443_5 - Applied Equity Analysis and Por3olio...

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Unformatted text preview: Applied Equity Analysis and Por3olio Management Lecture 5 Valua;on 101 •  A company is worth the sum of the future cash flows that it is able to generate •  Investors will adjust the value or “discount” these cash flows based on risk PV of Cashflow from Opera;ons PV of Cashflow from Non Opera;ng Ac;vi;es = Enterprise Value Cash Available to Debt Equivalents Cash Available to Equity Equivalents The Problems with Tradi;onal Financial Analysis Why do we need to reorganize the company’s financial statements? •  Traditional measures of performance, such as return on equity (ROE) and return on assets (ROA), include nonoperating items and financial structure that impair their usefulness. •  ROE mixes operating performance with capital structure, making peer group analysis and trend analysis less meaningful. ROE rises with leverage if ROIC is greater than the after-tax cost of debt. •  ROA and ROE commingle operating and nonoperating items. For instance, ROA includes the return on assets for excess cash, which is quite low (near 3 percent). Companies that hold large cash balances can have artificially low ROAs, even when their operating performance is strong. •  To ground our historical analysis, we need to separate operating performance from nonoperating assets and the financial structure used to finance the business. Return on Invested Capital (ROIC) •  Return on invested capital (ROIC) is calculated by dividing the company’s after-tax operating profits by the amount of net capital all investors have contributed to the company. •  Return on invested capital is independent of the company’s financial structure. After-Tax Operating Profit ROIC = Invested Capital The income statement will be reorganized to create net operating profit less adjusted taxes (NOPAT). NOPAT represents the after-tax operating profit available to all financial investors. The balance sheet will be reorganized to create invested capital. Invested capital equals the total capital required to fund operations, regardless of type (debt or equity). Free Cash Flow •  Free cash flow is the aSer ­tax cash flow available to all investors: debt holders, preferred stock, common equity holders, and so on. •  Unlike “cash flow from opera;ons” reported in a company’s financial statement, free cash flow is completely independent of financing and nonopera;ng items. FCF = NOPAT + Depreciation + Invested Capital •  ROIC and FCF rely on the identical inputs, NOPAT and invested capital. Thus, valuations based on discounted cash flow (DCF) and on economic profit will lead to identical results. Accoun;ng Statements Economic Statements Valua;on NOPLAT Free Cash Flow Cashflow from Opera;ng Ac;vi;es Non Op Assets Less Non Op Liabili;es Non Opera;ng Income Non Opera;ng Cash Flow Cashflow from Non Op Ac;vi;es Total Funds Invested Total Income to Investors Cashflow Available to Investors Enterprise Value Funds Provided by Debt Equivalents Payments to Debt Equivalents Cashflow to Debt Equivalents Debt Equivalents Value Funds Provided by Equity Equivalents Payments to Equity Equivalents Cashflow to Equity Equivalents Equity Equivalents Value Invested Capital Income Statement Balance Sheet Reorganizing Statements Invested Capital NOPLAT Free Cash Flow Cashflow from Opera;ng Ac;vi;es Non Op Assets less Non Op Liabili;es Non Opera;ng Income Non Opera;ng Cashflow Cashflow from Non Opera;ng Ac;vi;es Total Funds Invested Total Income to Investors Cashflow to Investors Enterprise Value Reorganizing the Balance Sheet: Invested Capital •  The accountant’s balance sheet mixes operating and financing items. As ROIC measures operating performance, both the numerator (NOPLAT) and the denominator (invested capital) must separate operating items from financing structure in a consistent manner. •  Let’s first derive invested capital. We start with the primary accounting identity: Assets = Total Liabilities + Equity •  Next, separate operating assets (like property, plant, and equipment [PP&E]) from nonoperating assets (like equity investments), and separate operating liabilities (like accounts payable) from financial liabilities (like interest-bearing debt). Operating Nonoperating Operating + Debt + Equity + = Assets Assets Liabilities Reorganizing the Balance Sheet: Invested Capital •  By separating line items and rearranging the accounting identity, Operating Nonoperating = Operating + Debt + Equity + Assets Assets Liabilities •  We can create two new terms, invested capital and total funds invested: Operating Operating Nonoperating + + = Debt + Equity Assets Liabilities Assets Invested capital equals operating assets less operating liabilities. Total funds invested equals invested capital plus nonoperating assets. Total funds invested can also be measured by summing debt plus equity! Total Funds Invested Opera;ng Assets Non Opera;ng Assets Opera;ng Liabili;es Debt Equivalents Equity Equivalents Reorganizing the Balance Sheet: An Example •  Let’s rearrange the accountant’s balance sheet into invested capital and total funds invested for a simple company (i.e., a company with only few line items). Accountant's balance sheet Assets Inventory Net PP&E Equity investments Total assets Liabili1es and equity Accounts payable Interest ­bearing debt Common stock Retained earnings Total liabili;es and equity Invested capital Prior year 200 300 15 515 150 200 50 200 600 Prior year 200 (125) 75 Current year 225 (150) 75 Net PP&E Invested capital 125 225 50 115 515 Current year 225 350 25 600 300 375 350 425 Equity investments Total funds invested 15 390 25 450 Inventory Accounts payable Opera;ng working capital Reconcilia1on of total funds invested Interest ­bearing debt Common stock Retained earnings Total funds invested 225 50 115 390 200 50 200 450 Opera;ng liabili;es are nebed against opera;ng assets. Nonopera;ng assets are not included in invested capital. Invested Capital: Opera;ng Perspec;ve Operating Assets Operating assets include current operating assets (working cash, accounts receivable, inventory, prepaid expenses), along with PP&E and net other longterm operating assets. Include capitalized leases and R&D as operating assets. − Operating Liabilities = Operating liabilities include non-interest-bearing current liabilities; the most common are related to suppliers (accounts payable), employees (accrued salaries), customers (deferred revenue and customer advances), and the government (income taxes payable). Invested Capital + Nonoperating Assets Nonoperating assets include excess cash, marketable securities, notes receivable, prepaid pension assets, nonconsolidated subsidiaries, and other equity investments). = Total Funds Invested Total funds invested from an operating perspective. Why Separate Nonopera;ng Items? •  Evalua&on by parts: A good analysis will separate accounts with different performance characteris;cs. For instance, excess cash will typically have much lower returns than opera;ng businesses. Total Asset Base 14% 3% Core Operations 9% Unit A 17% Unit B Excess Cash 0% Equity Investments Nonoperating Assets Invested Capital Invested Capital Non operating Debt Assets •  Invested Capital –  –  –  –  Opera;ng Working Capital Net PPE Intangibles & Goodwill Net Other Long Term Assets •  Opera;ng long term assets less opera;ng long term liabili;es •  Non Opera;ng Assets –  –  –  –  –  –  Excess cash Illiquid investments Non consolidated subsidiaries Equity investments Pension assets Other non op assets Equivalents Equity Equivalents •  Debt Equivalents –  Short and long term debt –  Notes payable and commercial paper –  Unfunded re;rement liabili;es –  Opera;ng leases •  Equity Equivalents –  Common stock, paid ­in ­ capital, retained earnings –  Accumulated Other Comprehensive Income –  Treasury stock –  Deferred Taxes How Much Cash Is Excess Cash? Method 1 Excess of 2% of Revenues Comments Requires only firm-specific information, but doesn’t handle differences in firm characteristics or current market environment. Method 3: Regression Regression of Log(Cash/Noncash Assets) on Independent variable Intercept Market/book Real size Cash flow/assets Method 2 Excess of Industry Median or Average Working capital/assets Data intensive (requires data for many firms), but handles industry-specific characteristics and differences across time. Be careful—the average can be affected by an asset sale at an industry rival (industry average will rise following sale). Capital expenditures/assets Total debt/assets Beta T-Stat −1.921 82.89 0.137 27.11 −0.046 15.09 0.171 4.71 −0.754 29.04 0.570 8.77 −0.301 101.44 Industry cash flow volatility 0.106 1.77 R&D/sales 1.776 21.02 Dividend dummy −0.100 8.94 Regulation dummy −0.010 0.23 Number of observations 87,117 Adjusted R-squared 18.69% Source: T. Opler, L. Pinkowitz, R. Stulz, and R. Williamson, “Corporate Cash Holdings,” Journal of Applied Corporate Finance 14 (2001): 55−67. Invested Capital: Financing Perspec;ve Debt + Debt Equivalents + Equity + Equity Equivalents = Total Funds Invested Debt includes all interest-bearing debt from banks and public capital markets. Debt equivalents include off-balance-sheet debt and one-time debts owed to others that are not part of ongoing operations (e.g., severance payments as part of a restructuring, an unfunded pension liability, or expected environmental remediation following a plant closure). Equity includes original investor funds (common stock and additional paid-in capital, net of treasury stock repurchased), investor funds reinvested into the company (retained earnings and accumulated other comprehensive income), and investor funds to be paid out shortly (dividends payable). Equity equivalents include accounts that arise because of noncash adjustments to retained earnings; they are similar to debt equivalents but are not deducted from enterprise value to determine equity value (e.g., most deferredtax accounts and income-smoothing provisions). Total funds invested from a financing perspective. Reorganizing the Income Statement: NOPLAT •  Net operating profit less adjusted taxes (NOPLAT) is the after-tax operating profit available to all investors. •  NOPLAT equals revenues minus operating costs, less any taxes that would have been paid if the firm held only core assets and was financed only with equity. •  Unlike net income, NOPLAT includes profits available to both debt holders and equity holders. •  In order to calculate ROIC and free cash flow properly, NOPLAT should be defined consistently with invested capital. •  For instance, if a nonoperating asset is excluded from invested capital, any income from that asset should be excluded from NOPLAT. NOPLAT •  NOPLAT includes profits available to both debt and equity holders •  Interest is a payment to debt holders not an opera;ng cost •  NOPLAT excludes –  Non opera;ng income –  Gains/ losses on asset sales not included in invested capital •  NOPLAT adjusts taxes to an all equity financed, pure opera;ng company Reorganizing the Income Statement: NOPLAT •  NOPLAT includes only operating-based income. Unlike net income, interest expense and nonoperating income are excluded from NOPLAT. Accountant's income statement Revenues Opera;ng costs Deprecia;on Opera;ng profit Interest Nonopera;ng income Earnings before taxes (EBT) Taxes Net income NOPLAT Current year 1,000 (700) (20) 280 (20) 4 264 (66) 198 Revenues Opera;ng costs Deprecia;on Opera;ng profit Opera;ng taxes NOPLAT 1 Current year 1,000 (700) (20) 280 (70) 210 Taxes are calculated on opera;ng profits. ASer ­tax nonopera;ng income Income available to investors 3 213 Do not include income from any asset excluded from invested capital as part of NOPLAT. Reconcilia1on with net income Net income 1 ASer ­tax interest expense Income available to investors 198 15 213 Treat interest as a financial payout to investors, not an expense. Determining Opera;ng Taxes 1.  Find and convert the tax reconcilia&on table. Search the footnotes for the tax reconcilia;on table. For tables presented in dollars, build a second reconcilia;on table in percentages, and vice versa. Data from both tables are necessary to complete the remaining steps. 2.  Determine taxes for “all ­equity” company. Using the percent ­based tax reconcilia;on table, determine the marginal tax rate. Mul;ply the marginal tax rate by adjusted EBITA to determine marginal taxes on EBITA. 3.  Adjust “all ­equity taxes” for opera&ng tax credits. Using the dollar ­based tax reconcilia;on table, adjust opera;ng taxes by other opera;ng items not included in the marginal tax rate. The most common adjustment is related to differences in foreign tax rates. Opera;ng Taxes: Step 1 •  Start by conver;ng the reported tax reconcilia;on table to percentages. To convert a line item from dollars to percent, divide the line item by earnings before taxes ($3,590 million in 2008). Earnings before taxes are reported on the income statement. Tax reconcilia1on $ million Income taxes at statutory rate State income taxes, net of federal Foreign rate differences Other, net Reported taxes 2004 2,769 215 (17) (25) 2,911 2005 3,249 279 (10) (51) 3,444 2006 3,258 261 5 23 3,547 2007 2,317 196 − (103) 2,410 2008 1,257 92 − (71) 1,278 Earnings before taxes 7,912 9,282 9,308 6,620 3,590 Step 1: Reformat tax reconcilia1on table percent Income taxes at statutory rate State income taxes, net of federal Foreign rate differences Other, net Reported taxes Source: Home Depot 2008 10 ­K, note 6. 2004 35.0 2.7 (0.2) (0.3) 36.8 2005 35.0 3.0 (0.1) (0.5) 37.1 2006 35.0 2.8 0.1 0.2 38.1 2007 35.0 3.0 − (1.6) 36.4 2008 35.0 2.6 − (2.0) 35.6 Opera;ng Taxes: Step 2 •  Next, use the percentage ­based tax reconcilia;on table to determine the marginal tax rate. You can use the company’s statutory rate plus state or local taxes to calculate a proxy for the marginal rate. •  In 2008, Home Depot paid 37.6 percent in federal (35.0 percent) and state (2.6 percent) taxes. •  Use this marginal rate to compute taxes on adjusted EBITA. In 2008, taxes on adjusted EBITA equaled $1,820 million (37.6 percent ;mes $4,845 million in EBITA). Opera;ng Taxes: Step 3 •  ASer compu;ng taxes on adjusted EBITA, search the dollar ­based reconcilia;on table for other opera;ng taxes. For Home Depot, the only opera;ng taxes paid beyond marginal taxes were foreign rate differences. •  In 2006, foreign rate differences resulted in $5 million of addi;onal opera;ng taxes. Therefore, increase taxes on adjusted EBITA by $5 million to determine opera;ng taxes in 2006. Opera1ng taxes 2006 2007 2008 Marginal tax rate 37.7% 38.0% 37.8% 38.0% 37.6% 8,214 9,731 10,231 7,787 4,845 = Marginal taxes on EBITA Step 3 2005 × Adjusted EBITA Step 2 2004 3,098 3,698 3,868 2,956 1,820 5 − − 3,873 2,956 1,820 Other opera;ng taxes Opera;ng taxes (17) 3,081 (10) 3,688 Free Cash Flow •  Free cash flow is the after-tax cash flow available to all investors: debt holders and equity holders. Unlike “cash flow from operations” reported in a company’s annual report, free cash flow is independent of financing and nonoperating items. Accountant's cash flow statement Net income Deprecia;on Decrease (increase) in inventory Increase (decrease) in accounts payable Cash flow from opera;ons Capital expenditures Decrease (increase) in equity investments Cash flow from inves;ng Increase (decrease) in interest ­bearing debt Increase (decrease) in common stock Dividends Cash flow from financing Free cash flow Current year 198 20 (25) 25 218 (70) (10) (80) (25) − (113) (138) NOPLAT Deprecia;on Gross cash flow Current year 210 20 230 Decrease (increase) in inventory Increase (decrease) in accounts payable Capital expenditures Free cash flow (25) 25 (70) 160 Subtract investments in opera;ng items from gross cash flow. ASer ­tax nonopera;ng Income Decrease (increase) in equity investments Cash flow available to investors 3 (10) 153 Evaluate cash flow from nonopera;ng assets separately from core opera;ons. Reconcilia1on of cash flow available to investors ASer ­tax interest Increase (decrease) in interest ­bearing debt Increase (decrease) in common stock Dividends Cash flow available to investors 15 25 − 113 153 Treat interest as a financial payout to investors, not an expense. Advanced Issues Capitalizing Research and Development (R&D) •  If a company has significant long-term R&D, do not subtract the annual R&D expense. Instead, capitalize R&D on the balance sheet and subtract an annualized amortization of this capitalized R&D. Capitalizing Operating Leases •  If a company has significant operating leases, capitalized the operating leases on the balance sheet and add back lease-based interest to operating profit. Convert the remaining rental expense to depreciation. Excluding Recognized Pension Gains and Losses •  Pension gains and losses booked on the income statement are usually hidden within cost of goods sold. Remove any recognized gains or losses from NOPLAT. Unrecognized gains do not flow through the income statement, so no change is required for unrecognized gains. ...
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This note was uploaded on 12/04/2011 for the course ENGL 201 taught by Professor Unknown during the Spring '07 term at Central Mich..

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