Unit 4 Large Company analysis v3 and Valuation copy 4

Credit Skills Academy !!!!

Advanced Level Course

Unit 4: !!!

Large Company Analysis and Valuation

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Senior authors: Keith Checkley FCIBS, Chartered Banker and Keith Dickinson FCIB

The authors have taken all reasonable measures to ensure the accuracy of the information contained in this topic and cannot accept responsibility or liability for errors or omissions from any information given or for any consequences arising.

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© Keith Checkley & Associates, February 2015

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Welcome to the Credit Skills Academy.

There have been previous financial crises but this time it is the severity and global impacts that are very different from what we have seen before. Never have banks and lending bankers received greater criticism over the quality of their lending than at the present time.

Media comment suggests that prudent lending principles have been disregarded in the quest in recent years for increased lending volumes and enhanced short term profitability. Analysts suggest that many of the prudential canons of lending have been overlooked and many lending bankers would benefit from a reconsideration and review of well tested and accredited lending principles. It is against this background that the Credit Skills Academy has been developed.

The modules in this Academy have been prepared to allow you and your colleagues instant access via e-learning and may be accessed as individual topics in which you are interested. We believe that they will also make an excellent basis for discussion with colleagues for mutual benefit.

We do hope that the extensive range will help you in your everyday job and also as someone interested in self development in the important area of Credit Skills.

Keith Checkley FCIBS and Keith Dickinson FCIB Senior authors


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Large Company Analysis and Valuation !

!!!Key learning outcomes 5

Introduction 6

External analysis 6

Credit framework 7

Using ratios 8

Limitations of ratio analysis 8

Specimen company 9

Ratios 10

Profitability 10

Liquidity - operating risk 11

Structure - financial risk 11

Market ratios 11

Du Pont analysis 12

Cash flow 14

Cash flow measures and cover ratios 15

Forecast 15

Forecast financial statements 16

Signs of distress 18

Beaver and Altman Z scores 19

Market and accounting valuation 20

Accounting methods 20

Market method 21

Free cash flow valuation 21

Summary 25

Review 26

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Key learning outcomes !� Appreciating techniques for the following:

� Assessing the financial strength of a company

� Deriving historic ratios

� Computing cash flow

� Forecasting financial statements

� Generating a business valuation.


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! INDUSTRY !

COMPANY

!PERFORMANCE RISK

– PROFITABILITY

!BUSINESS RISK

– OPERATING CYCLE FINANCIAL RISK –

FINANCIAL STRUCTURE

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Introduction !

Analysing company performance depends on measuring the financial information produced by companies in the form of annual reports, interim reports, prospectuses and other statutory information such as the 10Q quarterly statement in the United States. Company annual reports consist of:

• Directors’ report on the results for the years

• Auditor’s report confirming that the accounts conform with recognised accounting practice

• Income statement showing the income, costs and resulting profit or loss for the period

• Balance sheet as a “snapshot” of the companies assets and liabilities at the beginning and end of the period

• Cash flow summarising the sources and use of funds during the period

• Notes to the accounts consisting of details not included in the accounting statements. !

There is usually a wealth of information and detail, which make it difficult to assess the result purely on the directors’ report or the glossy pictures at the front of the publication. Companies present information in different formats and accounts analysis needs to view both internal and external information. Throughout this unit, Tesco plc, the UK retailer, is used as a reference.

!External analysis

!Before looking at a specific company, the external and industry environments need to be considered. The diagram below shows a stylised view of the credit process that can be used as the basis for business analysis and corporate valuation:

• Environment – factors beyond the control of the company such as the economy or political action

• Industry – some industries are more profitable than others and have the ability to produce superior returns

• Company profile and a range of ratios

• Cash flow analysis

• Role and competence of management. !

PROCESS

ENVIRONMENT

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CASH FLOW !!

MANAGEMENT

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Analysis framework

Suitable models could include the PESTLE model below which organises factors the company cannot directly control. Actions of government change the competitive landscape and companies have to adapt to shifting circumstances. Examples could include tax or exchange rate changes.

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POLITICAL ECONOMIC SOCIAL TECHNOLOGICAL LEGAL ENVIRONMENTAL

Government Business cycles Demographics Spending on Health & safety Pollution control stability & Interest rates Income R & D Employment Noise levels initiatives Exchange rates distribution Speed of regulations Parking

Regulation & Money supply Social mobility technology New restrictions restrictions deregulation Credit control Lifestyle changes New materials on trade and Planning Privatisation Inflation Qualifications and processes product standards restrictions Foreign trade Unemployment Working conditions Refinements Restrictions on Waste disposal

regulation Disposable Attitudes to work in equipment working hours Taxation policy income and leisure IT development Other EU

integration !

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Similarly, some industries are inherently more profitable than others and able to generate above-average returns over several periods. Other industries suffer from competitive pressures and organisations are unable to differentiate themselves sufficiently. This analysis can be summarised in the Porter model below. Such models assist in reviewing factors later that could influence growth and cash flow. !

SUPPLIER POWER See buyers

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THREAT OF ENTRY Economies of scale RIVALRY AMONG THREAT OF SUBSTITUTES

Absolute cost advantages EXISTING FIRMS Buyer propensity Capital requirements Concentration to substitute Product differentiation Diversity of competitors Relative price/

Government and Product differentiation performance legal barriers Excess capacity and of substitutes Retaliation by exit barriers

established producers Cost conditions !!!

BUYER POWER PRICE SENSITIVITY BARGAINING POWER

Cost of product relative Size and concentration of buyers to total costs relative to suppliers

Product differentiation Buyers’ switching costs Competition between buyers Buyers’ information

Buyers’ ability to backwards integrate

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(Reference: Prof Michael Porter, Harvard Business School)

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Using ratios !

Spreading the accounts by combining information from the statements and notes in the annual reports allows:

• standardisation of the format of the accounts by “spreading” all the information including the notes to the accounts in a standard format

• combination of the statements and notes in one schedule

• calculation ratios from the income statement, balance sheet and cash flow statement

• examination of the ratios for changes over time and against peer groups. !

This process allows the analyst to understand the performance of the company and the financial strength of the balance sheet. Ratio analysis is therefore a framework for informed decision making.

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Limitations of ratio analysis !

Ratios are based on the accounting model and you should bear in mind that there are international and local differences, which may need adjustment for more exact study, for example:

• Ratios are not necessarily “good” or “bad” – you have to understand the sector and the profile of the business; for example, food stores groups often appear illiquid based on a snapshot balance sheet analysis of current assets minus current liabilities.

• International differences in legal systems, taxation methods, and requirement to publish statutory financial information and inflation.

• Differences in the implementation of international accounting standards or local accounting practice (GAAP).

• Accounts are based on historic asset values rather than market values.

• Seasonal factors can distort the figures; for example, the borrowings in the balance sheet may not reflect the pattern of borrowing during the accounting period.

• Off balance sheet items appear to reduce borrowings without changing commitments. The US accounting standard FASB 13 uses certain tests to ascertain if a lease is an operating lease and therefore not included as borrowings on the balance sheet. The alternative is a finance or capital lease, which is treated in a similar manner to a loan. It should be noted that some countries do not require capitalisation of any leases under local GAAP.

• Some companies employ “window dressing” in order to boost earnings. One method is to move costs from the income statement to the balance sheet, which results in an increase in profits; for example, increasing the depreciation period on a class of assets does not change cash flow, but reduces current costs in the income statement.

• Comparisons between companies are difficult since large companies have a number of divisions with varied financial characteristics. Peer group examination is not possible without adjustment.

• Peer group analysis of average companies may not always assist since average performance is not necessarily “good”. You often need to review the sector leaders to understand best practice.

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Specimen company !

The next sections consider the accounts of Tesco plc to demonstrate the main ratios. This is a UK retail group that has grown rapidly in recent years. !

The first stage is to review the numbers and look for trends. You can say that the company’s turnover and profits have grown in the past five years. Similarly, the balance sheet has grown in line with turnover. !

Below, there are the Income Statements and Balance Sheet. Each line is numbered and the references are used in the ratios and other schedules. The notation is B for balance sheet, P for the profit and loss account (income statement), C for cash flow and R for ratios. !

Income Statement !! Tesco plc Year 1 Year 2 Year 3 Year 4 Year 5


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Specimen company

The next sections consider the accounts of Tesco plc to demonstrate the main ratios. This is a UKretail group that has grown rapidly in recent years.

The first stage is to review the numbers and look for trends. You can say that the company’sturnover and profits have grown in the past five years. Similarly, the balance sheet has grown inline with turnover.

Below, there are the Income Statements and Balance Sheet. Each line is numbered and thereferences are used in the ratios and other schedules. The notation is B for balance sheet, P for theprofit and loss account (income statement), C for cash flow and R for ratios.

Income Statement

Assets

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Assets Tesco plc Year 1 Year 2 Year 3 Year 4 Year 5!


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Specimen company

The next sections consider the accounts of Tesco plc to demonstrate the main ratios. This is a UKretail group that has grown rapidly in recent years.

The first stage is to review the numbers and look for trends. You can say that the company’sturnover and profits have grown in the past five years. Similarly, the balance sheet has grown inline with turnover.

Below, there are the Income Statements and Balance Sheet. Each line is numbered and thereferences are used in the ratios and other schedules. The notation is B for balance sheet, P for theprofit and loss account (income statement), C for cash flow and R for ratios.

Income Statement

Assets

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Liabilities

Tesco plc Year 1 Year 2 Year 3 Year 4 Year 5

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Liabilities

Ratios

Profitability is the result of the decisions taken by management of what to make and how and atwhat price to sell it. It is usual to express returns as percentages on the Income Statement and asreturns against various measures of the capital employed in the business.

Profitability

The profitability is calculated at the gross margin, net operating profit and profit before tax lines.In this example, the company appears to grow year on year. This is borne out by the returnsmeasures which are a combination of the Income Statement and the Balance Sheet. The return onassets and equity increase showing greater returns to shareholders.

Ratios

Ratios !

Profitability is the result of the decisions taken by management of what to make and how and at what price to sell it. It is usual to express returns as percentages on the Income Statement and as returns against various measures of the capital employed in the business.

!Profitability

The profitability is calculated at the gross margin, net operating profit and profit before tax lines. In this example, the company appears to grow year on year. This is borne out by the returns measures which are a combination of the Income Statement and the Balance Sheet. The return on assets and equity increase showing greater returns to shareholders.

!Ratios

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Tesco plc Year 1 Year 2 Year 3 Year 4 Year 5!


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Liabilities

Ratios

Profitability is the result of the decisions taken by management of what to make and how and atwhat price to sell it. It is usual to express returns as percentages on the Income Statement and asreturns against various measures of the capital employed in the business.

Profitability

The profitability is calculated at the gross margin, net operating profit and profit before tax lines.In this example, the company appears to grow year on year. This is borne out by the returnsmeasures which are a combination of the Income Statement and the Balance Sheet. The return onassets and equity increase showing greater returns to shareholders.

Ratios

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Liquidity - operating risk

Liquidity describes the operating cycle and the use of cash. The organisation purchases raw materials from its creditors and these are processed into finished goods and sold and become debtors or accounts payable. Industries differ in their requirements for cash, but the more cash that is tied up in the cycle, the more risk in the business for a creditor. Stocks have to be financed and if the company pays more in interest to finance the cycle, less cash is left to pay creditors. This company is efficient in maintaining a gap between creditors and debtors and using cash takings to fund purchases. This is confirmed by the funding gap, which is calculated as:

Debtor days + inventory days – creditor days !Structure - financial risk

Financial risk includes working capital and long term assets and how they relate to the capital injected by the shareholders. By raising debt, there are implications for the shareholders:

• Shareholders can increase the capital available while limited their investment

• Interest on debt is tax deductible and has to be repaid in accordance with repayment schedules

• Creditors look to the shareholders to provide a margin of safety

• If the earnings on the invested capital are more than the borrowed funds, then the shareholders’ returns are leveraged.

The implication is that an increase in debt extends the risk to creditors since dividends can be deferred if there are insufficient returns. On the other hand, failure to repay bank loans is an act of default, which could be followed by the bank’s appointment of a receiver.

The above ratios detail the working capital in two ratios: the current ratio is simply the current assets divided by the current liabilities. The quick ratio uses the current assets minus stock as its base since stock may not be immediately saleable as “near cash”.

The gearing or leverage ratios use short and long term debt divided into shareholders’ funds. There are several variants of these ratios, such as total debt divided by total assets, but the aim is to demonstrate the degree of leverage. Creditors prefer low debt ratios although shareholders desire high leverage since it magnifies earnings. The degree of leverage also has implications for the weighted average cost of capital (WACC) since high gearing usually reduces the cost of capital within reasonable bands.

This company is not highly geared at 55% although gearing has increases slightly in the five year period. The solvency or interest cover ratio divides the interest payable into the net operating profit (profit before interest and tax). This shows how many times the current interest cost that could be covered by existing profits. !Market ratios

The ratios considered so far are all historic or backward-looking, whereas market ratios can include consideration of current share prices and provide an insight of what investors think of the prospects for the company. The two essential ratios are the P/E and market to book ratios.

The data required is the number of shares and the market prices per share over time. The P/E ratio demonstrates how much investors are prepared to pay for each unit of reported profits. The calculation is:

Market price per share/Net profit after tax per share

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The market to book is simply the market price divided by the book value per share and gives an indication of how investors regard the company. In this example, the P/E ratio has improved, whereas the market to book is more variable.

!Market ratios

! Tesco plc Year 1 Year 2 Year 3 Year 4 Year 5!


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The market to book is simply the market price divided by the book value per share and givesan indication of how investors regard the company. In this example, the P/E ratio has improved,whereas the market to book is more variable.

Market ratios

The dividend payout per share shows the return on each share held. This has remained broadlyconstant and has not impacted the dividend cover since the overall financial results haveimproved.

Du Pont analysis

The Du Pont ratios are based on the pyramid of ratios developed by E I Dupont de Nemours toevaluate business performance. The general approach is to break ratios down into theircomponents to simultaneously illustrate the financial health of the business.

The key ratio is the return on shareholders’ equity and this can be broken down into threecomponents, which can be multiplied together to produce the return on equity:

• Return on sales = Net profit after tax/sales = Profit for shareholders on each $1 of turnover

• Asset turnover = Sales/total assets

• Asset leverage = Net profit after tax/shareholders’ funds

Du Pont (Core) ratios

The following diagram shows the three ratios and their components from the Income Statementor Balance Sheet. The return on equity is of key importance to shareholders since it measures thereturn they receive relative to other investments such as government bonds. It is therefore thereward for risking their capital and investing in the business.

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The dividend payout per share shows the return on each share held. This has remained broadly constant and has not impacted the dividend cover since the overall financial results have improved.

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Du Pont analysis !

The Du Pont ratios are based on the pyramid of ratios developed by E I Dupont de Nemours to evaluate business performance. The general approach is to break ratios down into their components to simultaneously illustrate the financial health of the business.

!The key ratio is the return on shareholders’ equity and this can be broken down into three

components, which can be multiplied together to produce the return on equity:



• Asset leverage = Net profit after tax/shareholders’ funds !

Du Pont (Core) ratios Tesco plc Year 1 Year 2 Year 3 Year 4 Year 5

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The market to book is simply the market price divided by the book value per share and givesan indication of how investors regard the company. In this example, the P/E ratio has improved,whereas the market to book is more variable.

Market ratios

The dividend payout per share shows the return on each share held. This has remained broadlyconstant and has not impacted the dividend cover since the overall financial results haveimproved.

Du Pont analysis

The Du Pont ratios are based on the pyramid of ratios developed by E I Dupont de Nemours toevaluate business performance. The general approach is to break ratios down into theircomponents to simultaneously illustrate the financial health of the business.

The key ratio is the return on shareholders’ equity and this can be broken down into threecomponents, which can be multiplied together to produce the return on equity:



• Asset leverage = Net profit after tax/shareholders’ funds

Du Pont (Core) ratios

The following diagram shows the three ratios and their components from the Income Statementor Balance Sheet. The return on equity is of key importance to shareholders since it measures thereturn they receive relative to other investments such as government bonds. It is therefore thereward for risking their capital and investing in the business.

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The following diagram shows the three ratios and their components from the Income Statement or Balance Sheet. The return on equity is of key importance to shareholders since it measures the return they receive relative to other investments such as government bonds. It is therefore the reward for risking their capital and investing in the business.

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Du Pont ratios !

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Cost of Goods Sold Sales (27.594) 33,974

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Selling, G & A Expenses Total Expenses Net Profit (3,698) (32,012) after Tax Return on

(NPAT) Sales %

Depreciation Tax on Income (ROS) (733) (593) 1,369 4.03

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Other and Exceptional Costs Sales 183 33,974

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Net Interest Expense (170) =

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Cash + Marketable Securities 1,146

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Accounts Receivable Total Current Assets Sales Asset Turnover Return 597 3,457 33,974 (AUR) = on

1.55 Equity %

(ROE) 15.20

Stock (Inventory) Fixed Assets Total Assets 1,309 414 21,868

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Sundry Current Assets Investments + Other = 405 17,997

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Share Capital Total Assets 389 21,868 Asset Leverage

(AL) !

Retained Profit & Loss Net Worth 8,617 9,006 2.43

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Cash flow !

The analysis of liquidity, profitability and financial structure leads to cash flow. Any analyst needs to see both quantity and quality of cash flow to repay loans. If the company manages its assets efficiently, then it should generate cash and, statistically, if it has managed a healthy cash flow in the past, it may be able to achieve stability of growth in the future. Emphasis is now placed on cash flow as a key indicator. Whereas profit can be manipulated by using differing accounting standards and conventions, cash is real or less subject to possible manipulation.

!Cash flow statement


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Cash flow

The analysis of liquidity, profitability and financial structure leads to cash flow. Any lender needsto see both quantity and quality of cash flow to repay loans. If the company manages its assetsefficiently, then it should generate cash and, statistically, if it has managed a healthy cash flow inthe past, it may be able to achieve stability of growth in the future. Emphasis is now placed oncash flow as a key indicator. Whereas profit can be manipulated by using differing accountingstandards and conventions, cash is real or less subject to possible manipulation.

Cash flow statement

The cash flow above is derived from the Income Statement and Balance Sheet. This is in amodified statutory form and shows:

Operating profit (NOP)+ Depreciation / amortisation / non-cash itemsEarnings before interest, tax, depreciation & amortisation (EBITDA)+/- Changes in net working capitalNet operating cash flow (NOCF) – this is the cash generate by trading- Interest and dividends to providers of finance- Taxation- Capital expenditure- Exceptional and minority items

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The cash flow above is derived from the Income Statement and Balance Sheet. This is in a modified statutory form and shows:

Operating profit (NOP) + Depreciation / amortisation / non-cash items Earnings before interest, tax, depreciation & amortisation (EBITDA) +/- Changes in net working capital Net operating cash flow (NOCF) – this is the cash generate by trading - Interest and dividends to providers of finance - Taxation - Capital expenditure - Exceptional and minority items

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Cash flow before financing – this is the cash flow before any new debt or equity +/- Change in short term debt +/- Change in long term debt +/- Change in equity Change in bank over the period – this must reconcile to the starting and finishing bank.

!This statement above illustrates the trading cash in the net operating cash flow. This is distinct

from one-off profits such as the sale of a company or an investment. A lender needs to understand the level of cash generated in order to decide if the company can afford to repay the envisaged new cash flow. !

The net operating cash flow is used to pay interest to debt providers, dividends to shareholders, taxation to the government, investment in capital expenditure and minority and exceptional items. The resulting total is the cash flow before any new finance is received by the company. New debt and equity is then shown separately and the bottom line is the change in cash in the balance sheet. !Cash flow measures and cover ratios

The cash flow cover ratios use the three key lines of EBITDA, net operating cash flow and cash flow before financing and relate them to sales. The company is improving its EBITDA and NOCF cash; however the cash flow before financing ratio is more variable due to the investment in new capital goods. !

Cash flow Tesco plc Year 2 Year 3 Year 4 Year 5


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Cash flow before financing – this is the cash flow before any new debt or equity+/- Change in short term debt+/- Change in long term debt+/- Change in equityChange in bank over the period – this must reconcile to the starting and finishing bank.

This statement above illustrates the trading cash in the net operating cash flow. This is distinctfrom one-off profits such as the sale of a company or an investment. A lender needs to understandthe level of cash generated in order to decide if the company can afford to repay the envisagednew cash flow.

The net operating cash flow is used to pay interest to debt providers, dividends to shareholders,taxation to the government, investment in capital expenditure and minority and exceptional items.The resulting total is the cash flow before any new finance is received by the company. New debtand equity is then shown separately and the bottom line is the change in cash in the balance sheet.

Cash flow measures and cover ratios

The cash flow cover ratios use the three key lines of EBITDA, net operating cash flow and cashflow before financing and relate them to sales. The company is improving its EBITDA and NOCFcash; however the cash flow before financing ratio is more variable due to the investment in newcapital goods.

Cash flow

Forecast

The analysis so far has used historic information, but lending money or producing a valuationdepends on future prospects or the ability to generate cash. Creditors have to decide what degreeof risk is measurable credit process, which underpins credit decisions. This means that a forecastis required. The procedure in the model is to use drivers to plot the known financial statement lineitems. The balance sheet is then forced to balance using cash or short term debt. Here are thedrivers used:

Forecast drivers

!Forecast !

The analysis so far has used historic information, but lending money or producing a valuation depends on future prospects or the ability to generate cash. Creditors have to decide what degree of risk is measurable credit process, which underpins credit decisions. This means that a forecast is required. The procedure in the model is to use drivers to plot the known financial statement line items. The balance sheet is then forced to balance using cash or short term debt. Here are the drivers used: !

Forecast drivers


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Cash flow before financing – this is the cash flow before any new debt or equity+/- Change in short term debt+/- Change in long term debt+/- Change in equityChange in bank over the period – this must reconcile to the starting and finishing bank.

This statement above illustrates the trading cash in the net operating cash flow. This is distinctfrom one-off profits such as the sale of a company or an investment. A lender needs to understandthe level of cash generated in order to decide if the company can afford to repay the envisagednew cash flow.

The net operating cash flow is used to pay interest to debt providers, dividends to shareholders,taxation to the government, investment in capital expenditure and minority and exceptional items.The resulting total is the cash flow before any new finance is received by the company. New debtand equity is then shown separately and the bottom line is the change in cash in the balance sheet.

Cash flow measures and cover ratios

The cash flow cover ratios use the three key lines of EBITDA, net operating cash flow and cashflow before financing and relate them to sales. The company is improving its EBITDA and NOCFcash; however the cash flow before financing ratio is more variable due to the investment in newcapital goods.

Cash flow

Forecast

The analysis so far has used historic information, but lending money or producing a valuationdepends on future prospects or the ability to generate cash. Creditors have to decide what degreeof risk is measurable credit process, which underpins credit decisions. This means that a forecastis required. The procedure in the model is to use drivers to plot the known financial statement lineitems. The balance sheet is then forced to balance using cash or short term debt. Here are thedrivers used:

Forecast drivers

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The forecast assumes a sales growth of ten per cent in the next five years and cost structures maintained at approximately the same level as the last two years.

!Forecast financial statements

!Forecast statements can be generated from these statements as below:

!Forecast income Tesco plc


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The forecast assumes a sales growth of ten per cent in the next five years and cost structuresmaintained at approximately the same level as the last two years.

Forecast financial statements

Forecast statements can be generated from these statements as below:

Forecast income

Forecast assets

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Forecast assets Tesco plc


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The forecast assumes a sales growth of ten per cent in the next five years and cost structuresmaintained at approximately the same level as the last two years.

Forecast financial statements

Forecast statements can be generated from these statements as below:

Forecast income

Forecast assets

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Forecast liabilities

Tesco plc !

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Forecast ratios

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Forecast ratios Tesco plc


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Forecast ratios

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Forecast cash flow

Tesco plc

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Forecast cash flow

Signs of distress

Companies start to exhibit signs of distress and decline and these are typified by worsening ratios.Profitability ratios decline and turnover ratios such as asset turnover show lower activity.Borrowings tend to increase to fund the slowdown in the operating cycle.

• Core ratios – lower return on equity by a decline in the components of return on sales, assetleverage and asset turnover.

• Profitability – declining sales, profitability and possibly increasing overheads relative tosales.

• Liquidity – reduced working capital, declining creditor days and increasing stock and debtordays. This may also be combined with lower turnover and activity, giving rise to stagnation.

• Financial structure – weakened structure with more reliance on debt.

• Cash flow – reduced cash flow to meet commitments and negative trading cash flow.

The company used in the example shows few signs of bankruptcy with the balance sheetincreasing in strength over period.

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Signs of distress !

Companies start to exhibit signs of distress and decline and these are typified by worsening ratios. Profitability ratios decline and turnover ratios such as asset turnover show lower activity. Borrowings tend to increase to fund the slowdown in the operating cycle.

• Core ratios – lower return on equity by a decline in the components of return on sales, asset leverage and asset turnover.

• Profitability – declining sales, profitability and possibly increasing overheads relative to sales.

• Liquidity – reduced working capital, declining creditor days and increasing stock and debtor days. This may also be combined with lower turnover and activity, giving rise to stagnation.

• Financial structure – weakened structure with more reliance on debt.

• Cash flow – reduced cash flow to meet commitments and negative trading cash flow. !

The company used in the example shows few signs of bankruptcy with the balance sheet increasing in strength over period.

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Beaver and Altman Z scores

These methods pick out key ratios as indicators of a company’s financial health and attempt to show a link to companies that subsequently fail. Beaver studied a variety of long term and current ratios and found the best single predictor to be these ratios:

• Cash Flow/Total Debt

• Net Income/Total Debt

• Total Debt/Total Assets !

Failure ratios Tesco plc

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Beaver and Altman Z scores

These methods pick out key ratios as indicators of a company’s financial health and attempt toshow a link to companies that subsequently fail. Beaver studied a variety of long term and currentratios and found the best single predictor to be these ratios:

• Cash Flow/Total Debt

• Net Income/Total Debt

• Total Debt/Total Assets

Failure ratios

Another approach to failure prediction is to combine a number of ratios and calculate a score.Edward Altman in his paper published in 1968 (“Financial Ratios, Discriminant Analysis and thePrediction of Corporate Bankruptcy”, Journal of Finance, September 1968, 589-609) used multi-discriminant analysis to create a scoring system based on five key ratios. The ratios are thenmultiplied by a weighting factor to derive a score.

Altman’s Z-score: Z = 1.2 x Y1 + 1.4 x Y2 + 3.3 x Y3 + 0.6 x Y4 + 1.0 x Y5

where: Y1 = Working capital/Total assetsY2 = Retained earnings to date/Total assetsY3 = Profit from ordinary activities before interest and tax/Total assetsY4 = Market value/Book value of total debtY5 = Sales/Total assets

The ratios used and the weightings given to them were estimated empirically from extensiveanalysis of companies which had collapsed. It was found that such companies had commoncharacteristics in terms of selected financial ratios. The scores are:

• >2.99 Unlikely to fail• 1.8 > 2.99 Unsure• <1.8 Likely to fail

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Another approach to failure prediction is to combine a number of ratios and calculate a score. Edward Altman in his paper published in 1968 (“Financial Ratios, Discriminant Analysis and the Prediction of Corporate Bankruptcy”, Journal of Finance, September 1968, 589-609) used multi- discriminant analysis to create a scoring system based on five key ratios. The ratios are then multiplied by a weighting factor to derive a score.

Altman’s Z-score: Z = 1.2 x Y1 + 1.4 x Y2 + 3.3 x Y3 + 0.6 x Y4 + 1.0 x Y5

where: Y1 = Working capital/Total assets Y2 = Retained earnings to date/Total assets Y3 = Profit from ordinary activities before interest and tax/Total assets Y4 = Market value/Book value of total debt Y5 = Sales/Total assets

The ratios used and the weightings given to them were estimated empirically from extensive analysis of companies which had collapsed. It was found that such companies had common characteristics in terms of selected financial ratios. The scores are:

• >2.99 Unlikely to fail • 1.8 > 2.99 Unsure • <1.8 Likely to fail

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In the example above, the company shows increasing scores using both the Beaver and Altman approaches and this is confirmed by the other ratios calculated so far.

!Z-score models are used routinely by most of the large banks and accountancy firms, but you

should consider that they are based on the accounting model with all the weaknesses of other ratios, for example international comparisons. They may be used to:

• track a company’s progress over time

• compare companies of similar sizes in the same sector of industry. !

Nevertheless, this type of analysis adds more information to the traditional ratio analysis and should add weight to the same conclusion.

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Market and accounting valuation !

Once you have analysed an organisation and forecast the accounting statements forward, the data can be used to generate an equity valuation. There are many methods of valuing companies and the methods considered here are:

• Accounting net worth – the accounting value of the assets

• Adjusted accounting net worth – accounting value plus adjustments for land, brands, etc

• Market value – stock market value of the organisation

• Free cash flow valuation – projected future cash flows discounted at a suitable rate. !

Accounting methods

The accounting value of the company is defined by the shareholders’ equity or net worth. This is the share capital plus the retained earnings, which can be adjusted for value not contained on the balance sheet. There is potentially a long list of debits and credits which could include licences, knowledge, patents, human capital and research on the credit side and contingent liabilities or law suits on the debit side.

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Accounting worth Tesco plc

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In the example above, the company shows increasing scores using both the Beaver and Altmanapproaches and this is confirmed by the other ratios calculated so far.

Z-score models are used routinely by most of the large banks and accountancy firms, but youshould consider that they are based on the accounting model with all the weaknesses of otherratios, for example international comparisons. They may be used to:

• track a company’s progress over time

• compare companies of similar sizes in the same sector of industry.

Nevertheless, this type of analysis adds more information to the traditional ratio analysis andshould add weight to the same conclusion.

Market and accounting valuation

Once you have analysed an organisation and forecast the accounting statements forward, thedata can be used to generate an equity valuation. There are many methods of valuing companiesand the methods considered here are:

• Accounting net worth – the accounting value of the assets

• Adjusted accounting net worth – accounting value plus adjustments for land, brands, etc

• Market value – stock market value of the organisation

• Free cash flow valuation – projected future cash flows discounted at a suitable rate.

Accounting methods

The accounting value of the company is defined by the shareholders’ equity or net worth. This isthe share capital plus the retained earnings, which can be adjusted for value not contained on thebalance sheet. There is potentially a long list of debits and credits which could include licences,knowledge, patents, human capital and research on the credit side and contingent liabilities orlaw suits on the debit side.

Accounting worth

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Market method

Market methods start with the current share price and use multiples or ratios to derive a value per share. The P/E ratio is calculated as price per share/ earnings per share. The implied valuation is based on a P/E of 18 which is similar to the historic ratio. !

Market valuation


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Market method

Market methods start with the current share price and use multiples or ratios to derive a value pershare. The P/E ratio is calculated as price per share/ earnings per share. The implied valuation isbased on a P/E of 18 which is similar to the historic ratio.

Market valuation

Free cash flow valuation

There are several disadvantages with market and accounting valuations since they do not focuson the company’s ability to generate future cash and add value. Cash flow valuation appears tovalue wealth generation and the methodology is:

• Calculate the future free cash flows from the Income Statement

• Adjust the cash flow for tax on interest to yield the valuation free cash flow

• Select a method for valuing the organisation at the end of the five-year time horizon

• Calculate a terminal value based on the final free cash flow

• Calculate a weighted average cost of capital (WACC)

• Discount the five years of cash flows by the WACC

• Discount the terminal value at the WACC.

The resulting amount is the Enterprise Value from which you:

• subtract debt and minority interests

• add cash.

This is the value of the equity of the organisation.

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!Free cash flow valuation !

There are several disadvantages with market and accounting valuations since they do not focus on the company’s ability to generate future cash and add value. Cash flow valuation appears to value wealth generation and the methodology is:

• Calculate the future free cash flows from the Income Statement

• Adjust the cash flow for tax on interest to yield the valuation free cash flow

• Select a method for valuing the organisation at the end of the five-year time horizon

• Calculate a terminal value based on the final free cash flow

• Calculate a weighted average cost of capital (WACC)

• Discount the five years of cash flows by the WACC

• Discount the terminal value at the WACC.

The resulting amount is the Enterprise Value from which you:

• subtract debt and minority interests

• add cash.

This is the value of the equity of the organisation.

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Valuation inputs and cash flow !

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Valuation inputs and cash flow

The graphic above shows the inputs required for the cost of capital and the terminal valuecalculation. The valuation cash flow is made up of the operating free cash flow adjusted for thetax relief on interest. This is the potential cash available to debt holders as interest and equitystakeholders as dividends.

Cost of capital

The cost of capital is derived from the Capital Asset Pricing Model:

Formula: RE = RF + ß (RM - RF)

where: RE = Required rate of return on equity (equity cost)RF = Risk free rate eg on 10 yr Government bondsRM = Expected return on the overall market for shares.ß = Beta

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Cost of capital




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Cost of capital




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Cost of capital




The graphic above shows the inputs required for the cost of capital and the terminal value

calculation. The valuation cash flow is made up of the operating free cash flow adjusted for the tax relief on interest. This is the potential cash available to debt holders as interest and equity stakeholders as dividends.

!Cost of capital

!!

The cost of capital is derived from the Capital Asset Pricing Model: !

Formula: RE = RF + ß (RM - RF) !

where: RE = Required rate of return on equity (equity cost) RF = Risk free rate eg on 10 yr Government bonds RM = Expected return on the overall market for shares. ß = Beta

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The beta is adjusted using these formulae:

• Asset (unleveraged) beta: BetaU = BetaL / [1+(1-tax) * (D/E)]

• Equity (leveraged) beta: BetaL = BetaU * [1+(1-tax) * (D/E)] !

The cost of debt is a future debentures rate. The merged cost or the weighted average cost of capital is derived using the formula:

WACC = D/D+E * Cost of Debt + E/D+E * Cost of Equity

The terminal value is derived using the Perpetuity or Gordon’s model to find the present value of the final cash flow growing in future periods at a constant rate. The formula is:

Terminal value: Final Cash Flow * ( 1 + Growth ) / ( Cost of Capital - Growth )

Terminal value

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The free cash flow brings together the cash flows, discount rate and terminal value. The present value of the cash flows and terminal value combine as the enterprise value. Subtracting the debt and minorities and adding cash produces the equity value. The valuation per share can then be compared to the current market value per share. !

Cash flow valuation

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!Valuation map

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This is a map of the valuation bringing together the various elements in a graphic form. The elements combine to form the calculated equity value.

There is no “correct” valuation and the comparison chart below shows the values from the different methods. The free cash valuation is determined by the key drivers in the forecast and is broadly similar to the current share price.

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Valuation comparison !

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Summary !

This section takes Tesco plc as a case and summarises each of the stages:

• Spreading the annual reports

• Reviewing the historic figures

• Framework for historic analysis

• Ratios and cash flows

• Forecast statements

• Bankruptcy analysis

• Market valuation

• Free cash flow valuation

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Large Company Analysis and Valuation !!!!!

Review !

The main points introduced here are:

� Analysing company performance depends on measuring the financial information produced by companies in the form of annual reports, interim reports, prospectuses and other statutory information.

� Before looking at a specific company, the external and industry environments need to be considered.

� Spreading the accounts by combining information from the statements and notes in the annual reports allows standardisation of the format of the accounts, combination of the statements and notes in one schedule, calculation ratios from the income statement, balance sheet and cash flow statement and examination of the ratios for changes over time and against peer groups.

� Ratios are based on the accounting model and you should bear in mind that there are international and local differences, which may need adjustment for more exact study.

� The funding gap is calculated as: Debtor days + inventory days – creditor days.

� P/E ratio = Market price per share/Net profit after tax per share

� Du Pont ratios are based on the pyramid of ratios developed by E I Dupont de Nemours to evaluate business performance.

Return on sales = Net profit after tax/sales = Profit for shareholders on each $1 of turnover

Asset turnover = Sales/total assets

Asset leverage = Net profit after tax/shareholders’ funds

� The analysis of liquidity, profitability and financial structure leads to cash flow. Any lender needs to see both quantity and quality of cash flow to repay loans.

� A forecast is required where creditors have to decide what degree of risk is measurable credit process, which underpins credit decisions.

� Companies start to exhibit signs of distress and decline and these are typified by worsening ratios. Profitability ratios decline and turnover ratios such as asset turnover show lower activity. Borrowings tend to increase to fund the slowdown in the operating cycle.

� Methods of valuing companies include:

Accounting net worth – the accounting value of the assets Adjusted accounting net worth – accounting value plus adjustments for land, brands, etc Market value – stock market value of the organisation Free cash flow valuation – projected future cash flows discounted at a suitable rate.

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CSA Member Activity 1 – Personal Assignment Choose any Large Company from the Internet. Make a non financial and a financial analysis of performance. Prepare a short report say 4 to 5 pages for review by the CSA Director of Studies. You may use (if you wish) the Xcel spreadsheet FSE in the Academy files.

Credit Skills Academy !!!!!!!This is one in a series of topics about credit, designed for easy access by banking professionals with a special interest in this field !

Unit 4 Large Company analysis v3 and Valuation copy 4

Documents

Transcript of Unit 4 Large Company analysis v3 and Valuation copy 4