443_6 - Applied Equity Analysis and Por3olio...

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Unformatted text preview: Applied Equity Analysis and Por3olio Management Lecture 6 Using ROIC to Compare Opera?ng Performance •  To measure historical operating performance, compute ROIC by comparing NOPLAT to invested capital: •  The ROIC at Home Depot outpaced Lowe’s by approximately five percentage points during the early 2000s. This gap disappeared in 2005, when Home Depot began acquiring other companies. Home Depot and Lowe's: Return on Invested Capital ROIC With or Without Goodwill? •  Compute ROIC both with and without goodwill and acquired intangibles, because each ra?o analyzes different things. CVS Caremark: Return on Invested Capital –  To measure aggregate value crea?on for the company’s shareholders, measure ROIC with goodwill. –  ROIC excluding goodwill measures the underlying opera?ng performance of the company and its businesses and is used to compare performance against peers and to analyze trends. Note: This presentation sometimes shortens goodwill and acquired intangibles to goodwill. Understanding Value Crea?on: Decomposing ROIC •  in 2008, Home Depot’s ROIC (8.0%) lagged Lowe’s ROIC (8.9%) by approximately one percentage point. •  But what is driving this drop in performance? •  Can these losses be recovered? •  To better understand ROIC, we can decompose the ratio as follows: Profit Margin Capital Efficiency •  As the formula demonstrates, a company’s ROIC is driven by its ability to (1) maximize profitability, (2) optimize capital efficiency, or (3) minimize taxes. This equation can be organized into a tree … Understanding Value Crea?on: Decomposing ROIC •  From a margin perspective, Home Depot’s operating margin was 6.8 percent versus 8.3 percent for Lowe’s. The lower operating margin is primarily attributable to higher selling, general, and administrative (SG&A ) expense. •  According to press reports, the rise in SG&A reflects the cost of additional floor personnel to improve the customer experience. Whether this translates to higher sales through better service in the future is a key to the company’s valuation. Home Depot and Lowe's: ROIC Tree, 2008 Gross margin Home Depot 33.7 percent Lowe's Opera&ng margin 34.2 1 SG&A /revenues Home Depot ROIC without goodwill ROIC with goodwill Home Depot 8.0 Lowe's 8.9 Lowe's Home Depot 8.3 Lowe's 9.1 Premium over book capital Home Depot 3.5 Lowe's 2.7 Home Depot 24.4 8.3 Lowe's 22.8 Deprecia&on/ revenues 13.3 Lowe's Home Depot Lowe's Pretax ROIC 6.8 14.6 Home Depot Opera&ng cash tax rate 2.5 Lowe's 3.2 Home Depot 37.4 Revenues / invested capital Lowe's 37.5 Home Depot 1.95 Opera&ng working capital/revenues 4.9 Home Depot Lowe's 1.77 Lowe's Fixed assets/revenues 46.4 Home Depot Lowe's 1 Implicit interest expense related to capitalized opera?ng leases has been removed from selling, general, and administra?ve (SG&A) expense. 4.0 52.5 Understanding Value Crea?on: Line Item Analysis   To complete a thorough analysis, each tree branch should examined separately over time and across competitors.   For operating current assets and liabilities, we can convert each line item into “days,” using the following formula: Home Depot and Lowe's: Operating Current Assets in Days Inventories have risen slightly at Lowe’s: from 85 to 94 days. Understanding Value Crea?on: Decomposing Growth •  Once revenues have been disaggregated, analyze revenue growth from an operational perspective. The most standard decomposition is: Home Depot and Lowe’s: Revenue Growth Analysis, 2008 percent Square feet/store Transac&ons/store Home Depot Revenues/store Home Depot Revenues Home Depot −7.9 Lowe's −0.1 −7.1 Lowe's −4.4 −9.5 Lowe's −6.5 Dollars/transac&on Home Depot Number of stores Home Depot 7.5 Lowe's Lowe's −0.5 0.0 Transac&ons/square foot Home Depot −6.0 Lowe's −4.4 −2.8 1.8 Lowe's −3.3 Home Depot •  Growth trees can be built using advanced versions of the decomposition formula presented above. •  How is Home Depot driving revenue growth? Credit Health and Capital Structure •  In the final step of historical analysis, focus on how the company has financed its operations. Ask: •  How is the company financed? That is, what proportion of invested capital (IC) comes from creditors versus equity holders? •  Is this capital structure sustainable? •  Can the company survive an industry downturn? •  To assess the aggressiveness of a company’s capital structure, examine: •  Liquidity—the ability to meet short-term obligations. We measure liquidity by examining the interest coverage ratio. •  Leverage—the ability to meet long-term obligations. Leverage is measured by computing the market-based debt-to-value ratio. Credit Health and Capital Structure— Liquidity •  The interest coverage ratio measures a company’s ability to meet short-term obligations: Home Depot: Measuring Interest Coverage $ million •  EBITDA/interest measures the ability to meet short-term financial commitments using profits, as well as depreciation dollars earmarked for replacement capital. •  EBITA/interest measures the ability to pay interest without having to cut expenditures intended to replace depreciating equipment. 2006 9,790 11,435 2007 7,251 8,944 2008 4,359 6,144 12,393 9,768 6,990 Interest Rental expense Interest plus rental expense 392 958 1,350 696 824 1,520 624 846 1,470 Coverage ra&os EBITA/interest EBITDA/interest EBITDAR/interest plus rental expense 25.0 29.2 9.2 10.4 12.9 6.4 7.0 9.8 4.8 EBITA EBITDA 1 EBITDAR 1 Earnings before interest, taxes, deprecia?on, amor?za?on, and rental expense. Credit Health and Capital Structure—Liquidity •  EBITDA interest coverage (?mes interest earned) is the most widely used ra?o for large companies with access to public capital markets. Yield to Maturity1 by Ra&ngs Class, 2009 Interest Coverage Ra&o Three ­Year (2005−2007) Medians 9.10 26.5 7.07 22.2 6.09 6.19 19.8 17.0 17.2 5.33 4.83 5.05 4.44 4.68 4.75 4.20 16.2 10.5 3.31 AAA AA+ AAA 9.44 AA A BBB BB B CCC AA AA− A+ A A− BBB+ BBB BBB− BB+ BB 1Monthly average of yields. •  Although interest coverage is the primary driver of a company’s ra?ng, it is not the only driver. Other drivers include capital intensity, debt to value, among others. ...
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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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