After mastering the material in this chapter, you will be able to:

Transcription

1 After mastering the material in this chapter, you will be able to: 1. Know how to access information, identify competitors, and use financial statement analysis in valuation ( ) 2. Measure the performance of a company using rates of return ( , 2.9, 2.14) 3. Examine a company s asset utilization and working capital management (2.8, 2.10) 4. Analyze a company s fixed assets and financial leverage ( ) 5. Assess a company s competitive advantage (2.15) 6. Describe measurement and implementation techniques (2.16)

2 C H A P T E R 2 Financial Statement Analysis Bloomberg provides various financial ratios as part of its database services. Below, we show a sample of the financial ratios Bloomberg reports for Dell Inc. (Dell) and Hewlett-Packard Company (HP) as reported on August 10, In this chapter, we will learn how to measure ratios like these and how we use these ratios in valuation work. Although Dell and HP are direct competitors, some of their financial ratios are not similar. The financial ratios for Dell and HP Bloomberg highlight how a company might not be a good comparable for a particular valuation analysis even though it is a direct competitor. Choosing comparable companies is just one important use of financial statement analysis in valuation work. 1 Dell Inc. Hewlett-Packard Company Profitability Ratios Gross margin % 17% 19% 18% 18% 24% 24% 24% 24% 24% Operating margin % 5% 6% 5% 4% 7% 9% 9% 10% 10% Profit margin % 4% 5% 4% 3% 7% 7% 7% 7% 7% Return on assets % 11% 11% 9% 5% 8% 9% 8% 7% 7% Return on common equity % 62% 73% 62% 29% 16% 19% 22% 19% 22% Return on capital % 53% 63% 48% 19% 15% 17% 17% 14% 15% Activity Ratios Days to sell inventory Days to collect accounts receivable Asset turnover Debt Factors and Leverage Total debt to total assets Total debt to common equity Total debt to EBITDA Assets/Equity Net debt to shareholders equity Liquidity Analysis Cash ratio Quick ratio Current ratio Inventory to cash days Growth Sales growth % 3% 6% 0% 13% 6% 14% 13% 3% 10% EBITDA growth % 26% 17% 4% 24% 25% 32% 18% 11% 12% Net income growth % 28% 14% 16% 42% 158% 17% 15% 8% 14% In this chapter, we explore how to analyze financial statements and how that analysis is used in valuation. 1 Bloomberg L. P. provides a dynamic network of delivering data, news, and analytics through various access platforms; see for more information and a description of the company, its products, and its services. 31

3 32 Chapter 2 Financial Statement Analysis CHAPTER organization Using Ratios in Valuation Information about the company and its industries Competitive analysis Driving/ assessing forecasts Estimating debt and preferred cost of capital Identifying comparable companies Measuring Performance Return on assets Return on investment Return on equity Adjusting for excess assets Disaggregating the return on assets Measuring cost structure Financial Statement Analysis Asset Utilization Property, plant, and equipment turnover ratios Ability to pay current liabilities Time to pay accounts payable Time to sell inventory Time to collect receivables Fixed Assets and Leverage Assessing Competitive Advantage Remaining depreciable life Capital expenditures Financial leverage ratios Coverage of fixed payments Cost leadership Differentiation Strategic positioning Identifying competitive advantage Sustaining competitive advantage Measurement and Implementation Flows and stocks Inflation adjustments Timing adjustments Influential observations Negative denominators INTRoDUCTIoN Financial statement relations, or financial ratios, are ratios of various financial statement items that attempt to measure certain economic concepts. These economic concepts include such characteristics as a company s operating performance, operating risk, financial risk, growth, efficiency, and asset utilization. We typically use financial ratios to analyze a company relative to its competition and relative to itself over time. We use ratios rather than the numbers in the financial statements directly because we typically need to control for the scale or size of the company before we can make comparisons with other companies or even with the same company over time. For example, instead of comparing operating income as it is reported in the income statement, we compare operating income scaled (divided) by some other financial statement number that reflects the scale of the company, such as the company s sales or assets. Sometimes, we use non-accounting information when calculating financial relations as an alternative way to adjust for scale, such as number of employees, number of stores (or the square feet of retail space), or number of tons of output. In this chapter, we discuss how to measure and use financial ratios. We begin with a discussion of the ways to use financial ratios when valuing a company. We then focus on accounting-based rates of return, which are a type of financial ratio. It is important to understand that while we use financial ratios as proxies for certain economic concepts, they are, by their nature, accounting-based ratios, not market-based ratios, and therefore are imprecise measures of those economic concepts. However, they are often the best measures available, and we know from scholarly research that these financial ratios contain useful information. We choose the definition and measurement of specific financial ratios to fit the context of our analysis. We continue our discussion by showing how to decompose accounting-based rates of return into their components and then by discussing ways we can analyze a company s working capital management, fixed assets structure, and capital expenditures. We often use these types of financial ratios as drivers (assumptions) in a financial model used to forecast a company s financial statements and free cash flows. We also discuss how to analyze a company s leverage and financial risk as well as how to use its financial statement information in combination with information not reported directly in its financial statements.

4 Chapter 2 Financial Statement Analysis 33 Analyzing the financial statements of a company and its competitors entails the following steps. First, we examine the businesses in which the company operates to identify its potential competitors and potential comparable companies. Second, we analyze all of the companies financial statements and adjust them for potential distortions due to differences in accounting techniques and estimates, excess assets, the structuring of certain types of transactions (for example, leases), and any other potential distortions. Third, we qualitatively assess whether any of the companies has a potential competitive advantage. We then analyze the companies quantitatively using financial ratios and other performance metrics to determine how the performance amongst the companies has changed over time and the extent to which our assessments of competitive advantage are observable. Finally, we use our analysis to guide our forecasts, choose comparable companies to measure various costs of capital, and choose comparable companies as the basis to estimate market multiples. 2.1 SOURCES OF INFORMATION Naturally, we need to collect a substantial amount of information in order to analyze a company and its industry. In this section, we discuss the sources of such information. We analyze information on the industry, the company, its actual and potential competitors, other potential comparable companies, and even its suppliers and customers. Information About a Company Many company websites, especially for publicly traded companies, are a very rich source of information (for example, in the investor relations section of the website). Companies often provide access to the company s annual and quarterly reports, earnings announcements, government-filed reports, press releases, conference calls, and information on annual meetings with shareholders (typically transcripts or recordings of important speeches and/or question-and-answer sessions with stockholders). A company s annual and quarterly reports contain, in addition to company financial statements, information about the company s history, operations, operating segments, competition, and more. A company will also issue a press release soon after a significant event occurs. Even privately held companies, which have no public disclosure requirements, often have a substantial amount of information available on their websites. Even if a company does not have a website (a rarity, to be sure), publicly owned companies have to file financials and other reports with the government. For example, in the United States, publicly traded companies must file annual reports (Form 10 K) and quarterly reports (Form 10-Q) with the U.S. Securities and Exchange Commission (SEC). A company must file its 10 K reports within 90 days of its fiscal year-end and its 10 Q reports within 45 days of each quarter s end. These reports contain extensive information about a company, including some (limited) information on its industries and major customers. Companies must also file a report with the SEC when a significant event occurs for the company (Form 8 K), when it notifies shareholders of a shareholders meeting (a proxy statement), when it proposes to issue certain types of securities (a registration statement), and for a variety of other events or circumstances. All of these public filings are available on the SEC s EDGAR website. 2 In addition to filing reports with the SEC, companies often must (or choose to) file reports with government agencies. For example, the Department of Transportation requires airline and commercial trucking companies to file certain reports with it. Banks and other financial institutions also must file with other various government agencies. In almost all countries, there are filing requirements that companies must meet in order to be listed on an exchange. Foreign private issuers (foreign companies listed on U.S. securities exchanges) generally file Form 20-F as both a registration statement and an annual report. The Form 20 F report is similar in content to the S 1 registration statement and 10 K annual report filed by U.S. companies. According to U.S. generally accepted accounting principles (GAAP), companies must report certain (limited) accounting information for example, revenues, operating assets, and operating incomes for each of their operating segments. 3 According to U.S. GAAP, an operating segment is a part of a com- lo1 Know how to access information, identify competitors, and use financial statement analysis in valuation 2 The SEC s EDGAR website contains all public filings of U.S. listed companies. It can be found at edgar.shtml. 3 See Financial Accounting Standards Board, Statement of Financial Accounting Standards No. 131, Disclosures About Segments of an Enterprise and Related Information, June 1997.

5 34 Chapter 2 Financial Statement Analysis pany for which separate financial information is made available and evaluated by management, and that accounts for 10% or more of the company s revenues. The information reported should be the same as the information used internally for decision-making. Operating segments are typically of two types: industry segments and geographic segments. U.S. GAAP also requires companies to disclose their major customers, generally defined as customers who purchase 10% or more of the company s good and services. Operating segment information can be useful when valuing a company. However, detailed publicly available information is usually quite limited, and we generally need information not available to the public in order to analyze a segment in detail. Other sources of information include stock reports and financial analyst reports. Stock reports such as the Standard & Poor s Stock Reports (two-page company summaries) contain financial and other summary information for publicly traded companies in a quickly accessible and usable form. Analyst reports provide a wealth of information on the companies analysts follow and often include information about important competitors for a given company. Companies often list the analysts who write reports on them on their websites, and these analysts are also listed in certain publications (Nelson s Directory of Investment Research). We typically classify an analyst as either a sell-side analyst, a buy-side analyst, or an independent research analyst. Sell-side analysts work for brokerage companies and make recommendations that brokers use to advise clients on sales and purchases of securities. Buy-side analysts work for investment management companies and advise portfolio managers on the stocks they might purchase or sell. Independent research analysts work for companies that sell analyst reports to investors. Of course, analysts obtain much of their information from the management and financial statements of companies. Although analysts are likely to be more objective than managers are, we know that analysts are, on average, optimistic. 4 The financial press (newspapers, magazines, periodicals, and news websites), financial websites, stock exchanges, and certain services also provide information on companies. Articles in the financial press sometimes serve to collect and summarize information from a variety of sources (the company, its management, financial analysts, reports filed with the government, etc.). Financial websites such as Hoover s Inc., Google Finance, and Yahoo! Finance provide information about companies and their competitors in much the same way some stock reports do. Many stock exchanges provide information on the companies that have securities that trade on that stock exchange. Some companies for example, Thomson Reuters, Bloomberg, and Morningstar provide information on a company as well as conduct analyses using that information. Large archival databases are another source of individual company information. For example, the Center for Research in Security Prices at the University of Chicago has a comprehensive database of U.S. stock market data. Standard & Poor s Compustat is a standardized database containing accounting and some market data. Datastream and other databases provide financial statement and stock price information on companies all over the globe. Such databases allow one to investigate a company and its industry in a variety of ways. Wharton s Research Data Services (WRDS) from the Wharton School at the University of Pennsylvania provides convenient access to many databases with a web-based interface. Information About an Industry We also have extensive information available on industries. First, companies often disclose information on the industries in which they operate in their 10-K reports and in annual reports to shareholders. Many financial analysts specialize in certain industries and write industry reports as well as individual company reports. Some companies also issue reports containing information on an industry for example, Standard & Poor s Industry Surveys. Industry financial ratios are also made available in some of these publications. Most large industries have an industry or trade association. Such associations often issue industry or trade magazines that contain information on the industry, including various industry statistics. The financial press and financial websites also contain information about industries. 4 Various research studies document the extent to which analysts are optimistic; see, for example, Lin, H., and M. McNichols, Underwriting Relationships, Analysts Earnings Forecasts, and Investment Recommendations, Journal of Accounting and Economics 25 (1988), pp This article suggests that such optimism sometimes results from a conflict of interest of (at least sell-side) analysts. As it turns out, in the United States, a number of investment banks settled with federal securities regulators on the issue of conflicts of interests faced by their (sell-side) stock analysts. (See for a variety of press releases and other documents on this topic.)

6 Privately Held (Owned) Companies Chapter 2 Financial Statement Analysis 35 While we have extensive information available on publicly traded companies, we have substantially less information on privately held companies, unless we have the cooperation of the private company (for example, if we are valuing the company because it is considering an initial public offering). Companies like Dun and Bradstreet, Inc. and Robert Morris Associates collect limited information on privately held companies. There are also databases that provide some limited valuation data on private companies sold in change-of-control transactions. 2.2 HOW We use FINANCIAL RATIOS in valuation Scholarly research has shown that financial ratios contain useful information, 5 which provides empirical justification for their widespread use in valuation and other financial analyses. Generally, when we use financial ratios, we typically compare a company to itself over time a time-series analysis or to other comparable companies a cross-sectional analysis. We often use both types of analyses at the same time a combined time-series and cross-sectional analysis. While we often use the financial ratios of competitors as benchmarks for the company we are analyzing, we often do not have an absolute benchmark for what is a good or bad value. While we are getting ahead of ourselves a bit, we illustrate this point using the current ratio the ratio of a company s current assets to its current liabilities. Most companies have more current assets than current liabilities. We typically observe an average current ratio for a broad set of companies in the range of 1.5 to 2. A higher current ratio suggests a more liquid company. But what is a good current ratio? Is a good current ratio below the average or above the average? The answer to that question is, It depends. A low current ratio might suggest potential financial distress; but, if the company has processes in place that allow it to operate efficiently with a low current ratio (for example, very low inventory levels), then a low current ratio might suggest a source of competitive advantage. For example, Dell had a very low current ratio, and its working capital management techniques were seen as a source of competitive advantage. We face the same benchmarking issue for other types of ratios as well. Competitive Analysis Conducting a competitive analysis of a company and its industry provides a general understanding of both the company and its industry as well as an assessment of the company s position within the industry. We normally conduct a competitive analysis early in the process of valuing a company unless we are instructed to rely on forecasts provided to us by others, such as management forecasts. Such an analysis can provide insights into the key value drivers of a company s business and help us identify a company s sources of competitive advantage, if any. A competitive analysis often involves analyzing a company s vision, strategy, and strategic objectives. Measuring the Debt and Preferred Stock Costs of Capital The debt and preferred stock costs of capital are important inputs in most valuations. We use them when we unlever a company s equity cost of capital or lever its unlevered cost of capital, and when we measure a company s weighted average cost of capital. Since a company s debt and preferred stock are often not publicly traded, we often cannot measure its debt and preferred stock costs of capital directly from market data. In such cases, we typically measure the debt and preferred stock costs of capital using market data from comparable companies, and we determine the comparability of the companies, in part, using financial ratios. 5 A study that examines accounting-based rates of return directly is Amir, E. and I. Kama, The Market Reaction to ROCE Components: Implications for Valuation and Financial Statement Analysis, Working Paper, Tel Aviv University, November Also see the work of Ou, J., and S. Penman, Financial Statement Analysis and the Prediction of Stock Returns, Journal of Accounting and Economics 11 (1989), pp ; Holthausen, R., and D. Larcker, The Prediction of Stock Returns Using Financial Statement Information, Journal of Accounting and Economics 15 (1992), pp ; and Abarbanell, J., and B. Bushee, Abnormal Stock Returns to a Fundamental Analysis Strategy, Accounting Review 73 (1998), pp

7 36 Chapter 2 Financial Statement Analysis Preparing (Driving) and Assessing the Reasonableness of Financial Forecasts We use financial ratios to create or drive our forecast, and then we use other financial ratios to assess the reasonableness of our financial forecasts. Naturally, we do not use the same financial ratios to both drive and check the reasonableness of the forecasts. As we discuss in Chapter 4, one of the first steps in creating financial forecasts is to identify factors or forecast drivers to generate the forecasts. A common type of forecast driver is a growth rate, which may be one of the key factors (drivers) in a financial model. We also use financial ratios, such as expense ratios, as forecast drivers. Turnover ratios (the ratio of an item on the income statement to a balance sheet item for example, revenue to accounts receivable) are another common type of driver. Once we develop our forecasts, we use other financial ratios to help us assess the reasonableness of our forecasts. For example, we compare the rates of return (return on assets and return on equity) in our forecasts to the historic rates of return of the company, its industry, and its close competitors. We might also use liquidity ratios, asset utilization ratios, and asset composition ratios in a similar manner. Assessing the Degree of Comparability in Market Multiple Valuation Financial ratios can be useful in a market multiple valuation when assessing the comparability of the company we are valuing to other companies. We use financial ratios to assess the comparability of profitability, rates of return, cost structures, capital expenditure requirements, growth rates, and business risk. Assessing the comparability of these factors is extremely important in a market multiple valuation. Constraints and benchmarks in Contracts Investors often use financial ratios as either constraints or benchmarks in contracts. For example, debt contracts and to some extent preferred stock contracts often utilize financial ratios as constraints, called covenants, to protect investors rights. Investors might require a company to maintain a certain amount of liquidity, limit the amount of debt, or limit dividends by using various financial ratios. If a company violates any of these accounting-based covenants, called a technical default, the investors typically get additional rights, such as the right to accelerate the maturity of the debt and possibly charge a higher promised return. 6 Valuation in Practice 2.1 Example Debt Covenant for Dex Media, Inc. Dex Media, Inc. has debt agreements that require it to maintain a certain amount of earnings before interest, taxes, depreciation, and amortization (EBITDA) relative to its interest payments. We call ratios of this type coverage ratios. It describes one such covenant in its registration statement filed with the SEC so that it could issue additional securities as follows: The loan agreement includes certain financial covenants, including an interest coverage ratio based on EBITDA to interest expense with a minimum ratio of 4.75:1 and a debt to EBITDA ratio of 1.75:1 and other covenants limiting Dex s ability to incur additional debt or liens, pay dividends and make investments. Source: See its S-1 filing (registration statement for issuing securities), filed with the U.S. SEC on May 14, 2004, see p. F-109, available at: Investors use other contract provisions as well to prohibit the company from selling a significant amount of its assets or merging with another company. Investors also use financial ratios as benchmarks (or hurdles). For example, companies might have to meet certain hurdles described in a debt agreement to 6 See Duke, J., and H. Hunt, III., An Empirical Examination of Debt Covenant Restrictions and Accounting-Related Debt Proxies, Journal of Accounting and Economics vol. 1 3 (January 1990), pp ; and Press, E., and J. Weintrop, Accounting-Based Constraints in Public and Private Debt Agreements Their Association with Leverage and Impact on Accounting Choice, Journal of Accounting and Economics vol. 1 3 (January 1990), pp

8 Chapter 2 Financial Statement Analysis 37 draw cash from a line-of-credit. Some loans, called performance priced debt, determine the yield spread above U.S. Treasuries or LIBOR the borrower is charged based on accounting performance measures. In addition, companies sometimes use accounting-based measures of performance to compensate managers. Valuation Key 2.1 We use financial ratios in a variety of ways: to perform a competitive analysis of an industry or of a company within an industry, to assess business risk, to measure the debt and preferred stock costs of capital, to drive and assess the reasonableness of financial forecasts, to assess comparability for a market multiple valuation, and to set constraints or benchmarks in contracts. 2.3 IDENTIFYINg A ComPANY S INDUSTRY AND ITS ComPARABlE ComPANIES To identify a company s comparable companies, we generally begin by identifying a company s existing direct (or head-to-head ) competitors before identifying indirect and potential competitors. For example, if we were valuing Ford Motor Company (Ford), we would first identify what markets Ford serves. As it turns out, Ford competes in the worldwide auto, truck, financing, insurance, and leasing markets. Identifying Ford s competitors in the auto and truck markets is relatively straightforward. Its competitors in the financing, leasing, and insurance business include a much broader group of companies, ranging from other car manufacturers to numerous financial institutions and insurance companies. As discussed earlier, a good starting point for this analysis is Ford s 10-K report. In its 10-K, Ford provides information on its market share in the U.S. combined car and truck market as well as for its major competitors. For the year ended December 31, 2010, Ford reported that the top six companies in terms of market share in the combined U.S. auto and truck market were General Motors Corp. (GM), Ford, Chrysler Corporation, Toyota Motor Company (Toyota), Honda Motor Company LTD (Honda), and Hyundai-Kia. Ford provided market share data for each individual company as well as the fact that, together, these six companies had over an 85% share of the defined market. Ford also provided information on the non-u.s. market, information on the countries that are most important to it at the current time, and information on emerging markets that it believes will become more important to it over time. Standard and Poor s Industry Survey for Autos and Auto Parts identified over 20 different manufacturers of autos. 7 As of January 2012, Hoovers ( listed over 25 competitors for Ford. That list of competitors included other car manufacturers and such major financial institutions as Bank of America, Citigroup, and J.P. Morgan Chase. Therefore, analyzing a company like Ford requires an analysis of the various markets the company serves and of the competitors in each of those markets. We would also identify any of Ford s indirect competitors and any potential new competitors looming on the horizon. Indirect competitors would be companies that might affect the profitability of the auto industry but that are not directly in that space. Indirect competition may or may not be important for a company. For example, motorcycle manufacturers are indirect competitors for automobile manufacturers, but they do not have a substantive impact on either the profitability of or the demand for automobiles. Reducing the price of motorcycles would probably have a very small impact on the demand for autos. Economists would say that these two industries have a small cross-elasticity of demand. While indirect competition from motorcycle manufacturers is not very important for analyzing Ford, potential competition could be very important. Potential competitors from China, India, and South Korea could have a significant effect on the worldwide automotive market over time. Great Wall Automobile Co. of China started selling sport-utility vehicles in Russia in early 2005 at prices that were approximately 35% lower than other Asian imports. Chery Automobile, another Chinese automaker, is exporting to Europe and other locations. Both companies have plans to enter the U.S. market. All of these new or potential competitors, though small now, will likely influence the worldwide automotive industry over time. This potential competition would be important to assess in valuing Ford, as the increased competition may affect Ford s future profitability. 7 See Standard & Poor s Industry Surveys: Autos and Auto Parts, December 29, 2011, by Efraim Levy.

9 38 Chapter 2 Financial Statement Analysis Once we have identified a company s competitors, we will use those companies to perform a competitive analysis of the industry and determine which companies in the industry, if any, have a competitive advantage. In addition, as we discuss throughout the book, various steps in the valuation process require the identification of comparable companies. The relevant comparable companies used for specific steps in the valuation process are generally a subset of the competitors of a company. For example, when choosing comparable companies for a market multiple analysis, we have to consider which companies are similar to the company we are valuing based on such attributes as risk, profitability, and growth prospects. 2.4 THE GAP, INC. AN ILLUSTRATION OF THE Calculation AND ANALYSIS OF FINANCIAL RATIOS In this chapter, we use The Gap, Inc. (GAP) to illustrate the calculation and analysis of financial ratios. GAP is a global retailer operating retail and outlet stores that sell apparel, accessories, and personal care products for men, women, and children. We assume for illustrative purposes that GAP s management believes that the market is substantially undervaluing GAP, as GAP s management believes that it can improve GAP s performance in a variety of ways. In Exhibit 2.1, we present GAP s summary historical financial statements A2009 and A2010 (January 2010 and January 2011 fiscal year-ends, respectively) and hypothetical management forecasts (F2011 F2016) of its income statements, balance sheets, and summary free cash flow schedules. We do not show GAP s Statement of Cash Flows (though we show GAP s operating cash flow at the bottom of the schedule), nor do we show its footnotes and other supplemental disclosures. Rather, we discuss relevant footnotes and other disclosures in the chapter as needed. Naturally, a complete financial analysis includes a detailed review of all of a company s footnotes and other disclosures in its financial statements. Prior to the end of the 2010 fiscal year (end of January 2011), GAP distributed close to one billion dollars in dividends and share repurchases. This was excess cash that GAP management felt it did not need. GAP had a market capitalization (a measure of firm value) of roughly $11 billion at the end of its 2010 fiscal year (after the cash distributions to shareholders had been made). The GAP forecasts assume that management can improve the company s performance. Management believes it can grow revenues above market expectations, reduce GAP s operating expenses to improve GAP s cost structure, manage GAP s working capital better to reduce its investment in working capital, and reduce GAP s capital expenditure requirements without affecting its planned capital maintenance and expansion forecast. Using a cost of capital of 13.5% and a perpetual growth rate of 2.5% after 2016, we can use the valuation framework we discussed in Chapter 1 to value GAP using management s forecasts. We show this valuation in Exhibit 2.2. If management can attain its forecasts, this illustration indicates that GAP s market value would be $12.8 billion instead of $11 billion, which is a 16% increase in its value. Naturally, management and GAP s investors would all be pleased with such an improvement in GAP s performance. The issue, of course, is whether such an improvement is feasible. As we discuss in Chapter 4, when discussing forecasting models, we can use financial ratios resulting from the forecasts to help assess the reasonableness of the forecasts. To analyze GAP s historical performance, we use a set of comparison companies. The comparison companies we use are all companies in the Family Clothing Store industry classification (SIC ), which is the primary industry classification for GAP. The number of companies (other than GAP) in that industry, and for which we can measure the financial ratios, varies between 17 and 19 during any one year. We should note that while all of these companies have the same primary industry classification as GAP, they might not all be equally good competitors. This industry code includes such companies as American Eagle Outfitters, Inc. and Abercrombie & Fitch, which are direct competitors of GAP. This industry classification, however, also contains such companies as Casual Male Retail Group, Inc., which does not focus on the same type of shopper as GAP but rather focuses on big and tall men, and Nordstrom, Inc., which sells a broader set of merchandise. The companies also vary in business strategy, size, and other characteristics.

10 Chapter 2 Financial Statement Analysis 39 Exhibit 2.1 The Gap, Inc. Financial Statement and Free Cash Flow History for Fiscal Years 2009 and 2010 and Hypothetical Management Forecasts The GAP, Inc. Financial Statements and Free Cash Flows Income Statement ($ in millions) A2009 A2010 F2011 F2012 F2013 F2014 F2015 F2016 Revenue $14,197 $14,664 $15,251 $16,013 $16,814 $17,654 $18,096 $18,548 Cost of goods sold ,818 8,127 8,349 8,750 9,188 9,647 9,888 10,136 Gross margin $ 6,379 $ 6,537 $ 6,902 $ 7,263 $ 7,626 $ 8,007 $ 8,207 $ 8,413 Depreciation and amortization Operating expenses ,909 3,921 4,138 4,329 4,546 4,773 4,892 5,015 Operating income $ 1,815 $ 1,968 $ 2,089 $ 2,226 $ 2,337 $ 2,454 $ 2,515 $ 2,578 Interest expense Interest income Income before taxes $ 1,816 $ 1,982 $ 2,111 $ 2,249 $ 2,361 $ 2,479 $ 2,542 $ 2,605 Income tax expense ,023 Net income $ 1,102 $ 1,204 $ 1,283 $ 1,366 $ 1,434 $ 1,506 $ 1,544 $ 1,583 Balance Sheet ($ in millions) A2009 A2010 F2011 F2012 F2013 F2014 F2015 F2016 Cash balance $ 2,573 $ 1,661 $ 1,727 $ 1,814 $ 1,905 $ 2,000 $ 2,050 $ 2,101 Accounts receivable Inventory ,477 1,620 1,664 1,744 1,831 1,923 1,971 2,020 Other current assets Total current assets $ 4,664 $ 3,926 $ 4,062 $ 4,262 $ 4,476 $ 4,699 $ 4,817 $ 4,937 Property, plant, and equipment $ 7,427 $ 7,573 $ 7,909 $ 8,341 $ 8,879 $ 9,532 $10,332 $11,151 Accumulated depreciation ,799 5,010 5,684 6,392 7,135 7,915 8,714 9,534 Property, plant, and equipment (net) $ 2,628 $ 2,563 $ 2,225 $ 1,949 $ 1,744 $ 1,617 $ 1,617 $ 1,617 Other assets $ 693 $ 576 $ 599 $ 629 $ 660 $ 693 $ 711 $ 729 Total assets $ 7,985 $ 7,065 $ 6,886 $ 6,841 $ 6,880 $ 7,010 $ 7,145 $ 7,283 Accounts payable $ 1,027 $ 1,049 $ 1,059 $ 1,110 $ 1,165 $ 1,224 $ 1,254 $ 1,286 Accrued expenses ,104 1,046 1,088 1,142 1,199 1,259 1,291 1,323 Current portion of long-term debt Total current liabilities $ 2,131 $ 2,095 $ 2,147 $ 2,252 $ 2,365 $ 2,483 $ 2,545 $ 2,609 Long-term debt Non-current liabilities ,020 1,071 1,098 1,126 Total liabilities $ 3,094 $ 2,985 $ 3,072 $ 3,224 $ 3,385 $ 3,554 $ 3,643 $ 3,734 Common stock (and other) $ 5,924 $ 7,687 $ 7,687 $ 7,687 $ 7,687 $ 7,687 $ 7,687 $ 7,687 Retained earnings ,815 11,767 11,501 11,304 11,182 11,143 11,189 11,236 Total shareholders equity $ 4,891 $ 4,080 $ 3,814 $ 3,617 $ 3,495 $ 3,456 $ 3,502 $ 3,549 Total liabilities and equities $ 7,985 $ 7,065 $ 6,886 $ 6,841 $ 6,880 $ 7,010 $ 7,145 $ 7,283 Free Cash Flows ($ in millions) A2009 A2010 F2011 F2012 F2013 F2014 F2015 F2016 Earnings before interest and taxes (EBIT)... $ 1,822 $ 1,988 $ 2,111 $ 2,249 $ 2,361 $ 2,479 $ 2,542 $ 2,605 Income taxes paid on EBIT ,023 Earnings before interest and after taxes.... $ 1,106 $ 1,208 $ 1,283 $ 1,366 $ 1,434 $ 1,506 $ 1,544 $ 1,583 + Depreciation expense / Working capital and other changes Change in required cash Unlevered cash flow from operations $ 1,926 $ 2,455 $ 1,884 $ 1,995 $ 2,094 $ 2,199 $ 2,298 $ 2,355 Capital expenditures (net) Unlevered free cash flow $ 1,684 $ 2,205 $ 1,549 $ 1,563 $ 1,556 $ 1,545 $ 1,498 $ 1,536 Cash flow from operations... $ 1,922 $ 1,539 $ 1,951 $ 2,082 $ 2,185 $ 2,294 $ 2,348 $ 2,406 Exhibit may contain small rounding errors

11 40 Chapter 2 Financial Statement Analysis Exhibit 2.2 The Gap, Inc. s Discounted Cash Flow Valuation Using Hypothetical Management Forecasts The GAP, Inc. Discounted Cash Flow Valuation Cost of capital % Growth rate for free cash flow for continuing value % Billions of Dollars F2011 F2012 F2013 F2014 F2015 CV Firm F2015 Unlevered free cash flow for continuing value (CV).... $ 1,535.5 Discount factor for continuing value Unlevered free cash flow and CV $1,548.9 $1,562.9 $1,555.9 $1,545.4 $1,498.1 $13,959.2 Discount factor Present value $1,364.6 $1,213.3 $1,064.1 $ $ $ 7,411.0 Value of the firm $12,779.6 Exhibit may contain small rounding errors Generally, we would conduct a more detailed analysis of these companies before using them as comparable companies. Identifying a specific set of comparable companies for GAP is beyond what we cover in this chapter. We will discuss this issue in detail later in the book when we discuss the use of comparable companies in estimating the cost of capital and conducting a price multiples valuation. lo2 Measure the performance of a company using rates of return 2.5 measuring A COMPANY S PERFORMANCE USING ACCOUNTING RATES OF RETURN Accounting rates of return attempt to measure the performance of a company. We can measure a company s accounting rates of return in many ways. All of the alternatives are typically a measure of accounting income divided by a measure of the average level of investment used to generate that income. Some rates of return measure the amount of income generated for each dollar of investment; for example, a company with an annual income of $124 million and an investment of $1,240 million has a 10% rate of return on its investment. The 10% rate of return indicates that the company generates $1 of income each year for each $10 of investment. Conceptually, the higher the rate of return, the better the performance, ignoring the many pitfalls of using financial statement information to measure performance. We can compare a company s current rate of return to its historic rates of return in order to assess the change in its accounting-based performance over time, or we can compare it to the rates of return of competitor companies in order to assess its relative accounting-based performance. Naturally, it is important to ensure that you use a consistent numerator and denominator when measuring a particular type of rate of return. For example, if the denominator is average assets, then the numerator should be the income generated by those assets; thus, we would measure income before deducting interest expense (on an after-tax basis). If the denominator is average common equity, then the numerator should be income to the common equityholders. Similarly, if we measure income by excluding certain income effects from the numerator such as the effects of discontinued operations or the effects of excess assets, then we should exclude any assets related to the excluded income from the denominator. We discuss three rate of return measures that attempt to quantify the rate of return related to the company s invested capital: the return on assets (ROA), the return on investment (ROI), and return on (common) equity (ROE). Each of these rates of return attempts to measure the amount of income generated per dollar of invested capital given some specific definition of income and invested capital. Return on Assets The numerator in the return on assets (ROA) formula is unlevered income, and the denominator is average total assets for the period over which we are measuring the rate of return. To unlever income, we add back after-tax interest and other effects related to non-equity financing such as preferred dividends; we do

12 this to present what the income would have been had the company been completely financed with equity. The basic formula for computing ROA is Net Income Income Tax Rate for Interest2 3 Interest Expense ROA 5 Average Total Assets Chapter 2 Financial Statement Analysis 41 After reviewing GAP s footnote for income taxes (not shown in the chapter), we assume that GAP s effective income tax rate (income tax expense divided by income before taxes) of 39.3% ( $778/$1,982) is reasonable to use as the tax rate for interest. However, it should be noted that this is not always an appropriate assumption to make for the income tax rate for interest (we discuss this issue in more detail in the next chapter). GAP has $6 of interest expense and has no preferred dividends. The return on assets for GAP calculated for 2010 is $1, $6 ROA GAP, $7,985 1 $7,0652 /2 In the above formula, we assume that there are no minority interest positions in the company s subsidiaries (as GAP did not report any minority interest). If there were, we would reverse any impact of minority interest in the net income of subsidiaries, for the average total assets in the denominator represents the total assets, including any assets attributable to the minority interests. We often measure average total assets and other financial ratio denominators based on an average as the beginning-of-year balance plus the end-of-year balance divided by two. This calculation assumes the change in the denominator occurred evenly during the year and that the beginning and ending balances represent the average level of assets during the year. This might not be the case for companies that undertook a major acquisition or divestiture. In that case, we might compute the average from quarterly reports or perhaps from pro forma financials (based on the assumption that the transaction occurred at the beginning of the year). (2.1) Return on Investment The return on investment (ROI) is similar to the return on assets. The major difference between the two formulas is how we measure the denominator. In addition, the numerator is slightly different as well. The denominator for the return on investment is equal to average invested capital instead of average assets as used in the return on assets calculation. One way we can measure invested capital is to add the book value of debt to preferred stock and common equity, or looking at it from the asset side of the balance sheet we can subtract operating liabilities (accounts payable, wages payable, income taxes payable, deferred income taxes, etc.) from total assets. Some analysts add non-current net deferred tax liabilities to common equity under the assumption that this is not really a liability and that stockholder s equity was reduced when the deferred tax liability was recorded. They would make the same adjustment in calculating return on equity, discussed next. Since the denominator for the return on investment does not include investments by minority shareholders, we do not adjust the numerator by removing the adjustment to net income for minority interest as we did in the return on assets calculation. The reason some analysts prefer return on investment to return on assets is that the implicit financing costs of a company s operating liabilities are embedded in the company s operating expenses. (Recall our discussion of this point in Chapter 1.) As a result, it is usually quite difficult to add back the implicit financing costs of these operating liabilities; thus, to have a consistent numerator and denominator, we do not include the value of the operating liabilities in the denominator. The basic formula for the return on investment is Net Income Income Tax Rate for Interest2 3 Interest Expense ROI 5 (2.2) Average 1 Book Value of Debt 1 Preferred Stock 1 Common Equity 2 Since GAP has no debt and no preferred stock at the beginning or end of the year, the return on investment for GAP for 2010 is simply $1, $6 ROI GAP, $4,891 1 $ 4,0802 /2 Note that GAP did have a small amount of debt outstanding during the year when it drew down its revolver. If we knew the average debt outstanding over the year, we would include that in the denominator.

13 42 Chapter 2 Financial Statement Analysis Valuation Key 2.2 Rates of return measured using financial statements are popular performance measures. Rates of return measure the amount of income generated per dollar of capital invested, measured in a variety of ways. Alternative types of rates of return measures include return on assets, return on investment, and return on (common) equity. Sometimes, analysts use the return on long-term capital (long-term debt plus preferred stock plus common equity) as a rate of return measure, called the return on long-term investment. Because of the way the denominator is measured, we add back only the portion of interest attributable to long-term debt to our numerator when we measure the numerator for this rate of return. Return on (Common) Equity The return on (common) equity (ROE) measures the amount of income to common equity generated per dollar of equity invested (all measured using financial statement information). The basic formula for the return on equity is ROE 5 Net Income 2 Preferred Stock Dividends Average Common Equity Income to Common Equity 5 Average Common Equity (2.3) The return on equity for GAP for 2010 is ROE GAP, $1,204 2 $0 1$4,891 1 $4,0802 / Since GAP has no debt or preferred stock outstanding at the beginning and end of the year, the ROE and ROI will be very close. The only difference between them, in this case, is caused by the minimal amount of interest expense from debt outstanding at some point during the year, for we did not know the average debt balance for the denominator in the ROI calculation. The numerator for the return on (common) equity (ROE) is income available to common equityholders, and the denominator is the average common equity. The denominator is the average (common) equity of the company during the period over which we measure the numerator. Again, we typically measure this average by dividing the sum of the beginning and ending balances of the company s (common) equity by two. Since we do not deduct preferred stock dividends when measuring net income, we deduct it from the numerator to represent the income after all payments to non-common equity securities. Adjusting Financial Ratios for Excess Assets We can use alternative definitions for the numerator in the rate of return calculations; for example, we can exclude certain types of income from the numerator, such as income from excess assets, income from discontinued operations, one-time expenses from reorganizations, and extraordinary items. Regardless of the definition we use, however, we must make sure that our denominator is consistent with the definition of the numerator. For example, if we exclude income from excess assets in the numerator, we also exclude excess assets from the denominator. Valuation Key 2.3 Eliminating excess assets from rate of return measures is often very useful in order to gain a true sense of the profitability of a company s operations. That said, there are situations where eliminating the effect of excess assets is not preferred. For example, we would not eliminate excess assets if we wanted to understand the overall profitability of the company from the investors perspective. We use the definition that best fits the context of our analysis that best fits how we plan to use the ratio. No single definition dominates the alternatives in all contexts. For example, if we want to know the overall profitability of a company, we might prefer to include a company s excess assets; however, if we