Security Analysis and Valuation
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FINS3641:
Security Analysis and Valuation
Lecture Topic:
Financial Ratio Analysis (FRA)
To evaluate the past and predict the future
Residual Income Valuation (RIV)
1. Know the difference between accounting profit and economic profit
1. Accounting profit
• Guided by ACCT principles and standards
• Bottom line of income statement which is
sales less operating, finance and tax
expenses
2. Economic profit
• Guided by opportunity cost (OC) concept
• Is sales less operating costs, tax expense
and charges for the use of debt and equity
capital based on missed opportunities
2. Know the measurement of residual income &
corresponding valuation model
1. Definition: RI = net profit – OC of equity
expected by the shareholders
2. Measurement: ! = ! −"×!#$ ! − " ×!#$
3. Model: % = % + ∑!&$' ()!# *" × -!#$$. *" ! or % + ∑!&$' /01!# *" ×-!#$$. *" !
4. Strength: An appealing model; …; Readily
available accounting data
Weakness: Aggressive ACCT practices; …;
Non-zero OCI items
3. Know the process of residual
income valuation RIV
1. Know when to use RIV
2. Conduct test to be assured of honourable
accounting practices
3. Adjust net profit for non-recurring income
statement items and OCI items that are
materially different from zero
4. Estimate residual income
5. Implement different residual income
valuation models
1
2Infographic designed by the PVCE
team of educational developers
1. Profitability: 1.1 ROIC - A quant-based measure
1.1.1 Definition of return on invested capital: ROICt = !"#$%&!'()*+,*- /012,03!"#
Net operating profit
(NOP)
Less adjusted tax
(LAT)
Profit from core operations
before
1. Interest expense
2. Tax expense
i.e. EBIT
Tax reported on income statement is based
on earnings inclusive of income from non-
operating assets and after interest expense
To compute adjusted tax or income tax
related to core operations
1. Lower reported tax by the amount of
tax paid on non-operating income
2. Raise reported tax by the amount of tax
savings from interest expense
i.e. Operating cash tax
Invested capital
Cumulative amount of
investments in fixed
operating assets and
operating working capital
3
1. Profitability 1.1 ROIC - A quant-based measure
1.1.2 Fundamental drivers of ROIC
ROIC = !"#$%&2()*+,*- 4012,03
= 56'& 781*90,2(: 40+; ,0< 2()*+,*- 4012,03
= 56'& 756'& ×81*90,2(: 40+; ,0< 90,* 2()*+,*- 4012,03
= 56'& × (? 7 81*90,2(: 40+; ,0< 90,*) 2()*+,*- 4012,03
= 56'&2()*+,*- 4012,03 × 1 − ℎ
= 56'&9*)*(A* × 9*)*(A*2()*+,*- 4012,03× 1 − ℎ
Return on
invested
capital
1.
Operating
margin
3.
Operating
cash tax
rate
2. Invested
capital
turnover
4
1.1.2 Fundamental drivers of ROIC
1 Operating margin: Measurement of EBIT
Accounting-wise, EBIT = Sales – COGS – SG&A expenses – depn of PP&E
In practice:
EBIT = Sales
– [COGS – restructuring charges]
– [SG&A expenses – interest component of OL rental payment – expenses related to pensions]
– Depn of research asset
COGS SG&A expenses
Often includes
restructuring
charges
Often include
1. Operating lease (OL) rental payment (pre-AASB 16)
2. Expenses related to pensions
3. Amortn expense
4. Depn expense related to PP&E
R&D expenditure
Is often written off in the year
of occurrence, but R&D
expenses are intended to
generate future benefits in the
same fashion as PP&E
5
Notes to the Financial Statements
Note 2: Revenue and expenses, p 82
Depreciation of fixed assets 156.2
Amortisation of intangibles 25.1
Rental expenses relating to OL 40.7
Employee benefits expense: salaries & wages, …, defined benefit & contribution plans 1247.6
Note 5: People Costs
Defined benefit plans 26.7
Defined contribution plans 25.5
EBIT = Sales
– [COGS – restructuring charges]
– [SG&A expenses – interest component of OL rental payment
– expenses related to pensions ]
– depn of research asset
1.1.2 Fundamental drivers of ROIC
Income Statement: CSL Annual Report 2015
Continuing operations Notes US$m
Sales revenue 2 5,458.6
Cost of sales (2,605.9)
Gross profit 2,852.7
Other revenue 2 169.4
R&D expenses 6 (462.7)
Selling and marketing exp (498.3)
General & admin exp (287.5)
Finance costs 2 (59.6)
Profit before income tax exp 1,714.0
Income tax expense 3 (335.0)
Net profit for the period 1,379.0
1 Operating margin: Illustrated example based on CSL FY2015
1. Refer to Appendix 1 for estimation of the interest component of OL rental payment in the amount of US$13m
2. Refer to Appendix 2 for estimation of depn of capitalized research asset in the amount of US$195m
6
1.1.2 Fundamental drivers of ROIC
1 Operating margin: Illustrated example based on CSL FY2015
7
COGS 2,605.9
Less: Restructuring charges -
COGS, net of restructuring charges 2,605.9
Selling and marketing expenses (S&M) 498.3
General and administrative expenses (G&A) 287.5
SG&A 785.8
Less: Interest component of OL rental payment 13.0
Less: Defined benefit plans 26.7
Less: Defined contribution plans 25.5
SG&A, adjusted 720.6
Sales 5,458.6
Less: COGS, net of restructuring charges 2,605.9
Less: SG&A, adjusted 720.6
Less: Depreciation of R&A assets 195.0
EBIT 1,937.1
EBIT 1,937.1
Sales 5,458.6
Operating margin 35.5%
Note: R&D
expenses are NOT
deducted
Appendix 1: Implicit annual interest expense for FY 2015 related to
operating lease debt at the beginning of the FY 2015 or end of FY2014
Schedule of operating lease commitments
Timing Amount US$m Years from 2014
2015 39.8 1
2016 30.75 2
2017 30.75 3
2018 30.75 4
2019 30.75 5
2020 32.425 6
2021 32.425 7
2022 32.425 8
2023 32.425 9
2024 32.425 10
2025 32.425 11
2026 32.425 12
2027 32.425 13
Total 422.2
AR 2014; Note 13 OL commitments, p 121
Not later than one year 39.8
Later than 1 but not later than 5 yrs 123.0
Later than five years 259.4
Total 422.2
A discount rate of 4% is assumed and
applied to future lease commitments
Given the value of the operating lease
debt of US$ 325.0m at the beginning of
FY 2015 and the assumed cost of debt
of 4%, implicit interest charge related
to operating lease rental expense for
FY2015 is US$ 13.0m
FY discount rate PV US$m
4% 38.3
4% 28.4
4% 27.3
4% 26.3
4% 25.3
4% 25.6
4% 24.6
4% 23.7
4% 22.8
4% 21.9
4% 21.1
4% 20.3
4% 19.5
325.0
8
Appendix 2: Depn expense related to capitalised R&D expenses for FY 2015
Assume life of R&D expenses = 15 years
T = 0: CSL spent US$463m on R&D in FY2015. This is like
paying for a brand new asset. Therefore
• The whole amount 463 * 1 is capitalised.
• No depn is charged against this R&D asset.
T = -1 CSL spent US$466m on R&D in FY2014. By the end of
FY2015, the asset would be 1 year old. Therefore
• ⁄$ $% of the amount would have been depreciated.
• The remaining fraction 1 - ⁄$ $% = 0.933 or residual
amount = 466 * 0.933 = 435 would be carried forward
to FY2015 as research asset.
• ⁄$ $% of the original amount would be depreciated in
FY2015 due to straight line depreciation.
T = -2 to -14 etc
T = -15 CSL spent US$28m on R&D in FY2000. By the end of
FY2015, the asset would be 15 year old. Therefore
• ⁄$% $% of the amount would have been depreciated.
• The remaining fraction 1 - ⁄$% $% = 0 or no residual value
would be carried forward to FY2015 as research asset.