INVESTMENT BANKING LESSON 14 DETERMINING THE STRENGTH OF A COMPANY’S RETURN ON EQUITY Investment Banking (2 nd edition) Beijing Language and Culture University Press, 2013 Investment Banking for Dummies, Matthew Krantz, Robert R. Johnson,Wiley & Sons, 2014

WHAT’S IN THE NEWS OR WHAT’S THERE TO LEARN? SHANGHAI OPENS FIRST PRIVATE BANK!

VOCABULARY REVIEW – WHAT DO THESE WORDS MEAN? Present value and discount rate Discounted free cash flow Discounted free cash flow model Free cash flows (FCF) Weighted average cost of capital (WACC) Capital expenditures

VOCABULARY REVIEW – WHAT DO THESE WORDS MEAN? What is present value? The value of any asset is the present value of all future cash flows given a certain rate of return. What is the discount rate? The rate that puts future cash sum in today’s dollars. What does discounted free cash flow mean? time value of money; present value of cash flows; future value of cash flows; cash flow analysis

VOCABULARY REVIEW – WHAT DO THESE WORDS MEAN? What does the discounted free cash flow model tell you? the value of a company is equal to the value of all future free cash flows discounted at the weighted average cost of capital (WACC). What is free cash flow (FCF)? The amount of cash flow form operations after paying for capital expenditures. It is the money the company has left to pay it’s investors after it meets all it’s obligations (payments)

VOCABULARY REVIEW – WHAT DO THESE WORDS MEAN? Which of the following assets are capital expenditures? Office suppliesrentoffice furniture Building or plantutilitiesequipment Insurancetruck company car What is weighted average cost of capital (WACC)? Simply, the cost of funding for a company. The cost of capital.

A. INTRODUCTION B. IMPORTANCE OF RETURN OF EQUITY (ROE) AND OTHER PROFITABILITY RATIOS 1. Gross Profit Margin 2. Operating Profit Margin 3. Net Profit Margin

C. HOW DOES ROE GUIDE IB ACTIVITIES D. THE DUPONT ANALYSIS 1. Three-factor DuPont Method The breakdown of ROE a. Net Profit margin b. Total Asset Turnover c. Leverage

D. THE DuPONT ANALYSIS 2. Five-factor DuPont Method The Breakdown of Net Profit Margin a. Operating Profit Margin b. The Effect of Non-operating items c. The Tax Effect E. INTERPRETING THE RESULTS

How do IB judge how well a company is performing? For publicly held companies, it is how well is the stock doing. Has the stock risen or fallen recently? But how does the IB evaluate a privately held company? Trend analysis – Using ratios to compare against other companies in the same industry. Looking at past data and then projecting or making estimations for the future growth of a company.

Lesson 10 focused on the key ratios. Do you remember what some of them are? What does an IB and a company want to measure?

In this lesson, we will focus on the ratio that is considered the most important to investors, management and IB – Return on Equity (ROE).

Making money for owners is the goal of most businesses, since they provide risky capital. Owners expect to be rewarded. What are the things that drive rising stock prices and happy investors?

IB must estimate the long-term growth of the company: Long-term growth=ROE x (1-Dividend payout rate) in earnings The dividend payout rate is a % of net income the firm pays out in dividends. For example, if a firm earns $100 million & pays out $25 million in dividends the payout rate is 25%. If the same firm has an ROE of 20% then: Long term growth rate = 20% x (1-0.25) = 15%

The higher the dividend payout rate, the lower the future growth. Some companies pay out a large amount in dividends and others pay no dividends and reinvest to provide for future growth. REAL WORLD EXAMPLE: Warren Buffett’s Berkshire Hatthaway Co. has never paid a dividend but shareholders are pleased with an average 19.7% annual return over the last 45 years. Later we will look at Coca-Cola and it’s profitability but the next chart show Coca Cola’s return over the past 10 years.

Table 14-1Return on Equity for Coca-Cola YearReturn on EquityYear Return on Equity % % % % % % % % % %

Pros and Cons of ROE versus other Profitability measures – We will also look at: Gross profit margin Operating profit margin Net profit margin For an example we will break down perhaps the most recognized company in the world – Coca-Cola (ticker symbol: KO)

Income Statement Sales48,01746,54235,119 Cost of Goods Sold(19,053)(18,215)(12,693) Gross Profit28,96428,32722,426 Selling, Gen expenses(18,185)(18,154)(14,013) Earnings before interest, Tax10,77910,1738,413 Interest Income Interest Expense (397) (417) (733) Equity Income Other Income Earnings b4 taxes11,80911,45814,207 Taxes 2,723 2,812 2,370 Net Income 9,086 8,64811,837

Balance Sheet Current Assets30,32825,49721,579 Long-term Assets55,84654,47751,342 Total Assets86,17479,97472,921 Current Liabilities27,82124,28318,508 Long-term Debt14,73613,65614,041 Other Liabilities10,44910,114 9,055 Total Equity33,16831,92131,317 Total Liabilities/Equity86,17479,97472,921 Source: EDGAR

Companies want to grow and buy other companies and one of the factors is its ability to generate a high return on equity. But how a company gets that high return needs to be analyzed. Does it come from borrowing money – debt? From high profit margins? Or From medium profit margins and high turnover?

DuPont is a large US-based chemical company known for it’s many inventions and patents, heavy into research and development. The financial model, created by an engineer is used in corporate America and used by investment bankers.

There are 2 formulations breaking down ROE – The 3 factor model & 5 factor: 3 factor model looks at: Net profit margin Total asset turnover Leverage A higher ROE is the result by an increase in any of the 3 ratios.

This breakdown gives an IB a lot of insight on how they might help Coca-Cola increase ROE. They could increase their asset turnover however that would lower its net profit margin. The key for Coca- Cola is to have a balance between selling more COKE and not decreasing it’s net profit margin.

The five-factor model breaks down net profit margin into it’s 3 parts. Net profit margin measures how much of every dollar of sales the company is able to keep as earnings. a. Operating profit margin b. The effect of non-operating items c. The tax effect This helps the IB get an idea on how net profit margin is made and if there are any problem trends.

a. Operating Profit Margin: This measure tells the percentage (%) a company earns on sales before paying stockholders and bondholders (suppliers of capital) and taxes. In 2012 it was 22.4% for Coca-Cola.

b. Effect of non-operating items – Companies have large non-operating items that affect profitability. This takes into account everything in the Income statement between EBIT and Earnings Before taxes. These include: Interest income, Interest expense, Equity income and Other income. By separating out these sources of income and expenses, it allows the analyst to set apart the effects of the main business.

We’ve been only looking at one company, Coca-Cola. But analysis is really only as good as the analyst sees how it compares with other companies of the same industry. In Table 14-3, we will compare the results of Coca-Cola with it’s number 1 competitor, Pepsico (Pepsi).

Pepsi Coke Pepsi Coke Pepsi Coke Sales 65,49248,01766,504 46,54257,83835,119 Net Income 6,178 9,086 6,4438,648 6,32011,837 Total Assets 74,63886,17472,882 79,794 68,15372,921 Stockholder’s Equity 22,41733,16820,70431,921 21,27331,317 Source:EDGAR

Pepsi Coke Pepsi Coke Pepsi Coke ROE27.5%27.4%31.1% 27.1% 29.7% 37.8% Net Profit Margin 9.4%18.9%9.7% 18.6%10.9% 33.7% Asset Turnover Leverage WHAT DO YOU SEE IN THESE NUMBERS?

Coca-Cola & Pepsico are 2 very well run companies that really are simple. They both are known around the world. Coca-Cola has been ranked the #1 brand in the world. Pepsico ranked 22 nd. Both companies have the same ROE but get it in different ways. Pepsi’s net profit margin is half of Cokes, but it’s asset turnover is twice as high and Pepsi is more highly leveraged, with more debt than Coke.

What do you see when looking at Pepsi and Coke? There is more than one way to see good results as a company. Coke has a business model that relies on higher net profit margin, lower asset turnover and lower debt than Pepsi. The good news for Coke is that they can take on more debt if they want to grow their returns. Pepsi cannot take on more debt.

What do you see when looking at Pepsi and Coke? There is more than one way to see good results as a company. Coke has a business model that relies on higher net profit margin, lower asset turnover (not as effective using assets) and lower debt than Pepsi. The good news for Coke is that they can take on more debt if they want to grow their returns. Pepsi cannot take on more debt.

Coke has wider net profit margins & would do better than Pepsi if there was a “COLA WAR”! Pepsi’s net profit margin is thin and does not have a great margin of safety as Coke does. Pepsi does well in using its assets. Coke could do better and see more dollars from its assets. Both companies are selling at 21 and 20 times earnings. The Dow Jones average is 17 times earnings so you can see both companies are doing well.

Coke and Pepsi are too big to be taken over. But by doing the DuPont analysis IB can help them to be better acquisition candidates. Companies must focus on having a higher ROE. THIS IS THE MOST IMPORTANT MEASURE FOR COMPANIES LOOKING TO BE ACQUIRED BY OTHER FIRMS OR TO GO PUBLIC THEMSELVES. Investors look at ROE so management must do so as well. But, it’s also in how they got there and not achieved by high levels of debt.