CHAPTER TWELVE

McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
 Prepared by: Stephen H. Penman – Columbia University
With contributions by
Nir Yehuda – Northwestern University
Mingcherng Deng – University of Minnesota
Peter D. Easton and Gregory A. Sommers – Notre Dame and Southern
Methodist Universities
Luis Palencia – University of Navarra, IESE Business School
12-2
 What You Will Learn from this Chapter
 How ratios aggregate to explain Return on Common Equity
(ROCE)

 How economic factors determine ratios

 How financial leverage affects ROCE

 How operating liability leverage affects ROCE

 The difference between Return on Net Operating Assets (RNOA)

and Return on Assets (ROA)

 How profit margins, asset turnovers and their composite ratios

drive RNOA

 How borrowing costs are analyzed

 How profitability analysis can be used to ask penetrating questions

regarding the firm’s activities

12-3
 The Big Picture for this Chapter

Valuation involves forecasting residual earnings and

residual earnings growth

So, what drives residual earnings?

Growth in
ROCE
Book
Value

What drives
ROCE? What drives
This Chapter growth?
Next Chapter

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Analysis is the Preamble to Forecasting and Valuation

• Analysis establishes where the firm is now

• Forecasting asks how it will be different in the future

RE1 RE2
V  CSE0 
E
 2 
E E
0


RE1  ROCE1   E  1 CSE0
 
ROCE Driver Growth Driver

12-5
Analyzing ROCE: The Scheme

12-6
 First Level Breakdown of ROCE:
The Analysis of Leverage

The Effects of Leverage:

A. Financing Leverage
B. Operating Liability Leverage

12-7
 A. Analysis of Financing Leverage (FLEV)

Comprehensive Income (OI - Net Financial Expense)

ROCE  
Average CSE NOA  NFO

So, ROCE is a weighted return to operating activities and financing activities:

or,  NOA   NFO 

ROCE   x RNOA  -  x NBC
 CSE   CSE 
ROCE  RNOA  [FLEV x RNOA - NBC]

Spread

RNOA = OI (After tax) / NOA (Return on Net Operating Assets)

FLEV = NFO / CSE (Financial Leverage)
NBC = NFE (after tax) / NFO (Net Borrowing Cost)
SPREAD = RNOA – NBC (Operating Spread)

12-8
 The Financial Leverage Equation

ROCE = RNOA + FLEV × [RNOA – NBC]

The equation says that ROCE is driven by three factors:

1. Profitability of operations: RNOA

2. Financial Leverage: FLEV = NFO

CSE

3. Operating Spread: RNOA - NBC

12-9
How Financial Leverage Explains the Difference
Between ROCE and RNOA
SPR EA D = 6% SPR EA D = 4%
8%

6%

D iffe re n c e b e t w e e n R O C E a n d R N O A SPR EA D = 2%
(R O C E -R N O A ) 4%

SPR EA D = 1%
2%

SPR EA D = 0%
0%

S P R E A D = -1 %
-2 %

S P R E A D = -2 %
-4 %
0 .0 0 0 .2 5 0 .5 0 0 .7 5 1 .0 0 1 .2 5 1 .5 0 1 .7 5 2 .0 0
FLEV

R O C E = R N O A + [F L E V x S P R E A D ]

12-10
General Mills Inc.: Reformulated Balance Sheet

12-11
 Financial Leverage:
General Mills Inc., 2010
(In millions of dollars, average for year)

NOA 11,632 OI 1,177

NFO 6,099 NFE 251
CSE (before MI) 5,533 CI 926

FLEV = 6,099/5,533 = 1.102 ROCE = 16.7%

RNOA = 10.1%
NBC = 4.1%

ROCE = RNOA + [FLEV × (RNOA – NBC)]

= 10.1% + [1.102 × (10.1% - 4.1%)]
= 16.7%

12-12
 General Mills: What If?

What if RNOA fell to 2.0%?

ROCE = 2.0% + [1.102 × (2.0% - 4.1%)]

= -0.3%

Leverage becomes unfavorable!

12-13
Financial Leverage for a Firm with Negative
Leverage: Microsoft Corporation, 2003
(In millions of dollars)

NOA 12,829 OI 6,277

NFA 36,906 NFI 1,548
CSE 49,735 CI 7,825

FLEV = - 0.742 ROCE = 15.73%

RNOA = 48.93%
RNFA = 4.19%

 NFA 
ROCE  RNOA -    RNOA - RNF A 
 CSE 

 48 . 93 % - 0.742  48.93% - 4.19% 

 15.73%

12-14
 Microsoft: What If?
What if Microsoft paid a special dividend of $33 billion
(as it did in 2004)?

NOA 12,829
NFA 3,906
CSE 16,735

FLEV = - 0.233

ROCE = 48.93% - [0.233 × (48.93% - 4.19%)]

= 38.49%

Note: Paying dividends increases leverage and increases ROCE

12-15
B. The Analysis of Operating Liability Leverage
(OLLEV)
Operating liabilities lever the Return on Net Operating Assets
OI
RNOA 
OA - OL
What would be the operating profitability without operating liabilities?

OI  Implicit Interest (After Tax)

Return on Operating Assets ROOA   .
Operating Assets
where
Implicit Interest on Operating Liabilities (as a benchmark)
= Short-term Borrowing Rate (after tax) x Operating Liabilities

The Effect of OLLEV:

RNOA = ROOA + (OLLEV x OLSPREAD)
where OL
OLLEV 
NOA

OLSPREAD  ROOA  Short - term Borrowing Rate (after tax )

12-16
 Operating Liability Leverage:
General Mills Inc.
OA 17,126 OI 1,177
OL 5,494
NOA 11,632

OLLEV = 5,494/11,632 = 0.472

Short-term borrowing rate = 0.7% (after tax)

Implicit cost of operating liabilities = 5,494 × 0.007
= 38

1,177  38
ROOA   7 . 09 %
17 ,126

RNOA  7 . 09 %  0 .472  7 . 09 % - 0 . 7% 
= 10.1%

12-17
A Case of Extreme Operating Liability Leverage: Dell Inc.

Net Operating Assets (NOA) are negative!

Does this leverage add value? Yes!
Residual income from operations = $ 2,656 – (0.09 x -2028) = $2,839 million
12-18
Summing Financial Leverage and Operating
Liability Leverage Effects on ROCE

ROCE = ROOA + (RNOA – ROOA) + (ROCE – RNOA)

Return Effect of Effect of

With no Operating Liabilities Financing Liabilities
leverage

For General Mills,

16.7% = 7.1% + (10.1% - 7.1%) + (16.7% - 10.1%)

= 7.1% + 3.0% + 6.6%

12-19
Return on Net Operating Assets and Return on
Assets
OI
RNOA 
OA  OL

Net Income  Interest Expense (after tax)  Minority Interest

ROA 
Total Assets

Problems with ROA:

• Financial assets in denominator
• Financial income in numerator
• Operating liabilities not in denominator
• Net income is not comprehensive income

Median ROA is 7.1% since 1962 for U.S firms

Median RNOA is 10.5%

12-20
RNOA and ROA for Selected Firms, 2007

12-21
 FLEV and Debt-to-Equity Ratios

Debt - to - Equity  Total Debt

Equity

FLEV  NFO
CSE
Problems with Debt-to-Equity ratio:
• Excludes financial assets (which effectively defease debt)
• Includes operating liabilities

Median Debt-to-Equity is 1.22

Median FLEV is 0.43

12-22
 Second-Level Breakdown of ROCE:
Drivers of Operating Profitability

ROCE  RNOA  FLEV x RNOA - NBC 

↑
RNOA  PM  ATO
1. Operating profit margin:

PM  OI / Sales

2. Asset turnover: The ability to generate sales for a given asset base

ATO  Sales / NOA

3. Effect of financial leverage

12-23
Profit Margin and Asset Turnover Combinations for 238 Industries,
1963-2000

12-24
Typical Levels for ROCE, FLEV, OLLEV, RNOA, PM and ATO
ROCE(%) FLEV OLLEV RNOA(%) PM(%) ATO

Pipelines 17.1 1.093 0.154 12.0 27.8 0.40

Tobacco 15.8 0.307 0.272 14.0 9.3 1.70
Restaurants 15.6 0.313 0.306 14.2 5.0 2.83

Printing and publishing 14.6 0.154 0.374 13.6 6.5 2.20

Business services 14.6 0.056 0.488 13.5 5.2 2.95
Chemicals 14.3 0.198 0.352 13.4 7.1 1.91
Food stores 13.8 0.364 0.559 12.0 1.7 7.39
Trucking 13.8 0.641 0.419 10.1 3.8 2.88
Food products 13.7 0.414 0.350 12.1 4.4 2.74
Communications 13.4 0.743 0.284 9.1 12.5 0.76
General stores 13.2 0.389 0.457 11.3 3.5 3.55
Petroleum refining 12.6 0.359 0.487 11.2 6.0 1.96
Transportation equipment 12.5 0.369 0.422 11.2 4.5 2.47
Airlines 12.4 0.841 0.516 9.0 4.3 1.99
Utilities 12.4 1.434 0.272 8.2 14.5 0.59
Wholesalers, non-durable goods 12.2 0.584 0.461 10.2 2.3 3.72
Paper products 11.8 0.436 0.296 10.2 5.9 1.74
Lumber 11.7 0.312 0.384 10.4 4.0 2.60
Apparel 11.6 0.408 0.317 10.1 4.0 2.55
Hotels 11.5 1.054 0.201 8.5 8.2 1.04
Shipping 11.4 0.793 0.205 9.1 12.6 0.61
Amusements and recreation 11.4 0.598 0.203 10.1 9.5 1.10
Building and construction 11.4 0.439 0.409 10.6 4.5 2.06
Wholesalers, durable goods 11.2 0.448 0.354 9.9 3.4 2.84
Textiles 10.4 0.423 0.266 9.3 4.3 2.09
Primary metals 9.9 0.424 0.338 9.4 5.0 1.80
Oil and gas extraction 9.1 0.395 0.263 8.3 13.0 0.57
Railroads 7.3 0.556 0.362 7.1 9.7 0.78

Source: Standard & Poor’s COMPUSTAT®

12-25
 Third-Level Breakdown of ROCE:
Profit Margin Drivers

PM = Sales PM + Other operating income PM

GM Admin Exp Selling Exp R & D Taxes

Sales PM  - - - - ...
Sales Sales Sales Sales Sales

by product
or line of business

GM = Sales – Cost of Sales

Other Items PM  Other Operating Income/Sales
Subsidiary Income Equity Dividends
  
Sales Sales
Special Items Other Net Gain & Losses
  ...
Sales Sales

12-26
Third-Level Breakdown of ROCE: Asset Turnover
Drivers
1 Cash Acc. Rec. Inventory PPE
    ...  
ATO Sales Sales Sales Sales
Subsidiary Inv. Payables Pension Oblig.
  ... - - - ...
Sales Sales Sales

Some times other measures are used:

Days in Acc. Receivable = Acc. Receivable/ Avg. Sales per day

= 365 / Accounts receivable turnover

Inventory Turnover = Cost of Sales / Avg. Inventories

Acc. Payable Turnover = Purchases / Avg. Acc. Payable

12-27
 Nike, Inc.:
Reformulated Balance Sheets

12-28
 Nike, Inc.:
Reformulated Income Statements

12-29
Second and Third-Level Breakdown:
Nike and General Mills

12-30
 What-If Questions:
Nike and General Mills

12-31
 Third-Level Breakdown:
Analysis of Net Borrowing Cost

 FO After- tax Intereston FinancialObligations   FA After- tax Intereston FinancialAssets

NBC  x  -  NFO x 
 NFO FO FA

 FA UnrealizedGainson FA  PreferredStock Pref.Divs. 

 x 
  x  ---
 NFO FA NFO Pr eferredStock

For General Mills; 2010:

12-32
Tracking Profitability for Nike Over Years

12-33
Once More:
A Summary

12-34