Download (direct link):
The component measures of the return on invested capital are industry- and company-specific. For example, wholesalers typically have slim margins and high capital turnover, while telephone companies have high margins and low capital turnover. These ratios may also reflect the company's operating strategy relative to its competitors. Higher margins might compensate for lower capital turnover (although the best companies often outperform their competitors on all measures).
Once you have calculated the historical value drivers, analyze the results by looking for trends and comparing with other companies in the same industry. Try to assemble this into an integrated perspective that combines the financial analysis with an analysis of the industry structure (opportunities for differentiation, entry/exit barriers, etc.) and a qualitative assessment of the company's strengths and vulnerabilities.
Developing this integrated perspective is not a mechanical process, so it is difficult to generalize. But we can provide some examples:
• For consumer products companies with strong brand names, like Hershey Foods, you are likely to find high ROICs. The key issues tend to be about growth (market share, new products, managing the
Exhibit 9.8 Hershey Foods—1998 ROIC Tree1
distribution chain) and benchmarking performance against competitors (manufacturing costs, overhead, inventory management).
• For commodity companies, like paper or some chemical companies, you need to understand whether the company and the industry have been able to earn their cost of capital. In many cases they haven't. You then need to understand the short- and long-term supply/demand picture for the industry and evaluate competitor behavior. Try to identify where the industry is in its cycle and whether there are structural changes that will change the cycle permanently. Think about whether the company has any competitive advantages (technology, market access). Has the company been able to turn these advantages into higher returns than the industry average? How good a job has the company done at timing major capital expenditures?
While it is impossible to provide a comprehensive checklist for understanding a company's historical performance, here are some things to keep in mind:
• Look back as far as possible (at least ten years). This will help you to understand whether the company and the industry tend to revert to some normal level of performance and whether shortterm trends are likely to be permanent breaks from the past.
• Go as deep into the value drivers as you can, getting as close to operational performance measures as possible.
• If there are any radical changes in performance, identify the source of the change and determine whether it is real or perhaps just an accounting effect and whether any change is likely to be sustained.
Credit Health and Liquidity
The final step in the historical analysis is understanding the financial health of the company from a credit perspective. Here we are not concerned with value creation itself, but how has the company been financing its value creation. Specifically, is the company generating or consuming investors' cash? What proportion of invested capital comes from creditors rather than equity investors? How safe is this capital structure?
The best way to understand a company's financial health is to project its cash flows and develop a financing plan for a number of cash-flow scenarios. As a first step, an analysis of historical performance provides some early insights. Since this book's focus is not credit analysis, we will just touch on some of the important measures we use to analyze financial health. Exhibit 9.9 shows an analysis of Hershey Foods' historical financial health.
Exhibit 9.9 Hershey Foods—Financing Analysis
$ million 1995 1996 1997 1998
EBITA 525 579 646 61(1
Interest expense 46 52 79 36
EBITA/interest expense 10.9 11.1 8.2 7.1
Total interest-bearing debt 795 995 1,317 1,282
Total investor funds 2,175 2,501 2,573 2,791
Debt/total funds (book value) 36.6% 39.8% 51.2% 45.9%
Debt/total funds (market values) 7.8 9.8% 12.9% 12.6%
Net investment (39) 176 80 243
NOPLAT 323 371 442 434
Net investment rate -11% 47% 18% 57%
Gross investment 80 294 217 390
Gross cash flow 142 4S9 579 576
Gross investment rate 18% 60% 37% 63%
Net income available to common
Dividend payout ratio
110 115 122 129
282 273 336 341
39% 42% 36% 33%
Interest coverage, the amount of earnings available to pay interest expense, measures the company's financial cushion. It provides a sense of how far operating profits could fall before the company would have difficulty servicing its debt. We generally measure coverage as EBITA divided by interest expense and required preferred dividends. There are number of variations for this measure such as adding required lease payments to the denominator or adding depreciation back to the numerator. These may be helpful in some circumstances, particularly when you are trying to get a short-term perspective on the ability of the company to pay its creditors. For a long-term perspective, we generally stick with the basic ratio.