AFM 212 Week 2 Lecture 2-Update PDF

AFM 212 Week 2 Profit Analysis professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE Return on Equity (ROE) § The most common analysis metric used by managers and investors alike § ROE relates net income to the av...

AFM 212 Week 2 Profit Analysis professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE Return on Equity (ROE) § The most common analysis metric used by managers and investors alike § ROE relates net income to the average total stockholders’ equity § ROE measures return from the perspective of the company’s stockholders 22 professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE © Cambridge Business Publishers, 2021 3 Adjustment to Compute ROE ROE measures return to the controlling (parent company) stockholders. Noncontrolling interests: Must use the correct line items 1. Numerator: Use net income attributable to the parent company’s stockholders 2. Denominator: Use equity attributable to the parent company’s stockholders professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE What is Noncontrolling Interest? professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE ©Cambridge Business Publishers 5 ROE Calculated for Pfizer ROE for S&P 500 firms ranged from 13.7% to 17.3% from 2018-22. professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE © Cambridge Business Publishers, 2021 6 Adjustment to Compute ROE ROE measures return to the common stockholders Preferred Stock necessitates two adjustments: 1. Numerator: Subtract preferred dividends from net income 2. Denominator: Subtract preferred stock from stockholders’ equity professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE Which Accounts to Use to Compute ROE Occidental Petroleum Corporation ©Cambridge Business 7 Publishers professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE © Cambridge Business Publishers, 2021 8 Return on Equity § Performance analysis seeks to uncover the drivers of ROE and how those drivers have trended over time to better predict future performance. § Two methods to measure ROE drivers: 1. Traditional DuPont analysis that disaggregates ROE into components of profitability, productivity, and leverage 2. ROE analysis with an operating focus that distinguishes between operating and nonoperating activities Operating activities drive shareholder value professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE  DuPont Analysis professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE DuPont analysis § The name comes from the DuPont Corporation that started using this formula in the 1920s. § DuPont explosives salesman Donaldson Brown invented this formula of ROE disaggregation in an internal efficiency report in 1912 professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE © Cambridge Business Publishers, 2021 11 DuPont Disaggregation of ROE § ROE reflects both § Company performance (as measured by ROA) § How assets are financed (as measured by Financial Leverage) § ROE is higher when there is more debt and less equity for a given level of assets. § Tradeoff―greater debt means higher risk for the company professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE © Cambridge Business Publishers, 2021 12 Return on Assets Income Statement Balance Sheet § Return on assets (ROA) measures return from the perspective of the entire company (enterprise level). § This return includes both profitability (numerator) and total company assets (denominator). § To earn a high ROA, the company must be profitable and manage assets (hold the lowest level of assets possible to achieve the desired profit). § ROA analysis encourages managers to focus on both the income statement and the balance sheet. professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE © Cambridge Business Publishers, 2021 13 Return on Assets Boston Scientific Median ROA for S&P 500 firms: § 6.1% in 2018 § Ranged from 5.2% to 6.1% from 2014 – 2018 professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE © Cambridge Business Publishers, 2021 14 Financial Leverage § Financial leverage measures the relative use of debt versus equity to finance the company’s assets. § Financial leverage is important because debt is a contractual obligation and a company’s failure to repay principal or interest can result in legal repercussions or even bankruptcy. § Higher financial leverage means higher debt and interest payments. § All else equal, higher financial leverage increases the probability of default and possible bankruptcy. professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE © Cambridge Business Publishers, 2021 15 Financial Leverage Boston Scientific Median FL for S&P 500 firms: § 2.66 in 2018 § Ranged from 2.46 to 2.74 from 2014 – 2018 professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE © Cambridge Business Publishers, 2021 16 Disaggregation of Return on Assets What the company earns on each sales dollar Sales generated from each dollar invested in assets Managers can increase ROA by: § Increase PM: increase profitability for a given level of assets § Increase AT: reduce assets while still generating same profit level Or Both professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE Poll § Out of the two sources of profitability difference, profit margin and asset turnover, which one is affected greater by competition? professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE Academic readings § Soliman 2008 The Accounting Review (page 824) professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE © Cambridge Business Publishers, 2021 19 Putting It All Together professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE © Cambridge Business Publishers, 2021 20 Analysis of Profitability ( end) Gross Profit Margin § = Gross profit / Sales § Influenced by both the selling price of a company’s products and the cost to make or buy those products § Generally high and increasing gross profit margin is better § Low or decreasing gross profit margin signals more competition or less demand for the company’s products § Competitive intensity has increased § Product line has lost appeal § Product costs have increased § Product mix has changed § Volume has declined and fixed costs have not professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE © Cambridge Business Publishers, 2021 21 Analysis of Profitability Operating Expense Margin § Measures general operating costs for each sales dollar § Consider each expense in whatever detail the company provides in its income statement § Compare margins over time and against peers (making sure that peers have similar business models) professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE © Cambridge Business Publishers, 2021 22 Analysis of Profitability and Productivity professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE © Cambridge Business Publishers, 2021 23 Analysis of Productivity !"#$% § Asset Turnover (AT) = &'$(")$ +,-"# &%%$-%./0,1$ %-"-$1$/- 2-$1 § Turnover = &'$(")$ 3"#"/0$ %4$$- 2-$1 § Working capital turnover ratios: A/R turnover Inventory turnover A/P turnover !"#$% 789! = = = &'$(")$ &/6 &'$(")$./'$/-,(: ; ROA 16.6% § Average NOA < Average assets § NOA is net of operating liabilities § By Operating Focus, ROE(36.3%) is from operating (32.1%) and Nonnoperting return(4.2%) 39 professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE ROE and Financial Leverage § Financial leverage relates to the degree to which the company uses borrowed money § Financial leverage in an important measure of the risk a company is incurring with its reliance on debt § Financial leverage increases risk and it also increases the return to shareholders if the yield on the assets > borrowing rate on the debt § Operating approach shows that much more of Pfizer’s ROE is due to operating activities that make up its core business as opposed to financial leverage 40 professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE