Spring 2009 NBA 5060

Lecture 5 – Profitability Analysis

1. Why is profitability analysis important?

2. Profitability Analysis Relative vs. Absolute Analysis Cross-sectional vs. time-series

3. Profitability Ratios Return on Equity (ROA) Return on Assets (ROE) Decomposing these measures

4. Some Key Takeaways from Profitability Analysis

Additional Notes (not covered in class): Supplemental note on the economic relation between accounting ratios and the cost of capital

For 2/5/08: Compute the profitability, liquidity and solvency ratios for CBRL.

Lecture 4 Page 1 of 12

1. Why is ratio analysis important?

The value of a company depends on its ability to grow and generate profits:

The ability to grow and generate profits is a function of the firm’s operating, investing, and financing decisions. Ratio analysis provides a means of evaluating the effectiveness of the firm’s operating, investing, and financing policies:

Lecture 4 Page 2 of 12

Growth and Profitability

Product Market Strategies

Financial Market Strategies

Operating Managemen

t

Investment Manageme

nt

Financing Decisions

Payout Decisions

Sustainable Growth Rate

ROE

Dividend Payout Ratio

ROA CSLCEL

PM ATO

Sustainable Growth Rate

ROE

Dividend Payout Ratio

ROA CSLCEL

PM ATO

Operating Management

Investment Management

Financing Decisions

Payout Decisions

Goal: Evaluate effectiveness of the firm’s policies in each of these areas.

2. Profitability Analysis

Relative Analysis – compares the financial metrics of a firm relative to the financial metrics of some comparison (i.e. control) group. Absolute level of the numbers does not matter as much as whether they are higher or lower than the comparison group.

Two basic types of relative analysis:

Cross-sectional approach – compare the firm to industry peers on a number of dimensions.

Time series approach – use the historic performance of a firm as the benchmark.

Cross-sectional comparisons are useful in benchmarking how the firm is doing relative to industry peers, while a time series approach can reveal trends within the firm.

Absolute analysis – compares the financial metrics of a firm to absolute levels. Matters less where they rank relative to other firms.

e.g. Is operating cash flow positive? Does ROE exceed the cost of capital?

Lecture 4 Page 3 of 12

3. Basic Profitability Ratios

Lecture 4 Page 4 of 12

Return on Equity

Return on Assets

Profit Margin Asset Turnover

Financing Activities(Debt Policy)

OperatingActivities

InvestingActivities

Return on Assets (ROA)

Other common variations:

Disaggregating ROA:

What is a reasonable absolute benchmark for ROA?

What factors drive cross-sectional differences in ROAs?

Lecture 4 Page 5 of 12

Use of ‘Ending TA’ requires less data to form a time series

This is technically a mismatch of the numerator and denominator.

Return on Net Operating Assets (operating ROA)

You can decompose RONA similarly to ROA by simply multiplying and dividing by sales.

What is the appropriate absolute benchmark for RONA?

In general, which is a more appropriate profitability ratio, ROA or RONA?

Lecture 4 Page 6 of 12

Average Median ROAs, Profit Margins, and Asset Turnovers for 22 Industries from 1990-2004 (Source: Stickney, Brown and Wahlen, 2007, Financial Reporting and Statement Analysis, p.206)

Lecture 4 Page 7 of 12

Decomposing ROA into Profit Margin and Asset Turnovers:

Can be used to check for sustainability of improvement (or decline) in ROA

Decomposing Profit Margin – simply divide each net income line item by sales:

Sales:COGS:Selling & Admin:Depreciation & Amortization:Other Revenue:Income Taxes (add back tax on interest expense):

EBI:

Turnover Components (note this is not really a decomposition as the components do not sum to asset turnover):

These ratios are useful for (1) explaining trends in ROA (and ROE), (2) forecasting future financial statements and conducting sensitivity analysis, (3) explaining changes in value through their impact on ROE.

Lecture 4 Page 8 of 12

Technically, should be ‘sales on account’, but this is hard to measure.

Sales is more appropriate as a Total Asset decomposition, while COGS give s a better

measure of actual times inventory turns over.

Return on Equity (ROE)

Other variations you might run across:

Disaggregating ROE:

#1

#2

What is a reasonable absolute benchmark for ROE?

What factors will drive cross-sectional variation in ROEs?

Lecture 4 Page 9 of 12

4. Some Key Takeaways from Profitability Analysis:

I know how to compute all the ratios, but I’m still not sure I know when to actually use them.

There are two primary objectives to profitability analysis at this point. First, use ROA and ROE as a baseline evaluation of the firm relative to past performance (e.g. ROA seems to be deteriorating) or relative to other firms (e.g. Dell consistently has a higher ROE than other computer manufacturers). This will give you a quick glimpse of whether the firm is well positioned going forward. Second, use the ROA decomposition to determine the cause of increases (decreases) in profitability. This can help determine if the change in ROA is likely to be permanent or transitory. Finally, both ROA and ROE often tell similar stories. As we’ll see, ROA drives the value of the firm, while ROE drives the value of the equity. Hence, ROA tells you something about overall profitability and firm value while ROE tells you how effectively the firm is using its capital structure. Thus, they are important ratios for valuation purposes, as we’ll see later.

Firm X increased their asset turnover from 1.8 to 2.0. Is this good? Is this significant? How do I know?

More generally, this question reflects the lack of intuitive definitions for several of the ratios we examine. So the best way to evaluate this is to consider what the ratio actually means and do some sensitivity analysis (i.e. ‘as if’ calculations). In this case, the increase from 1.8 to 2.0 means that for every dollar of assets employed by the firm, the firm increased sales by $0.20. Thus, if the firm has $100 million in assets, efficiency improvements alone are responsible for a $20 million increase in revenue. You can then trace the improvement to earnings (via the profit margin), and EPS, which is particularly meaningful. If you tell investors that efficiency improvements alone contributed an additional $0.10 to this year’s EPS, they will be able to judge the economic significance of the improvement more readily than if you simply report a 0.2 increase in the asset turnover ratio.

I know weighted cost of capital (cost of equity capital) is a decent benchmark for ROA (ROE). Is there anything else I should look for?

Look for the relation between strategy and the components of ROA. If a firm is trying to be a cost leader, it should have relatively high turnover and low margins. The opposite is true for a product differentiator. If the ratios don’t seem to match up with the firm’s strategy, this requires further investigation.

Lecture 4 Page 10 of 12

A Supplemental Note OnThe Economic Relationship Between

Accounting Ratios and the Cost-of-Capital

Three accounting based return-on-investment (ROI) measures are among the most commonly used financial ratios in fundamental analysis: return-on-total-assets (ROA), return-on-net-assets (RONA), and return-on-equity (ROE). Students who encounter these financial ratios for the first time often find them a little confusing. The purpose of this note is to explain the rationale behind these ratios and discuss the economic relationship between each ratio and the cost-of-capital.

1. Constructing an accounting ROI

All three ratios use accounting numbers to measure the rate of return on investment (ROI). Each is a measure of earnings divided by a measure of the capital (or investment) base. The difference between the three lies in the definition of the capital base, earnings to that capital base, and the cost of that capital base.

The single most important concept to keep in mind in working with accounting ROIs is that the earnings and the cost of capital must be consistent with the capital base as defined in the denominator of the ratio.

Consider the following table:Ratio Representative Formula Capital

DefnEarnings

DefnCost of Capital

‘Normal’ levels

ROATotal

AssetsEBI Cost of

financing TA

Approx. 6%

RONANet

AssetsEBI Cost of

financing Net Assets

Approx. 9%

ROECommon

EquityNI Cost of

financing Equity

Approx. 12%

Notice that each ratio has a different definition of capital. Once you have selected a given definition of capital, you are constrained to choose a definition of earnings and a definition of the cost of capital which are consistent with that capital base. Mismatches result in ROIs that either understate or overstate economic performance.

2. ROA

For example, the capital base for ROA is total assets. What is the earnings generated by this capital base? It’s EBI (called “NOPAT” in your PHB textbook for “Net Operating Profit After Taxes”) This is the after-tax earnings with interest expense added back. We add the interest expense back because this expense is used to service debt, which is part of the capital base. We want to measure the return generating power of total assets. If we do not add back interest expense, we would understate the firm’s return generating power pertaining to its total assets.

Lecture 4 Page 11 of 12

What is the cost of this capital base? It’s the cost associated with financing the total assets of the company. The balance sheet equation tells us that total assets = s/t liab + l/t liab + shareholders’ equity so the appropriate cost of this capital should be the weighted average cost of capital (WACC) for these three sources of financing. For example, the typical firm has a capital structure of 1/3 s/t liabs (such as current payables and accruals), 1/3 l/t liabs (such as bonds etc.) and 1/3 equity. The WACC for this firm would be computed approximately as follows:

Source of Financing

Pretax Cost of Financing

Effect of Tax Shield

After-tax Cost of Financing

% Weight Contribution to WACC

Short term liabilities

Nil none Nil 1/3 0.0%

Long term liabilities

10.0% t=40% 6.0% 1/3 2.0%

Equity Investors

12.0% none 12.0% 1/3 4.0%

Estimated WACC for Total Assets 6.0%

In a competitive environment, the average firm’s ROA should be close to the cost of financing total assets. Indeed, as we saw in class, average ROA’s mean revert to 6%.

3. RONA

The same argument goes for returns on net asset. In this case, the denominator is total assets minus s/t liabilities. That is, we are interested in the returns to l/t debt and equity holders only. Therefore the WACC calculation is:

Source of Financing

Pretax Cost of Financing

Effect of Tax Shield

After-tax Cost of Financing

% Weight Contribution to WACC

Long term liabilities

10.0% t=40% 6.0% ½ 3.0%

Equity Investors

12.0% none 12.0% ½ 6.0%

Estimated WACC for Total Assets 9.0%

In fact we find that in large samples average RONA is around 9% (PHB, p. 9-7).

4. ROE

The capital base for ROE is capital provided by shareholders only. The earnings to this capital is therefore Net Income (that is, the earnings after we have paid interest and taxes). Moreover, the appropriate cost of this capital is the cost of financing by equity, which is approximately 12% to 13% in the U.S. (based on a market premium of 5 to 6 percent and a riskless rate of 6 to 7 percent -– see, for example the Copeland et.

Lecture 4 Page 12 of 12