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Horizontal and Vertical

Financial Analysis

Vertical analysis normalizes each statement by that particular


statements most important figure (with one exception, Cash Flows
one for which Vertical Analysis is futile). It is called vertical as it is a
comparison from within one year. For Income Statement, one
divides everything by that years sales. For Balance Sheet, figure to
divide by to normalize is Total Assets

Vertical analysis normalizes each statement by that particular


statements most important figure (with one exception, Cash Flows
one for which Vertical Analysis is futile). It is called vertical as it is a
comparison from within one year. For Income Statement, one
divides everything by that years sales. For Balance Sheet, figure to
divide by to normalize is Total Assets

There is so much one can say comparatively speaking - just by


looking at these two companies I/S
and B/S, side by side. Can you try to
describe some important
differences?

Source: Morningstar

Vertical analysis normalizes each statement by that particular


statements most important figure (with one exception, Cash Flows
one for which Vertical Analysis is futile). It is called vertical as it is a
comparison from within one year. For Income Statement, one
divides everything by that years sales. For Balance Sheet, figure to
divide by to normalize is Total Assets

There is so much one can say comparatively speaking - just by


looking at these two companies I/S
and B/S, side by side. Can you try to
describe some important
differences?
Among the most salient differences:
-Pepsis Gross Margin is 8% lower
-Pepsis appears more leveraged due
to higher INT Expense as % of sales
and due to higher Long Term Debt as
percentage of Total Assets
-Coca Cola appears to have a good
line of credit for short term borrowings, as its Short Term borrowing is
more than double that of Pepsis

Source: Morningstar

Horizontal analysis uses 1 year's worth of entries (i.e. each


individually, like Cash for baseline yr t=0, Inventory for baseline yr
t=0) as point of reference so that ensuing years are looked as
percentual differences relative to that baseline year (i.e. Casht=1
would be represented as percentage of Casht=0 like Casht=1 = 110%,
which means Casht=1=110% x Casht=0)

Horizontal analysis uses 1 year's worth of entries (i.e. each


individually, like Cash for baseline yr t=0, Inventory for baseline yr
t=0) as point of reference so that ensuing years are looked as
percentual differences relative to that baseline year (i.e. Casht=1
would be represented as percentage of Casht=0 like Casht=1 = 110%,
which means Casht=1=110% x Casht=0)

Example of extracting quick knowledge using horizontal analysis Balance Sheet Accounts
(such can be done with Income Statement and, less meaningfully, with Cash Flow Statement

100%

Accounts
Receivable
100%

PP&E

Goodwill
Long Term
Debt

Source: Morningstar

100%

100%

There is so much one can say comparatively speaking - just by


looking at these two companies I/S
and B/S, side by side. Can you try to
describe some important differences?

Horizontal analysis uses 1 year's worth of entries (i.e. each


individually, like Cash for baseline yr t=0, Inventory for baseline yr
t=0) as point of reference so that ensuing years are looked as
percentual differences relative to that baseline year (i.e. Casht=1
would be represented as percentage of Casht=0 like Casht=1 = 110%,
which means Casht=1=110% x Casht=0)

Example of extracting quick knowledge using horizontal analysis Balance Sheet Accounts
(such can be done with Income Statement and, less meaningfully, with Cash Flow Statement

100%

Accounts
Receivable
100%

PP&E

Goodwill
Long Term
Debt

Source: Morningstar

100%

100%

There is so much one can say comparatively speaking - just by


looking at these two companies I/S
and B/S, side by side. Can you try to
describe some important differences?
Given this analysis with a subset of
balance sheet accounts, we can infer:
-Both companies appear to have been
investing heavily and mirror each other
-Moreover, though both appear to be
have been similarly acquisitive (using
Goodwill data), Pepsi seems to have
spent more on internal/organic projects
(higher PP&E growth)
-Last point (higher organic investing due
to higher PP&E growth) can be considered as likelier when seen alongside
an A/R that went up too (as is the case
when new internal projects lunched)
- Turns out Pepsi has poured itself over
an internal division called Pepsi GNG,
which deals with nutritional goods

Financial Ratios, Value Multiples and


Fundamental Analysis
Differences and Relationships

Financial Ratios
(How well does this company Perform? How much does it rely on Leverage? Is the company
sufficiently Liquid to avert a last minute emergency (like an earthquake .. Ej. Toyota)?

Illustrative Financial Statements for Company X

What is the Invested Capital in a Business?


Viewed from IKs
vantage point

Invested Capital (IK) is the historical value (book value, not the market value) of capital that has been
Invested in company. With a little balance sheet rearrangement, we see that IK equals either Op. Cash +
A/R + Inv A/P STB + PPE + OLTA - OLTL or Equity + LTD Exc Cash. The latter (Equity+LTD-Exc Cash) is
quicker to calculate (when one needs to find IK) There is no need to tease out Equity  You use the total.
Contrast that with the Liabilities side, where you only use LTD

Summary of representative ratios and value multiples


Types of Ratios

1
Faster you convert your assets to
cash (or the longer the time
before you pay suppliers), the
better for your company b/c you
are using less resources to build
products. Youre more efficient

These Turnover ratios are


defined in annual terms!

Most Important Heuristics

A/R T.O.
[A/R]/Sales

Inv T.O.
[Inv]/Sales

2
The higher the profitability
ratios, the higher the amount
your company retains for every
dollar of sales

NI Margin
NI/Sales
EBIT Margin
EBIT/Sales
Gross Margin
[Sales-COGS]/Sales

Market Valuation Ratios

Liquidity Ratios

Leverage Ratios

These ratios measure the degree to


The higher the Market Valuation The higher the liquidity ratios, the which a company is leveraged and
the ratio is long term focused (it
Ratios, the higher the Value of the easier it should be for the company
Company (the Enterprise Value) to satisfy a short-term liability that looks at things payable after 1 year).
This ratio can be calculated at book
comes due within a year or the
value (very misleading) and at
easier to deal with emergencies
Market Value (very indicative)

EBITDAX =

EBITX

SALESX =

EV
EBITDA

EV
EBIT

EV
SALES

Current = CA / CL
Ratio
Quick = [CA-Inv] / CL
Ratio

Book Leverage =
DB
DB + EB

Cash = [Cash + M/S] / CL


Ratio
Market Leverage =
DM
DM + EM

A/P T.O.
[A/P]/Sales

ST/LT = Short Term / Long Term


SE = Equity Book Value (Stockholders Equity)
M/S = Marketable Securities (cash-like)
LTD = Long Term Debt
OLTL = Other LT Liabs
FA = Fixed Assets (PPE)
CA = All Current Assets
CL = All Current Liabilities
OLTA = Other LT Assets
A/R = Accounts Receivable
A/P = Accountas Payable
Inv = Inventory
Supp Purch = Supplier Purchases

Inv. Capital=IK CA-CL+PPEnet+OLTA-OLTL = LTD + SE

P-to-B X = EM = Ps
SE
SE/#sh

Interest =
Coverage

M/S = Marketable Securities


convertible to cash anytime
Inv = Inventory

EBIT
Interest

DB = LTD
EB = SE
EM = # shares x Pstock or Market Cap

Performance (How Profitable and Efficient is a company?)


Performance

-[(COGS + SG&A) DEP]


Tax effect

(1-T)

EBIT
S

Profit
Margin

ROIC
inorganico

EBIT
SALES

ROIC
orgnico

SALES
Q
Efficiency

(1 - GWDef )

Sales
IK-GW

PPEnet+OLTA+CA
IK-GW
OLTL + CL

Performance
Performance
(How Profitable and Efficient is a company?)
TBD
Profitability and Efficiency

Can I lower expenses?

If PPE goes
up, Dep too!

-[(COGS + SG&A) DEP]


Tax effect

Profit
Margin

ROIC
inorganico

(1-T)

EBIT

EBIT
SALES

ROIC
orgnico

Goodwill
deflator
GWDef = GW
IK

How fast are Sales Growing?

Can we increase prices?

SALES
Q
TBD Sales
Efficiency
IK-GW

(1 - GWDef )

Can I sell to new customers?


Sell more to current customers?

PPEnet+OLTA+CA
IK-GW
OLTL + CL

Are we converting
CAs to cash
fast enough?

Can we lower our IK by


using providers as
short term lenders?

This makes my IK lower, but


how does this Liability take
away Fin or Op flexibility

LTD + TE GW Exc Cash = IK-GW = Op. Cash + CA CL + PPEnet + OLTA OLTL

Examine the CAs and CLs


using Turnover (TO) ratios
and
Ratios

Leverage Liquidity
Liquidity

Leverage
LTD = Book Leverage = 1 - E
IK
LTD + TE

This is the % measure


that you use to weightaverage your WACC

Dm = Capital structure
Dm + Em

EBIT
INT

Considers coverage on
Debt interest

EBIT
INT+Pr

Considers coverage on Debt


Principal + Debt Interest

CA
CL

Considers how much your


CAs cover your CLs 1-to-1

CA-INV
CL

Considers how much your CAs


(exc. Invs that might not sell)
can cover your CLs 1-to-1

Leverage Liquidity
Liquidity

LTD = Book Leverage = 1 - E


IK
LTD + TE

Ability to satisfy debt


over long horizon

(Book)

Leverage

Leverage

Dm = Capital structure
Dm + Em

How much of what I have invested


has come from bondholders?

Ability to cover your short term


liabilities during catastrophe

(Market)

Leverage

This is the % measure


that you use to weightaverage your WACC

EBIT
INT

Considers coverage on
Debt interest

EBIT
INT+Pr

Considers coverage on Debt


Principal + Debt Interest

CA
CL

Considers how much your


CAs cover your CLs 1-to-1

CA-INV
CL

Considers how much your CAs


(exc. Invs that might not sell)
can cover your CLs 1-to-1

If I enter a crisis, would I be able to


pay the senior claims or would I
require a fire sale to pay them?

All are
Financial Ratios

Linking

Performance
Profitability and Efficiency

and

Unifying concept:
g* = Sustainable
growth rate

Leverage
(Book)

All are
Financial Ratios

Linking

Performance
Profitability and Efficiency

and

Leverage
(Book)

Unifying concept:
g* = Sustainable
growth rate
(Lectures 5 and 6)

g*= Maximum growth that is possible without needing to issue new stock

g* =

PM x Eff x Fl x (1-d)
1 (PM x Eff x FL x (1-d))
,where d = 1

NI Div
EBIT x (1 T)

g* is higher if you increase your profit margin (PM) or efficiency (Eff) or if you lever your company more (FL)
EBIT
SALES

Sales
IK

IK
E

Value Multiples
(How valuable is this company?)

Value Multiples Financial Ratios


Value Multiples
While several value multiples exist, the
ones shown below are certainly the best
to compare your firm to others
EBITx = EV
EBIT

Considers sales,
margins & CAPex

EBITDAx =

EV
EBITDA

Considers margins
And sales

SALESx =

EV
SALES

Considers sales

Value Multiples Financial Ratios


Value Multiples
While several value multiples exist, the
ones shown below are certainly the best
to compare your firm to others

Rationale of
Value multiples
EBITDAx

EBITx = EV
EBIT

Considers sales,
margins & CAPex

Pepsi
11.8x

EBITDAx =

EV
EBITDA

Considers margins
And sales

SALESx =

EV
SALES

Considers sales

Coke
14.5x

Coke is valued higher for every dollar


of EBITDA generated than Pepsi.
This can be due to higher FCFs,
higher growth, lower WACC
or a mix of all!

Value Multiples Financial Ratios


Value Multiples
While several value multiples exist, the
ones shown below are certainly the best
to compare your firm to others

Rationale of
Value multiples
EBITDAx

EBITx = EV
EBIT

Considers sales,
margins & CAPex

Pepsi

Coke

11.8x

EBITDAx =

EV
EBITDA

Considers margins
And sales

SALESx =

EV
SALES

Considers sales

14.5x

Coke is valued higher for every dollar


of EBITDA generated than Pepsi.
This can be due to higher FCFs,
higher growth, lower WACC
or a mix of all!
WHY?
EV
EBITDA

Em + Dm
EBITDA

FCFo x (1+g)
(Rwacc g)
EBITDA

Value Multiples Financial Ratios


Value Multiples
While several value multiples exist, the
ones shown below are certainly the best
to compare your firm to others

Rationale of
Value multiples
EBITDAx

EBITx = EV
EBIT

Considers sales,
margins & CAPex

Pepsi

Coke

11.8x

EBITDAx =

EV
EBITDA

Considers margins
And sales

SALESx =

EV
SALES

Considers sales

14.5x

Coke is valued higher for every dollar


of EBITDA generated than Pepsi.
This can be due to higher FCFs,
higher growth, lower WACC
or a mix of all!
WHY?
EV
EBITDA

Em + Dm
EBITDA

FCFo x (1+g)
(Rwacc g)
EBITDA

Fundamental
Analysis
Deuda Libro

Deuda
Largo Plazo
Equity Libro

Patrimonio
Patrimonio

$ invertido por compaias

Fundamental
Analysis
Deuda Libro

Deuda
Largo Plazo
Equity Libro

Patrimonio
Patrimonio

$ invertido por compaias

Fundamental
Analysis
Deuda Libro

Deuda
Largo Plazo

Deuda
Mercado

Equity Libro

Patrimonio
Patrimonio

Equity
Mercado

$ invertido por compaias

Fundamental
Analysis
Cuanto vale la Deuda y el
Patrimonio en el Mercado?
Deuda Libro

Deuda
Largo Plazo

Deuda
Mercado

Equity
Mercado

Equity Libro

Patrimonio
Patrimonio

$ invertido por compaias

Fundamental
Analysis
Deuda Libro

Deuda
Largo Plazo

Deuda
Mercado

Equity Libro

Patrimonio
Patrimonio

Equity
Mercado

$ invertido por compaias

Fundamental
Analysis
Deuda Libro

DB

Deuda
Largo Plazo
Equity Libro

EB

Patrimonio
Patrimonio

Valor Economico de Instrumentos

DM

(que es igual al valor economico de la empresa)

Deuda
Mercado
compare

EM

Equity
Mercado

 Para calcular el valor de esos instrumentos, se usa la teoria de Finanzas Corporativas

$ invertido por compaias

Fundamental
Analysis
Valor Economico de Instrumentos

Deuda Libro

DB

DM

Deuda
Largo Plazo

(que es igual al valor economico de la empresa)

Deuda
Mercado
compare

Equity Libro

EB

EM

Patrimonio

Equity
Mercado

Patrimonio

Ganancias Operativas antes de Intereses y Taxes

FCF = Flujo de Caja Libre = EBIT x (1-T) + Depreciacion Inversiones Incrementos de Capital Trabajo
Rwacc

= El promedio de Costo de Capital de TODOS los inversionistas = Re x Em + Rd x (1-T) x Dm


Em+Dm
Em+Dm
Re = Riesgo Libre + Beta Equity x (Prima Mercado)

Re = Riesgo Libre + Corporate Spread

Fundamental
Analysis

Cuando el crecimiento de los flujos de caja son constantes,


esta formula (lado derecho) es muy util para acelerar los calculos

Your
Opinion

Markets
Opinion

DM+EM

<

Fundamental
Analysis

= Buy stock

Value
Multiples

>

Fundamental
Analysis

= Sell stock

Value
Multiples

Fundamental
Analysis

Value
Multiples

Indifferent

Value
Multiples
Profitability

Efficiency

Leverage
(Book)

Liquidity

Leverage
(Market)

Fundamental
Analysis

Reliance on Debt to
support business

Performance

Economic
Value expected
of Company

Ability
to weather
bad surprises

Profitability

Efficiency

Leverage
(Book)

Liquidity

Value
Multiples

Leverage
(Market)

Fundamental
Analysis

Unifying concept:
g* = Sustainable
growth rate
(Lectures 5 and 6)

Value
Multiples

Financial Ratios

Reliance on Debt to
support business

Performance

Economic
Value expected
of Company

Ability
to weather
bad surprises

Profitability

Efficiency

Leverage
(Book)

Liquidity

Value
Multiples

Leverage
(Market)

Fundamental
Analysis

Unifying concept:
g* = Sustainable
growth rate
(Lectures 5 and 6)

A mix of
the two

Financial Ratios

Reliance on Debt to
support business

Performance

Value
Multiples

Economic
Value expected
of Company

Ability
to weather
bad surprises

Profitability

Efficiency

Leverage
(Book)

Liquidity

Value
Multiples

Leverage
(Market)

Fundamental
Analysis

Unifying concept:
g* = Sustainable
growth rate
(Lectures 5 and 6)

A mix of
the two

Financial Ratios

Reliance on Debt to
support business

Performance

Value
Multiples

Economic
Value expected
of Company

Ability
to weather
bad surprises

Profitability

Efficiency

Leverage
(Book)

Liquidity

Markets
Opinion

Value
Multiples

Leverage
(Market)

Your
Opinion

Fundamental
Analysis

Unifying concept:
g* = Sustainable
growth rate
(Lectures 5 and 6)

Note: A company could have great performance but poor prospects


(Ex. Blackberry)

APPENDIX

In spite their popularity, why did we


leave aside Performance ratios like
ROA and ROE, in favor of ROIC?

But what about ROA and ROE as measures of profitability??????

Lets consider ROA =


This figure has a few problems. While helpful, it has the following two issues:
- In its denominator, it includes things that are double counted
- Remember that Total Assets (TA) = Total Liabilities (TL) + Total Equity (TE)
- In here, you are dividing by Total Assets, which means TL + TE .
- TE part is OK, but TL is the sum of CL, LTD and OLTL instead of just LTD !!!
More problems: this financial ratio has as its numerator a figure that is affected by the
quantity of financing:
- The more debt, the higher its Interest Expense, the lower its Net Income
- Remember that Net Inc = Sales COGS Other Expenses Interest Expense Taxes

The above comments make this figure less useful for comparing between companies. Two
exact companies, selling the same exact amount, could have very different levels of Interest
Expense (one borrows more than the other one). It also has (as noted above) a denominator
which includes more than what were investing.

DO YOU SEE THE CHALLENGE OF USING THIS AS A RELIABLE COMPARISON FIGURE?

But what about ROA and ROE as measures of profitability??????

Lets consider ROE =


This figure has a few problems too. While helpful, it has following two issues:
- In its denominator, dividing by Shareholders Equity ignores that there is other capital
(Long Term Debt) that is ALSO helping the company finance its new projects
- Remember that, at least, Total Assets in ROA included LTD while ROE ignores LTD
altogether (though TA includes more than LTD, is better than just Equity)
More problems: this financial ratio has as its numerator a figure that is affected by the
quantity of financing (same as before):
- The more debt, the higher its Interest Expense, the lower its Net Income
- Remember that Net Inc = Sales COGS Other Expenses Interest Expense Taxes

Once again, the above comments make this figure less useful for comparing companies. Two
exact companies, selling the same exact amount, could have very different levels of Interest
Expense (one borrows more than the other one). It also has (as noted above) a denominator
which ignores the fact that there is more capital (in the form of Long Term Debt) that might
be in use alongside equity to invest.
DO YOU SEE THE CHALLENGE OF USING THIS AS A RELIABLE COMPARISON FIGURE?

Note: There are few exceptions where using ROE is better than the alternative. One such exception is to use ROE for financial services (banks) companies. Notwithstanding, this is beyond the scope of the course.

What is the alternative?

ROIC = EBIT x (1-T)


IK
.. where IK = SE + LTD

ROIC IS the alternative

ROIC = EBIT x (1-T)


IK
.. where IK = SE + LTD

ROIC IS the alternative


- ROICs numerator uses profitability figure which is NOT yet affected by Interest Expense
- ROICs denominator uses STRICTLY (without double counting) the actual invested capital
Conclusion: Of all the widely used profitability ratios, please make sure you always consider this class, so
you can discriminate against many, and so you can favor ROIC. ROIC Allows you to compare companies of
different capital structure (different levels of debt) and is consistent on both the numerator and
denominator sense. Isnt that great?
An interesting kink: If two companies are similar but one started a century ago and one started 10 years
ago, the average Invested Capital of the newer company will be higher (because the older companys IK
started long time ago Even ROIC is not totally perfect)

Can we adapt Dupont to ROIC?

ROIC as more than just a ratio: The DuPont Model (starting with ROE)
Originally, the DuPont Model was developed using ROE

ROIC as more than just a ratio: The DuPont Model (starting with ROE)
Originally, the DuPont Model was developed using ROE
Shareholders equity as recorded on balance sheet

ROE = NI/ SE

= [NI/ Sales] x [Sales / Tot Assets] x [(Tot Assets)/SE]

But, remember that LTD + SE equals IK, which stands for Invested Capital
ROE = NI/ SE

[NI/ Sales]

x [Sales / Tot Assets]

ROE

[Net Inc Margin] x

[Assets Turnover]

x [ Tot Assets / SE]


x [Equity Multiplier]

ROIC as more than just a ratio: The DuPont Model (starting with ROE)
Originally, the DuPont Model was developed using ROE
Shareholders equity as recorded on balance sheet

ROE = NI/ SE

= [NI/ Sales] x [Sales / Tot Assets] x [(Tot Assets)/SE]

But, remember that LTD + SE equals IK, which stands for Invested Capital
ROE = NI/ SE

[NI/ Sales]

x [Sales / Tot Assets]

ROE

[Net Inc Margin] x

[Assets Turnover]

x [ Tot Assets / SE]


x [Equity Multiplier]

With this re-composition of ROE, you can compare 2 companies with each other and can actually
see, even if the 2 companies have equal ROEs, whats different between them
Now, we know that ROE is distorted by capital financing artifacts (Net Inc has the effects of
financing). Even considering the Equity Multiplier effect as a separate contributor to ROE, Total
Assets includes more than what we want (it is not strictly Invested Capital!!!)

ROIC as more than just a ratio: The DuPont Model (adapting it to ROIC)
Originally, the DuPont Model was developed using ROE
Shareholders equity as recorded on balance sheet

ROE = NI/ SE

= [NI/ Sales] x [Sales / Tot Assets] x [(Tot Assets)/SE]

But, remember that LTD + SE equals IK, which stands for Invested Capital
ROE = NI/ SE

[NI/ Sales]

x [Sales / Tot Assets]

ROE

[Net Inc Margin] x

[Assets Turnover]

x [ Tot Assets / SE]


x [Equity Multiplier]

With this re-composition of ROE, you can compare 2 companies with each other and can actually
see, even if the 2 companies have equal ROEs, whats different between them
ROIC = EBIT(1-T)/ IK
Now, we know that ROE is distorted by capital financing artifacts (Net Inc has the effects of
financing). Even= considering
the
Equity
Multiplier effect
separate
ROIC
[EBIT
x (1-T)
/ Sales]
x as a[Sales
/ IK]contributor
x
1 to ROE, ROE is
still saddled by the very core of its weakness: it still remains ROE!

ROIC as more than just a ratio: The DuPont Model (adapting it to ROIC)
Originally, the DuPont Model was developed using ROE
Shareholders equity as recorded on balance sheet

ROE = NI/ SE

Long Term Debt, as recorded on balance sheet

= [NI/ Sales] x [Sales / Tot Assets] x [(Tot Assets)/SE]

But, remember that LTD + SE equals IK, which stands for Invested Capital
ROE = NI/ SE

[NI/ Sales]

x [Sales / Tot Assets]

ROE

[Net Inc Margin] x

[Assets Turnover]

x [ Tot Assets / SE]


x [Equity Multiplier]

With this re-composition of ROE, you can compare 2 companies with each other and can actually
see, even if the 2 companies have equal ROEs, whats different between them
ROIC = EBIT(1-T)/ IK
Now, we know that ROE is distorted by capital financing artifacts (Net Inc has the effects of
financing). Even= considering
the
Equity
Multiplier effect
separate
ROIC
[EBIT
x (1-T)
/ Sales]
x as a[Sales
/ IK]contributor
x
1 to ROE, ROE is
still saddled by the very core of its weakness: it still remains ROE!
ROIC

= [After Tax Operating Inc Margin]


A measure of Profitability
Margin that is not affected
by Interest Expenses

[ Efficiency ]

A truer measure of how efficient


is the company to generate sales
(how many resources does it take
to generate a sale)

1
In ROIC, we dont
need Equity multiplier,
as we are evaluating
returns based on
whole invested
capital

ROIC as more than just a ratio: The DuPont Model (adapting it to ROIC)
Originally, the DuPont Model was developed using ROE
Shareholders equity as recorded on balance sheet

ROE = NI/ SE

Long Term Debt, as recorded on balance sheet

= [NI/ Sales] x [Sales / Tot Assets] x [(Tot Assets)/SE]

But, remember that LTD + SE equals IK, which stands for Invested Capital
ROE = NI/ SE

[NI/ Sales]

x [Sales / Tot Assets]

ROE

[Net Inc Margin] x

[Assets Turnover]

x [Tot Assets / SE]


x [Equity Multiplier]

With this re-composition of ROE, you can compare 2 companies with each other and can actually
see, even if the 2 companies have equal ROEs, whats different between them
ROIC = EBIT(1-T)/ IK
Now, we know that ROE is distorted by capital financing artifacts (Net Inc has the effects of
financing). Even= considering
the
Equity
Multiplier effect
separate
ROIC
[EBIT
x (1-T)
/ Sales]
x as a[Sales
/ IK]contributor
x
1 to ROE, ROE is
still saddled by the very core of its weakness: it still remains ROE!
ROIC

= [After Tax Operating Inc Margin]


A measure of Profitability
Margin that is not affected
by Interest Expenses

[ Efficiency ]

A truer measure of how efficient


is the company to generate sales
(how many resources does it take
to generate a sale)

1
In ROIC, we dont
need Equity multiplier,
as we are evaluating
returns based on
whole invested
capital

ROIC as more than just a ratio: The DuPont Model (adapting it to ROIC)
Originally, the DuPont Model was developed using ROE
Shareholders equity as recorded on balance sheet

Long Term Debt, as recorded on balance sheet

ROE = NI/ SE = [NI/ Sales] x [Sales / Tot Assets] x [(Tot Assets)/SE]


ROIC = EBIT(1-T)/ IK
But, remember that LTD + SE equals IK, which stands for Invested Capital
ROIC
=
[EBIT x (1-T) / Sales]
x
[Sales / IK]
ROE = NI/ SE =
[NI/ Sales] x [Sales / Net Assets] x [Total Assets / SE]
ROIC
= [After Tax Operating Inc Margin] x [ Efficiency ]
ROE
= [Net Inc Margin] x [Assets Turnover]
x [Equity Multiplier]

With this re-composition of ROE, you can compare 2 companies with each other and can actually
see, even if the 2 companies have equal ROEs, whats different between them
Now, we know that ROE is distorted by capital financing artifacts (Net Inc has the effects of
financing). Even considering the Equity Multiplier effect as a separate contributor to ROE, ROE is
still saddled by the very core of its weakness: it still remains ROE!

ROIC as more than just a ratio: The DuPont Model (adapting it to ROIC)
Originally, the DuPont Model was developed using ROE
Shareholders equity as recorded on balance sheet

Long Term Debt, as recorded on balance sheet

ROE = NI/ SE = [NI/ Sales] x [Sales / Tot Assets] x [(Tot Assets)/SE]


ROIC = EBIT(1-T)/ IK
But, remember that LTD + SE equals IK, which stands for Invested Capital
ROIC
=
[EBIT x (1-T) / Sales]
x
[Sales / IK]
ROE = NI/ SE =
[NI/ Sales] x [Sales / Net Assets] x [Total Assets / SE]
ROIC
= [After Tax Operating Inc Margin] x [ Efficiency ]
ROE
= [Net Inc Margin] x [Assets Turnover]
x [Equity Multiplier]

With this re-composition of ROE, you can compare 2 companies with each other and can actually
see, even if the 2 companies have equal ROEs, whats different between them

OUR REVISED DUPONT MODEL

Now, we know that ROE is distorted by capital financing artifacts (Net Inc has the effects of
financing). Even considering the Equity Multiplier effect as a separate contributor to ROE, ROE is
still saddled by the very core of its weakness: it still remains ROE!

ROIC as more than just a ratio: The DuPont Model (adapting it to ROIC)

ROIC = EBIT(1-T)/ IK
ROIC

[EBIT x (1-T) / Sales]

ROIC

= [After Tax Operating Inc Margin]

[Sales / IK]

[ Efficiency ]

OUR REVISED DUPONT MODEL


Example of using DuPont Model
Company X with ROIC = 15%

Competitor of Company X, also with ROIC = 15%

ROIC as more than just a ratio: The DuPont Model (adapting it to ROIC)

ROIC = EBIT(1-T)/ IK
ROIC

[EBIT x (1-T) / Sales]

ROIC

= [After Tax Operating Inc Margin]

[Sales / IK]

[ Efficiency ]

OUR REVISED DUPONT MODEL


Example of using DuPont Model
Company X with ROIC = 15%
EBIT x (1-T)/Sales = 30%
Sales/(Invested Capital) = 0.5
EBIT x (1-T)/Sales x Sales/(Inv. Capital) = 15%

Competitor of Company X, also with ROIC = 15%


EBITx(1-T)/Sales = 50%
Sales/(Invested Capital) = 0.3
EBIT x (1-T)/Sales x Sales/(Inv. Capital) = 15%

ROIC as more than just a ratio: The DuPont Model (adapting it to ROIC)

ROIC = EBIT(1-T)/ IK
ROIC

[EBIT x (1-T) / Sales]

ROIC

= [After Tax Operating Inc Margin]

[Sales / IK]

[ Efficiency ]

OUR REVISED DUPONT MODEL


Example of using DuPont Model
Company X with ROIC = 15%
EBIT x (1-T)/Sales = 30%
Sales/(Invested Capital) = 0.5
EBIT x (1-T)/Sales x Sales/(Inv. Capital) = 15%

Competitor of Company X, also with ROIC = 15%


EBITx(1-T)/Sales = 50%
Sales/(Invested Capital) = 0.3
EBIT x (1-T)/Sales x Sales/(Inv. Capital) = 15%

With the DuPont model, we can say that, in spite of both companies having same ROIC, Company X has lower After Tax
Operating Income margin, but makes up the difference with respect to competitor by generating more sales for every dollar of
capital invested (in other words, it has lower profitability margin but is more efficient than its competitor!)

There is another misunderstood


couple of ratios we shall clarify:

There is another misunderstood


couple of ratios we shall clarify:
Leverage Ratios
(should we use book or market values?)

What about determining how leveraged (apalancamiento) a company is?

When we talk about Leverage Ratios, we think of Long Term Debt as % of Enterprise Value
Why?

What about determining how leveraged (apalancamiento) a company is?

When we talk about Leverage Ratios, we think of Long Term Debt as % of Enterprise Value
Why? Lets examine this ratio (and see why Market vs. Book Value) through an example

What about determining how leveraged (apalancamiento) a company is?

When we talk about Leverage Ratios, we think of Long Term Debt as % of Enterprise Value
Why? Lets examine this ratio (and see why Market vs. Book Value) through an example
What does this
ratio appear to tell
us?

Calculation

CL
CA

LTD
LTD + SE

0.95

1.04

24,283
25,497

18,154
17,441

30%

13,656
13,656+31,635

DM
DM+ EM

50%

20,568
20,658+20,745

7%

15%

13,656
13,656+177,690

20,568
20,568+114,120

Source: Morningstar and YahooFinance

What is the problem with this ratio


to measure Leverage?

What about determining how leveraged (apalancamiento) a company is?

When we talk about Leverage Ratios, we think of Long Term Debt as % of Enterprise Value
Why? Lets examine this ratio (and see why Market vs. Book Value) through an example
What does this
ratio appear to tell
us?

Calculation

CL
CA

LTD
LTD + SE

0.95

1.04

24,283
25,497

18,154
17,441

30%

13,656
13,656+31,635

DM
DM+ EM

50%

However, when looking at


only the long term capital
portions (LTD and SE), we
find that Pepsi is 1.6 times
more leveraged than Coke

20,568
20,658+20,745

7%

15%

13,656
13,656+177,690

20,568
20,568+114,120

Source: Morningstar and YahooFinance

Using this Quick Ratio,


which is a short-term ratio,
we are initially led to believe
the company is similarly
leveraged

But when we look at the


true market values (using
LTD ~ DM, because for big
and solvent companies this
is the case), Pepsi is 2 (twice)
more leveraged than Coke!

What is the problem with this ratio


to measure Leverage?

What about determining how leveraged (apalancamiento) a company is?

When we talk about Leverage Ratios, we think of Long Term Debt as % of Enterprise Value
Why? Lets examine this ratio (and see why Market vs. Book Value) through an example
What does this
ratio appear to tell
us?

Calculation

CL
CA

LTD
LTD + SE

0.95

1.04

24,283
25,497

18,154
17,441

30%

13,656
13,656+31,635

DM
DM+ EM

50%

This ratio is focused on Current Assets and


Using this Quick Ratio,
Current Liabilities. Thus, it is not a measure
which is a short-term ratio,
we are initially led to believe of long term leverage (is actually a measure of
liquidity, as noted earlier)
the company is similarly
leveraged

However, when looking at


only the long term capital
portions (LTD and SE), we
find that Pepsi is 1.6 times
more leveraged than Coke

This ratio is a better measure of long term


leverage . However, it ignores fact that capital
that has been raised/invested by companies
may be more or less valuable than its historical
value (What if my company has grown
tremendously since inception and has great
prospects? Would book value be good then?

20,568
20,658+20,745

7%

15%

13,656
13,656+177,690

20,568
20,568+114,120

Source: Morningstar and YahooFinance

What is the problem with this ratio


to measure Leverage?

But when we look at the


true market values (using
LTD ~ DM, because for big
and solvent companies this
is the case), Pepsi is 2 (twice)
more leveraged than Coke!

.. but using market values to estimate the


leverage ratio of the company is the best way
to gauge the leverage of the company (If the
economic activity today is substantially more,
by using Dm and Em to estimate leverage, we
make sure we assess leverage more attuned
with the economics of the business (because
that is more informative than book values)

What about determining how leveraged (apalancamiento) a company is?

When we talk about Leverage Ratios, we think of Long Term Debt as % of Enterprise Value
Why? Lets examine this ratio (and see why Market vs. Book Value) through an example
What does this
ratio appear to tell
us?

Calculation

CL
CA

LTD
LTD + SE

0.95

1.04

24,283
25,497

18,154
17,441

30%

13,656
13,656+31,635

DM
DM+ EM

50%

This ratio is focused on Current Assets and


Using this Quick Ratio,
Current Liabilities. Thus, it is not a measure
which is a short-term ratio,
we are initially led to believe of long term leverage (is actually a measure of
liquidity, as noted earlier)
the company is similarly
leveraged

However, when looking at


only the long term capital
portions (LTD and SE), we
find that Pepsi is 1.6 times
more leveraged than Coke

This ratio is a better measure of long term


leverage . However, it ignores fact that capital
that has been raised/invested by companies
may be more or less valuable than its historical
value (What if my company has grown
tremendously since inception and has great
prospects? Would book value be good then?

20,568
20,658+20,745

7%

15%

13,656
13,656+177,690

20,568
20,568+114,120

Source: Morningstar and YahooFinance

What is the problem with this ratio


to measure Leverage?

But when we look at the


true market values (using
LTD ~ DM, because for big
and solvent companies this
is the case), Pepsi is 2 (twice)
more leveraged than Coke!

.. but using market values to estimate the


leverage ratio of the company is the best way
to gauge the leverage of the company (If the
economic activity today is substantially more,
by using Dm and Em to estimate leverage, we
make sure we assess leverage more attuned
with the economics of the business (because
that is more informative than book values)

Soooooo, ratios are all good to quickly understand self and competition. However,
-Please be VERY careful using Profitability ratios that are affected by financing effects
- Using these type of distorted ratios makes it difficult to compare apples to apples
-When calculating Leverage Ratios (to see how much long term debt there is as % of total Enterprise
Value) please rely on market values versus book values (historical figures):
-Using book value figures blatantly ignores that companies could have raised lots of capital that
today, as things may have turned out, may be worth more or less than
- The Invested Capital may have led to great value creation since first raised and, as such,
companies can actually be less leveraged than historical data suggests
-Yet, calculating market leverage ratios is not possible when companies are not public

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