Analyzing The Company’s Performance In Business Valuations — Part 2
Analyzing The Company’s Performance In Business Valuations — Part 2
ROIC, WACC, and growth in cash flows drive enterprise value. By analyzing historical revenue growth, we can estimate the potential for growth in the future. In the last post, I had addressed an article on analyzing the company’s performance in business valuations. The first part of the article focused on ROIC, and the link to the article is here. In this article, I shall focus on analyzing the company’s performance in business valuations — part 2 by focusing on revenue growth.
The estimation of year-to-year revenue growth is simplistic, but the results can be misleading. Three principal factors distort revenue growth:
- The outcomes of changes in currency values,
- Mergers and acquisitions (M&A)
- Variations in accounting policies.
We need to remove any distortions generated by these conclusions to forecast organic revenue growth better. For all, we examine its impact on performance measurement, forecasting, and, finally, valuation.
Analyzing The Company’s Performance In Business Valuations — Part 2: Currency Effects
Multinational corporations administer the business in multiple currencies. After each reporting period, these revenues get converted to the reporting company’s base currency. If foreign currencies increase in value relative to the firm’s base currency, this translation at more favorable rates will drive to more significant revenue numbers. Therefore, revenue growth may not reveal increased pricing power or more significant quantities sold, but just depreciation in the company’s home currency.
IT services companies like TCS and Accenture face different impacts on currency fluctuations. Each company has similar geographic mixes, with nearly half of each company’s revenues from the US. Since each company translates USD into a home currency for its consolidated financial statements, exchange rates will affect each company quite differently. TCS translates US dollars from its North American business into INR. Given the weakening of the INR against the US dollar, TCS has a higher chance of reporting higher revenues due to currency effects.
Analyzing The Company’s Performance In Business Valuations — Part 2: Mergers And Acquisitions (M&A)
Growth through acquisition may have very complex outcomes on value creation than internal growth because of the sizable premiums a business must pay to acquire another firm. Hence, it is essential to comprehend how firms have generated historical revenue growth: organic strategy or acquisition.
Companies need to disclose acquisitions on their financial statements. Without voluntary disclosure, removing the effect of acquisitions from stated revenues can be challenging. Unless an acquisition is regarded as material by the company’s accountants, business filings do not need to report or even notify the acquisition. For larger acquisitions, a firm will report pro forma statements that recast historical financials as though the acquisition gets executed at the start of the fiscal year. Organic revenue growth, then, should be estimated applying for the pro forma revenue numbers. If the target company openly reports its financial data, we can manually build pro forma statements by linking the acquirer’s revenue and target for the earlier year. However, be cautious: the bidder will introduce partial-year revenues from the target period after the acquisition closes. To remain consistent from year to year, reconstructed prior years must incorporate only partial-year revenue.
Accounting Changes And Irregularities
The Financial Accounting Standards Board (FASB) in the United States and the International Accounting Standards Board (IASB) offer recommendations every year regarding certain business transactions’ financial treatment through formal standards or topic notes published by authorized task forces. Differences in a company’s revenue recognition policy can significantly influence revenues through the year of adoption, misrepresenting the one-year growth rate. Hence, we need to reduce their effects on understanding actual historical revenue trends.
Decomposing Revenue Growth to Develop an Integrated Perspective of Growth Drivers
After eliminating the impacts of mergers and acquisitions, currency translations, and accounting changes from the year-to-year revenue growth numbers, examine organic revenue growth from an operational aspect.
Revenues = (Rev/Units) * Units
Applying this formula decides whether prices or quantities are accelerating growth. Do not, though, mix revenue per unit with a price. If revenue per unit is increasing, the change could be due to escalating prices, or the firm could be changing its product mix from low-price to high-price items.
Companies prefer to report depending on the industry’s standards and competitors’ practices. For example, most retailers give data on the number of stores they operate, the square feet in the stores, and the transaction volume. It is plausible to develop a deeper understanding of the business by linking distinct operating statistics to cumulative revenues.
For instance, Revenues = (Revenues/Stores) * No. of Stores
Credit Health and Capital Structure
Till now, we have concentrated on the company’s operating performance and its capacity to create value. We analyzed the principal drivers of value: a firm’s return on invested capital and organic revenue growth. In the closing step of historical analysis, we concentrate on how the business has funded its operations. What proportion of invested capital originates from creditors instead of from equity investors? Is this capital structure sustainable? Can the business endure an industry downturn? How much cash, if any, has been allocated to shareholders?
To estimate a company’s capital structure, we need to do four analyses. First, measure liquidity applying coverage ratios. Liquidity estimates the firm’s capability to suffice short-term obligations, like interest expenses and rental payments. Subsequent, assess leverage applying debt to EBITDA and debt to value. Leverage estimates the firm’s strength to meet commitments over the long term. To assess equity, calculate the payout ratio and operating value to EBITDA. The payout ratio estimates the percentage of income given to shareholders. Operating value to EBITDA estimates shareholders’ projected expectations of financial performance.
Measuring Leverage
Recently, interest rates have descended to abnormal lows, making interest coverage ratios uncharacteristically high. To assess leverage in this low-interest-rate environment, various analysts estimate and assess debt multiples such as debt to EBITDA or debt to EBITA. Given its much larger denominator, debt to EBITDA tends to be more steady, making estimates over time much clearer. The ratio further does a better work of identifying businesses exposed to rollover risk and widening default spreads, neither of which gets captured at low-interest rates.
A secondary reason the debt-to-EBITDA ratio has increased in repute suggests the extended use of convertible securities. Many convertibles compensate through the likely conversion to equity rather than interest, causing interest coverage ratios artificially high. By applying the debt-to-EBITDA ratio, one can develop a more thorough understanding of the risk of leverage.
To completely appreciate the leverage risk, analyze the relationship between return on equity (ROE) and return on invested capital (ROIC):
ROE = ROIC + [ROIC-(1-T)kd]*(D/E)
As the equation explains, a firm’s ROE is a continuing function of ROIC, its expanse of ROIC above its after-tax cost of debt (kd), and debt-to-equity ratio (D/E). Let us examine a company earning an ROIC of 10% and has an after-tax cost of 5% debt. We can increase ROE by either increasing its ROIC (through operating improvements) or enhance its debt-to-equity ratio (by swapping debt for equity). Although each strategy can drive an equal change in ROE, increasing the debt-to-equity ratio makes the ROE more sensitive to operating performance (ROIC). Therefore, while increasing the debt-to-equity ratio can improve ROE, it raises the risks faced by shareholders.
Payout Ratio
The dividend payout ratio equals cumulative dividends divided by net income accessible to common shareholders. We can completely understand the company’s financial situation by examining the payout ratio to its cash flow reinvestment ratio:
- If the firm has a high dividend payout ratio and a reinvestment ratio greater than 1, then it must be borrowing money to finance negative free cash flow, to repay interest, or dividends.
- A business with positive free cash flow and low dividend payout is presumably paying down debt (or acquiring excess cash). In this condition, is the business transferring up the valuable tax benefits of debt or accumulating cash needlessly?
Final Thoughts
While analyzing a company’s performance for valuations, it is more beneficial to disaggregate value drivers — both ROIC and revenue growth — as far as possible. If feasible, link operational performance measures with every key value driver. If there are any drastic changes in performance, recognize the source. Discover whether the change is transient, permanent, or solely an accounting effect. If feasible, conduct your analysis on a fine-grained level, not just on the business as a whole. Real insight comes from examining individual business units, product lines, and customers.
