Daves Chapter 10 Condensed Financial Statements and Financial Analysis DES Chapter 10

Using the Corporate Valuation Spreadsheet Look at the file: Home Depot (for Ch 9-11, WACC, default inputs).xls. This file will be called Home Depot.xls for short. DES Chapter 10

Steps to Estimate Value Using the Corporate Valuation Spreadsheet The valuation spreadsheet has seven interrelated worksheets: (1) Proj & Val (2) Inputs (3) WACC (4) Hist Analys (5) Condensed (6) Comprehensive (7) Actual DES Chapter 10

DES Chapter 10

The Condensed Sheet You don’t need to do your analysis on a financial statements as complicated as those in the Comprehensive or Actual sheets. The spreadsheet automatically condenses the Comprehensive sheet into a format called the Condensed sheet. See DES Chapter 10 and its Appendix (continued) DES Chapter 10

The Condensed Sheet (continued) Rationale for including additional items in the condensed financial statements: (1) provide more detail and accuracy in reporting operating performance (2) account for nonoperating performance (3) allow us to convert GAAP-based statements into free cash flows (continued) DES Chapter 10

The Condensed Sheet (continued) Relative to Van Leer’s financials, the condensed statements provide details on: Operating performance Nonoperating performance Adjustments due to GAAP DES Chapter 10

Additional Detail - Operating Performance Other Short- and Long-Term Operating Assets/Liabilities Short-term operating assets/liabilities – example: payroll advances to their employees Other short-term operating assets/liabilities are catch-alls for such items. Long-term operating assets – example: goodwill and intangibles, deposits held by suppliers, deferred charges Other long-term operating assets is a catch-all line item for assets of these types. DES Chapter 10

DES Chapter 10

Additional Detail - Nonoperating Performance Long-Term Investments and Nonoperating Income activities that are not operating activities noncontrolling investments in other firms investments in real estate or other stocks and bonds These investments are accounted for in long-term investments; income from these investments is reported in the nonoperating income account. DES Chapter 10

Additional Detail - Nonoperating Performance After-Tax Extraordinary Income not related to the firm’s continuing operations one-time events classified as extraordinary items- examples: settlement of a lawsuit, casualty losses due to flood, fire, or tornado, and gains or losses on the extinguishment of debt) items that relate to a firm’s decision to discontinue a segment of its operations (sale or closure of a subsidiary, division, or major segment of its business) DES Chapter 10

Additional Detail - Nonoperating Performance All Short-Term Debt levels vary based on short-term cash needs, and are not targeted used to meet any excess or unanticipated cash needs firms have many different types of short-term debt, but only the total is relevant to valuation includes the portion of the long-term debt that will come due within a year. DES Chapter 10

Additional Detail - Nonoperating Performance Other Long-Term Liabilities Claims by investors other than shareholders - example: minority interest (e.g., the company being valued owns a majority, but less than 100%, of a subsidiary firm; minority interest is reported as a liability of the parent representing that portion of the subsidiary’s assets that belong to the minority shareholders in the subsidiary) A single line item called other long-term liabilities is the catch-all. DES Chapter 10

Additional Detail - Nonoperating Performance Par Plus PIC Less Treasury Firms are using stock repurchases to distribute cash to shareholders shares repurchased are called treasury stock sale of stock is recorded in two accounts, one account called Par and the other PIC PIC stands for paid-in-capital (aka capital surplus) dividend reinvestment plans (DRIPs) Because only the net effect of equity accounts is important for estimating intrinsic value, the model has one account called par plus PIC less treasury. DES Chapter 10

Additional Detail - Nonoperating Performance Preferred Stock Preferred stock is another source of capital Preferred stockholders have priority over common Preferred stockholders typically do not have the right to vote DES Chapter 10

Adjustments Due to GAAP Deferred taxes Most firms one sets of books for stockholders, another for the IRS for the IRS, firms make accounting choices to minimize taxable income, but for investors, they are required to follow GAAP the IRS allows firms to use accelerated depreciation GAAP accounting suggests that firms use straight-line depreciation taxes reported on the stockholder statements may be either more or less than the taxes the company actually pays DES Chapter 10

Adjustments Due to GAAP Deferred taxes is the cumulative difference between the taxes the company has reported paying and the taxes it actually paid. DES Chapter 10

The Condensed Sheet The following two slides show the condensed balance sheet and income statements for Home Depot, with the “additional” items circled: (continued) DES Chapter 10

(continued) DES Chapter 10

DES Chapter 10

Calculating Free Cash Flow Additional items in the reporting format have implications for: calculation of net operating profit after taxes (NOPAT) total operating capital free cash flow This section describes these changes. Calculations are shown in the Hist Analys worksheet. (continued) DES Chapter 10

Calculating Free Cash Flow (continued) FCF Calculation Step 1: Operating Profits Most companies include some nonoperating income items when calculating EBIT, but using condensed financials makes it easy to calculate pre-tax operating profits Sales COGS - SGA - Depreciation = Operating profits This step is shown in the next slide . . . (continued) DES Chapter 10

(continued) DES Chapter 10

Calculating Free Cash Flow (continued) FCF Calculation Step 2: NOPAT Operating profit – Tax on operating income + Extraordinary income(after tax) = NOPAT OK, so you need to know tax on operating income . . . (continued) DES Chapter 10

Calculating Free Cash Flow (continued) FCF Calculation Step 3: Tax on Operating Income Differences in Reported Taxes and Actual Taxes Reported taxes – Taxes reported but not paid = Actual taxes Taxes on Nonoperating Income Actual taxes + Taxes saved due to interest deductions – Taxes paid on interest income – Taxes paid on nonoperating income = Tax on operating income These steps are shown in the next slide . . . (continued) DES Chapter 10

(continued) DES Chapter 10

Calculating Free Cash Flow (continued) FCF Calculation Step 4: Total Operating Capital Net operating working capital + Operating long-term capital = Total operating capital Total operating capital, year t + Total operating capital, year t-1 = Investment in Operating Capital, year t (continued) DES Chapter 10

Calculating Free Cash Flow (continued) FCF Calculation Step 5: Free Cash Flow NOPAT - Investment in Operating Capital = Free Cash Flow Steps 4 & 5 are shown in the next slide . . . (continued) DES Chapter 10

DES Chapter 10

Analyze the Historical and Current Situation. Corporate information resources: Mergent or Thomson ONE B-School library Internet (continued) DES Chapter 10

Source: http://finance.yahoo.com/ (continued) DES Chapter 10

Analyze the Historical and Current Situation (Continued). Now consider the list of options in the frame on the left side of the Home Depot screen: (continued) DES Chapter 10

Source: http://finance.yahoo.com/ (continued) (Continued at right) Source: http://finance.yahoo.com/ (continued) DES Chapter 10

Analyze the Historical and Current Situation (Continued). Select “Profile” (circled on the slide) for background information about the company. You will get the following screen: (continued) DES Chapter 10

Source: http://finance.yahoo.com/ (continued) DES Chapter 10

Analyze the Historical and Current Situation (Continued). Once in the “profile,” there is another list of linked options -- click on the one called “Ratio Comparison.” This brings up “Valuation” ratios - several other categories of useful ratios may be chosen (see circled selections). Note the ratio comparisons of the individual company with both the industry and sector. You will use them soon. (continued) DES Chapter 10

Source: http://finance.yahoo.com/ (continued) DES Chapter 10

Analyze the Historical and Current Situation (Continued). Input ratio data for competitors (but this is already done this for you in Home Depot.xls). Check “average” of historical ratios. Check “trend” of historical ratios. Check “most recent ratio,” compared with competitors/industry. Use “graph button” to look at historical ratios. (continued) DES Chapter 10

Analyze the Historical and Current Situation (Continued). What can you say about the company’s past performance with respect to: Profitability (NOPAT/Sales and other ratios)? Efficiency (Operating capital/sales and other ratios)? Comparison to its industry? (continued) DES Chapter 10

Analyze the Historical and Current Situation (Continued). What are important issues? What are signs of financial strength? Signs of financial weakness? Signs of a growing versus a declining industry? What is the life cycle of a firm? (continued) DES Chapter 10

Analyze the Historical and Current Situation (Continued). Important aspects for projections: Sales growth Profitability changes Asset Utilization Working Capital Debt level (continued) DES Chapter 10

Analyze the Historical and Current Situation (Continued). More issues to examine: ROIC over time—does the company have good investment opportunities? Cash accumulation Extraordinary items Free Cash Flow Dividend policy DES Chapter 10