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1 Lecture 4 Historical profitability analysis • Valuation models based on forecasts of net dividends (or theoretically equivalent forecasts), but • Such forecasts must be consistent with our beliefs about future profitability 2 Historical profitability analysis Purpose: • To find ratios useful for forecasting future profitability Forecasts: • Sales forecast • Different kinds of ratios • Which ratios? 3 Historical profitability analysis • Operating profitability – – Sales and OI for each segment NOA for the company as a whole • Financial performance – which together with financial leverage determine • Total profitability 4 Operating profitability For each segment (and the company as a whole) we will determine • Rate of sales growth (Sgr) • Core operating profit margin (cPM) For the company as a whole we will determine • Asset turnover (ATO) • Core return on net operating assets (cRNOA) 5 Operating profitability NCC – Construction Sweden Net sales 2005 2006 19 354 22 098 Rate of sales growth (Sgr) Sgr06 Sales06 / Sales05 1 22098 / 19354 1 14,2% 6 Operating profitability NCC – Construction Sweden 2005 Net sales Core operating income 2006 22 098 1 236 Core operating profit margin (cPM) cOI 06 1236 cPM 06 5,6% Sales 06 22098 7 Operating profitability Two quasi-segments • Discontinued operations • Other and eliminations 8 Operating profitability NCC – Group total 2005 Net sales Core operating income Net operating assets 2006 55 876 2 385 7 322 Asset turnover (ATO) Sales 06 55876 ATO06 7,6 NOA05 7322 9 Operating profitability Technical issue: for all flow/stock and stock/flow ratios, e.g. - ATO = Sales / NOA cRNOA = cOI / NOA Use beginning-of-period stock values (not average values) 10 Operating profitability NCC – Group total 2005 Net sales Core operating income Net operating assets 2006 55 876 2 385 7 322 Core return on net operating assets (cRNOA) cOI 06 2385 cRNOA06 32,6% NOA05 7322 11 Operating profitability du Pont formula cRNOA cOI / NOA cPM ATO cOI / Sales Sales / NOA 12 Operating profitability NCC – Group total 2005 Net sales Core operating income Net operating assets 2006 55 876 2 385 7 322 du Pont formula cOI 06 cOI 06 Sales 06 cRNOA06 cPM 06 ATO06 NOA05 Sales 06 NOA05 13 Operating profitability The company as a whole • Calculate – – – – Sales growth (Sgr) Core operating profit margin (cPM) Asset turnover (ATO) Core return on net operating assets (cRNOA) • Compare with the corresponding ratios for the industry – Convert industry ATO and RNOA to measures with goodwill 14 Operating profitability • Include unusual items to calculate – Operating profit margin (before tax) (PM) – Return on net operating assets (before tax) (RNOA) (final measure of operating profitability) 15 Financial performance • Core borrowing cost (cBC) • Core return on financial assets (cRFA) – determine together with the relationship between financial liabilities (FL) and financial assets (FA) • Core net borrowing cost (cNBC), or • Core return on net financial assets (cRNFA) – Add unusual net borrowing cost to arrive at • Net borrowing cost (NBC), or • Return on net financial assets (RNFA) 16 Financial performance Core borrowing cost (cBC) 2005 Core financial expense (before tax) (cFE) Financial liabilities (FL) Core borrowing cost (before tax) (cBC) 2006 245 3 153 7,8% cFE06 245 cBC 06 7,8% FL05 3153 17 Financial performance Core return on financial assets 2005 Core financial income (before tax) (cFI) Financial assets (FA) Core return on financial assets (before tax) (cRFA) 2006 108 2 710 4,0% cFI 06 108 cRFA06 4,0% FA05 2710 18 Financial performance Core net borrowing cost (FL > FA) 2005 Core financial income (before tax) (cFI) Financial assets (FA) Core return on financial assets (before tax) (cRFA) Core financial expense (before tax) (cFE) Financial liabilities (FL) Core borrowing cost (before tax) (cBC) 2 710 4,0% 245 3 153 7,8% Core net financial expense (before tax) (cNFE) Net financial liabilities (NFL) Core net borrowing cost (before tax) (cNBC) 2006 108 137 443 30,9% 19 Financial performance Determinants of the core net borrowing cost cNBC cNFE / NFL FL / NFL FA / NFL cBC cRFA cFE / FL cFI / FA FL05 FA05 cNBC 06 cBC 06 cRFA06 NFL05 NFL05 20 Financial performance Core return on net financial assets (FA > FL) 2005 Core financial income (before tax) (cFI) Financial assets (FA) Core return on financial assets (before tax) (cRFA) Core financial expense (before tax) (cBC) Financial liabilities (FL) Core borrowing cost (before tax) (cBC) 5 000 6% 240 3 000 8% Core net financial income (before tax) (cFI) Net financial assets (NFA) Core return on net financial assets (before tax) (cRNFA) 2006 300 60 2 000 3,0% cNFE06 cNFI 06 60 cNBC 06 3% cRNFA06 NFL05 NFA05 2000 21 Financial performance • Include unusual items to calculate – Total net borrowing cost – Note that a positive sign in the income statement means a negative unusual net financial expense, and vice versa 22 Total profitability Determinants of total profitability Total profitability Financial leverage Operating profitability Financial performance 23 Total profitability 2005 Operating income (before tax) (OI) Net operating assets (NOA) Net financial expense (before tax) (NFE) Net financial liabilities (NFL) Income after financial items (Iafi) Taxes (T) Net income (NI) Total equity (E) Return on equity (ROE) ROE 06 NI 06 1708 24,8% E05 6879 2006 2 392 7 322 129 443 2 263 -555 1 708 6 879 24 Total profitability 2005 Operating income (before tax) (OI) Net operating assets (NOA) 2006 2 392 7 322 Income after financial items (Iafi) Taxes (T) 2 263 -555 Effective tax rate T06 555 tr06 24,5% Iafi06 2263 Return on net operating assets after tax RNOAat 06 RNOA06 (1 tr06 ) OI 06 2392 (1 tr06 ) (1 0,245) 24,7% NOA05 7322 25 Total profitability 2005 Net financial expense (before tax) (NFE) Net financial liabilities (NFL) 2006 129 443 Net borrowing cost after tax (NBCat) NFE06 129 NBCat 06 NBC 06 (1 tr06 ) (1 tr06 ) (1 0,245) 22,0% NFL05 443 If the effective tax rate deviates significantly from the marginal tax rate, a more accurate determination of RNOAat and NBCat must be made (see Ch. 3, p. 18). 26 Total profitability Net operating assets (NOA) 2005 7 322 Net financial liabilities (NFL) 443 Total equity (E) 6 879 Financial leverage (FLEV) NFL05 443 FLEV05 0,06 E05 6879 2006 27 Total profitability ROE NI / E FLEV NFL / E RNOA NBC OIat / NOA NFEat / NFL The leverage formula (with RNOA and NBC after tax) ROE 06 RNOAat 06 FLEV05 ( RNOAat 06 NBCat06 ) ROE06 = 24,7% + 0,06∙(24,7% – 22,0%) = 24,8% 28 Total profitability Minority interest and minority income Calculate • Return on minority income (rMINT) • Proportion of minority interest (pMINT)