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The Firm, Its Claimants, and the Capital market

The Capital Market: Trading Value The Investors: The claimants on value

The Firm: The Value generator

Cash from Loans Operating Activities Investing Activities Financing Activities

Debt holders
Interest and Loan repayments

Cash from Secondary sale of Debt Debt Holders

Cash from share issue

Dividends and cash from Share repurchase

Cash from Shareholders sale of Shares


BUSINESS ACTIVITIES : All Stocks and Flows for a firm Products & Inputs markets

Firm OR
Net Operating Assets (NOA)

Capital Markets

Net financial Assets (NFA)

Debt holders or Debt issuers




Operating activities


Financing activities

F = Net cash flows to debt holders and issuers ; d = Net cash flows to shareholders NFA (net financial assets) = financial assets financial liabilities C= Cash flows from operations; I = cash investment NOA = Net operating assets = operating assets operating liabilities OR = Operating revenue; OE = Operating expense; OI = operating income; NFI = Net financial income

Modeling a Business: A Simple Framework

#1 Raise Capital

#2 Invest in Business

#3 Generate Profit

Debt Equity

PPE Working Capital


#4 Reinvest/Return

Reinvest in Business Service/Paydown Debt Dividends/Buy-backs

Operating Operating revenue Operating expense (excluding goodwill, one time items, interest and expected return on plan assets for pensions) Income (loss) on operating associates = Pre-Tax Operating Profit (EBIT) Tax on operations is assumed to be at the statutory rate = NOPAT

Financing Interest income (expense) Dividend income Gain/Loss on financial investments Foreign currency gains (losses) Preferred dividends Pension interest cost Pension expected return on plan assets Implied interest expense on capitalized operating leases = Net Financial Income (Expense) Pretax Tax on financing is assumed to be at the statutory rate = Net Financial Income (Expense)

Other Income (loss) on nonoperating associates Other non-operating income (expense) Minority interest Tax adjustment = Other Income (Expense)

NOPAT + Net Financial Income (Expense) + Other Income (Expense) = Net Income

BALANCE SHEET Operating Assets Operating Liabilities = Net Operating Assets Financial Liabilities Financial Assets = Net Debt Other Assets Other Liabilities = Net Other Assets
Total Assets Total Liabilities and Equity

Operating Liabilities Operating Assets Financial Obligations Shareholders Equity Financial Assets

Net Operating Assets

Total Capital (Book) Net Debt

Net Operating Assets

Shareholders Equity

GAAP BALANCE SHEET ( Conceptual stock of shareholder value)
Liabilities and Equity Operating liabilities Financial Obligations Common shareholders equity Total claims Rs. OL FO CSE ----------OL + FO + CSE Assets Operating Assets Financial Assets Rs. OA FA ----OA + FA

Total assets

Reformulated Balance Sheet

Fin. Obligations and Owners Equity Financial Obligations Financial Assets Net Financial Obligations Common shareholder equity Rs. FO (FA) ---------------NFO CSE ---------------NFO + CSE Operating Assets Operating Assets Operating Liabilities Rs. OA (OL)

Net operating Assets


Issues to resolve: Cash, Long term equity investments, notes receivable (short term And long term), accrued expenses (interest), Deferred tax assets and liabilities, Minority interest, leases, dividends payable

Balance Sheet A traditional balance sheet shows assets (left) and liabilities plus equity (right)

Cash Mkt Sec Assets Receivables Inventory PPE Assets

10 5 8 12 50 85

Payables Debt Equity

10 60 15

Liabilities Equity



An economic balance sheet shows NOA (left) and invested capital (right)

Receivables NOA Inventory PPE Payables NOA

8 12 50 (10) 60

Debt Cash Mkt Sec Equity Invested Cap

60 (10) (5) 15 60

Net debt


INCOME STATEMENT (Conceptual Flow or change in shareholder value)

GAAP Net revenue COGS Gross margin Operating expenses EBIT Income taxes EBIT(1-t) Extraordinary items Net income Preferred dividends Net income available to common Rs. xxx Xxx Xxx Xxx Xxx Xxx Xxx Xxx Xxx Xxx xxx Reformulated Income Statement Operating revenue Operating expense Operating income Finance expense xxx Finance revenue (xxx) Net finance expense Rs. OR (OE) OI

(NFE) --------Earnings

Issues to resolve :Income from subsidiary, currency gain or loss, income/ loss from discontinued operations, abnormal gain and losses on extraordinary items Interest on capitalized construction costs, interest income, tax allocation

Income Statement

Traditional income statement:

Economic income statement:


70 (40) (17) 13

Revenue COGS SG&A Tax on Ops NOPAT

70 (40) (17) (5) 8


Interest exp Interest inc EBT

(5) 1 9 Interest exp Interest inc Tax on NFE (5) 1 1 (3) NFE

Tax expense



Net income

Net income

Net income


GAAP Reformulated Statement of cash flows Cash flows from operations Cash investment Cash flows from operations + Cash flows from investing + Cash flows from financing = Change in cash flows xxx xxx xxx xxx Free Cash Flow Equity Financing flows: Dividends and share repurchase xxx Share issues (xxx) ------Debt Financing Flows: Net purchase of financial assets xxx Interest on Financial assets (xxx) Net issue of debt (xxx) Interest on debt xxx -------C I -----CI

( The Accountants viewpoint)

F ------Total Financing Flows d+F (Reflects the thought process of the treasurer Or the CFO and they reflect management Activities)

Cash Flow

A traditional cash flow statement:

An economic cash flow statement:

Net income Receivables Operating Inventory Payables Depreciation Investing

5 (2) (3) 2 6 NOPAT Receivables Inventory Payables Depreciation 8 (2) (3) 2 6 (12) FCFO

Capital exp


Capital exp


Principal debt Dividends

10 (1)

NFE Principal debt Cash

(3) 10 (5) FCFF


5 Dividends 1 FCFE

Cash Flow = Income less Delta Balance Sheet Cash flow = Income Statement Balance Sheet

= NOPAT Receivables FCFO Inventory Payables Depreciation Capital exp 8 (2) (3) 2 6 (12) =


Receivables Inventory Payables PPE

2 3 (2) 6 NOA

NFE FCFF Principal debt Cash

(3) 10 (5)


Debt Cash Mkt Sec

10 (5) 0 Net debt



Net Income



The Operating Cycle


Operating Asset Turnover (Revenue/NOA)

NOPAT Margin (NOPAT/Revenue)

Net Operating Assets


Operating Profit (NOPAT)

The Profitability Map

Operating Asset Turnover Low High High Multiple Target Area

Operating Margin



Sales NOA =


NOPAT Margin x

Operating Asset Turnover =

Source: Morgan Stanley Research; Valuing and Measuring a Technological Edge: Finding the FASSTESTSM Companies, October 10, 2000

The Pillars of ROE

The Profitability Tree Operating Asset Turnover + Leverage Effect


NOPAT margin


Traditional DuPont Model Net Profit Sales Sales Assets Assets Equity


The Basic Connection

Sales less COGS SG&A R&D Taxes

Operating Income Operating Profit Margin

Financial Expense less G/(L) on Investments



Net Operating Asset Turnover

Net Financial Expense (NFE)

Operating Assets less Operating Liabilities

Leverage (NFO/Equity)

Net Operating Assets

Cash plus Investments less Debt


Leverage Effect


Net Financial Obligations (NFO)

Source: Morgan Stanley Research; The Apples to Apples Earnings Monitor Trevor Harris, December 10, 2000

ADJUSTMENTS LIFO PENSIONS AND OPEBs GOODWILL Amortisation, Impairment and unrecorded Indefinite life intangibles Available for sale securities Equity investments Securisation Preferred dividends Leases

Intrinsic Value: A Road Map




Residual Income (operating)



Residual Income (equity)

Intrinsic Value Compare and Contrast Cash Flow Models Cash flow models are easy to understand. These models are a form of the familiar NPV analysis. Cash flow is not aligned with focus of forecast: Analysts/ investors typically focus on near-term earnings. Cash flow (and hence most of the value in a cash flow model) typically comes late in the lifecycle. Furthermore, cash flows require a forecast of the balance sheet. Cash flows are volatile: Cash flows are more volatile and less predictable than earnings. They are difficult to forecast. Residual Income Models Focuses predominantly on what we know: Current value book value and near-term residual income are usually the largest component and the terminal value component of value is often the smallest. Returns can be benchmarked. Residual income equals the difference between what the firm earns in a period and what it was expected to earn given its beginning book value. Connects the calculation of intrinsic value directly to the profitability tree, making it possible to uncover how changes in profitability affect residual income and value.

For entity-levels models (DCF and ROIM), consistency between operating and financing drivers is important. Be careful not to miss (or double count) items that dont fall neatly into these categories, like associate income, minority interest, other categories, etc Dont ignore a changing capital structure: WACC should reflect the leverage profile of the company over the forecast period.

REFORMULATED SHAREHOLDERS EQUITY Beginning BV of equity + Net effect of changes in shareholders equity + capital contributions - share repurchase - dividends = Net cash contributions ( negative net dividends) + Effective of operations and nonequity financing + Net income + Other comprehensive income* - Preferred dividends = Comprehensive income available to common shareholders Closing BV of equity *Other Comprehensive income includes translation gains and losses, unrealised gains or losses on available for sale securities, gain or loss on some derivative instruments (fair value hedges and cash flow hedges)

Drivers of Free Cash flows and the Disposition of Free cash 1. Free cash flow = Operating income Change in Net operating Assets C I = OI NOA Free cash flow is also the dividend from operations 2. Free cash flow = Change in net financial assets Net financial income + Net dividends C I = NFA NFI + d 3. Free cash flow = Net financial expenses Change in net financial obligations + net dividends C I = NFE NFO + d

Drivers of Net Operating Assets and Net Indebtedness 1. Net operating assets (end) = Net operating assets (beginning) + operating income Free cash flow NOA t = NOA t-1 + OI t (C t I t)

2. Change in Net operating assets = Operating income Free cash flow NOA = OI t ( C t I t ) 3. Net Financial assets (end) = Net financial assets (begin) + Net financial income + Free cash flow - net dividends NFA t = NFA t-1 + NFI t + ( C t I t ) d t 4. Change in Net Financial Assets = Net income + Free cash flows Net dividends NFA t = NFI t + ( C t I t ) d t

5. Net Financial Obligations (end) = Net financial obligations (beginning) + Net Financial expense Free cash flow + Net dividends NFO t = NFO t -1 + NFE t - (C t I t) + d t

6. Change in Financial Obligations = Net Financial expense Free cash flow + net dividends NFO t = NFE t ( C t I t) + d t

What Generates Value 1. CSE t = CSE t-1 + earnings t net dividends t 2. CSE t = NOA t NFO t

Beginning stocks NOA t-1 NFO t-1 CSE t-1

Flows OI t ( C t I t) NFE t ( C t I t) + d t OI t NFE t d t

Ending stocks NOA t NFO t CSE t

Operating and Financial Accruals 1. OI = ( C I ) + I + operating accruals OI = C + operating accruals

2. NFE = i + financing accruals

3. NOA t = NOA t-1 + I t + operating accruals 4. NFO t = NFO t-1 ( C t I t) + i t + financing accruals + d t

The Analysis of Profitability

ROCE=Earning / CSE = RNOA + (FLEV X SPREAD) Interest expense and MI

Level 1


NBC = NFE / NFO PM = OI / sales

Level 2

ATO = sales / NOA

Dell, Oracle, HUL, GM, MICROSOFT

Level 3

Sales PM

Other items PM

Gross margin Expense Ratios Ratio

Financial statement line items:

Other OI / sales Individual asset and Ratios liability turnovers

Borrowing cost drivers

Earnings = Comprehensive income, CSE = Common shareholders equity, OI = Operating Income ( after tax), NOA = Net operating Assets, NFE = Net financial expenses, NFO = Net Financial obligations.

ROCE = Return on equity, RNOA = Return on net operating Assets, ROOA = Return on operating Assets, NBC= Net borrowing cost, OLLEV= Operating liability leverage, OLSPREAD= Operating Liability leverage spread, FLEV= Financial leverage, SPREAD= Operating spread, PM= Operating profit margin, ATO= Asset turnover

Performance Indicators Leverage : pipelines, utilities, hotels Low leverage : business services, printing and publishing and chemicals Low leverage but high operating leverage : business services High financial and operating leverage : airlines, trucking High margins and high turnovers : printing and publishing and chemicals Low turnovers and high margins : pipelines, shipping, utilities and communications High turnovers and low margins : food stores, apparels, retail stores

ROCE RNOA in financing

Level 1

Core OI from sales NOA

Core other items NOA

Unusual items NOA




Core sales PM

ATO ATO x core Sales PM Core NBC Unusual financing items

Level 2 In core sales PM x ATO

Level 3
in core Sales PM drivers in ATO drivers in core other income components in unusual Item components in core NBC drivers

in unusual in NFO components components





Changes in sales for Business segments or product lines

Changes in individual Assets turnovers

Changes in NFO components

Forecasting Checks :UNUSUAL ITEMS Unusual items are those that wont be repeated and also items that appear each Period but cannot be forecasted. Usually listed as extraordinary items. Gross margins may also be impacted by Unusual items ( special order or strike). Examples: ( adjusted for taxes) Special charges Nonrecurring items, assets write downs Changes in estimates, Accounting changes Start up costs expensed ( pre opening costs for Wal Mart, Target, Starbucks) Profit and loss in asset sale, discontinued operations, currency gains and losses Gains from share issues in subsidiaries, Unrealized gains and losses on equity investments Extraordinary operating items Derivative gains and losses (operations)

Read Management Discussion and Analysis for clues

Issues with Sustainable Earnings Restructuring charges, asset impairments (bleeding back) R&D (Merck & Co) Advertising ( Coco cola) Pensions ( English Electric) Changes in estimates Realised gains and losses (cherry picking : beware of firms with huge investments) Unrealised gains and losses on equity investments Other income (includes interest income)

QUALITY OF EARNINGS Unexplained changes in accounting, especially when performance is poor. Unexplained transactions that boost profits ( e.g. asset sales). Unusual increases in accounts receivable in relation to sales increases. Unusual increases in inventories in relation to sales increases. An increase gap between reported income and cash from operations. An increasing gap between firms reported income and its tax income ( aggressive reporting, e.g. warranty expenses). Unexpected large asset write off (may be due to changed business environment). Qualified audit opinions or changes in independent auditors that are not well justified. Related party transactions or transactions between related entities.

Key Drivers : Select Industries

Industry Automobiles Beverages Cellular phones Commercial real estate Computers Fashion clothing Internet commerce Non fashion clothing Pharma Retail

Key economic factors Model design and production efficiency Brand management and production innovation Population covered and churn rates Square footage and occupancy rates Technology path and competition Brand management and design Hits per hour Production efficiency Research and development Retail space and sales per square foot

Key ReOI drivers Sales and margins Sales Sales and ATO Sales and ATO Sales and margins Sales and advertising/sales Sales and ATO Margins Sales Sales and ATO