DuPont Analysis

While making my way through the Chartered Financial Analysis (CFA) level 1 curriculum in the Financial Reporting and Analysis (FRA) section, I encountered one of the most important tools in financial statement analysis--the DuPont Analysis. I’d like to take a moment to explain not only the process for completing this analysis but also breakdown the potential usefulness of it.

We will begin the conversation with the ratio known as return on equity or ROE. This is a measure of the total return based on the amount of book equity the firm has in its capital structure. Return is simply net income as this is the allocation of earnings that equity investors have title to. The simplest form of the DuPont analysis breaks the ROE calculation into two portions, the first is return on assets (ROA) and the second is the financial leverage ratio. ROA can be viewed as a measure of how efficiently the firm is utilizing the assets they have while the financial leverage ratio (sometime called the equity multiplier) is the amount of debt in proportion to the amount of equity a firm has within this capital structure.

 This shows us that changes in ROE can be linked to either a change in the return on assets or the amount of leverage used within the business. While this is a base line equation, we can continue to break this down further. We can next break the ROA into two separate factors, net profit margin and asset turnover.

In doing this breakout, we are not able to determine that changes in ROE can be attributed to changes in net margins, asset efficiency (asset turnovers) and use of leverage.

The last step to breaking out the DuPont equation is taking a look at net profit margin. We can view net profit margin as a function thee key areas, the first of which is the earnings before interest and taxes (EBIT) margin, sometime referred to as the operation margin. This is the income the firm earned from normal operations without consideration of capital structure. The second factor is the interest burden which takes earnings before taxes (after interest) and compares it to EBIT. This will indicate how much of the firm’s earnings are being used to service the debt within the capital structure. The last factor is the tax burden which shows us the firm’s tax rate. 

This allows us to analyses changes in the net profit margin of the firm based on operating changes (EBIT margin) changes in debt service costs (interest burden) and tax rates. Finally, we can combine all these calculations to end with the five step DuPont analysis of ROE.

Apply simply cross multiplication and this equation breaks down to net income over equity, or ROE. As analyst, we are able to look at ROE of a firm and determine what factors have helped the firm achieve their given ROE. More importantly, we can analyses time-series data and determine what is causing changes in ROE form one period to another. For example, if a firm has a 10% increase in ROE year over year and you apply the DuPont analysis to determine that this change is caused by an increase in the use of leverage it will be much less favorable than an identical firm which had the same 10% increase due to improved efficiency or margins (asset turnover or EBIT margin). 

Control Premiums

In valuation, there are times that some practitioners believe it is appropriate to apply the so-called “control premium” to their valuation process. While I have mixed thoughts on the use of this control premium, I would like to explain the concept along with my thoughts on when and when not to apply it. I will also shed some light as to the reasons for my mixed thoughts on the use of control premiums in practice.

To begin this discussion, I’d like to talk about what a control premium theoretically is. To help better explain this think about yourself as an investor in Microsoft; as an individual shareholder it is likely that you have little to no influence over the direction of the company. This is because of the sheer size of the firm and your likely minority position. In the event that you had the ability to control the firm you would theoretically be able to make certain decisions that are in your best interest, as an equity owner, and thus be willing to pay a premium. While this is a very simplified explanation, I would like to take a closer look at why one might be willing to pay this premium.

Take for example a firm such as Jos A Bank, a men’s clothing retailer who has a balance sheet loaded with cash and virtually no debt. Corporate Finance 101 teaches us that the cost of debt is almost always cheaper than the cost of equity. The second part of this lesson is that adding debt to the capital structure, to the extent that the additional risk of bankruptcy is offset by the cheaper capital and tax benefits associated with debt, will lower the cost of capital for the firm. Taking this lesson and applying it to the Jos A Bank situation, a controlling owner could increase the use of leverage within the firm and therefore lower the cost of capital and increase the number of profitable projects the firm can pursue or the net present value of their current projects. In essence, having this controlling interest allows for an increase in the value of the firm and thus the purchaser would theoretically be willing to pay a premium from the current minority stake price.

In valuation, there are three primary models used in practice to determine your final valuation: discounted cash flow, comparable companies and precedent transactions. While I do not want to get into the details in this post, I would like to discuss each of the three and why or why not you would potentially apply a control premium.

When looking at a discounted cash flow valuation model, one is forecasting future economic benefits to an ownership stake and then discounting these benefits to today’s dollars using an appropriate rate that reflects the risk associated with the cash flows. Now if one believed that they would be able to achieve more economic benefit from the firm by gaining a controlling interest, and intended to gain this control, they would be able to forecast the additional economic benefit into the model. This would then be discounted and the final value would already factor in the added value for control, thus a control premium would not be appropriate for the discounted cash flow model.

Comparable companies model takes a set of firms which are similar to the firm being valued and analyses key multiples. For example, if firm A is comparable to firm B and firm A is currently trading for 7.5 times EBITDA, then it might be safe to say that firm B is also worth 7.5 times EBITDA. There are many details to this valuation process that I will not cover in this post, but the key take away is that you are comparing the current trading price of comparable firms. Back to the original discussion about Microsoft, most shareholders are minority shareholders. Thus, the currently trading price would generally represent a minority interest and thus one who intended to purchase a controlling interest would then apply the control premium to the comparable companies model.

Lastly, precedent transactions takes a look at historical deals done in the open markets in which a buyer purchases a firm similar to the firm you are valuing. For example, firm C was purchased for 8.0 times EBIT, and firm D is similar to firm C. Thus, firm D might be worth 8.0 times EBIT to a purchaser. Now the key here is that this is based on a purchase price; implying that control is achieved. Therefore, the price paid would already have a control premium factored in and thus a control premium should not be added to the precedent transactions model.

To summarize thus far, it would theoretically be appropriate to apply a control premium to the comparable companies model only, but not to the discounted cash flow or present transactions model. Now enters the question as to what premium to add if you do intend to apply this. In practice many will rely on the data that is provided by Mergerstat for control premium. This can range from about 20-30% on average and is based on the premiums paid on historic transactions over a selected time horizon. This is where I find myself torn on the control premium.

I’d like to reflect on what a control premium is; recall that is the additional price one would pay for control due to the added value that comes from control of the firm. Also recall that if we used intrinsic valuation methods such as a discounted cash flow, we would factor this added value into the cash flows. One could value the company as it stands using the discounted cash flow model then value the same firm again but this time applying the added future income from the ability to control the firm. The differences in these two valuations would theoretically be the value of control, or the control premium. Mergerstat data on the other hand is simply historical premiums paid, but fully independent of the current firm and potential control benefits. I believe that it would be more advantageous to use the intrinsic valuation method to determine the value of control rather than simply applying the historical average. Also, remember that Mergerstat data is a statistic that has its own standard error which can be quite large and make confidence intervals wide.

This is not to say that the other side of the argument is not strong as well. First, conducting two discounted cash flow valuations with any level of accuracy will likely be very time consuming. Secondly, these models are based completely on forecasted data, which has a level of uncertainty associated with it. Lastly, it is very common in practice to apply the control premium based on Mergerstat data, thus it is hard to ignore widely-accepted practices.

In conclusion, I have used the terms “theoretical” often in this post to stress that I do not have a clear view on the proper way to handle this in practice. However, I do believe that this helps explain the basis for both sides of the argument and allows one to make their own decision on the use of control premiums in valuation. 

Beta

Anyone who has ever dealt with valuation or modern corporate finance has probably encountered the use of beta. In modern finance beta is the key relative risk measure used in the Capital Asset Pricing Model (CAPM) to determine the risk premium demanded by equity investors. I’d like to take a minute to talk about what exactly beta is measuring along with methods by which to determine the beta used in CAPM.

Let’s begin with what exactly beta is meant to measure. Beta is a measure of systemic risk of a security versus the market as a whole. It is generally viewed as the covariance between the returns of the security and the returns of the aggregate market divided by the variance of returns of the aggregate market. Or rewritten as the correlation between the returns of the stock and the aggregate market multiplied by the standard deviation of the stock returns dividend by the standard deviation of aggregate market returns. 

Most commonly these calculations are done using a simple regression with the returns of the aggregate market being the independent variable and the returns of the stock being the dependent variable. The regression result will provide the coefficient of the x variable which will represent beta. In essence, if we apply the simple linear equation (Y = mX + B) the “m” is beta which show how much of a movement can be expected in the given stock based on the movement of the aggregate market. It is common to use the returns of the S&P 500 to represent the market and between a 3-5 year time horizons for return data.

While much more could be said regarding the technical side of regressing to find beta, I would like to look at one simple fact. In any regression the coefficient of determination (R²) indicates how much of the data can be explained by the regression model. Put simply, it is a measure of accuracy within the regression model. In almost any regression model to find beta, the R² will be very low (0.30 or less), this leads us to question the accuracy of using this method to calculate such an important variable when calculating the cost of equity capital.

Before I get into an alternative method for beta, I would like to shift our focus back to what beta measures for a moment. Beta is the measure of systemic risk of a firm, and part of this risk is both operating risk and financial risk. Operating risk can be defined as the risk inherent in a firm that is fully financed with equity, essentially the risk of the business if it had not required debt payments. The firm’s operating risk is impacted by the amount of fixed versus variable costs. The other part of this risk is financial risk, which is the risk as firm’s equity holder bear due to the use of leverage and thus required debt payments. Now in calculating a regression beta we will have a result of levered beta, which is the beta that includes both operating risk and financial risk. Let’s now jump to an alternative method for calculating beta. 

An alternative that is commonly used is to first identify the firm’s industry and collected data on a group of comparable companies. Then take these firms and run a simple regression to calculate beta. The betas collected, as described above, are levered betas. Since our firm, and each firm in the group of comparable companies will most likely have different uses of leverage, we must “unlever” these betas. The process of unlevering beta is essentially factoring in both the amount of debt capital used as compared to equity capital along with the benefits provided by the tax shield offered from interest payments. Levered beta can also be calculated from unlevered beta. The calculations for both are described below.

To continue with the alternative beta calculation, you first must take the levered betas found through regression and unlevered each of these based on each firms respective debt to equity capital structure and corporate marginal tax rate. Then a mean or median of these unlevered betas can be used to determine and estimate for the industry beta; the choice of mean of median will be a judgment based on variance of these betas. Once the industry’s unlevered beta is found, the beta can be relevered using our given firm’s debt to equity structure and marginal tax rate to determine the beta used within the CAPM.

Now you may ask “what is the benefit of completing this process versus using a simple regression?” Well as discussed above, simple regressions have very low predictability value and can lead to misleading betas. By using this alternative, you are collecting date on multiple firms within the industry which can eliminate some of the risk of having an outlier. Is it perfect? No, but I do believe that it can provide a better estimate of the true systemic risk of a firm. 

Hope you found this interesting. 

My CPA Exam Journey

I have been asked by the student accounting group at my graduate program to talk to both undergrad and graduate accounting students about my journey throughout the CPA exam. As almost all of these students are in the process of, or planning on soon sitting for the exams, I hope sharing my experience will be helpful in better preparing them to pass. While I am in no way a “CPA Guru,” I have taken the exam very recently and can share the tips and tricks I learned along the way. Hope you enjoy.

Let us begin by talking about the structure of the Uniform CPA exam. As of 2013, the exam consisted of four individual sections. These sections are Auditing & Attestation (AUD), Business Environment & Concepts (BEC), Financial Accounting & Reporting (FAR), and Regulation (REG). Other sources will better explain the content of each exam. Each consists of four testlets, the first two have three multiple choice sets with 24 questions. AUD is followed by six simulation questions which test application of the material. BEC’s fourth testlet is a writing sample in which you must complete three short pieces that are scored on both technical content and grammatical structure. FAR and REG both have four testlets as well; however, each of the three first multiple choice sets have 30 questions and the fourth is again a simulation set. AUD and BEC both offer the tester three hours to complete, while FAR and REG offer four hours. Again, outside sources can offer a more detailed explanation of the structure, as this is simply an overview.

When it comes to registering for the CPA exam, you must first have completed the required education for your respective state; details can be found here. For my state (Michigan) and many others, you apply through NASBA. After applying and being approved, you will receive a Notice to Schedule (NTS), this allows you to register with Prometric to take the exam. Remember that testing is only offered in the first two months of each quarter, so plan ahead. I believe a key to success is to register for the exams ahead of time, as doing this adds a level of “stress” to stop the procrastination.

When to take each exam and the amount of time you will need to study for each will vary depending on your situation. For me, I took the exams over the summer of 2013 and in the following order: BEC, FAR, AUD and REG. I planned to spend the summer studying full-time, so this worked out well for me. The one piece of advice I can offer is to take your anticipated “hardest” sections first. When you get to the last exam you are most likely going to be burnt out from CPA exams and your motivation levels will be at all-time lows. Thus, taking your “strongest” sections last will make it that much easier to study. When deciding how much time to dedicate to study, just be honest with yourself. Don’t over plan study time, but don’t short yourself.

When it comes down to study techniques, I recommend using a prep program like Becker. Full disclosure, I am a campus representative for the program and did receive the material at no cost. However, I can confidently say that I believe that they offer the best prep program for the CPA. Regardless of your prep program you use, make sure you first watch or read the lectures then complete as many multiple choice questions as possible. The multiple choice questions are KEY. Most prep programs license their questions for previously used AICPA exam questions, which makes them very relative to the potential exam questions. The more multiple choice questions you complete, the better your retention rate and recall speeds will be on exam day, which is essential to success. I personally completed thousands of questions over the three months I spent studying; but I would like to think that my exam scores reflect this well.

One of the best study habits that I can offer is to set time aside for it. This is imperative to making sure you complete all the necessary preparation prior to exam day. Life offers you a multitude of distractions and more attractive opportunities. You will have to learn to give up your social life for a few months and be willing to turn down the night at the bar in exchange for reviewing IFRS standards. Yes, this will be undesirable, but in the end it will be worth it. As with everything, balance is a necessity, but don’t let this be an excuse to skip on studying in exchange for a few beers or dinner and a movie.

A great way to ensure you stay focused and have the physical and mental energy to get through your day is not only exercise regularly but to also eat healthy. I am neither a dietitian nor a personal trainer, so I will leave the details to the professionals: I will only offer the idea of plentiful cardiovascular exercise combined with a balanced diet. It will be very easy to snack on “junk” all day long while you’re cramming for the CPA, DON’T DO IT!

You will also need the support of your family and friends along the way. If you are in a relationship, prior to starting the exams explain the entire thing to your significant other. Doing this will help him or her better understand not only the importance of this exam, but also the tremendous time dedication it will require. Most people won’t understand how in-depth this exam is and why you can’t socialize more. You can try to explain it to them, but you’ll quickly get sick of this. Accept the fact that they will pressure you and you must be able to say no and ignore their comments and maintain focus. Once you’re done with the exams take them all out to the bar to celebrate and insist on each of them buying you a drink to celebrate, win-win.

For support and focus, I also utilized Another71.com. This site offers a great forum board filled with motivation and support. It is also a great place to either ask or answer questions. During my studying, I would ask questions on topics I did not understand to other members. I also would answer as many questions as I could on material that I understood. Doing this allowed me to reinforce my knowledge and I believe helped improve my performance on the exams.

When prepping for exam day, be ready for stress. The stress level for the first exam will be the worst, as you don’t know exactly what to expect. Don’t worry, they get less and less stressful as you get through them. Make sure you get a good night’s sleep before the exam and stay away from sleep aids as they leave you with “medicine head” the next morning. I am a huge coffee guy and believe that it is necessary for life; however, make sure you know how you react to caffeine prior to taking too much before the exam. You will be stressed as it is, you don’t need a case of the jitters to compliment the stress. Simply put, just relax. If you are prepared, you’ll do fine and there will be no need to worry.

To help alleviate the stress, I recommend packing everything you need in a clear plastic bag the night before. You must have both your state issued ID along with your NTS to get into the testing center. Forgetting either of these will leave you taking the exam at a different time. Weeks prior to exam day, make sure your ID matches your NTS name perfectly, you don’t want any issues on exam day. I am not sure if this applies to all Prometric centers, but mine allowed me to bring snacks in and leave them in the locker. I brought a few power bars to eat in between testlets; remember that these are three and four hour exams and your brain needs power.

I recommend dressing is layers, you will never know how the testing room will be. You will be checked for metal prior to entering the room. Leave hats, belts, watches, rings, etc. at home. Just make sure you are comfortable. I wore athletic shorts, a tee and my Jesus cruiser-style flip-flops to two of my exams. Being comfortable makes the four hours of hell a bit easier to handle.

Have you ever tried to write with a dried up dry-erase marker on a flimsy laminated sheet of graph paper? Well guess what! You will get the opportunity to very soon. Yes, it is as bad as I make it sound, they will give you two markers and I can ensure you that one will be completely dried up and the other will be darn close. Luckily you shouldn't need to write too much down; just be aware of what you will have to use. You can go and get new markers or sheets, but this will consume some of your valuable testing time.

Once you’re in the exam, you will be allowed to leave for breaks between testlets; however, your time does not stop ticking. I do recommend taking breaks between each to stretch your legs and get the blood flowing, and bathroom breaks are great too. Each time you leave, you will need to sign back in using your ID and a finger print, so make sure to factor this time into your plans.

Waiting for your exam score will feel like an eternity, but don’t worry it will come sooner or later. If you have more sections to take, stay focused and keep studying. If you are all done, crack open an ice cold beer and relax. While I am confident that you’ll pass them all on your first attempt if you dedicate the time, if you don’t—just relax. You can retake exams in the next testing window, just make sure you put more time into preparation for the next round. Passing isn't as much a function of smarts as a function of time dedicated to expanding your knowledge.

Best of luck to all you test takers!

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Financial Statement Flow

Having a strong understanding of the “flow” through financial statements is essential in the valuation process. One must create forecasts and make assumptions that will impact pro-forma financials and should be able to identify how these will flow through the three primary financials. I thought it would be worthwhile to create a post covering the basic flow between each of the primary financials. As with many of my posts, this will have an emphasis on valuation uses and therefore will include certain details that are of particular concern to valuation modeling. Enjoy.

To help guide our conversations, I have created a simple graphic that outlines the most important flows between statements.  I will reference these flows and their colors through the post to help the reader gain a better understanding.

 

Due to the web of flows that is created here, I will start at the top of the income statement and work my way through these in what will hopefully be a coherent manner. Let’s get started.

The income statement starts with revenue less Cost of Goods Sold (COGS) to get gross income and then Sales, General and administrative (SG&A) along with Depreciation and Amortization (D&A) expenses are subtracted to get earnings before interest and tax (EBIT). In some financials D&A in consolidated within SG&A so be on the lookout for this. D&A (purple line) has two primary flows, first of which is to the balance sheet into the Accumulated Depreciation account. The amount of D&A expense will be added to the accumulated depreciation account to calculate Net PP&E. Remember too that only the “D” portion will flow into accumulated depreciation account, not the amortization. If a firm has no intangible assets to amortize, this is easy; however if they consolidate this you might have to dig into the footnotes to determine what amount is actually attributable to depreciation. The second flow for D&A is into the Statement of Cash Flows as an add-back to operating cash flow. Since D&A is a non-cash expense, it must be added back to net income.

Now let’s look at Interest Expense and Income (orange and brown lines). Interest Expense/Income can be found as a line item on historical financials, thus this commentary only applies to forecasting future financials. The general rule of thumb is to calculate interest expense as the average debt—(beginning balance+endining balance)/2—multiplied by the interest expense for the given debt. The same calculation is used for interest income but based on the average cash balance. You can also see the dark orange flow line from payments and issuance of Long-Term Debt (LTD), this will impact the balance and thus the interest expense.

Net Income (NI) is arguable the most important flow to understand. NI is represented by the light-red line and flows into two primary areas. First, NI is used as the starting basis for the indirect cash flow statement creation. The second flow is one that is most often forgotten, NI flows into the Retained Earnings on the balance sheet. Jumping over to the statement of cash flows, we can also see the flow between dividends under the cash flow from financing section to retained earnings (dark red line). Dividends paid will reduce the retained earnings balance while net income will increase it.

Let’s now turn out attention to some balance sheet accounts that have yet to be addressed. The Accounts Receivable (A/R), Inventory, and Accounts Payable (A/P) are all considered working capital (W/C). There may be other items such as accruals, however this is a simplified example. The change in these account balance (light blue) will flow into the statement of cash flows under the cash flow from operations section. I used the term “delta in W/C” to indicate that the change in these could either be an increase in cash flow or a decrease in cash flow. If there is an increase in net working capital (current assets less current liabilities) then this will be a use of cash and therefore a subtraction from net income; the opposite applies if it was a decrease in net working capital. We must also remember that in this instance the net working capital calculation does not include cash.

Next let’s look at the Property, Plant and Equipment (PP&E) account on the balance sheet. We can see the flow between the investing section of the statement of cash flows and the PP&E account on the balance sheet (yellow). If a firm has CapEx it will be an outflow of cash on the statement of cash flow but will be capitalized as an asset and added to PP&E on the balance sheet. Conversely, if a firm sells a piece of equipment it will be a cash inflow on the statement of cash flows while it will reduce the PP&E account on the balance sheet (both the PP&E and accumulated depreciation will be reduced as they relate to the asset being sold).

Lastly, we take a look at the bottom of the statement of cash flows to see that the ending cash balance (green line) will flow back to the balance sheet for the respective period ending. The beginning cash balance comes from the cash balance on the opening balance sheet (not shown in the image).

While this is a very simplified explanation of the flow between the statements, I do hope it puts its all in prospective and helps you better understand the process. Again, I did not list every single flow, only those most important to creating pro-forma forecasted financials. If you have questions or need clarifications, feel free to ask.