the firm’s expected future performance as capturedby accounting-based measures through the present value of abnormalearnings.

Key termsabnormal earnings (AE)

abnormal profitability

abnormal ROCE (AROCE)

biased accounting

book value of equity (CSE)

capital asset pricing model (CAPM)

clean-surplus accounting

comprehensive earnings (CE)

dirty-surplus accounting

cost of equity capital (rE)

economic rent

fundamental value

intrinsic value

net income (NI)

prices-led earnings

non-recurrent earnings

recurrent earnings

residual earnings

return on common equity (ROCE)

stock abnormal rate of return(SARR)

stock abnormal return (SAR)

stock return (SR)

stock rate of return

transitory earnings


45


• assess the performance of a firm, as far as a shareholder is concerned,using accounting tools

• assess the performance of a firm, as far as a shareholder is concerned,using market-based performance measures

• understand why accounting-based performance measures may differfrom market-based performance measures

• appreciate the limitations of the accounting-based performancemeasures

• appreciate the limitations of market-based measures

• understand how a firm’s fundamental value is related to the firm’sexpected future performance

• understand why a firm’s fundamental value of equity may differ fromits book value of equity.

Sample examination questions1. How may information bearing upon performance evaluation explain

the difference between a firm’s market value of equity and book valueof equity?

2. How does a firm’s stock return differ from its comprehensiveearnings?

3. Which benchmark would you use in order to assess how good a firm’sreturn on common equity is? What is the intuition for making thiscomparison? Discuss any potential problems associated with it.

4. How does a firm’s stock rate of return relate to its return on commonequity?

5. Construct a two-period numerical example to show that the presentvalue of abnormal earnings yields the same fundamental value forequity regardless of accounting choices.

6. Earnings Management Inc. is a ‘darling’ of Wall Street analysts. Itscurrent market value of equity is $15m and its book value of equity is$5m. Analysts know that the firm’s book value will grow by 10 percent per year forever for sure. The cost of equity capital is 15 per cent.The firm’s return on common equity is believed to stay constant in thefuture indefinitely. Given these assumptions, what is the market’sexpectation of the firm’s return on common equity?


46


47

Appendix

Reconciling the present value of expected dividends (PVED) and thepresent value of abnormal earnings (PVAE)

Assuming that the PVED holds:

(A1)

Given clean surplus accounting:

NDt+1 = CEt+1 + CSEt – CSEt+1 (A2)

NDt+2 = CEt+2 + CSEt+1 – CSEt+2 (A3)

Substituting (A2) and (A3) into (A1) yields:

Equivalently:

(A4)

As the horizon and the number of dividend terms in (A1) expands, thenumber of abnormal earnings terms in (A4) increases and the present valueof the book value of equity term in (A4) converges towards 0. The PVAEhence obtains.

( ) ( ) ( ).....

)()

1

)

11

((2

2

2

21* +−++

+=++

+++

rCSE

rAEE

rAEE

CSEVE

E

E

tt

E

ttt

( ) ( ) ( ))()

1

)

11

((2

2

2

121*

rCSE

rCSErCEE

rCSErCEE

CSEVE

E

E

ttEt

E

tEttt ++

++++ −−

++

−+=

( ) ( ).....

)

1

)

1

((2

21* +++

=+

++

rNDE

rNDE

VE

t

E

tt

Notes


48

Chapter 4: Financial analysis: thedeterminants of performance

Aim of the chapterThe aim of this chapter is to analyse the drivers of current profitability, byconducting the so-called financial analysis. We will develop a framework toenable the analyst to perform financial analysis, as shown for the Ryanaircase. We will first introduce the concept of return on net operating assets(RNOA, the typical measure of business profitability) and abnormaloperating income (AOI), and then move to the investigation of the linkbetween business profitability (RNOA) and bottom-line profitability (ROCE)by conducting the so-called first-level breakdown ROCE. We will then focuson the analysis of the drivers of business profitability itself (known assecond-level breakdown ROCE). Finally, we will investigate the linkbetween business profitability and free cash flow.


• understand how financial analysis can be conducted

• understand and critically explain the concepts of business profitabilityand abnormal operating income

• critically explain the difference between RNOA and ROA

• understand the concept of cost of capital for the firm, and be able tomeasure it

• explain (and formally derive) how bottom-line profitability can beexplained on the basis of business profitability and financial leverage(known as first-level breakdown ROCE)

• demonstrate how RNOA can be broken down into its drivers, andexplain the meaning of each of these drivers (known as second-levelbreakdown ROCE)

• explain how business profitability relates to free cash flow

• describe the empirical evidence on the typical median values offinancial ratios for US firms

• conduct the analysis of profitability for a given firm.

Essential readingPenman, S. Financial statement analysis and security valuation. (Boston, Mass.:

McGraw-Hill, 2007) third edition [ISBN 0071254323 (pbk)], Chapter 11.

Further readingNissim, D. and S. Penman ‘Ratio analysis and equity valuation: from research

to practice’, Review of Accounting Studies (6), 2001, pp. 109−54.Palepu, K., V. Bernard and P. Healy Business analysis and valuation. (Mason,

Ohio: South-Western College Publishing, 2004) third edition [ISBN0324118945], Chapter 4.

Chapter 4: Financial analysis: the determinants of performance

49

IntroductionIn the previous chapter we described the measure of bottom-lineprofitability (ROCE). The aim of this chapter is to focus on the drivers ofROCE, and in particular on one of these drivers, the RNOA (the typicalmeasure of business profitability).

To do so we need to conduct financial analysis, which aims to investigatewhat drives financial statements, in essence what drives profitability.Financial analysis focuses on the present and past; basically on where theprofitability of the firm is now. But this understanding (and framework) isessential also in order to forecast where the firm will move in the future(by conducting prospective analysis, as described in the next chapter). Theforecasts, in turn, determine the value, so much that the profitabilitydrivers identified in this chapter are sometimes referred to as value drivers.In short, financial analysis is a necessary step before conducting forecastingand valuation. (Note that financial analysis enables the analyst to discoverthe ratios that determine the value of the firm, whereas ratio analysisinvolves simply the assessment of how various line items in a financialstatement relate to one another.)

The aim of this chapter is to focus on the financial analysis of profitability(called profitability analysis) and to develop a framework to enable theanalyst to identify the key drivers of profitability (the Ryanair case will beused as a reference). Therefore, we will answer the following questions:What are the drivers of bottom-line profitability (ROCE)? How doesfinancial leverage affect ROCE? What are the drivers of businessprofitability (RNOA)? What is a measure of abnormal business profitability?What is the link between business profitability and free cash flow?

The chapter is organised as follows. We will first focus on the return ofoperating activities only (or rather the so-called business profitability) tointroduce the concept of return on net operating assets and abnormaloperating income, and then move to the investigation of the link betweenbusiness profitability and bottom-line profitability (first-level breakdownROCE). We will then analyse the drivers of business profitability itself(known as second-level breakdown ROCE). Finally we will investigate thelink between business profitability and free cash flow.

Activity 4.1

Financial analysis data are provided commercially by investment advisory services (amongothers: Moody’s Handbook of Common Stocks by Moody’s/Mergents, and The Value LineInvestment Survey by Value Line). Visit the Value Line web site, and analyse Part 3 –Ratings and reports of the Value Line investment survey (a one-page detailed summaryavailable at www.valueline.com/freedemo/productsamples.html). Identify and describe thehistorical financial results and ratios proposed by Value Line analysts for this company.

Financial analysis: time-series and cross-sectionalanalysis

In conducting financial analysis, it is important to refer not simply toindividual ratios, but to ratios in relation to comparable ratios. Theparameters of comparison are:

• the aggregate economy

• the industry or the major competitors within the industry (calledcross-sectional analysis)

• the firm’s past performance (known as time-series analysis).


50

The comparison of the firm to the economy enables analysts to understandthe influence of economic fluctuations on a firm’s performance (i.e. howthe firm reacts to the business cycle).

In cross-sectional analysis, analysts compare the firm either to the averageindustry value (if the firms in the industry are homogenous in terms oftechnology, products, markets) or to a set of firms in the industrycomparable in terms of structural characteristics (e.g. size, geographicalmarket, product market, etc.). (Note that for multi-industry firms, analystsoften refer to a rival that operates in many of the same industries, oralternatively they construct a composite industry average ratio based on theproportion of total sales derived from each industry.)

Finally, in time-series analysis, analysts examine a firm’s relative performanceover time to determine whether it is improving or deteriorating.

Business profitability (RNOA)Firms raise cash from capital markets to invest in financing assets that arethen turned into operating assets. They then use the operating assets inoperations. This involves buying inputs from suppliers and applying themwith operating assets to produce the goods and services to be sold tocustomers. Operating activities thus involve trading with customers andsuppliers in the product/services and input markets. In contrast, financingactivities involve trading in financial markets. The separation betweenfinancing and operating activities emerges, and has been clearly stated inthe reclassification of financial statements proposed in Chapter 2. In theincome statement we identify the profit flows from either operating orfinancing activities; analogously in the balance sheet we find the net assetsor obligations put in place in order to generate the flows from the twoactivities.

The comparison of the flows from operating activities to the relevantoperating stocks yields a ratio that measures business profitability as a rateof return, the return on net operating assets (RNOA), which can bemeasured as follows:

(4.1)

where OI = operating income (after taxes); NOA = net operating assets(i.e. difference between operating assets and operating liabilities) at thebeginning of the period.

More commonly, financial analysts define RNOA by looking at the averagebetween NOA at the beginning of the period (BP) and NOA at the end ofthe period (EP), or rather:

(4.2)

The operating profitability measure (RNOA) gives the percentage return ofthe net operating assets (NOA), and therefore measures how profitably acompany is able to deploy its operating assets to generate operating profits.As such, RNOA expresses the return to all the claimholders (bothshareholders and debt-holders).

RNOA enables us to analyse business profitability effectively for tworeasons. First, it considers (after tax) income on a comprehensive (cleansurplus) basis, as defined in Chapter 3. Second, it appropriately

[ ])()(2

1 EPNOABPNOAOIRNOA+

=

)(BPNOAOIRNOA =


51

distinguishes between operating and financing activities. Interest-bearingfinancial assets are treated as negative financial obligations, and thus they donot affect the operating profitability. Instead operating liabilities reduce theneeded investments in operating assets providing for operating liabilityleverage (OLL, calculated as operating liabilities divided by net operatingassets), and thus are subtracted from the denominator.

Activity 4.2

Go back to the financial statements of Ryanair provided in Chapter 2. Estimate the value ofRNOA (using both methods) for each year during the period 1999–2005.

Below you can find our example for the financial analysis of Ryanair’s RNOA.

Financial analysis of RNOA: Ryanair

To conduct the time-series analysis of Ryanair’s RNOA, we calculate its RNOAover time (as shown in the table here). Although there has been a decrease inthis ratio between 2003 and 2004, the RNOA in year 2005 remains over 25per cent.

To conduct cross-sectional analysis, we need to compare Ryanair’s RNOA withthe ratio of its competitors (e.g. EasyJet and South West), as shown in thetable below.

It emerges that Ryanair’s RNOA is significantly higher than that of EasyJetand South West over the last four years.

An alternative measure of business profitability is ROA (return on assets),which is calculated as:

(4.3)

where NI = net income; IE = interest expenses; TA = total assets.

Activity 4.3*

Go back to the financial statements of Ryanair and calculate the value of ROA for eachyear during the period 1999–2005. Compare these values with the ones estimated forRNOA.


Although ROA is commonly used, it is affected by some drawbacks. On theone hand it considers net income rather than comprehensive earnings, and onthe other it mixes up financing and operating activities. In particular:

• interest income, which is part of the financing activities, is included inthe numerator

• total assets, that include both financing and operating assets, constitutethe denominator

• operating liabilities instead are excluded from the denominator.

It follows clearly that the difference between ROA and RNOA is explained bythe operating liability leverage and the amount of financial assets relative tototal assets. This difference finds confirmation in the empirical evidence

TAIENIROA +

=


52

1999 2000 2001 2002 2003 2004 2005RNOA= OI/NOA(BP) 0.91% 0.56% 0.45% 0.31% 0.36% 0.22% 0.25%RNOA=OI/(1/2*(NOA(EP)+NOA(BP))) 0.14% 0.10% 0.07% 0.06% 0.07% 0.05% 0.05%

RNOA 1999 2000 2001 2002 2003 2004 2005

Easyjet n.a. n.a. 19.40% 21.80% 4.50% 1.50% n.a.

South West 17.50% 18.10% 12.50% 9.90% 12.20% 13.10% 0.00%

about the two measures. The median RNOA for NYSE and AMEX firms overthe period 1963–99 is equal to 10.0 per cent, whereas the median ROA is6.8 per cent (see Nissim and Penman, 2001). The RNOA measure is closerto what we typically think of as an average business profitability (pleaserefer to Figure 6.2 to have a preliminary idea on the typical behaviour ofRNOA over time). Conversely, the ROA measure is below what we wouldexpect the cost of capital for the firm to be, and seems more in line with adebt capital rate. (It follows that values of ROA reported in texts and in thebusiness press often seem too low, and this seems to be due to poormeasurement.)

Operating incomeLet us now focus on the numerator of RNOA, or rather operating income.In order to calculate operating income, we need to make a distinctionbased on the presence of dirty- or clean-surplus accounting.

In presence of dirty-surplus accounting (which means, as previouslyexplained, that income items are considered as part of equity rather than inthe income statement), operating income can be written as:

OI = CE + NFE (4.4)

where NFE = net financial expense (after taxes) (= financial expense (FE)on financial obligations – financial revenue (FR) on financial assets).

Conversely, in presence of clean-surplus accounting (when comprehensiveearnings equal net income), the operating income is calculated as follows:

OI = OR – OE = NI + NFE (4.5)

where OR = operating revenue; OE = operating expenses (after taxes).

Operating income is an accounting measure of net value added fromoperations. If everything goes well (and the firm adds value), operatingincome is a positive value. Why does it represent a measure of operatingvalue added? Let us refer to the business process of the firm. Trading withsuppliers involves giving up resources and this loss of value is namedoperating expenses. The inputs purchased have value because they can becombined with the operating assets to yield products and services to besold to customers. The sale of these products and services generatesoperating revenues. The difference between operating revenues andoperating expenses represents operating income (as shown in equation(4.5)), and is a measure of value added by operating activities.

The benchmark to evaluate RNOA: the cost of capital for the firmPayoffs must be discounted at a rate that reflects their risk, and the risk foroperations may be different from the risk for equity (measured by the costof equity, as illustrated in Chapter 3). The risk in operations is referred toas firm risk (or operational risk) and arises from factors that may affectbusiness profitability. Just as an example consider the sensitivity of sales torecession and other shocks: this sensitivity determines the operational risk.

Activity 4.4

Focus now on an airline company, such as Ryanair. What is the level of its operationalrisk in comparison to companies operating in other industries? What are itsdeterminants?


53

The operational risk is relatively high for airline companies in comparisonwith other industries. In fact, people fly less during recessions and fuelcosts are subject to shocks in oil prices.

The required return that compensates for this operational risk is the cost ofcapital for the firm (rF, also referred to as normal rate of return or cost ofcapital for operations). Since this is the required return for operatingactivities, it is the benchmark against which to evaluate RNOA.

In the long run, the value of the firm depends on where RNOA standsrelative to this norm (rF), as implied in the measure of abnormal operatingincome (illustrated in the next section). In the long run, and in the absenceof any barriers to competitive forces (i.e. the possibility of achieving thecompetitive equilibrium status), RNOA will tend to be pushed towards thecost of the firm’s capital (rF). Therefore the cost of capital for operationsrepresents the benchmark against which to evaluate the RNOA of a givencompany. (Note that the implication is that since rF is lower than rE, thenRNOA tends to be pushed to a lower level than ROCE.).

Computing the cost of capital for the firmThe cost of capital for operations (rF) is sometimes referred to as theweighted average cost of capital (WACC), where capital consists of allfinancial claims (debt and equity capital). The required return to invest inoperations is calculated as the weighted average of the required return ofthe shareholders and the cost of net financial debt, and the weights aregiven by the relative values of equity and debt in the value of the firm.Therefore the WACC can be obtained as:

(4.6)

where VE = market value of equity; VD = market value of debt; rD = costof debt capital; T = tax rate reflecting the marginal tax benefit of interest.

To compute the WACC, please find here below some insights.

Weights assigned to the cost of debt and equity represent theirrespective fractions of total capital, measured at market values.

The market value of debt can be reasonably approximated by the bookvalue of debt, if interest rates have not changed significantly since the timethe debt was issued. Otherwise, the market value of debt can be estimatedby discounting the future payouts at the current market interest ratesappropriate for the specific firm. Note that for both short-term and long-term financing debt should be considered as part of capital whencomputing WACC, whereas for internal consistency operating liabilities(such as accounts payable and accruals) should not be included.

The market value of equity is instead very complicated to calculate in aforward-looking perspective. It represents the very amount that analysts tryto estimate through all the valuation process, but it is required to get thevaluation itself. To solve this problem, a common approach used by analystsis to insert target ratios of debt to capital (VD/(VD + VE)) and equity tocapital (VE/(VD+VE)) in the WACC calculation. For example, you canexpect (also taking into account historical values) that a firm will maintaina capital structure that is 45 per cent debt and 55 per cent equity over thelong run. An alternative approach to solve the problem is to use areasonable approximation of the value of equity (based for example onmultiples of next year’s earnings forecasts). In a valuation process, whichwill be extensively explained in Chapter 7, this approximation can be used

( )Tr

VVVr

VVVrWACC DDE

D

EDE

E

F −+

++

== 1***00

0

00

0


54

as a weight in an initial calculation of WACC, which in turn can be used inthe discounting process to generate an initial estimate of the value of thefirm. This initial estimate of the value of equity can then be used in place ofthe guess to arrive at a new measure of WACC, on the basis of which a newvalue can be estimated. The process can be repeated until the value used inthe WACC calculation and the estimated value of the firm converge.

The cost of debt (rD) should be based on current market interest rates.For privately held debt, with no quoted rates, the cost of debt can becalculated as interest expenses (from the income statement) divided byinterest-bearing debts (from the balance sheet). The cost of debt should beexpressed on a net-tax basis, because we use this cost of capital as abenchmark for RNOA, which is calculated on the basis of operating incomeafter taxes. The after-tax interest rate can be calculated by multiplying themarket interest rate by one minus the marginal (or effective) corporate taxrate (as previously shown in equation (4.6)). In a forward-lookingperspective, which is the one needed in any valuation (as discussed inChapter 7), the current interest rate on debt will be an appropriate proxyfor the future expected cost of debt, if the assumed capital structure infuture periods is the same as the historical structure. However, when theanalyst projects a change in the capital structure, it is essential to estimatethe expected cost of debt given the new level of the debt-to-capital ratio.One method of estimation could be based on the estimation of the expectedcredit rating for the firm at the new level of debt, and consequently on theuse of the appropriate debt interest rate for that category. Note that in aforecasting perspective, the cost of debt should be expressed on a net-of-taxbasis because it is after-tax cash flows that are discounted (as discussed inChapter 7, ‘Discounted cash flow method’ section).

As regards the estimation of the cost of equity, please refer to the discussionin Chapter 3.

We now have the estimates of all the elements needed to compute the WACC.

Activity 4.5*

Calculate the WACC for Ryanair in the year 2005. Make appropriate assumptions whenrequired. Keep this answer, as you will need it in the application of valuation methods inChapter 7.


Abnormal (residual) operating income (AOI)Abnormal (residual) operating income (AOI, ReOI) can be defined as theoperating income in excess of the operating income required for the netoperating assets in the balance sheet to be earning at the relevant cost ofcapital. It can thus be viewed as the ‘actual’ operating income minus the‘normal’ operating income, which can be thought of as the charge for usingnet operating assets. Normal operating income can be defined as the netoperating assets (at the beginning of the period) multiplied by the cost ofcapital for the firm (rF). Therefore, the abnormal operating incomemeasures the abnormal earnings from net operating assets, and formallycan be written as:

(4.7)

where OI denotes the after-tax operating income. Abnormal operatingincome charges the operating income with a charge for using net operatingassets. Abnormal operating income is also referred to as economic profit or

)(BPxNOArOIAOI F−=


55

economic value added. Note that some consulting firms have taken thisconcept (and terms) as trademarks for their valuation products (we willdiscuss the general form of the economic value added valuation model inChapter 7).

Activity 4.6*

Go back to the financial statements of Ryanair, and calculate the AOI measure for eachyear during the period 1999–2005.


As outlined in Chapter 3, abnormal (residual) earnings can be broken downinto its drivers. Similarly we can identify the abnormal operating incomedrivers. Given that RNOA = OI/NOA (BP), it follows that OI = RNOA ×NOA(BP). Substituting this in equation (4.7), we obtain:

(4.8)

From this equation, it is clear that the drivers of residual operating incomeare: abnormal RNOA (ARNOA), which is the difference between RNOA andrF; and NOA. This means that AOI is driven by the amount of NOA put inplace at the beginning of the year and the profitability of those assetsrelative to the relevant cost of capital. Therefore by comparing RNOA andits benchmark, we introduce the concept of AOI.

Let us now focus on the abnormal RNOA. Three different situations can occur:

1. AOI = 0 ↔ RNOA = rF : The firm shows a ‘normal rate of return’ onits NOA.

2. AOI > 0 ↔ RNOA > rF : If accounting is unbiased, the firm iscreating economic value (economic rents).

3. AOI < 0 ↔ RNOA < rF : If accounting is unbiased, the firm isdestroying economic value.

Link between business and bottom-line profitabilityThe bottom-line profitability (ROCE, as illustrated in Chapter 3) is affectedboth by operating activities (whose profitability has been discussed in theprevious sections of this chapter) and financing activities. The first level ofbreakdown of ROCE allows us to distinguish the profitability of operatingand financing activities, and also to distinguish the effect of financialleverage. Furthermore, the first-level breakdown is a way to identify a linkbetween business profitability and bottom-line profitability. Formally, thisdecomposition of ROCE can be written as:

ROCE = RNOA + FLEV(RNOA – NBC) = RNOA + (FLEV*SPREAD) (4.9)

Activity 4.7*

Formally derive the first-level breakdown of ROCE.

(*The solution to this activity can be found in the Appendix at the end of this chapter.)

From equation (4.9), it emerges clearly that ROCE can be broken downinto three drivers:

1. RNOA = return on net operating assets (= OI/NOA), a measure ofhow profitably the firm employs its net operating assets (as previouslyexplained)

2. FLEV = financial leverage (= NFO/CSE), a measure of the degree to

)(

)()()()(

BPARNOAxNOABPxNOArRNOABPxNOArBPRNOAxNOAAOI FF =−=−=


56

which net operating assets are financed by net financial obligations(NFO) or by common shareholders’ equity (CSE)

3. SPREAD = operating spread (= RNOA – NBC), where NBC = netborrowing costs (after tax).

In short, ROCE is determined by operating profitability, financial leverageand the operating spread.

Financial leverage levers the ROCE up or down through financing liabilities.This means that the extent to which net operating assets (NOA) are financedby common shareholders’ equity (CSE) or net financial obligations (NFO)affects ROCE. In particular, ROCE (bottom-line performance) is levered upover the RNOA (operating profitability) if the firm has financial leverage andthe return from operations is greater than the borrowing costs. In this casethe firm earns more on its equity if NOA are financed by NFO, provided thatthe spread is positive (i.e. profitability of operations higher than netborrowing costs).

Figure 4.1 shows how the difference between ROCE and RNOA changeswith FLEV according to the level of the spread. If a firm has zero FLEV, thenROCE = RNOA. If a firm has (positive) FLEV, then the difference betweenROCE and RNOA is determined by the very amount of FLEV and theoperating spread.

• If the spread is positive (i.e. RNOA > NBC), it is commonly said tohave favourable leverage (or favourable gearing): this implies that theRNOA is levered up to generate a higher ROCE.

• If the spread is negative (i.e. RNOA < NBC), the FLEV effect is negative(as will be shown in the case of Ryanair).

To the presence of financial leverage can be attached alternatively good orbad news. There is good news (financial leverage generates greater return toshareholders) if the firm earns more on its operating assets than itsborrowing costs. Conversely, financial leverage hurts shareholders’ return, ifit doesn’t.

(Please read Penman, 2007, p. 374, to see how the analysis changes inpresence of net financial assets instead of net financial obligations.)

Figure 4.1 Influence of FLEV over ROCE and RNOA

Source: Adapted from Penman (2003, p. 352)


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-0.06

-0.04

-0.02

0

0.02

0.04

0.06

0.08

0.1

FLEV

RO

CE-

RN

OA 4% SPREAD

2% SPREAD-2% SPREAD0 SPREAD

0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1 1.1 1.2 1.3 1.4 1.5 1.6 1.7 1.8 1.9 2

The empirical evidence for the sample of NYSE and AMEX firms over theperiod 1963–99 used in the study by Nissim and Penman (2001) shows amedian FLEV 0.40 (much lower than the value measured for thedebt/equity ratio, equal to 1.19). This occurs because FLEV recognised onlyfinancial obligations, and also recognised that financial activities reducefinancial obligations. It is interesting to note that about 20 per cent of firmshave negative financial leverage, which means that they hold financialassets rather than financial obligations (as shown in the Ryanair case). Alsonote that there is considerable variation across industries as regards thevalue of financial leverage. The median net borrowing cost after tax is 5.2per cent, while the spread over the net borrowing cost is positive at themedian. The higher median value of ROCE (12.2 per cent) in comparisonwith the median value of RNOA (10.0 per cent) indicates that typicallypositive FLEV combines with positive spread to lever ROCE favourably.

Activity 4.8

Go back to the financial statements of Ryanair, and show the first-level breakdown foreach year during the period 2000–04. Use a graph to support your answer.

Below you can find the first-level breakdown for Ryanair’s ROCE.


58

First-level breakdown ROCE (RNOA, FLEV, SPREAD): RYANAIR

The aim is to explain Ryanair’s comparatively high ROCE in relation to itscomponents of RNOA, FLEV and NBC. Figure 4.2 shows that Ryanair’sRNOA exceeds ROCE considerably between 2000 and 2004, leading us toconclude that its high return is primarily due to operating activities andthat increasing debt does not create value to the shareholders.

Figure 4.2

Potentially, the difference between RNOA and NBC indicates that thecompany can use leverage to create value. However, the FLEV is negativedue to the company’s strategy to maintain a high position of cashequivalents and other financial assets as deposit for certain derivativefinancial instruments and debt financing arrangements entered into bythe group. The negative FLEV affects ROCE in a harmful way. Specifically,instead of creating value with the leverage, Ryanair is destroying value.Potentially, Ryanair could use leverage to increase the return toshareholders, but due to its strategy of maintaining high investment infinancial assets, Ryanair does not benefit from its profitable operations.

Furthermore, FLEV is an indicator of the risk involved in financingactivities. Consequently, the negative FLEV means that Ryanair isconservatively financed and one could argue that the company could takemore risk in order to raise the ROCE and create value to theshareholders.

Determinants of business profitabilityIn the second level of breakdown, the focus is specifically on the drivers ofoperating profitability (which in turn is identified as a driver of bottom-lineprofitability, as shown in the previous section). The decomposition ofbusiness profitability (called also the Du Pont model) leads to:

(4.10)

where PM = profit margin; ATO = net operating asset turnover.

The profitability of operations comes from two sources:

• profit margin, or rather a profitability measure: RNOA is higher themore of each pound of sales ends up in operating income

• net operating asset turnover, which is an efficiency measure: RNOA ishigher the more sales are generated from net operating assets.

Note that an analogous decomposition is possible for ROA, which can bethought as the product of two factors:

(4.11)

where ROS = return on sales (also known as net profit margin), and AT = asset turnover. The return on sales indicates how much the firm isable to keep as net income for each pound of sales. Asset turnover indicateshow many pounds of sales the firm is able to generate from each pound ofits assets.

In terms of empirical evidence, the mean value for PM is 6.2 per cent,while that for ATO is 2.33 per cent for the same sample of NYSE and AMEXfirms over the period 1963–99 (Nissim and Penman, 2001). Empiricalevidence also suggests that firms can generate the same RNOA withdifferent combinations of PM and ATO. This is very much determined bythe nature of the industry to which the firm belongs, as will be shown inthe next activity.

Activity 4.9

Please visit the web page http://pages.stern.nyu.edu/~adamodar/pc/datasets/mgnroc.xlsto get a sense of the typical values of profit margins and asset turnover in the UnitedStates, classified by industry. Then plot these values on an XY diagram.

The result you will obtain by plotting the PM and ATO values of differentindustries over an XY diagram is the one shown in Figure 4.3. We clearlyobserve a trade-off between PM and ATO. PM and ATO reflect thetechnology for delivering the services. On the one hand, there are capital-intensive industries, with low ATO and high PM (examples are:electric/water utilities, precious metals, securities brokerage industries). Onthe other hand, we find competitive businesses, characterised by low PMand high ATO (examples are: food wholesalers, building materials,groceries, human resources and pharmacy services industries).

ROSxAT

AssetsSalesx

SalesNIROA ==

PMxATO

NOASalesx

SalesOI

NOAOIRNOA ===


59

Figure 4.3 PM and ATO combinations

In the next sections we will focus our attention on each of the two driversof RNOA.

(Please read Penman, 2007, for a description of the third-level breakdown,which refers to the identification of the drivers of profit margin, operatingasset turnover and net borrowing cost.)

Profit marginProfit margin measures how much the firm is able to keep as operatingprofits (after taxes) for each pound of sales it makes. In short, it reveals theprofitability of each pound of sales. Formally, it is calculated as:

(4.12)

Over time, profit margin is a more variable measure than operating assetturnover. This happens because profit margin, like ROCE, tends to bedriven by competition to ‘normal’ levels over time (for an analysis of theROCE behaviour over time please refer to Chapter 6, ‘Empirical evidence onthe patterns of accounting resources’ section).

Net operating asset turnoverNet operating asset turnover indicates the ability of NOA to generate sales,or rather how many pounds of sales the firm is able to generate for eachpound of its NOA. The formula for the ATO calculation is:

(4.13)

Operating asset turnover (ATO) tends to be rather stable over time, in partbecause it is so much a function of the technology of an industry, whichobviously tends not to change very frequently.

)(BPNOASalesATO =

SalestaxafterOIPM )(

=


60

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Dots show means

Activity 4.10

Go back to the financial statements of Ryanair, and show the second-level breakdown(referred to RNOA) for each year during the period 1999–2005.

Below you can find the second-level breakdown for Ryanair’s ROCE.

Business profitability and free cash flowsAs discussed in Chapter 2, the reformulated cash flow statement identifiesthe (operating and financing) flows over a period. The cash flowsassociated with operating activities are cash from operations (C) and cashinvestments in operations (I). By comparing these operating flows we getthe free cash flow (FCF), which can be calculated as:


61

1999 2000 2001 2002 2003 2004 2005

PM (after tax) 17.79% 18.83% 20.16% 23.02% 28.37% 21.23% 21.93%

ATO (NOAt–1) – 2.980 2.261 1.369 1.278 1.052 1.155

Second-level breakdown ROCE (PM and ATO): Ryanair

By looking at the RNOA (as calculated in Activity 4.2), we clearly observesignificantly better performance of Ryanair in comparison to other firmsin the industry. (Just to make a few examples: in 2004, RNOA (beginningof the period) is equal to 9.9 per cent for the airline industry overall, 1.5per cent for EasyJet and 13.10 per cent for South West). Although aftertwo exceptional years (1999 and 2000), the RNOA of Ryanair decreased,it remains at a relatively high and stable level of around 20 per cent. Thisaccounts for the good performance of Ryanair.

In order to get further understanding as to what are the drivers behindthis high RNOA, we will look into its drivers, namely profit margin (PM)and operating asset turnover (ATO), by conducting second-levelbreakdown ROCE. Table 4.1 shows the values for the two drivers over theperiod 1999–2005.

Table 4.1

The ATO is very low compared to the industry (in 2004 ATO is equal to2.16 for EasyJet). Indeed, Ryanair is a very capital-intensive company. Tounderstand why ATO is lower than the industry level we need to examineRyanair’s investment policy. Ryanair owns most of its fleet and thus hashigh investments (high CAPEX). (Ryanair’s PPE constituted 95 per cent ofits operating assets in 2004, compared with 40 per cent for EasyJet.)EasyJet instead has a lot of its aircraft under leases, which enables it tohave a stronger ATO, to which is accompanied nevertheless a lower grossmargin (because leasing rents are higher than depreciation charges).

The ATO is stable over time. This is not surprising given that nosignificant technological progress has been made. Hence Ryanair is notable to generate more sales with fewer assets.

Therefore PM is the key driver of RNOA. Ryanair’s PM is tremendouslyhigh compared with other firms in the industry. (Just to cite a fewexamples: in 2004 the PM was equal to 0.68 per cent for EasyJet, 9.59per cent for South West and 6.70 per cent for the industry overall.)

It is thus necessary to analyse the drivers of PM by performing the third-level breakdown of ROCE.

FCF = Cash flow from operations – Cash investments in operations = C – I (4.14)

FCF represents the net cash generated (or absorbed) by operations, whichdetermines the ability of the firm to satisfy its debt- and equity-holders. Ifthe FCF is positive, operating activities are generating net cash; if FCF isnegative, operating activities absorb net cash.

The calculation of FCF starting from the GAAP statement of cash flow iscomplex because it requires a reformulation to correct for themisclassification of some operating and financing cash flows. However, ifthe balance sheet and the income statement are appropriately reformulated(according to what has been explained in Chapter 2), the calculation ofFCF becomes straightforward. By recalling equation (2.5), FCF can beexpressed as follows:

FCF = Operating income – Change in net operating assets = OI – ΔNOA(4.15)

This means that operations generate operating income, and FCF is the partof operating income remaining after reinvesting some of it in NOA. (If theinvestment in NOA is higher than the operating income, the FCF isnegative. This implies that an infusion of cash is required.) There emerges a clear link between FCF and business profitability. In fact, recalling thatRNOA = OI/NOA(BP), equation (4.15) can be rearranged as:

(4.16)

The calculation of FCF is important for preparing pro-forma future cashflow statements for the discounted cash flow (DCF) analysis, the mostcommon valuation technique, which will be discussed in Chapter 7.

Chapter summaryThis chapter has uncovered the drivers of the current bottom-lineprofitability (ROCE), and focused attention on the measure of businessprofitability (RNOA), by conducting financial analysis of profitability. Thisenables analysts not just to penetrate the financial statements, but also toprovide a framework to understand how these drivers affect the value ofthe firm (i.e. how the business affects the financial statement drivers, andhow in turn they affect ROCE and abnormal earnings). By focusing on thepresent and the past, financial analysis is an essential step beforeconducting prospective analysis and valuation.

In the profitability analysis framework, the first-level breakdown ROCEenables analysts to uncover the key drivers of bottom-line profitability,which are business profitability, financial leverage and the operatingspread. The first driver is business profitability, which is measured by thereturn on net operating assets (RNOA): it refers to operating activities only,and measures how profitably a company is able to deploy its operatingassets to generate operating profits. Nevertheless, ROCE is levered up overthe RNOA if the firm has financial leverage and the return from operationsis greater than the borrowing costs (which means positive operatingspread). This qualifies the so-called favourable leverage, an increase inROCE over RNOA induced by borrowing.

The second-level breakdown enables analysts to identify the key drivers ofbusiness profitability itself, which are profit margin (PM) and net operatingasset turnover (ATO). The former is a profitability measure that indicateshow much of each pound of sales ends up in operating income. The latter is

)()( BPNOANOARNOA

BPNOAFCF Δ

−=


62

an efficiency measure expressing the technology of the firm, which indicateshow many pounds of sales are generated from net operating assets.Empirical evidence shows a trade-off between PM and ATO: similar RNOAare generated with quite dissimilar combinations of PM and ATO in differentindustries.

By comparing business profitability (RNOA) and its relevant cost of capital(cost of capital for the firm, sometimes referred to as weighted average costof capital), we introduced the concept of abnormal (residual) operatingincome (AOI), which can be viewed as the ‘actual’ operating income minusthe ‘normal’ operating income (i.e. the operating income required for theNOA to be earning at the relevant cost of capital). This concept (alsoknown as economic value added or economic profit) is the basis of avaluation method described in Chapter 7.

Key terms


• understand how financial analysis can be conducted

• understand and critically explain the concepts of business profitabilityand abnormal operating income

• critically explain the difference between RNOA and ROA

• understand the concept of cost of capital for the firm, and be able tomeasure it

abnormal operating income (AOI)

abnormal operating income drivers

abnormal RNOA

business profitability

clean-surplus accounting

cost of capital for the firm

cost of capital for operations

cost of debt

cost of equity

cross-sectional analysis

dirty-surplus accounting

Du Pont model

economic profit

economic value added

economic value

economic rent

favourable gearing

favourable leverage

financial analysis

firm risk

first level of breakdown

free cash flow (FCF)

market value of debt

market value of equity

normal operating income

normal rate of return

operating liability leverage (OLL)

operational risk

profitability analysis

ratio analysis

required return

residual operating income (ReOI)

return on net operating assets(RNOA)

return on sales (ROS)

second level of breakdown

target ratios

time-series analysis

value drivers

weighted average cost of capital(WACC)

weights assigned to the cost of debtand equity


63

• explain (and formally derive) how bottom-line profitability can beexplained on the basis of business profitability and financial leverage(known as first-level breakdown ROCE)

• demonstrate how RNOA can be broken down into its drivers, andexplain the meaning of each of these drivers (known as second-levelbreakdown ROCE)

• explain how business profitability relates to free cash flow

• describe the empirical evidence on the typical median values offinancial ratios for the US firms

• conduct the analysis of profitability for a given firm.

Sample examination questions1. Under what conditions is the measure of business profitability (RNOA)

equal to the measure of bottom-line profitability (ROCE)?

2. Describe the commonly used measure of return on assets (ROA), andcritically discuss its main limits. Then relate these limits to the lowvalue empirically measured for ROA in comparison to RNOA.

3. What is the benchmark against which to evaluate RNOA? Why?

4. Discuss why financial leverage should lever up the return on commonequity.

5. How does business profitability relate to free cash flow?

6. Critically explain the meaning of the abnormal operating incomeconcept.

7. The reformulated financial statements of company ABC are as follows(values in millions of dollars):

2005 2006

PPE 1000 1700Accounts receivable 500 500Inventories 500 500Operating liabilities (100) (300)Bonds payable (200) (1200)Common equity 800 1200

Sales 2100Operating expenses 1700Interest expenses 120Tax expense 30Net income 250

a) Calculate ROCE, RNOA, FLEV and FCF for the firm in the year2006.

b) Show the first-level breakdown ROCE for the year 2006.

c) Show the second-level breakdown ROCE for the year 2006.


64

AppendixAs we have seen in Chapter 3, the return on common equity, can be writtenas:

(A1)

where CE = comprehensive earnings, CSE = common shareholders’ equity.

Comprehensive earnings in equation (A1) is composed of operating income(OI) and net financial expenses (NFE) as in equation 4.4. Thus equation(A1) can be rewritten as follows:

(A2)

As implied in equation (4.1), operating income is generated by netoperating assets and the operating profitability measure (RNOA) (OI =RNOA × NOA(BP)). Similarly, net financial expenses (NFE) is generated bynet financial obligations (NFO) and the rate at which the NFE is incurred,which is the net borrowing cost (NBC) (NFE = NBC × NFO). On this basis,equation (A2) formally becomes:

(A3)

This equation represents the weighted average of the return of operatingactivities and the (negative) return from financing activities. It can berearranged as:

(A4)

⎟⎠⎞

⎜⎝⎛−⎟

⎠⎞

⎜⎝⎛= NBC

CSENFORNOA

CSENOAROCE

))()((2

1 EPCSEBPCSENFEOIROCE+

−=

))()((2

1 EPCSEBPCSECEROCE+

=


65

( ) )*( SpreadFLEVRNOANBCRNOACSENFORNOAROCE +− =⎟

⎠⎞

⎜⎝⎛ −+=

Notes


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143 valuation securities analysis chap1-4

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