OPPapers.com

Miss

What you will learn

• How ratios aggregate to explain Return on Common Equity (ROCE)

The Analysis of Profitability

• How financial leverage affects ROCE • How operating liability leverage affects ROCE • The difference between Return on Net Operating Assets (RNOA) and Return on Assets (ROA) • How profit margins, asset turnovers and their composite ratios drive RNOA

1

2

Recall:
• We began by identifying a role for the residual income model in valuation

A Reminder of the Process of Fundamental Analysis
Step 5 - Trading on the Valuation •Outside Investor Compare Value with Price to BUY, SELL, or HOLD •Inside Investor Compare Value with Cost to ACCEPT or REJECT Strategy Step 4 - Convert Forecasts to a Valuation

V E −B V = B0 + ∑ ρ R Et + T T T ρE t =1
E 0 T −t E

• We identified the central role of ROCE in valuation Since:

earn t − ( ρ E − 1)Bt-1 = [ROCE t − ( ρ E − 1)] Bt-1
• We reformatted the Income Statement to draw attention to the components of Comprehensive Income (the numerator in ROCE) • We reformatted the Balance Sheet to draw attention to the components of CSE (the denominator in ROCE) • We recognized that the component of earnings which adds value is OI and the assets used to generate that value are NOA • The focus now is on the drivers of operating income
3

Step 3 - Forecasting Payoffs •Measuring Value Added •Forecasting Value Added

Step 1 - Knowing the Business •The Products •The Knowledge Base •The Competition •The Regulatory Constraints

Strategy

Step 2 - Analyzing Information •In Financial Statements •Outside of Financial Statements

• A valuation model guides the process • Forecasting is at the heart of the process and a valuation model specifies what is to be forecasted (Step 3) and how a forecast is converted to a valuation (Step 4). What is to be forecasted (Step 3) dictates the information analysis (Step 2)
4

Forecasting and the Analysis of Current Profitability

Cutting to the Core: The...