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Financial Analysis : WACC, Ratios & Valuation Prep - Overview and Walthrough written by : William F Bryant continued from Statements In order to make use of some of the planning metrics and ratios, it is necessary to understand what it costs a company to use the types of capital. This may sound peculiar since you put a price on cash, but we actually encounter this all the time in daily lives. For example, if you have a credit card, it costs you the interest rate to use the credit available to you. This situation is no different for companies, except that the market has the final say on costs. In the instance of equity, shareholders expect a growth of earnings to which they hold a claim and therefore see their equity value increase. In the instance of debt, a corporate entity will offer a bond, of which there are many types, that requests a certain amount of capital at a suggested rate. The market will then determine whether the rate is commensurate to the risk of solvency, amongst other things, of the company. If the market doesn’t like the interest rate, the price of the bond will decrease with respect to face value, corresponding to a higher interest rate. If the market offers a lot of demand for the bond, the opposite will happen. I make a brief mention of bonds due to the fact that it is one of the sources of capital to which you must understand the cost (cost of debt) for the particular company, but its understanding is straight-forward. The other source of capital is, as mentioned, equity. While equity is the capital raised at an IPO, it is also all retained earnings after liabilities are met for each period. You can think of earnings as a type of yearly loan to the company on the hopes that the management team can increase the value of the company with the continued use of earnings. Both sources, therefore, have expectations about the payment returned to them for the use of funds. Debt holders want a stream of cash, equity holders hope for capital gains in a later sale. Combine these two sources of capital with their respective weight of total capital contribution and we find the weighted-average cost of capital (WACC) for the company. The expected return on equity for domestic value companies is low. One of the reasons is that the risk-free rate, for all intents and purposes is around 1% spot on a 5-yr treasury. I used the CAPM to evaluate the cost of equity for the firm I choose, which I will call Firm S. I regressed daily log returns (remember to final report in annual terms) onto my chosen market portfolio representation, the Russell 2000 Value index, for the three-year period 2017 – 2019. Analysts and firms have their quick favorites to set up a market portfolio representation and I believe the domestic value would represent this firm well for these purposes. The Beta = 0.61 and the E[r(equity)] =5%. On this point some analysts would disagree and list this company as an aggressive growth company. I would retort that aggressive growth jumps only occur with increased market share and then growth settles. Another point is that inflation and price increases will contribute to any slowing and we will not see 10 -12% growth. This company I chose for the representation of the financial statements does not actually have corporate bonds outstanding so I will calculate a bond offering. It is interesting that a company does not make use of some tax shielding given that debt is significantly cheaper than equity and has been for several years, with the additional benefits of decreasing the WACC of the firm and actually lowering the cost of equity in a levered firm. Of course, if these companies did not have plans for increasing capacity then one of the only other uses would be for stock repurchases. In a bloated market, like today, the feeling that shares are overvalued would negate this usage, but overvalued shares are also the best time to use shares for M&A transactions, as this Firm S did in 2018. An additional note that I would like to make is that while capital is investor supplied and the accruals and accounts payable arise from operations and their impact is found in the cash flows, not in the cost of debt; the decision on when to pay the accounts is a financing decision and the corresponding savings (or not) is a choice. Paying a discount on accounts payable or holding the cash and foregoing the terms changes cash flows and will, in turn, affect all Returns On (RO) ratios (ROA, ROE, ROIC) and so on.
Perhaps, this firm finds that an upgrade to systems and machinery increases inventory usage efficiency, reducing costs 10% per year for 5 years. This is anticipated to be a 5-year $50,000,000 project. The firm will release a continuously callable, zero premium, 5-yr, 2.5% coupon, semi-annual $50,000,000 bond to pay for the upgrades. The market will make the final determination of whether this is acceptable or not, which will reflect a premium or discounted pricing. A number of things can be done to “sweeten” the deal for bond buyers if a particular rate is desired by the offering firm, but is too low for the bond buyers, such as adding a call premium, perhaps offering a puttable bond or even attaching warranties if the prospects for increasing firm value are positive. If you visit FINRA’s website you can find lists of bond offerings to get an idea of comparable credit ratings and yield offerings. Without going through a full credit spread calculation, I simply compared some investment grade corporate bonds and current YTM expectations for expiration in 2026, however the ratios calculated for interest coverage, leverage, liquidity, profitability and cash-flow to debt will all contribute to this grade assessment. There are tax recording stipulations for bonds selling at a premium or a discount but we will just assume the bond sells at par. As of this writing, the alcoholic beverage industry trends at a 5% debt structure weighting and this bond would put the firm at a 5.8% debt to 94.2% equity structure with a WACC around 4.8% for a 38% tax rate. Now some calculations on historic, pre debt period. In order to get an idea of where a firm sits for overall performance we need the ROIC, operating profitability, capital requirements and free cash flows. The ROIC is measured against the WACC to determine if invested capital is returning more than the cost of capital, thereby gaining in value.
ROIC = NOPAT/Op Capital = 15.37% >4.8% = WACC --- previous year = 18.63% Investors are getting productive assets in exchange for their capital investments, just don’t expect this going forward. Even if we would like to gauge Firm S as an aggressive growth firm with a comparable 12% WACC or the current alcoholic beverage industry equity growth rate ave of 11.4%, there is still comfort in the ROIC. The downward trend would normally be a signal for a deeper look into capital investments, but given an acquisition there are a number of possibilities that may have influenced this number. *Operating Profit : OP = NOPAT/Revenue = 7.14% --- previous = 7.18% I used revenues net of excise tax to stand for revenue and EBIT(1-t) or after-tax operating income for the numerator. This may differ if you are looking at comparative companies that use operating margin. Remember this if you are using industry comps. Regardless, this is actually under the industry average. The operating margin would be around 11%, but the industry average at this time period was 24.47%. That said, this is trending upward from 2 years prior and so, again, there may other issues at play in operational expenses that affect this ratio. One of the things that I thought was interesting in this regard was the fact that this management made the change to keep 2 years-worth of inventory on-hand. The timing of this decision would affect this margin if it was made shortly before this period of an acquisition. Operating Profit Margin is also on of the ways in which credit ratings are determined. If you surf for credit key ratios by ratings and industry, you will find papers and links (some of which are login required) that offer insight into financial metrics and credit ratings. An old Moody’s chart:  Capital Requirement Ratio = Total Net Op Capital/Revenues = 46.49% --- previous year = 38.54%
Revenues, net of excise tax. This ratio reveals how much capital is tied up to produce the revenues. This is obviously closely related to the OP statistic and it shows that significantly more capital was used to generate revenues YoY. Because many of these stats are related, the dramatic increase in AR, Inv and attributable changes, due to the acquisition, come into consideration. It is also common that an acquisition may not have the economies of scale of the acquiring firm, operational or managerial efficiencies or the same capital structure; all of these things will be weighted in the acquiring firm until these stats can be ironed out. While the previous few ratios are used to evaluate investor capital usage and whether the investors are seeing efficient and effective usage of the capital, other measures that have been used by consulting firms have been MVA and EVA or Market Value Added and Economic Value Added. For those of you who have not listened to my commentary on economics, market places are behaviorally affected transactions. The MVA is entirely a market measure which may or may not have any relation to the anticipated future earnings, of which, the price of the share is supposed to be related. The MVA is a weak measure, although I understand the attempt, and while you could argue consecutive time comparisons, the fact is that during times of behavioral frenzies and inflationary influences or modern monetary (money printing) theory, this measure no longer works. It is best to stick to hard asset productivity measures to determine inf invested capital is actually working. The EVA, is similar to the ROIC to WACC comparison and uses the WACC. It is more a measure of effectiveness of managerial decisions for capital investment and the corresponding after-tax profit. It is the NOPAT – WACC*Total net Op Capital. You can see how it is closely related to the previous calculations and is used to approximate what profit is left after covering for the cost of the capital invested. It is always important to keep in mind not only the numbers, but what the numbers are actually telling you in the given economic environmental conditions … do they make sense? liquidity ratios: *current ratio = current assets/current liabilities = 1.21 --- previous year = 1.92 Substantially more liquid assets than liabilities with which bills can be paid, although there was a drop in this ratio note the change in cash and equivalents. *quick ratio = (current assets – inventories)/current liabilities = 0.62 --- previous year = 1.34 industry average = 0.23 The quick ratio is a nice relative measure as to how much of the current assets is comprised of the inventory, which is of course influenced by raw material prices. Because inventories aren’t nearly as liquid as other assets, there is much less available liquidity than first perceived with which to pay liabilities. efficiency ratios: asset turnover ratio = revenue/total assets = 0.84 --- previous year = 0.64 Dollar in sales for each dollar in of an asset. Again, excise tax has a direct affect on revenues. I know, I repeat myself, but it is important to drive home costs of business in a given industry and to remain consistent in calculations. fixed asset turnover = revenue/net fixed asset = 0.48 --- previous year = 0.39 Age of the fixed assets will be more relevant during rising inflation for much the same reason as FIFO. Newer items will cost more than mature, aged fixed assets. days sales outstanding (DSO) = AR/(Revenues/365) = 15.89 --- previous year = 12.49 Cash. When a company makes a sale on credit, there is a time period before that sale becomes recorded as cash. The average time for this to occur is the DSO. This ratio extends its usefulness in the Cash Conversion Cycle. The firm is currently collecting on sales, on the average of, 15.89 days later up from the previous year. inventory turnover = COGS/Inventory = 5.99 --- previous year = 6.88 COGS is relevant to inventory in that inventory is recorded at cost, whereas in the other ratios revenue is used which includes both costs and profit. If it happens that COGS are reported net of depreciation, put the depreciation back in that is associated with the operations. In this particular case we are evaluating Cost of Revenues. Realize that you may, if possible, remove the extra inclusion of marketing and such in the cost of revenue since this is not the turnover of the inventory. But you may also want to include it. Just be aware of the ratios you are comparing it to and what you have included in your calculation. This implies that 6 times per year, every two months merchandise is fully resupplied, down from the previous year where inventory was turned over just under 7 times. Recall, however the amount of inventory that the firm decided it would hold (2 years-worth of inventory). leverage ratios: For now, this firm doesn’t yet have any debt except for capital lease obligations. In the next excerpt I will conduct financial planning and full financial statement pro-formas that will incorporate debt and future evalutations. debt-to-asset = total debt/total asset = 0.2% --- previous year = 0.0% 0.2% of assets are financed by debt. This ratio can also be restricted to only long term debt and investor supplied capital instead of total assets. debt to equity = total debt/total common equity = 0.0035 or 0.35% Financing breakdown. Dollar of debt to dollar of equity. Less than 1 cent of debt for each dollar of equity. The industry average during this time period was 0.02. As was mentioned, this firm does not use debt financing apart from capital leases. market debt ratio = total debt/(total debt + market value of equity) If possible, this ratio can use the market value of the debt. This ratio, relative to market rates of interest, will give you a good idea how the market views this company during different business cycles and economic cycles. credit ratios: interest coverage = EBIT/interest expense This ratio is most important if times cycle to low economic activity and creditors need to determine how far sales can be rolled back and payments on bond debt can still be made. Of course, this also reflects the extent to which leverage has been pushed and whether the firm is entering into a solvency crisis. EBITDA to coverage = (EBITDA + Lease Payments)/(Interest + Principal payments + Lease Payments) Expands debt obligations from just the interest payments on debentures or secured bond, note liabilities. This ratio will take into consideration other payments on the schedule including leases and the EBITDA will add back the DA to the EBIT for a more accurate reflection of available cash to pay obligations. There are no principal payments for the firm at this time so the coverage ratio would be approximately 97x. profitability: net profit margin = net income to common/revenues = 8.02% --- previous year = 8.61% Profit per dollar of sales. In the case of this Firm the calculation is actually using the income available to common equity excluding extraordinary items and net revenue. The net margin for the industry fluctuates substantially YoY. It seems that around 10% would be on par with industry benchmarks. When using references for industry benchmarks doublecheck formulas used for computations, the number of industry participants reporting and any other data that might affect finals stats. operating profit margin = EBIT/revenue = 11.59% --- previous year = 11.64% This calculation reveals a bit more about the net profit margin from the operational perspective. If net profit is lower than previous years or in comparison to competitors the it is in the operational efficiencies or interest payments. The op profit margin will indicate if issues are in operations. The industry benchmark is right around 25% during this time period so this firm was well below the benchmarks. There were, as mentioned several times, significant changes to managerial decisions regarding inventories, CAPEX, and an acquisition. gross profit margin = gross profit/revenue = 49.1% --- previous year = 51.4 Bold. Straight forward. Dependent on COGS or Cost of Revenues. Industry average was reported at 58.36%. The firm is below the average, however, for this industry there may be variations in the way COGS is reported or even unique regional, municipal excise taxation that would affect net revenues. basic earning power = EBIT/total assets = 13.7% --- previous year = 18.1% Removes the influence of taxes and financing decisions. This drop would be concerning if the firm hadn’t went into a long term investment of a M&A transaction. The degree to which this will be of concern would be better measured in the follow up year once the firm is back under unified managerial guidance. ROA = net income/total assets = 9.5% --- previous year = 13.4% ROE = net income/common equity = 13.6% --- previous year = 18.6% The more one views the drop in several of the ratio categories, the more one could lean toward to fact that a significantly less efficient firm was purchased. This is actually why the acquisition was selected strategically. The firm had a market segment and product lines that the acquiring firm had not yet developed and given that their operations were more efficient the synergies of the acquisition would, in this case, have a good possibility of being realized. market values: price/earnings = Stock Price/EPS = 45.43 --- previous year = 50.70 The price per dollar of earnings. This is, of course, a current ratio, but the idea is that what you are willing to pay for earnings should be related to your anticipation of future growth in earnings. Whether this growth is in capital gains or dividends and how you perceive taxation is another matter. Due to future potential, high growth firms have higher P/E ratios. The stock closed on the last day of 2019 at $377.85. earnings per share (EPS) = net income/shares outstanding = $8.31 --- previous year = $7.45 price to cash flows = Stock Price/(net income + DA)/shares outstanding = $22.62 previous year = $25.88 price to EBITDA = $1.88 --- previous year = $2.25 market to book: Market pricings, obviously, reveal the general beliefs that the market has on the strategic decisions being made by the firm. They are the pulse for the behavioral trends in the industry as well as whether the firm is anticipated to meet these trends. After the acquisition made by the firm, the stock jumped 185% in 18 months.
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