Analyzing the Company’s Performance in Business Valuations

Analyzing the Company’s Performance in Business Valuations

Analyzing a company’s current and past performance in business valuations is essential to projecting its future. So a meticulous analysis of historical performance is a crucial valuation component. Before we start with the analysis, we should re-organize the financial statements. 

The analysis of the company’s performance includes analyzing ROIC and revenues. I have segregated this article into two parts, and the current article covers my analysis on ROIC, and part-2 would cover the revenue analysis.

In my view, when analyzing performance, always start with the core components of value creation: return on invested capital (ROIC) and revenue growth. Analyze trends in the company’s long-run performance and its performance relativistic to its rivals so that you can build your forecasts of future cash flows on plausible hypotheses about the firm’s key value drivers.

Begin by analyzing ROIC, both with and without goodwill. ROIC with goodwill includes the company’s capability to generate value over and above premiums paid for acquisitions. ROIC without goodwill is a more reliable measure of the company’s underlying operating performance than its peers. Next, drill down into the segments of ROIC to develop a combined view of the company’s operating performance and recognize which aspects of the business are significant for its overall performance. Following, measure what accelerates revenue growth. Does revenue growth stem, for example, more from organic growth or from currency effects, which are mostly beyond management control and presumably not sustainable? Lastly, evaluate the company’s financial health to ascertain whether it has the financial resources to manage the business and secure investments for growth.

Analyzing the Company’s Performance in Business Valuations – Returns on Invested Capital

When we re-organize the financial statements into operating and non-operating parts of the business, we derived the NOPAT from the Income statement and Invested capital from the balance sheet. ROIC takes these inputs:

ROIC = NOPAT/Invested Capital

Firms that publish ROIC in their annual reports may calculate it by applying starting invested capital, ending capital, or the aggregate of the two. Considering profit is estimated over a whole year, whereas capital is estimated solely at one point in time, I suggest to average starting and ending invested capital. If the business is extremely seasonal, capital is evolving vastly at its fiscal close, contemplate applying quarterly averages.

ROIC is a more reliable analytical tool than the return on equity (ROE) or returns on assets (ROA) for explaining the company’s performance because it concentrates singularly on a firm’s operations. ROE combines operating performance with capital structure, causing peer-group analysis and trend analysis less insightful. ROA—still when measured on a pre-interest basis—is an imperfect measure of performance because it covers non-operating assets and overlooks the benefits of accounts payable and other operating liabilities that collectively decrease the volume of capital needed from investors.

Analyzing ROIC with and without Goodwill and Acquired Intangibles

Goodwill and acquired intangibles are intangible assets acquired in an acquisition. We need to compute ROIC both with and without the goodwill and acquired intangibles.

The idea to calculate ROIC with and without goodwill is that each ratio explains different things. ROIC with goodwill measures whether the firm has earned satisfactory returns for shareholders, factoring in the acquisitions’ price. ROIC, excluding goodwill, estimates the underlying operating performance of a business. It shows you whether the underlying economics generates ROIC over the cost of capital. It would get applied to compare a firm’s performance against that of peers and to dissect trends. It is not affected by the price premiums paid for acquisitions. ROIC without goodwill is furthermore appropriate for projecting future cash flows and anchoring strategy. A business does not need to pay more on acquisitions to expand organically, so ROIC without goodwill is a more appropriate baseline for forecasting cash flows. Ultimately, companies with a high ROIC without goodwill will likely generate more value from growth, while businesses with low ROIC without goodwill will likely generate more value by improving ROIC.

Correctly estimating ROIC with goodwill leads to the next challenge: ROIC may expand even without improvements to the underlying business. There are situations where a business unit presented a new strategic plan stating it expected to develop its ROIC over time. On the outside, its forecast seemed exciting. However, I have always noticed that the ROIC included goodwill, and the proposed improvement in ROIC would be caused only by goodwill remaining fixed as the business increased profits organically. The management team would win accolades for growing ROIC solely due to the accounting for goodwill, not an underlying growth to the business.

Decomposing ROIC to Develop a Unified Aspect of Company Economics

To explain how I interpret a firm’s economics based on the decomposition of its ROIC, I recognize which parts of a firm’s business are driving the company’s ROIC. For that, I split apart the ratio as follows:

ROIC = (1-Operating Cash Tax Rate) * (EBITA/Revenues) *( Revenues/Invested Capital)

The above equation is one of the most potent equations in financial analysis. It proves the degree to which a firm’s ROIC gets driven by its capability to maximize profitability (EBITA divided by revenues, or the operating margin), optimize capital turnover (measured by revenues over invested capital), or reduce operating taxes.

Once you have determined the historical drivers of ROIC, compare them with different organizations’ ROIC drivers in the related industry. You can later measure this perspective against your analysis of the industry structure (opportunities for differentiation, barriers to entry, or exit) and a qualitative evaluation of the firm’s strengths and weaknesses.

Analyzing the Company’s Performance in Business Valuations – Line Item Analysis

A thorough valuation model will change every line item in the firm’s financial statements into some ratio. For the income statement, most items get measured as a percentage of sales. (Exceptions exist: operating cash taxes, for example, should be determined as a % of pretax operating profits, not as a % of sales.) For the balance sheet, each line item gets estimated as a percentage of revenues (or as a percentage of the cost of goods sold for inventories and payables, evading contortion caused by fluctuating prices). For operating current assets and liabilities, you can further change each line item into days, applying the following formula:

Days = 365 * (Balance Sheet Item/ Revenues)

Operating Analysis Using Nonfinancial Drivers

In an outside analysis, ratios get limited to financial performance. However, if you are operating from inside a company, link operating drivers right to ROIC. By assessing the operating drivers, you can properly evaluate whether any discrepancies in competitors’ financial performance are sustainable.

Consider airlines, which for security reasons, need to publish an enormous quantity of operating data. Operating statistics involve the number of employees, estimated using full-time equivalents, and available seat-miles (ASMs), the conventional measurement of airlines’ capacity. For airlines, operating margin gets driven by three principal factors: aircraft fuel, labor expenses, and other expenses.

Labor Expenses/Revenues = (Labour Expenses/ASM) / (Revenues/ASM)

The ratio of labor expenses to revenues is a capacity of labor expenses per ASM and revenues per ASM. Labor expenses per ASM are the labor costs needed to fly one ASM, and revenues per ASM symbolize the average price charged per ASM.

We can further disaggregate the Labor Expense to ASM using the below formula:

Labor Expenses/ASM = (Labor Expenses/Employees) / (ASM/Employees)

Two elements drive labor expenses per ASM: the first part describes the average salary per full-time employee; the second evaluates FTE productivity (millions of ASMs flown per employee). Moreover, the variations in productivity can get driven by diverse route structures and the service level.

Analyzing performance utilizing operating drivers provides additional insight into the competitive differences in industries like airlines. 

Final Thoughts

Although it is challenging to give a comprehensive checklist for dissecting a company’s historical financial performance while performing business valuations, my suggestion is to look at its historical performance. Long time horizons will enable you to discover whether the company and industry manage to return to some average performance level and whether short-term trends are likely to be continual.


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