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FS analyysi > V_alue c_reation ja P_rofitability > Flashcards

V_alue c_reation ja P_rofitability Flashcards

1
Q

The ultimate goal of a firm is to?

A

The ultimate goal of the firm is to maximize the value of its equity.

Can we link managerial decisions to the value creation of the firm?

  • -> Finance and accounting research has produced many approaches for this
  • -> One approach is the concept of Economic Value Added (Also known as ’Economic Profit’, ’Excess Profit’ etc.)
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2
Q

How firms create more value?

A
  1. Increase the return on the existing base of capital: by increasing revenues without increasing expenses, decreasing expenses without decreasing revenues or decreasing risk.
  2. Invest where the return is greater than the firm’s cost of capital.
  3. Divest where the return is less than the firm’s cost of capital.
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3
Q

How to measure value creation?

A

A) Value creation
= Are we as profitable as we are supposed to be?
–> Economic Value Added or other similar concepts

B) Investors’ required rate of return = How profitable are we supposed to be?
–> Cost of capital (WACC), Capital structure

C) Actual performance
= How profitable are we in reality?
–> Return on invested capital, ROIC

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4
Q

When does a firm create value?

A

A firm creates value for only, if its profitability is greater than its cost of capital! ELI if its net operating profit after taxes is greater than its cost of capital.

This leads us to the following statements:

(1) EVA > 0, if ROIC > WACC
(2) EVA = 0, if ROIC = WACC
(3) EVA < 0, if ROIC < WACC

The management of the firm should:

  • maximize ROIC via its components
  • mimimize WACC via its components
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5
Q

What are the components of ROIC and WACC that managers should affect?

A

??? Katso video module 3 - value creation and profitability

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6
Q

Given the definition of EVA, a firm can create value by:
Maximizing earnings (profits)
Minimizing the amount of Invested capital
Minimizing the cost of capital, WACC

A

Firm can create value by:

1) Maximizing earnings (profits)
2) Minimizing the amount of Invested capital
3) Minimizing the cost of capital, WACC

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7
Q

What is EVA?

A

EVA = Economic Value Added

EVA is the part of earnings that remains after paying all financing cost to debt and equity investors.

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8
Q

Miten EVA:n kaava voidaan purkaa:

EVA = (ROIC-WACC) × InvestedCapital

A

EVA = (ROIC-WACC) × InvestedCapital

= ROIC × InvestedCapital - WACC × InvestedCapital

= (NOPAT/Inv.Capital) × Inv.Capital - WACC × Inv.Capital

= NOPAT - WACC × InvestedCapital
–>
ELI tuo vika selitettynä:

NOPAT = Operational performance

WACC × InvestedCapital = Cost of financing

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9
Q

Return on invested capital, ROIC

A

ROIC = Nopat / ((inv.capital_t + inv.capital_t-1)/2)

  • Note that ROIC is very important!
  • Financial assets and liabilities are typically close to market values, but operating assets and liabilities are not
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10
Q

Note that financial ratios can be calculated in many ways!

A

Note that financial ratios can be calculated in many ways:

ROI, ROIC, RONA, ROCE, ROA, ROTA…

Sometimes ROCE even refers to Return on Common Equity

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11
Q

Return on Capital Employed (ROCE)

A

ROCE = EBIT / capital employed

Capital Employed = Total Assets – Current Liabilities

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12
Q

More on interpreting ROIC

A

The level of ROIC:

  • An comparison with the required rate of return (WACC)
  • A comparison with competitors (benchmarking)

The trend of ROIC over time:

  • Stable
  • Increasing
  • Decreasing
  • Fluctuating
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13
Q

More on interpreting ROIC

A

The level of ROIC:

  • An comparison with the required rate of return (WACC)
  • A comparison with competitors (benchmarking)

The trend of ROIC over time:

  • Stable
  • Increasing
  • Decreasing (jos laskee vuosien mittaan, niin se on huono)
  • Fluctuating
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14
Q

Is value creation an everyday thing?

More on decomposing EVA

A

Value creation is embedded in every decision a firm makes every day.

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15
Q

Firm-level ROIC can be decomposed based on any aspect relevant to business.

For example: project-level and customer-level.

A

Firm-level ROIC can decomposed to project-level ROICs
–> ROIC and its components need to be considered in every investment decision

Firm-level ROIC can be decomposed to customer-level ROICs
–> ROIC and its components need to be considered in every customer decision

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16
Q

What is the problem with ROIC?

A

ROIC as such does not explain whether profitability (and value creation) is driven by:

  • High margins or
  • An effective use of invested capital

We can address this issue by decomposing ROIC into the profit margin and the turnover rate of invested capital.

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17
Q

Decompose ROIC into the profit margin and the turnover rate of invested capital.

A

ROIC
= Nopat/Sales × Sales/(Invested capital)

–> Jossa:
Nopat/Sales = Profit Margin (PM)

Sales/(Invested capital) = Invested Capital Turnover rate (ICTO)

18
Q

What is the other name for Invested Capital Turnover rate (ICTO)?

A

ICTO is also called as:

Asset Turnover Rate (ATO)

19
Q

Profit margin (in ROIC)

A

NOPAT/Sales known as a profit margin.

Other profit margins can also be calculated in a similar way

  • Net income/Sales
  • EBIT/Sales

Interpretations are similar to NOPAT/Sales, but different levels in I/S allow focusing on different cost items.

20
Q

What high profit margin indicates ?

A

High profit margin indicates:

  • Strong pricing power and/or
  • Good cost control
21
Q

TRUE OR FALSE?

“Profit margins and operating margins tend to be higher in USA than in Europe”

A

TRUE!

Profit margins and operating margins were both about 2% higher in USA than in Europe in 1995-2019.

22
Q

What high turnover rate of invested capital implies?

A

High turnover rate of invested capital implies an effective use of capital received from both equity and debt holders.

23
Q

Our competitor is more profitable than we are (and can therefore create more value), even though we have a higher profit margin, but why?

A

Our profit margin (15%) is greater than that of our competitor (11%)
-> We are good at marketing/pricing/production etc.

The problem is that our Invested capital turnover rate is low, if compared to the competitor (1.5 vs. 1.8)

  • We have poor working capital management, and/or
  • We do not use wisely long-term capital obtained from investors
24
Q

Can profit margin be decomposed to extract information on the cost structure of the firm?

A

YES!

Profit margin can be decomposed to extract information on the cost structure of the firm.

25
Q

What ROIC measures?

A

ROIC measures operating profitability!

26
Q

What ROE measures?

A

Return on equity (ROE) measures the profitability taking into account returns earned on operations and the effect of financial leverage.

27
Q

What is formula for ROE?

A

ROE_t
=(NOPAT_t − Net financial costs adjusted for taxes_t) / ((Equity_t+Equity_t−1)/2)

Remember that NOPAT excludes financial items!

28
Q

Are ROIC, ROE and WACC are related?

A

YES!

–> ROIC, ROE and WACC are related!

ROIC
= NOPAT/(Invested capital)
=(NI+NFC)/(D+E)

NI=Net income (profit)
NFC=Net financial costs adjusted for taxes
D=Net interest bearing debt
E=Equity

29
Q

Are ROIC, ROE and WACC are related?

A

YES!

–> ROIC, ROE and WACC are related!

ROIC
= NOPAT/(Invested capital)
=(NI+NFC)/(D+E)

NI=Net income (profit)
NFC=Net financial costs adjusted for taxes
D=Net interest bearing debt
E=Equity

Note that NI/Equity = ROE

30
Q

Net borrowing rate (NBR)

A

Net borrowing rate (NBR) = NFC/Debt

31
Q

Together ROIC, ROE and NBR are what?

Together WACC, RE and RD are?

A

ROIC, ROE and NBR are accounting rate of returns
-> ROIC is a weighted average of ROE and NBR

WACC, RE and RD are market rate of returns
-> WACC is a weighted average of RE and RD

Weights can be based on book or market values.

32
Q

What is spread analysis?

A

We can express ROE as a function of ROIC, NBR and capital structure

This is called a spread analysis!

And we can do the same for R_E, which again shows similarities between accounting and market rate of returns…

33
Q
  • Accounting rate of returns show WHAT performance?

- Market rate of returns show WHAT performance?

A
  • Accounting rate of returns show a firm’s actual performance
  • Market rate of returns show a firm’s required performance, as required by investors.
34
Q

DuPont identity

A

We can decompose ROE like we decomposed ROIC!

This decomposition is known as the DuPont identity (time subscripts omitted (=jättää pois)):

ROE
= Net income/Sales × Sales/Invested capital × 𝐈𝐧𝐯𝐞𝐬𝐭𝐞𝐝 𝐜𝐚𝐩𝐢𝐭𝐚𝐥/𝐄𝐪𝐮𝐢𝐭𝐲

ELI SELITETTYNÄ:

  • > PROFIT MARGIN = Net income/Sales
  • > INVESTED CAPITAL TURNOVER RATE = Sales/Invested capital
  • > FINANCIAL LEVERAGE = 𝐈𝐧𝐯𝐞𝐬𝐭𝐞𝐝 𝐜𝐚𝐩𝐢𝐭𝐚𝐥/𝐄𝐪𝐮𝐢𝐭𝐲
35
Q

Residual income (RI)

A

Residual income (RI) is a concept similar to EVA

  • Residual income: based on ROE and the cost of equity
  • EVA: based on ROIC and WACC
36
Q

What is the formula for Residual income (RI)?

A

RI = (ROE − R_E ) × Equity

Equity on siis = (Equity_t + Equity_t-1)/2

37
Q

Mihin Residual Income (RI) focuses on?

A

RI focuses on the value creation directly from equity owners’ perspective.

38
Q

For what purpose is Residual Income (RI) useful for?

A

Residual Income (RI) is especially useful in equity valuation models!

39
Q

Value creation is an important framework for analyzing WHAT?

A

Value creation is an important framework for analyzing the financial performance of the firm!

40
Q

We can decompose profitability measures like ROIC and ROE to trace what?

A

We can decompose profitability measures like ROIC and ROE to trace the key drivers of profitability, and consequently, the sources of value creation.

FS analyysi (14 decks)

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