Ratio Analysis

Framework for Business Analysis and Valuation

STEP 1 Understanding the Past
1. Information Collection 2. Understanding the Business 3. Accounting Analysis 4. Financial Ratio Analysis 5. Cash Flow Analysis

STEP 2 Forecasting the Future

1. Structured Forecasting 2. Income Statement Forecasts 3. Balance Sheet Forecasts 4. Cash Flow Forecasts

STEP 3 Valuation
1. Cost of Capital 2. Valuation Models
Residual Income-Based Valuation Cash Flow-Based Valuation

3. Valuation Ratios 4. Complications

Negative Values Value Creation and Destruction though Financing Transactions

Overview of Ratio Analysis

Techniques Caveats Decision Context Dupont Framework Factors Influencing Margin Versus Turnover Trade-Off

Interactive Case Using eVal

Techniques of Ratio Analysis

Time-Series Analysis: Comparing a firms ratios across time

Facilitates the identification of changes in performance and the detection of the underlying causes

Cross-Sectional Analysis (comps): Comparing a firms ratios with the ratios of comparable firms

Facilitates the identification of differences in performance and the detection of the underlying causes

Three Caveats of Ratio Analysis

There is no generally accepted set of rules for computing ratios Ratios do not provide answers, they just help direct you in your search for answers Managers know that investors fixate on certain ratios, and many window-dress accordingly

Decision Context: The Key Drivers of Value

ROE

Create value by generating long-run ROE that exceeds r Business strategy and competitive environment Accounting distortions affect short-run ROE

Growth in Equity

Magnifies value created by ROE If ROE>r, then growth creates value If ROE<r, then growth destroys value

Basic Dupont Framework

Return on Equity (Income/Equity)

Net Profit Margin x Asset Turnover x (Income/Sales) x (Sales/Assets) x

Total Leverage (Assets/Equity)

detailed margin analysis

detailed detailed solvency turnover analysis and liquidity anlysis

Advanced Dupont Framework

Return on Equity (Income/Equity)

RNOA + ( Spread x Financial Leverage ) (NOI/NOA) (RNOA (1-t).i) (Debt/Equity) __________________ Net Operating Margin x NOA Turnover (NOI/Sales) (Sales/NOA) detailed margin analysis detailed detailed solvency turnover analysis and liquidity analysis

The Margin versus Turnover TradeOff

35% 30%

Profit Margin

25% 20% 15% 10% 5% 0% 0 1 2 3 4 5 6 7 8 9 10 11 Turnover ROE=10% ROE=20%

Factors Influencing the Margin vs. Turnover Trade-Off

Lower turnover (and higher margins) result from:

industry-wide production technology that requires significant capital investment following a product differentiation versus a cost leadership strategy

following a vertical integration versus an outsourcing strategy

Ratio Analysis in eVal

Start eVal Click View Ratio Analysis button

time-series analysis

Go to Data Center Sheet, sort by Industry, and load competitors or industry composites

cross-sectional analysis

Interactive Case: Task 1

Identify an example of an industry that operates with low turnover ratios and high margins and another example of an industry that operates with high turnover ratios and low margins. In each case, explain the features of the industrys production technology that lead to these ratios.

Interactive Case: Task 2

Identify an example of a product differentiator and an example of a cost leader within a particular industry. In each case, try to select an example where the strategy is appropriately reflected in the turnover ratios.

Interactive Case: Task 3

Identify an example of a vertical integrator and an example of an outsourcer within a particular industry. In each case, try to select an example where the strategy is appropriately reflected in the turnover ratios

Recap

Ratio analysis should take place within a clear decision context. Ratio analysis does not provide answers, it just helps guide your search for answers. Ratios should be interpreted in the context of the firms business environment Use of canned ratio analysis software simplifies ratio analysis BUT must know how ratios have been computed