Performance Evaluation Chapter 18 Robinson, Munter and Grant

Robinson, Munter & Grant Chapter 182 Learning Objectives Segment reporting Segment performance evaluation US and international standards Residual Income Economic Value Added

Robinson, Munter & Grant Chapter 183 IAS 14 Segments Business segment: Distinguishable component of an enterprise providing an individual product or service or group of related products or services. Geographic segment: Components of a consolidated entity that provide goods or service within a particular economic environment. One will be primary the other secondary, depending on the entity’s dominant source of risk and returns.

Robinson, Munter & Grant Chapter 184 Reportable Segments IAS 14 Segment revenue is at least 10% of total revenue for the firm; Segment result, profit or loss, is at least 10% of total profit or loss; or Assets are at least 10% of total assets.

Robinson, Munter & Grant Chapter 185 Reportable Segments IAS 14 Segments below the 10% threshold may be disclosed or aggregated with other segments Reported segments must represent at least 75% of consolidated revenues

Robinson, Munter & Grant Chapter 186 Required Segment Disclosures Primary segments – IAS 14 Segment revenue Segment result –Exclude extraordinary items, interest expense, income tax expense, certain losses and corporate-level expenses Carrying amount of segment assets Segment liabilities Segment asset acquisitions

Robinson, Munter & Grant Chapter 187 Required Segment Disclosures Primary segments – IAS 14 Segment depreciation and amortization Other significant segment noncash expenses Segment profit or loss from equity investments Reconciliation of segment amounts to consolidated amounts

Robinson, Munter & Grant Chapter 188 Required Segment Disclosures Secondary segments – IAS 14 When primary segment is business Secondary segment is Geographic and must report –Segment (external) revenue by geographic area –Segment assets by geographic location of assets –Acquisitions of segment assets by geographic location –Apply 10% threshold

Robinson, Munter & Grant Chapter 189 Required Segment Disclosures Secondary segments – IAS 14 When primary segment is geographic Secondary segment is Business and must report –Segment (external) revenue –Segment assets –Acquisitions of segment assets

Robinson, Munter & Grant Chapter 1810 Reportable Segments SFAS 131 Operating segments are –A component of an enterprise engaged in business activity for which it may earn revenues and incur expenses, about which separate financial information is available that is evaluated regularly by decision makers… Same 10% and 75% thresholds apply

Robinson, Munter & Grant Chapter 1811 Required Segment Disclosures Operating segments – SFAS 131 General information about segments and their identification Segment profit and loss and additional income statement items Segment assets

Robinson, Munter & Grant Chapter 1812 Required Segment Disclosures Operating segments – SFAS 131 Reconciliation to corporate amounts Information about products, services and geographic areas Revenues from major customer if 10% or more of revenues is derived from there.

Robinson, Munter & Grant Chapter 1813 Required Segment Disclosures Operating segments – SFAS 131 Additional income statement information External revenues Internal revenues Interest revenue Interest expense Depreciation, depletion, and amortization Other significant non- cash items Unusual items Equity method income Income tax expense or benefit Extraordinary items

Robinson, Munter & Grant Chapter 1814 Motorola Segments Personal communications Semiconductor products Global Telecom Solutions Commercial, Governmental and Industrial Solutions Broadband Communications Integrated Electronics Systems Other Products

Robinson, Munter & Grant Chapter 1815 Motorola Segments Segment descriptive information Principal products and services Industry Strategy Customers Competition Payment terms Backlog Intellectual property Inventory, Raw materials, Right of return and Seasonality Facilities

Robinson, Munter & Grant Chapter 1816 Segment Ratio Analysis Segment margin Segment profit (loss)/Segment revenue Segment EBITDA margin

Robinson, Munter & Grant Chapter 1817 Segment Ratio Analysis Motorola Segment Margin Personal Communication-17.2%-2.5%5.1% Global Telecommunicat-21.6%10.9%-7.3% Commerc/Government11.8%9.5%15.0% Broadband Communicat-15.3%36.6%11.6% Semiconductor Products-43.4%-2.1%8.4% Integrated Electronics-9.4%6.4%7.4% Other Products73.0%-32.0%-78.6%

Robinson, Munter & Grant Chapter 1818 Segment Ratio Analysis Segment turnover Segment revenue/Segment assets Segment ROA Segment profit/Segment assets

Robinson, Munter & Grant Chapter 1819 Segment Ratio Analysis Motorola Segment Turnover Personal Communication Global Telecommunicat Commerc/Government Broadband Communicat Semiconductor Products Integrated Electronics Other Products

Robinson, Munter & Grant Chapter 1820 Segment Ratio Analysis Motorola Segment ROA Personal Communication-40.4%-4.0%9.5% Global Telecommunicat-30.5%12.9%-6.5% Commerc/Government24.5%13.8%24.3% Broadband Communicat-12.8%30.3%8.8% Semiconductor Products-28.4%1.8%7.9% Integrated Electronics-18.7%13.9%16.7% Other Products30.2%-9.4%-22.7%

Robinson, Munter & Grant Chapter 1821 Segment Ratio Analysis Segment ROA – DuPont Analysis Segment margin * Segment turnover Segment debt ratio Segment liabilities/Segment assets

Robinson, Munter & Grant Chapter 1822 Segment Ratio Analysis Nokia Segment Debt Ratio Networks38.1% Mobile Phones80.0%64.7% Ventures108.8%36.1%

Robinson, Munter & Grant Chapter 1823 Segment Ratio Analysis Use of the equity method can distort operating margins Equity earnings represent the share of profits or losses from unconsolidated investments of significant influence Equity earnings (loss) return: Equity earnings or loss/Equity investments

Robinson, Munter & Grant Chapter 1824 Segment Ratio Analysis Additional considerations when comparing segments of different firms –Differences in accounting practices/standards –Definition of segments may vary –Currency differences are alleviated when ratios are used in comparative analyses

Robinson, Munter & Grant Chapter 1825 Residual Income Net income – dollar cost of equity –Dollar cost of equity = Cost of equity ($) * cost of equity (%) Is negative when ROE<Cost of equity (%) [(EBIT (1-tax rate)) – (Assets*WACC)]

Robinson, Munter & Grant Chapter 1826 Residual Income Motorola example Pretax income$ 1,168 Tax rate30% Stockholders’ equity (book value)$ 16,828 (75.1%) Debt (long- and short-term)$ 5,593 (24.9%) Total capital$ 22,421 Cost of equity (CAPM)12.8% Cost of debt7.0%

Robinson, Munter & Grant Chapter 1827 Residual Income Motorola example WACC = 10.83% (.07 * (1-.3) *.249) + (.128 * (.751)) Residual income = ($1,611) ($1,168(1-.3)) – ($22,421*.1083)

Robinson, Munter & Grant Chapter 1828 Economic Value Added Developed by Stern Stewart & Company EVA® = NOPAT – C%(TC) –NOPAT = Net operating profits after taxes Adjustments are made to arrive at an economic (rather than GAAP) measure of earnings –C% = Cost of capital –TC = Total capital employed Motorola’s 1999 EVA® = ($1,170)

Robinson, Munter & Grant Chapter 1829 Residual Income and Security Selection Will firms that use residual income measures for evaluation internally have better shareholder returns? Can a residual income approach be used to improve an investor’s selection of securities? Research on these issues is mixed.

Robinson, Munter & Grant Chapter 1830 Summary International and US standards of segment disclosures Evaluation of segment performance –Ratio analysis Residual income EVA®