Horizontal and Vertical

Financial Analysis
Vertical analysis normalizes each statement by that particular
statement’s 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 year’s sales. For Balance Sheet, figure to
divide by to normalize is Total Assets
Vertical analysis normalizes each statement by that particular
statement’s 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 year’s 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
statement’s 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 year’s 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:

-Pepsi’s Gross Margin is 8% lower
-Pepsi’s 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 borrow-
ings, as its Short Term borrowing is
more than double that of Pepsi’s

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
There is so much one can say -
comparatively speaking - just by
looking at these two companies’ I/S
100% and B/S, side by side. Can you try to
describe some important differences?
Accounts
Receivable

100%

PP&E

100%
Goodwill

Long Term 100%

Debt

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)

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
There is so much one can say -
comparatively speaking - just by
looking at these two companies’ I/S
100% and B/S, side by side. Can you try to
describe some important differences?
Accounts
Receivable Given this analysis with a subset of
balance sheet accounts, we can infer:
100% -Both companies appear to have been
investing heavily and mirror each other
PP&E -Moreover, though both appear to be
have been similarly “acquisitive” (using
Goodwill data), Pepsi seems to have
spent more on internal/organic projects
100% (higher PP&E growth)
Goodwill -Last point (higher organic investing due
to higher PP&E growth) can be consi-
dered as “likelier” when seen alongside
Long Term 100% an A/R that went up too (as is the case
Debt when new internal projects lunched)
- Turns out Pepsi has poured itself over
an internal division called Pepsi GNG,
Source: Morningstar 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?

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 CA-CL +
LTA+FA-OLTL or SE + LTD. The latter (SE+LTD) is quicker to calculate (when one needs to find IK), as all it
takes is add book value of debt (LTD) with Stockholder Equity (abbreviated as SE) There is no need to tease
out SE account
You use the total. Contrast that with the Liabilities side, where you only use LTD)
 Summary of representative ratios and value multiples
1 2 3 4 5
Types of Ratios

Market Valuation Ratios Liquidity Ratios Leverage Ratios

Faster you convert your assets to The higher the profitability These ratios measure the degree to
cash (or the longer the time The higher the Market Valuation The higher the liquidity ratios, the which a company is leveraged and
ratios, the higher the amount
before you pay suppliers), the Ratios, the higher the Value of the easier it should be for the company the ratio is long term focused (it
your company retains for every
better for your company b/c you Company (the Enterprise Value) to satisfy a short-term liability that looks at things payable after 1 year).
are using less resources to build dollar of sales comes due within a year or the This ratio can be calculated at book
products. You’re more efficient easier to deal with emergencies value (very misleading) and at
Market Value (very indicative)
These Turnover ratios are
defined in annual terms! NI Margin Current = CA / CL
NI/Sales EBITDAX = EV Ratio
EBITDA
A/R T.O. Book Leverage =
EBIT Margin DB
[A/R]/Sales Quick = [CA-Inv] / CL DB + EB
EBIT/Sales EBITX = EV Ratio
EBIT
Most Important Heuristics

Inv T.O. Gross Margin Cash = [Cash + M/S] / CL

[Inv]/Sales Ratio
[Sales-COGS]/Sales SALESX = EV
SALES 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
P-to-B X = EM = Ps Interest = EBIT
OLTL = Other LT Liabs
FA = Fixed Assets (PPE)
SE SE/#sh Coverage Interest
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
M/S = Marketable Securities DB = LTD
convertible to cash anytime EB = SE
Inv. Capital=IK
CA-CL+PPEnet+OLTA-OLTL = LTD + SE . Inv = Inventory 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
EBIT
Margin
SALES
P
ROIC ROIC
inorganico orgánico SALES
Q
(1+ % ) Sales
Efficiency
IK-GW PPEnet+OLTA+CA
GoodWill % IK
OLTL + CL
 Performance
Performance
TBD (How Profitable and Efficient is a company?)
Profitability and Efficiency

If PPE goes
Can I lower expenses? up, Dep too!

-[(COGS + SG&A) – DEP]

Tax effect
(1-T)
EBIT
S How fast are Sales Growing?

Profit
EBIT
Margin
SALES
P Can we increase prices?
ROIC ROIC
inorganico orgánico SALES Can I sell to new customers?
Q Sell more to current customers?

(1+ % ) TBD
Efficiency
Sales
IK-GW PPEnet+OLTA+CA
Are we converting
CA’s to cash
fast enough?
GoodWill % IK Can we lower our IK by
OLTL + CL using providers as
“short term lenders”?
GW%= IK - 1
IK-GW This makes my IK lower, but
how does this Liability take
away Fin or Op flexibility

Examine the CA’s and CL’s

using Turnover (TO) ratios
LTD + TE = IK = CA + PPEnet + OLTA – (CL + OLTL) and Ratios
 Leverage ≠ Liquidity
Leverage Liquidity
EBIT Considers coverage on
INT Debt interest
LTD = Book Leverage = 1 - E
IK
LTD + TE

EBIT Considers coverage on Debt

This is the % measure INT+Pr Principal + Debt Interest
that you use to weight-
average your WACC

Dm = Capital structure CA Considers how much your

Dm + Em CL CA’s cover your CL’s 1-to-1

Considers how much your CA’s

CA-INV
(exc. Inv’s that might not sell)
CL
can cover your CL’s 1-to-1
 Leverage ≠ Liquidity
Leverage Liquidity
Leverage

EBIT Considers coverage on

(Book)

Ability to satisfy debt

INT Debt interest

over long horizon

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

EBIT Considers coverage on Debt

This is the % measure INT+Pr Principal + Debt Interest
that you use to weight-
average your WACC
Leverage

Ability to cover your short term

Dm = Capital structure CA Considers how much your

liabilities during catastrophe

(Market)

Dm + Em CL CA’s cover your CL’s 1-to-1

Considers how much your CA’s

CA-INV
(exc. Inv’s that might not sell)
CL
can cover your CL’s 1-to-1

How much of what I have invested If I enter a crisis, would I be able to

has come from bondholders? pay the senior claims or would I
require a fire sale to pay them?
 All are
Financial Ratios

Linking Performance and Leverage T

Profitability and Efficiency (Book)

Unifying concept:
g* = Sustainable
growth rate
 All are
Financial Ratios

Linking Performance and Leverage T

Profitability and Efficiency (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 IK
SALES 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 Considers sales,

EBIT margins & CAPex

EBITDAx = EV Considers margins

EBITDA And sales

SALESx = EV Considers sales

SALES
 Value Multiples ≠ Financial Ratios
Value Multiples
While several value multiples exist, the
Rationale of
ones shown below are certainly the best
to compare your firm to others
Value multiples
EBITDAx
EBITx = EV Considers sales,
EBIT margins & CAPex Pepsi Coke
11.8x 14.5x

EBITDAx = EV Considers margins Coke is valued higher for every dollar

EBITDA And sales of EBITDA generated than Pepsi.
This can be due to higher FCF’s,
higher growth, lower WACC
or a mix of all!
SALESx = EV Considers sales
SALES
 Value Multiples ≠ Financial Ratios
Value Multiples
While several value multiples exist, the
Rationale of
ones shown below are certainly the best
to compare your firm to others
Value multiples
EBITDAx
EBITx = EV Considers sales,
EBIT margins & CAPex Pepsi Coke
11.8x 14.5x

EBITDAx = EV Considers margins Coke is valued higher for every dollar

EBITDA And sales of EBITDA generated than Pepsi.
This can be due to higher FCF’s,
higher growth, lower WACC
or a mix of all!
SALESx = EV Considers sales WHY?
SALES
FCFo x (1+g)
EV Em + Dm ≈ (Rwacc – g)
EBITDA EBITDA EBITDA
 Value Multiples ≠ Financial Ratios
Value Multiples
While several value multiples exist, the
Rationale of
ones shown below are certainly the best
to compare your firm to others
Value multiples
EBITDAx
EBITx = EV Considers sales,
EBIT margins & CAPex Pepsi Coke
11.8x 14.5x

EBITDAx = EV Considers margins Coke is valued higher for every dollar

EBITDA And sales of EBITDA generated than Pepsi.
This can be due to higher FCF’s,
higher growth, lower WACC
or a mix of all!
SALESx = EV Considers sales WHY?
SALES
FCFo x (1+g)
EV Em + Dm ≈ (Rwacc – g)
EBITDA EBITDA EBITDA
 Fundamental
Analysis
Deuda Libro
Deuda
Largo Plazo

Equity Libro
Patrimonio
Patrimonio
 Fundamental
Analysis
$ invertido por compañias

Deuda Libro
Deuda
Largo Plazo

Equity Libro
Patrimonio
Patrimonio
 Fundamental
Analysis
$ invertido por compañias

Deuda Libro
Deuda Deuda
Largo Plazo Mercado
Equity Libro
Patrimonio
Equity
Patrimonio
Mercado
 Fundamental
Analysis
Cuanto vale la Deuda y el
$ invertido por compañias

Patrimonio en el Mercado?
Deuda Libro
Deuda
Largo Plazo
Deuda
Mercado ?
Equity Libro
Patrimonio
Patrimonio
Equity
Mercado ?
 Fundamental
Analysis
$ invertido por compañias

Deuda Libro
Deuda Deuda
Largo Plazo Mercado
Equity Libro
Patrimonio
Equity
Patrimonio
Mercado
 Fundamental
Analysis
$ invertido por compañias

Valor Economico de Instrumentos

Deuda Libro (que es igual al valor economico de la empresa)
DB
Deuda
Largo Plazo
DM
Deuda
Mercado
compare
Equity Libro

EB
Patrimonio
Patrimonio EM
Equity
Mercado

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

 Fundamental
Analysis
$ invertido por compañias

Valor Economico de Instrumentos

Deuda Libro (que es igual al valor economico de la empresa)
DB
Deuda
Largo Plazo
DM
Deuda
Mercado
compare
Equity Libro

EB
Patrimonio
Patrimonio EM
Equity
Mercado

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
Market’s Your
Opinion Opinion

DM+EM

Value
Multiples < Fundamental
Analysis = Buy stock
Value
Multiples > Fundamental
Analysis = Sell stock
Value
Multiples = Fundamental
Analysis Indifferent
 Value
Multiples
Profitability Efficiency Leverage Liquidity Leverage
(Book) (Market)

Fundamental
Analysis
 Reliance on Debt to
Performance support business Economic
Value expected
of Company
Ability
to weather
bad surprises Value
Multiples
Profitability Efficiency Leverage Liquidity Leverage
(Book) (Market)

Fundamental
Analysis

Unifying concept:
g* = Sustainable
growth rate
(Lectures 5 and 6)
 Value
Financial Ratios Multiples

Reliance on Debt to
Performance support business Economic
Value expected
of Company
Ability
to weather
bad surprises Value
Multiples
Profitability Efficiency Leverage Liquidity Leverage
(Book) (Market)

Fundamental
Analysis

Unifying concept:
g* = Sustainable
growth rate
(Lectures 5 and 6)
 A mix of Value
Financial Ratios the two Multiples

Reliance on Debt to
Performance support business Economic
Value expected
of Company
Ability
to weather
bad surprises Value
Multiples
Profitability Efficiency Leverage Liquidity Leverage
(Book) (Market)

Fundamental
Analysis

Unifying concept:
g* = Sustainable
growth rate
(Lectures 5 and 6)
 A mix of Value
Financial Ratios the two Multiples

Reliance on Debt to
Performance support business Economic
Value expected
of Company
Ability Market’s
Opinion
to weather
bad surprises Value
Multiples
Profitability Efficiency Leverage Liquidity Leverage Your
(Book) (Market) 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 we’re 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

- ROIC’s numerator uses profitability figure which is NOT yet affected by Interest Expense
- ROIC’s 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. Isn’t 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 company’s 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] x [ Tot Assets / SE]

ROE = [Net Inc Margin] x [Assets Turnover] 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] x [ Tot Assets / SE]

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 ROE’s, what’s 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] x [ Tot Assets / SE]

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 ROE’s, what’s 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
ROIC the
[EBIT Equity
x (1-T) Multiplier effect
/ Sales] x as a[Sales
separate
/ 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 Long Term Debt, 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] x [ Tot Assets / SE]

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 ROE’s, what’s 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
ROIC the
[EBIT Equity
x (1-T) Multiplier effect
/ Sales] x as a[Sales
separate
/ 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] x [ Efficiency ] x 1

A truer measure of how efficient In ROIC, we don’t

A measure of Profitability need Equity multiplier,
Margin that is not affected is the company to generate sales
as we are evaluating
by Interest Expenses (how many resources does it take returns based on
to generate a sale) “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]

But, remember that LTD + SE equals IK, which stands for “Invested Capital”

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

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 ROE’s, what’s 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
ROIC the
[EBIT Equity
x (1-T) Multiplier effect
/ Sales] x as a[Sales
separate
/ 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] x [ Efficiency ] x 1

A truer measure of how efficient In ROIC, we don’t

A measure of Profitability need Equity multiplier,
Margin that is not affected is the company to generate sales
as we are evaluating
by Interest Expenses (how many resources does it take returns based on
to generate a sale) “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 ROE’s, what’s 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 ROE’s, what’s 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] x [Sales / IK]

ROIC = [After Tax Operating Inc Margin] x [ 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] x [Sales / IK]

ROIC = [After Tax Operating Inc Margin] x [ Efficiency ]

OUR REVISED DUPONT MODEL

Example of using DuPont Model
Company X with ROIC = 15% Competitor of Company X, also with ROIC = 15%
EBIT x (1-T)/Sales = 30% EBITx(1-T)/Sales = 50%
Sales/(Invested Capital) = 0.5 Sales/(Invested Capital) = 0.3
EBIT x (1-T)/Sales x Sales/(Inv. Capital) = 15% 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] x [Sales / IK]

ROIC = [After Tax Operating Inc Margin] x [ Efficiency ]

OUR REVISED DUPONT MODEL

Example of using DuPont Model
Company X with ROIC = 15% Competitor of Company X, also with ROIC = 15%
EBIT x (1-T)/Sales = 30% EBITx(1-T)/Sales = 50%
Sales/(Invested Capital) = 0.5 Sales/(Invested Capital) = 0.3
EBIT x (1-T)/Sales x Sales/(Inv. Capital) = 15% 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 What is the problem with this ratio
ratio appear to tell to measure Leverage?
Calculation us?

CL 0.95 1.04
CA
24,283 18,154
25,497 17,441

LTD
LTD + SE 30% 50%

13,656 20,568
13,656+31,635 20,658+20,745

DM
DM+ EM 7% 15%

13,656 20,568
13,656+177,690 20,568+114,120

Source: Morningstar and YahooFinance

 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 What is the problem with this ratio
ratio appear to tell to measure Leverage?
Calculation us?

Using this “Quick Ratio”,

CL 0.95 1.04 which is a short-term ratio,
we are initially led to believe
CA the company is similarly
24,283 18,154 leveraged
25,497 17,441

However, when looking at

LTD only the long term capital
LTD + SE 30% 50% portions (LTD and SE), we
find that Pepsi is 1.6 times
more leveraged than Coke

13,656 20,568
13,656+31,635 20,658+20,745

But… when we look at the

DM true market values (using
DM+ EM 7% 15% LTD ~ DM, because for big
and solvent companies this
is the case), Pepsi is 2 (twice)
13,656 20,568 more leveraged than Coke!
13,656+177,690 20,568+114,120

Source: Morningstar and YahooFinance

 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 What is the problem with this ratio
ratio appear to tell to measure Leverage?
Calculation us?

Using this “Quick Ratio”, This ratio is focused on Current Assets and
CL 0.95 1.04 which is a short-term ratio, Current Liabilities. Thus, it is not a measure
we are initially led to believe of long term leverage (is actually a measure of
CA the company is similarly liquidity, as noted earlier)
24,283 18,154 leveraged
25,497 17,441

This ratio is a better measure of long term

leverage . However, it ignores fact that capital
However, when looking at that has been raised/invested by companies
LTD only the long term capital may be more or less valuable than its historical
LTD + SE 30% 50% portions (LTD and SE), we value (What if my company has grown
find that Pepsi is 1.6 times tremendously since inception and has great
more leveraged than Coke prospects? Would book value be good then?
13,656 20,568
13,656+31,635 20,658+20,745

.. but using market values to estimate the

But… when we look at the leverage ratio of the company is the best way
DM true market values (using to gauge the leverage of the company (If the
DM+ EM 7% 15% LTD ~ DM, because for big economic activity today is substantially more,
and solvent companies this by using Dm and Em to estimate leverage, we
is the case), Pepsi is 2 (twice) make sure we assess leverage more attuned
13,656 20,568 more leveraged than Coke! with the economics of the business (because
13,656+177,690 20,568+114,120 that is more informative than book values)

Source: Morningstar and YahooFinance

 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 What is the problem with this ratio
ratio appear to tell to measure Leverage?
Calculation us?

Using this “Quick Ratio”, This ratio is focused on Current Assets and
CL 0.95 1.04 which is a short-term ratio, Current Liabilities. Thus, it is not a measure
we are initially led to believe of long term leverage (is actually a measure of
CA the company is similarly liquidity, as noted earlier)
24,283 18,154 leveraged
25,497 17,441

This ratio is a better measure of long term

leverage . However, it ignores fact that capital
However, when looking at that has been raised/invested by companies
LTD only the long term capital may be more or less valuable than its historical
LTD + SE 30% 50% portions (LTD and SE), we value (What if my company has grown
find that Pepsi is 1.6 times tremendously since inception and has great
more leveraged than Coke prospects? Would book value be good then?
13,656 20,568
13,656+31,635 20,658+20,745

.. but using market values to estimate the

But… when we look at the leverage ratio of the company is the best way
DM true market values (using to gauge the leverage of the company (If the
DM+ EM 7% 15% LTD ~ DM, because for big economic activity today is substantially more,
and solvent companies this by using Dm and Em to estimate leverage, we
is the case), Pepsi is 2 (twice) make sure we assess leverage more attuned
13,656 20,568 more leveraged than Coke! with the economics of the business (because
13,656+177,690 20,568+114,120 that is more informative than book values)

Source: Morningstar and YahooFinance

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