Reorganise the financial statements to reflect economic, instead of accounting, performance.

Measure and analyse the company’s return on invested capital (ROIC) and economic profit to evaluate the company’s ability to create value

Break down revenue growth into four components: organic revenue growth, currency effects, acquisitions and accounting changes

Assess the company’s financial health and capital structure to determine whether it has the financial resources to conduct business and make short-and long-term investments

Separate operating performance from non-operating items and the financing obtained to support the business.

ROIC and Free Cash Flow (FCF) are independent of leverage and focus solely on the operating performance of the business.

OA +NOA = OL + (D +DE) + (E + EE)◦ OA = Operating assets◦ NOA = Non-operating assets◦ OL = Operating liabilities◦ D = Debt◦ DE = Debt equivalent◦ E = Equity◦ EE =Equity equivalents

Invested Capital +NOA = Total Funds Invested = (D+DE) + (E + EE)

Invested capital = OA – OL

ACCOUNTANT’S BALANCE SHEET

Previous year Current

year

Liabilities and Equity

Share capital 50 50

Retained earnings 115 200

Interest-bearing debt 225 200

Accounts payable 125 150

Total liabilities and equity 515 600

Assets

Net PPE 300 350

Equity investments 15 25

Inventory 200 225

Total assets 515 600

INVESTED CAPITAL

Previous year Current year Net PP&E 300 350 Inventory 200 225 Accounts payable (125) (150) Operating working capital 75 75 Invested capital 375 425 Equity investments 15 25 Total funds invested 390 450 Share capital 50 50 Retained earnings 115 200 Interest-bearing debt 225 200 Total funds invested 390 450

Interest is not subtracted from operating profit. It is considered a payment to company’s

financial investors. Exclude any non-operating income, gains, or

losses generated from assets excluded from invested capital.

Effects of interest expense and non-operating income are removed from taxes. ◦ Start with reported taxes, add back the tax shield

caused by interest expense, and remove taxes paid for non-operating income.

Model all financing cost (including interest and tax shield) in the cost of capital.

Taxes on non-operating income should be netted against operating income.

ACCOUNTANT’S INCOME STATEMENT

Current year Revenue 1,000 Operating cost (700) Depreciation (20) Operating profit 280 Interest (20) Non-operating income 4 Earnings before taxes (EBT) 264 Taxes (66) Net profit 198

NOPLAT

Current year Revenue 1,000 Operating cost (700) Depreciation (20) Operating profit 280 Operating taxes (assume 25%) (70) NOPLAT 210 After tax non-operating income 3 Total income to all investors 213 Reconciliation with net profit Net profit 198 After tax interest 15 Total income to all investors 213

ROIC = (NOPLAT/Invested Capital) ROIC is used to measure how the

company’s core operating performance has changed and how the company compares with its competitors, without the effects of financial structure and non-operating items distorting the analysis.

FCF = NOPLAT + Non-Cash Expenses – Investments in Invested Capital

Cash flow from non-operating assets should be evaluated separately from core operations

ACCOUNTANT’S CASH FLOW

Current year

Net income 198

Depreciation 20

Decrease (increase) in inventory (25)

Increase (decrease) in accounts payable 25

Cash flow from operations 218

Capital expenditures (70)

Decrease (increase) in equity investments (10)

Cash flow from investing (80)

Increase (decrease) in interest-bearing debt (25)

Increase (decrease) in common stock 0

Dividends (113)

Cash flow from financing (138)

FREE CASH FLOW Current year

NOPLAT 210

Depreciation 20

Gross cash flow 230

Decrease (Increase) in inventory (25)

Increase (Decrease) in accounts payable 25

Capital expenditures (70)

Gross investment (70)

Free cash Flow 160

After tax non-0perating income 3

Decrease (increase) in equity investments (10)

Cash flow available to investors 153

After tax interest expense 15

Decrease (increase) in interest-bearing debt 25

Decrease (increase) in share capital 0

Dividends 113

Cash flow available to investors 153

Specifically excess cash and marketable securities are excluded.◦ Excess cash represents temporary imbalances in

the company’s cash position. Operating liabilities should not be

considered as a form of financing. ◦ Assumption that operating liabilities are a form of

financing is inconsistent with the definition of NOPLAT.

The book value of net property, plant and equipment is always included in the operating assets.

Adjust reported goodwill upwards to recapture historical amortisation and impairments.◦ To maintain consistency, amortisation and

impairments are not deducted from revenues to determine NOPLAT.

An unrecorded goodwill should be added to recorded goodwill.

Operating lease Expensed investments: advertising, and

research and development

Excess cash and marketable securities.◦ To asses the minimum cash needed to support

operations, look for a minimum clustering of cash to revenue across the industry.

Illiquid investments, non-consolidated subsidiaries and other equity investments.

Pre-paid and intangible pension assets

Unfunded retirement liabilities Operating lease Reserves for plan decommissioning Reserve for restructuring

Deferred tax liability◦ To be consistent use cash taxes to compute

NOPLAT

Earnings before interest, tax, and amortisation of goodwill (EBITA) is the starting point

Exclude non-operating incomes, gains and losses Adjust income for hidden assets Consider operating cash taxes on EBITA

◦ Use marginal tax rate to eliminate tax effect◦ Use cash taxes actually paid◦ Subtracting the increase in deferred taxes lead to cash

taxes Reconcile net income to NOPLAT to ensure that

the reorganisation is complete

It represents the cash available for investment and investor payout, without having to sell non-operating assets or raise additional capital. ◦ Gross cash flow has two components: NOPLAT and

Non-cash operating expenses. The two most common non-operating expenses

are depreciation and employee stock option. ◦ ESOPs represent value being transferred from

shareholders to company employees. ◦ If ESOPs are added back to NOPLAT, those must be

valued separately. ◦ If they are not added back, there is no need to value

them separately.

Change in operating working capital Net capital expenditure

◦ It is estimated by taking the change in the net PP&E plus depreciation.

◦ Change in the gross PP&E should not be considered as gross investment because when assets are retired gross PP&E is reduced without any cash flow implication.

Change in capitalised operating leases

Investment in acquired intangibles and goodwill◦ For acquired intangible assets, where cumulative

amortisation has been added back, investment is estimated by computing the change in net acquired intangibles.

◦ For intangibles that are being amortised, the method that is being used for estimating net investment in PP&E is used.

Change in other long-term operating assets, net of long-term liabilities.

Non-cash increase should be adjusted (e.g. exchange difference, and change in fair value)

Reinvestment ratio = Gross investment/Gross cash flow

If the ratio is rising without a corresponding increase in growth, examine:◦ Whether the company’s investments are taking

longer to blossom than expected; or◦ Whether the company is adding capital in

efficiently

ROIC = NOPLAT/Average Invested Capital When ROIC is used to measure historical

performance for company’s shareholders, ROIC should be measured with goodwill.

ROIC excluding goodwill measures the company’s internal performance and is useful for comparing operating performance across companies and for analysing trends.

Economic profit = Invested capital × (ROIC – WACC)◦ Invested capital is measured at the beginning of

the year. Economic profit measures the one-year

performance on historical book value. The change in market value measures

changing expectations about future economic profits.

ROIC = (1 – Cash tax rate) × (EBITA/Revenues) ×

(Revenues/ Average invested capital)

Components of ROIC

ROIC

18.2

Pre-tax ROIC 25.5

Cash tax rate 28.6

Operating margin 11.0

Average capital turns 2.3

Gross margin 31.8

31.8

SG&A/Revenues 19.1

Depn /Revenues 1.7

Op WC /Revenues 4.2

FA /Revenues 38.9

Compare historical value drivers with drivers of other companies in the same industry

What are the sources of competitive advantage?

Is the competitive advantage sustainable?

Convert every line item to some type of ratio, for example:◦ Operating ratios◦ Each line item in the balance sheet as a

percentage of revenue

If, available, analyse the operating data. By evaluating operating drivers, one can

better assess the sustainability of financial spreads among competitors.

Example: Airlines industry◦ (Labour expense/Revenue) =◦ (Labour expense/Total employees) × ◦ (Total employees/Available seat miles flown ) × ◦ (Available seat miles flown /Revenue)

Value of a company is driven by ROIC, WACC and growth

Growth is defined as growth in cash flows Assuming profit margins and reinvestment

rates stabilise to a long-term level, long-term growth in cash flows will be directly ties to long-term growth in revenues.

By analysing historical revenue growth, one can assess the potential for growth going forward.

IBM: Revenue Growth analysis (Per cent) [Ref: Valuation Mc Kinsey Exhibit 7.16]

2001 2002 2003

Organic revenue growth 0.5 (1.8) (2.6)

Acquisition 0.5 2.1 5.4

Divestiture 0 (3.3) 0

Currency effects (3.9) (2.5) 7.0

Reported revenue growth (2.9) (5.5) 9.8

Revenues earned in different currencies are translated in the reporting currency.

Reported revenue is affected by the weakening or strengthening o currencies against the reporting currency during the reporting period.

Thus a rise in revenue may not reflect increased pricing power or greater quantities sold, but just a depreciation of the company’s home currency.

Revenues = (Revenue/Unit) × Units Revenue per unit does not represent the

price If revenue per unit is rising, the change

could be due to rising prices or due to the change in the product mix from low-priced to high-priced items

Revenue Growth Analysis: Retail Chain (Per cent) (Ref: Valuation, McKinsey, Exhibit 7.19

Revenue 11.3

11

Revenue per store (0.1) 90.1) Number of stores 11.4

Number of transactions per store (3.7)

Dollar per transaction 3.7

Square feet per store 4.2

Number of transactions per square foot 4.2

New store development is an investment choice, where as same-store sales growth reflects store-by-store operating performance.

New stores require large capital investments, where as comparable (that is, year-to-year sale store sales) requires little incremental capital. ◦ Higher revenue and less capital leads to higher

ROIC

Interest coverage ratio EBIT/Interest or EBIDTA/Interest

◦ (EBITA/Interest) measures the company’s ability to repay interest without having to cut expenditures intended to replace depreciating equipment.

EBITDAR/(Interest + Rental Expense)◦ Important for companies engaged in industries

like retailing business

ROE = ROIC + [ROIC – (1 – T) kd] × (D/E)◦ ROE is a direct function of its ROIC, its spread of

ROIC over its after-tax cost of debt, and book-based debt-equity ratio

To assess leverage, measure company’s (market) debt-to-equity ratio over time and against peers.

Look back as far as possible (at least 10 years)◦ This allows to determine whether the company and

industry tend to revert to some normal level of performance, and whether short-term trends are likely to be permanent.

Disaggregate value drivers, both ROIC and revenue growth◦ If possible, link operational performance measures

with each key value driver. If there is any radical change in performance,

identify the source.◦ Determine whether the change is temporary or

permanent, or merely an accounting effect.

Value the operating leases: Capitalise the asset value on the balance sheet, and the implied debt as liability◦ Rental Expenset =

Asset Valuet - 1× [kd + (1/Asset Life)]

◦ Asset Valuet – 1 =

[Rental Expenset ] ÷ [kd + (1/Asset Life)]

Break down the rental expenses into two components: interest expense and depreciation◦ Implied interest payment should be added back to

EBITA and taxes should be adjusted to remove the interest tax shield

Capitalising R&D expense:◦ Choose an amortisation period, for example 10

years; use product and industry characteristics to guide your choice

Unlike ROIC, FCF does not change when expenses are capitalised