COURSE PROGRESSION

Week
Financial statements and information outside of f/s
5

Week
Analytical tools and techniques for financial analysis
6

Week Strategic financial modeling and forecasting

7 ASSIGNMENT : CASE STUDY NO 2

Week
Quality of earnings and financial statements
8

1
ANALYTICAL TOOLS AND TECHNIQUES FOR
FINANCIAL ANALYSIS
Sources:
• CFA Institute curriculum
• Various companies’ internet sites
• Author’s documentation

2
COURSE CONTENT

1. Introduction
2. Overview of analytical approaches, tools and techniques
3. Common ratios used in financial analysis (with a focus on profitability and
valuation)
4. Forecast future performance : introduction to financial modeling (going
through main P&L items through several examples)

3
INTRODUCTION

• Well … no introduction this week J

4
COURSE CONTENT

1. Introduction

2. Overview of analytical approaches, tools and

techniques
3. Common ratios used in financial analysis (with a focus on profitability and
valuation)
4. Forecast future performance : introduction to financial modeling (going
through main P&L items through several examples)

5
TOOLS AND TECHNIQUES: INTRODUCTION

• There are plenty of analytical approaches, tools and techniques available to

perform financial analysis.
• Examples:
- Charts.
- Regressions.
- Common-size analysis.
- Segment analysis.
- Financial ratios.
- Etc.

6
GRAPHS: EXAMPLE

Source : L’Oréal annual report 2017

7
GRAPHS: EXAMPLE

Source : L’Oréal annual report 2017

8
GRAPHS: EXAMPLE

Source : L’Oréal annual report 2017

9
REGRESSION: EXAMPLE

14.0

y = 0.1176x + 5.8177 12.0

R² = 0.2687
10.0
US GDP Change

8.0

6.0

4.0

2.0

0.0
-40.0 -30.0 -20.0 -10.0 0.0 10.0 20.0 30.0 40.0

-2.0

-4.0
Sales Growth - Ford

Source : CFA curriculum

10
REGRESSION: EXAMPLE

• Regressions quantify statistical relationships.

• For instance, an analyst might use regression analysis combined with a
forecast for GDP growth as one input to forecast sales growth and earnings.
• The data used to create the previous chart include:
- Data for years 1954–2011.
- Nominal U.S. GDP growth from the U.S. Department of Commerce Bureau of
Economic Analysis (www.bea.gov).
- Total revenue for Ford Motor Company from Compustat.

11
COMMON-SIZE ANALYSIS

• Common-size analysis:
- Express financial data in relation to a single financial statement item or base.
• Vertical common-size:
- Balance sheet: each item as a percent of total assets.
- Income statement: each item as a percent of total net revenues.
- Cash flow: each line as a percent of sales, assets, or total in and out.
- Highlights composition and identifies what is important.
• Horizontal common-size:
- Percentage increase or decrease of each item from the prior year or
showing each year relative to a base year.
- Highlights items that have changed unexpectedly or have unexpectedly
remained unchanged.

12
COMMON-SIZE BALANCE SHEET EXAMPLE:
SINGLE COMPANY, TWO PERIODS

Partial common-size balance sheet, Co. XYZ

Period 1 Period 2
% of Total % of Total
Assets Assets
Cash 25 15
Receivables 35 57
Inventory 35 20
Fixed assets, net of 5 8
depreciation
Total assets 100 100

Period 2: receivables are 57% of total assets.

What are possible reasons for the increase in receivables?

Source : CFA curriculum

13
COMMON-SIZE BALANCE SHEET EXAMPLE:
SINGLE COMPANY, TWO PERIODS

• The company is making more sales on a credit basis rather than a cash
basis (perhaps in response to some action taken by a competitor).
• The increase may have occurred because of a change in another asset
category - for example, a decrease in the level of inventory or cash.
• Another possible reason is that the company has either:
- Lowered its credit standards.
- Relaxed its collection procedures.
- Adopted more aggressive revenue recognition policies.

14
COMMON-SIZE BALANCE SHEET EXAMPLE:
CROSS-SECTIONAL, SAME TIME

Partial common-size balance sheet, Co. 1 and Co. 2

Assets Company 1 Company 2

% of Total % of Total
Assets Assets
Cash 38 12
Receivables 33 55
Inventory 27 24
Fixed assets net of depreciation 1 2
Investments 1 7
Total Assets 100 100

Source : CFA curriculum

15
COMMON-SIZE BALANCE SHEET EXAMPLE:
CROSS-SECTIONAL, SAME TIME

• Company 1 is clearly more liquid (with liquidity defined as a function of how

quickly assets can be converted into cash) than Company 2, which has only
12% of assets available as cash, compared with the highly liquid Company 1,
for which cash is 38% of assets.
• Given that cash is generally a relatively low-yielding asset and thus not a
particularly efficient use of excess funds, why does Company 1 hold such a
large percentage of total assets in cash? Potential answers could include the
followings:
- The company is preparing for an acquisition.
- The company maintains a large cash position as insulation from a particularly
volatile operating environment.

16
SEGMENT ANALYSIS

17
SEGMENT ANALYSIS EXAMPLE: L’ORÉAL

Source: Kepler Cheuvreux - L’Oréal Autumn conference, Sept. 2018

18
SEGMENT ANALYSIS EXAMPLE: L’ORÉAL

Source : L’Oreal annual report (2011, 2017)

19
SEGMENT ANALYSIS EXAMPLE: L’ORÉAL

Note 2 to the financial statements of L'Oréal (2011):

• “The Cosmetics branch is organized into four sectors, each operating with
specific distribution channels:
- Professional Products Division: products used and sold in hair salons.
- Consumer Products Division: products sold in mass-market retail
channels.
- L’Oréal Luxury Division: products sold in selective retail outlets, i.e.
department stores, perfumeries, travel retail, the Group’s own boutiques and
certain online sites.
- Active Cosmetics Division: products for “borderline” complexions (i.e.
neither healthy nor problematic), sold through all health channels such as
pharmacies, para-pharmacies, drugstores and medispas.”

20
SEGMENT ANALYSIS EXAMPLE: L’ORÉAL

Note 2 to the financial statements of L'Oréal (2011 - cont.)

• “The non-allocated item includes expenses incurred by the Functional
Divisions, fundamental research and the costs of stock options not allocated to
the Cosmetics Divisions. It also includes activities that are auxiliary to the
Group’s core businesses, such as insurance, reinsurance and banking.
• ‘The Body Shop’ branch: The Body Shop offers a wide range of naturally
inspired cosmetics and toiletry products (…). The Body Shop net sales and
operating profit are characterized by strong seasonal fluctuations due to a high
level of activity during the last few months of the year.”
• “The Dermatology branch, consisting of Galderma, a joint venture between
L’Oréal and Nestlé, meets the needs of dermatologists and their patients. Data
by branch and by Division are prepared using the same accounting principles
as those used for the preparation of the consolidated financial statements.”
• “The performance of each branch and Division is measured on the basis of
operating profit.”

21
SEGMENT ANALYSIS EXAMPLE: L’ORÉAL

• Segment profitability can be further analyzed / decomposed:

- Each segment’s operating return on sales (i.e. operating profit margin) can
be calculated (operating profit divided by sales). This ratio measures the
operating profitability of the segment relative to revenues.
- Each segment’s operating return on assets can be calculated (operating
profit divided by operating assets). This ratio measures operating
profitability relative to assets.
- Each segment’s operating asset turnover can be calculated (sales divided
by operating assets). This ratio measures how much revenue is generated
per unit of assets.

Analysts can use these ratios to either evaluate each segment over time to
assess the contribution of one segment versus another to the company’s
total profitability and/or to evaluate a segment of one company compared with
a competing entity.

22
SEGMENT ANALYSIS EXAMPLE: L’ORÉAL

Opertating profit/Sales

Source: Kepler Cheuvreux - L’Oréal Autumn conference, Sept. 2018

23
SEGMENT ANALYSIS EXAMPLE: L’ORÉAL

Source: L’Oréal’s Presentation of annual results, February, 2018

24
FINANCIAL RATIOS

• Financial Ratios:
- Express one number in relation to another.
- Standardize financial data in terms of mathematical relationships expressed
as percentages, times, or days.
- Facilitate comparisons - trends and across companies.

25
FINANCIAL RATIOS INTERRELATION

interreliés

• Ratios are interrelated:

- An inefficient firm (with low asset turnover, low receivables turnover, low
inventory turnover) is likely to have:
- Poor profitability (low return on sales, low return on assets, low return on
equity), leading to:
- Low market valuation (low price earnings ratios, etc.), leading to:
- Difficulty in selling equity, leading to:
- High leverage (high debt-to-equity, etc.), leading to:
- High cost and risky funding (high funding costs in terms of higher
interest expense and stricter credit policies from trade creditors),
leading to:
- Poor profitability, and so on.

26
COMPUTATION IS NOT ANALYSIS !!!

• Financial analysts should go beyond collecting data and computing numbers.

• Analysis encompasses computations and interpretations, as well as direct
experience the company’s business.
• Analysis of past performance:
- What aspects of performance are critical to successfully competing in the
industry?
- How well did the company perform (relative to own history and relative to
competitors)?
- How? Why? What caused the performance?
- Does the performance reflect the company’s strategy?

27
LIMITS OF USING FINANCIAL ANALYSIS TOOLS

• Not every ratio is relevant in every situation:

- Some ratios are irrelevant for certain companies.
- Some ratios are redundant.
- Industry-specific ratios can be as important as general financial ratios.
• Different sources categorize some ratios differently and include different
ratios.
• Differences in accounting standards can limit comparability.

Different users and questions will focus on different ratios:

• Creditors: particular focus on solvency ratios (leverage and coverage).
• Investors: focus on market ratios (P/E and P/B for instance) combined with
financial ratios.

28
EXAMPLE: INDUSTRY SPECIFIC FINANCIAL
ANALYSIS TOOLS

• Industry-specific ratios can be as

important as general financial ratios. Average revenue per available room - United
States hotel industry - 2001 to 2018 (USD)
• Example: the hotel industry tracks:
- Occupancy rate = Rooms sold
divided by rooms available.
- Average daily rate (ADR) = Total
room revenue divided by number of
rooms sold.
- “Revpar” (revenue per available
room) = Total room revenue (net of
discounts, sales, meals and tax,
adjusted by occupancy rate)
divided by number of rooms
available in a given period.

29
COURSE CONTENT

1. Introduction
2. Overview of analytical approaches, tools and techniques

3. Common ratios used in financial analysis (with a

focus on profitability and valuation)
4. Forecast future performance : introduction to financial modeling (going
through main P&L items through several examples)

30
TYPE OF RATIOS
Category Description
Activity Activity ratios. How efficient are the firm’s operations and the
firm’s management of assets? NOT COVERED !!!

Liquidity Liquidity ratios. How well is the firm positioned to meet short-
term obligations? NOT COVERED !!!

Solvency Solvency ratios. How well is the firm positioned to meet long-
term obligations? NOT COVERED !!!

Profitability Profitability ratios. How much and how is the firm achieving
returns on its investments?
(ROE, ROA, Dupont Analysis)
Valuation Valuation ratios. How does the firm’s performance or financial
position relate to its market value?
(P/E, P/B, EPS, dividend payout)

31
MEASURE OF PROFITABILITY: RETURN ON
EQUITY (ROE)

What rate of return has the firm earned on the shareholders’ equity it had
available during the year?

• The general form of the rate of return computation:

Amount of return
Rate of return =
Amount invested

• Applied to shareholders’ equity:

Net income
ROE =
Average equity

32
DECOMPOSE ROE / DUPONT ANALYSIS

• Decomposing ROE into its component parts is useful to determine:

- What drives a company’s ROE.
- The reasons for changes in ROE over time for a given company.
- The reasons for differences in ROE for different companies.
- Why a company’s overall profitability (as measured by ROE) is a function
of its efficiency, operating profitability, taxes, and use of financial leverage.
- The relationship between the various categories of ratios and how they all
influence the return on the investment of the owners.
• Decomposition of ROE is sometimes referred to as DuPont analysis
because it was originally developed at that company.

33
DECOMPOSE ROE INTO ROA AND LEVERAGE

Net income
ROE =
Average equity

Net income Average assets

= ×
Average assets Average equity

= ROA × Leverage

A company can increase its ROE with either:

• A business strategy, i.e. by increasing its ROA.
• A financial strategy, i.e. by increasing its use of leverage (expressed by how
many dollars of assets are supported by each dollar of equity) as long as
returns on the incremental investment exceed the cost of borrowing .

34
DECOMPOSE ROE – USE OF LEVERAGE

• Leverage is measured as average total assets divided by average

shareholders’ equity (computed as avg. Assets – avg. Liabilities):
- If a company had no leverage (i.e. no liabilities), its leverage ratio would
equal 1.0 and ROE would exactly equal ROA. As a company takes on
liabilities, its leverage increases.
- As long as a company is able to borrow at a rate lower than the marginal
rate it can earn investing the borrowed money in its business, the company is
making an effective use of leverage and ROE would increase as leverage
increases (i.e. Net income will increase faster than avg. equity).
- If a company’s borrowing cost exceeds the marginal rate it can earn on
investing in the business, ROE would decline as leverage increased
because the effect of borrowing would be to depress ROA.

35
RETURN ON ASSETS (ROA)

• What rate of return has the firm earned on the assets it had available to use
during the year?
• ROA measures the return earned by a company on its assets.
• The higher the ratio, the more income is generated by a given level of assets.

Net income
ROA =
Average assets

36
PROFITABILITY, COMPETITION, AND BUSINESS
STRATEGY
Net income
ROA =
Average assets

Net income Revenue

ROA = ×
Revenue Average assets

In other
words, ROA
Profit margin × Turnover (efficiency)
can be
thought of as:

A company can increase its ROA in two basic ways:

• By increasing operating profitability (operating profit margin).
• By increasing asset turnover - that is, better asset utilization (efficiency).

37
DECOMPOSING RETURN ON EQUITY

ROE = Profit margin × Turnover × Leverage

Net income Revenue Average assets

ROE = × ×
Revenue Average assets Average equity

Three basic factors underlying profitability:

• Profit margin, an indicator of profitability. Shows how many dollars of
income the company can generate for each dollar of revenue.
• Turnover (i.e. the asset turnover ratio), an indicator of efficiency. Shows how
many dollars of revenue the company can generate for each dollar of its
assets.
• Leverage, an indicator of solvency. Shows how many dollars of assets are
supported by each dollar of equity.

38
DECOMPOSING RETURN ON EQUITY:
COMPARATIVE ANALYSIS

To what extent ROE:

• . . . was derived from selling a high margin product or keeping expenses
low, i.e. deriving more profits from each $1 of sales? (return on sales, net
profit margin)
• . . . was derived from generating higher sales from a lower investment in
assets? (efficient use of assets, also known as turnover or efficiency)
• . . . was derived from investing a lower amount of equity, i.e. by using more
debt in its capital structure? (financial leverage)

=> The decomposition illustrates that a company’s ROE is a function of its net
profit margin, its efficiency, and its leverage.

39
DECOMPOSING RETURN ON EQUITY:
COMPARATIVE ANALYSIS

Co. A Co. B Co. C Average

Sales ($) 2,000 4,000 6,675 4,225
NI ($) 200 200 200 200
Average assets ($) 1,000 2,000 1,500 1,500
Average equity ($) 1,000 1,000 1,000 1,000
Average liabilities ($) 0 1,000 500 500
ROE (NI/Equity) 20.0% 20.0% 20.0% 20.0%
Net profit margin
(NI/Sales) 10.0% 5.0% 3.0% 4.7%

Turnover (Sales/Assets) 2 2 4.45 2.82

Leverage (Assets/Equity) 1 2 1.5 1.50

40
DECOMPOSING RETURN ON EQUITY:
COMPARATIVE ANALYSIS

• All three companies have the same ROE.

- Company A’s ROE is driven by its net profit margin (10% versus 4.7%
average for the three companies).
- Company B’s ROE is driven by its leverage (2× versus 1.5× average for the
three companies). Its turnover is below average, and its profit margin is very
slightly above average.
- Company C’s ROE is driven by its turnover (4.45× versus 2.82× average).

41
DECOMPOSING RETURN ON EQUITY:
COMPARATIVE

42
DECOMPOSING RETURN ON EQUITY:
COMPARATIVE ANALYSIS
AAPL HPQ DELL

ROE 27.19% 21.50% 61.19%

Net income/Sales Net profit margin 14.88% 7.04% 4.06%

Sales/Average assets Asset turnover 1.00 1.17 2.26

Average assets/
Financial leverage 1.83 2.61 6.67
Average equity

ROE decomposition for three actual companies, using 2008 data for Apple
(AAPL), Hewlett-Packard (HPQ), and Dell (DELL).
=> What was the source of each firm’s return on equity?

Source : Companies’ financial statements (2008)

43
DECOMPOSING RETURN ON EQUITY:
COMPARATIVE ANALYSIS

• Source of each firm’s return on equity?

- For Dell: significantly higher financial leverage and asset turnover
compensated for low net profit margin.
- For Apple: the net profit margin is much higher (reflects a strategy of
competing on product features rather than price), and asset turnover is
lower (reflects a strategy of having own retail stores).

In addition – from financial statements analysis:

• Apple’s lower turnover reflects its retail strategy, which requires increased
investment in PPE.
• The significant amount of cash on its balance sheet, which generates non-
operating income does not generate “revenue”.

44
DECOMPOSING RETURN ON EQUITY:
COMPARATIVE ANALYSIS – UPDATED DATA

Apple Hewlett Packard Dell

Source : Gurufocus, 2019

45
DUPONT ANALYSIS: FURTHER
DECOMPOSITION
• ROE = Net income / Average equity
• Decompose ROE into five factors

Net income EBT EBIT

ROE = × ×
EBT EBIT Revenue

Revenue Average assets

× ×
Average assets Average equity

This further decomposition can be interpreted as:

ROE = Tax burden × Interest burden × EBIT margin

× Total asset turnover × Leverage
46
DUPONT ANALYSIS: FURTHER
DECOMPOSITION – EXAMPLE

47
DUPONT ANALYSIS: FURTHER
DECOMPOSITION

• Tax burden (Net income / EBT): measures the effect of taxes on ROE.
- Reflects the percentage of pretax profits the company “keeps” as net
income after deducting the tax expense. High value for the tax burden =>
the company can keep a higher percentage of its pretax profits (note:
indicating a lower tax rate or a more efficient tax strategy). A lower value for
the tax burden ratio implies the opposite.
• Interest burden (EBT/EBIT): captures the effect of interest on ROE.
- Reflects the percentage of pre-interest-and-tax profits the company
“keeps” as pretax profit after deducting the interest expense. Lower
borrowing costs increase ROE, and higher borrowing costs reduce ROE
(note: not taking into account potential interest income).
• EBIT margin (EBIT/Revenue) or operating margin (if operating income is
used in the numerator).
- Captures the effect of EBIT margin (operating margin if operating income is
used) on ROE, i.e. the effect of operating profitability on ROE.
48
DUPONT ANALYSIS: ILLUSTRATION AND
COMMENTS (DATA FROM PREVIOUS EXAMPLE)
Lower than 1 except in
presence of tax credit. The higher the
The higher the better, better, i.e. lower
Lower than 1 if net
i.e. lower taxes and / or CGS and / or lower
interest expense >
better tax strategy. operating
net interest income,
expenses.
or conversely.

Net income EBT EBIT

ROE = × ×
EBT EBIT Revenue

Revenue Average assets

× ×
Average assets Average equity

49
DUPONT ANALYSIS: FURTHER
DECOMPOSITION

• This 5-step decomposition expresses a company’s ROE as a function of its:

- Tax rate.
- Interest burden.
- Operating profitability.
- Efficiency.
- Leverage.
• An analyst can use this framework to determine what factors are driving a
company’s ROE.
• The decomposition of ROE can also be useful in forecasting ROE based
upon expected efficiency, profitability, financing activities, and tax rates.

50
TYPE OF RATIOS
Category Description
Activity Activity ratios. How efficient are the firm’s operations and the
firm’s management of assets? NOT COVERED !!!

Liquidity Liquidity ratios. How well is the firm positioned to meet short-
term obligations? NOT COVERED !!!

Solvency Solvency ratios. How well is the firm positioned to meet long-
term obligations? NOT COVERED !!!

Profitability Profitability ratios. How much and how is the firm achieving
returns on its investments?
(ROE, ROA, Dupont Analysis)
Valuation Valuation ratios. How does the firm’s performance or financial
position relate to its market value?
(P/E, P/B, EPS, dividend payout)

51
VALUATION RATIOS: PRICE-TO-EARNINGS
RATIO

• P/E relates earnings per common share to the market price at which the
stock trades, expressing the “multiple” that the stock market places on a firm’s
earnings.

Price
P/E =
Earnings per share

High P/E may indicate either:

• Firm is valued highly by market, possibly because of growth expectations.
• That a firm may have very low earnings per share.
• That the share is quite expensive vs. its peers.

52
VALUATION RATIOS: PRICE-TO-EARNINGS
RATIO

• The price-to-earnings ratio (P/E) - probably the most widely cited indicator in
discussing the value of equity securities - relates share price to the
earnings per share (EPS).
• The P/E expresses the relationship between the price per share and the
amount of earnings attributable to a single share (i.e. how much an investor
in common stock pays per dollar of earnings).
• In general, a high P/E indicates that the market places a high value on the
earnings of a company. Higher P/E stocks are sometimes referred to as
“glamour” or “growth” stocks and lower P/E stocks as “value” stocks.

53
VALUATION RATIOS: PRICE-TO-BOOK RATIO

• P/B (Price to book value) is the ratio of price per share to book value per
share.
• This is an indicator of market judgment about the relationship between a
company’s required rate of return and its actual rate of return (assuming
that book values reflect the fair values of the assets):
- A price-to-book ratio of 1 can be interpreted as an indicator that the
company’s future returns are expected to be exactly equal to the returns
required by the market.
- A ratio greater than 1 would indicate that the future profitability of the
company is expected to exceed the required rate of return.
- A ratio lower than 1 would indicate that the company is not expected to
earn excess returns.

54
DIVIDEND-RELATED QUANTITIES – DIVIDEND
PAYOUT RATIO

• Percentage of earnings that the company pays out as dividends to

shareholders.
• The ratio reflects a company’s dividend policy. Optimal dividend policy is a
function of many factors, but in general, a company balances current dividend
payout with future growth.
• The amount of dividends per share tends to be relatively fixed because any
reduction in dividends has been shown to result in a disproportionately large
reduction in share price. As a result, the dividend payout ratio tends to
fluctuate mostly with earnings. Therefore, conclusions about a company’s
dividend payout policies should be based on examination of payout over a
number of periods.

Dividend payout ratio = Dividends per share

Earnings per share

55
EXAMPLE: L’OREAL

Source: Kepler Cheuvreux - L’Oréal Autumn conference, Sept. 2018

56
EXAMPLE: L’OREAL

Dividends per share

Dividend yield =
Price
57
COURSE CONTENT

1. Introduction
2. Overview of analytical approaches, tools and techniques
3. Common ratios used in financial analysis (with a focus on profitability and
valuation)

4. Forecast future performance : introduction to

financial modeling (going through main P&L items
through several examples)

58
MODEL BUILDING: EXAMPLES OF POSSIBLE
USES OF RATIOS

• Sales forecast (percent change from horizontal common-size income

statement)

• Expenses (from common-size income statement)

• Gross profit (gross profit margin)
• Operating profit (operating profit margin)

• Assets (days receivable, days payable, PP&E turnover)

• Liabilities (leverage ratios)

• Cash flow

59
MODEL BUILDING: DEFINITION AND EXAMPLES
OF POSSIBLE USES OF RATIOS

• Analysts often need to forecast future financial performance. They use data
about the economy, industry, and company to arrive at a company’s forecast.
The results of an analyst’s financial analysis, including common-size and ratio
analyses, are integral to this process, along with the judgment of the analysts.
• Based on forecasts of growth and expected relationships among the financial
statement data, the analyst can build a model (sometimes referred to as an
“earnings model”) to forecast future performance.
• A forecast should not just be a mechanical exercise of extrapolating from
historical performance and historical ratios; however, information gained from
ratio analysis from prior years can provide useful input.

60
FROM RATIOS TO FINANCIAL MODELING – AN
OVERVIEW

• Income statement modeling : revenue.

• Income statement modeling : operating costs.
- Cost of good sold (COGS).
- Selling, General and Administrative Expenses (SG&A).
• Income statement modeling : non-operating costs.
- Financing expenses.
- Corporate income tax.
• Income statement modeling : other items.
• Balance sheet and cash flow statements modeling.

61
FORECASTING – FINANCIAL MODELING

• Sales Forecast

• Expenses
• Gross Profit
• Operating Profit

• Assets
• Liabilities

• Cash Flow

62
TOP-DOWN AND BOTTOM-UP APPROACHES –
INTRODUCTION

1. Top-Down Approach.
- Start with the economy.
- Look at successively more narrowly defined levels.
2. Bottom-Up Approach.
- Begin with individual product lines, locations, or business segments.
- Aggregate projections over products / segments to reach the company level.
- Aggregate company revenues to reach the industry level.
3. Hybrid Approach.
- Combine top-down and bottom-up approaches.

63
TOP-DOWN APPROACHES

“Growth relative to GDP growth” approach

Forecast the Relate the

growth rate of company’s Forecast real Forecast
nominal gross growth rate to GDP and company’s
domestic the growth of inflation revenues
product (GDP) nominal GDP

“Market growth and market share” approach

Evaluate the
Forecast Apply the
company’s Forecast
growth in a current and expected
particular market share company’s
anticipated revenues
market market share to the forecast

64
BOTTOM-UP AND HYBRID APPROACHES

Bottom-up approaches. Hybrid approaches.

• For each of a company’s major • Combine top-down and bottom-up
products or segments, project approaches: one can use one
changes in volume and changes in approach for individual product
price. lines, and then aggregate for the
• Capacity-based measures (e.g. company as a whole.
store sales year-to-year). • It may uncover implicit assumptions
or errors present in one or both
other approaches (trial and error).
• In practice - this approach is the
most commonly used.

65
REVENUE MODELING – INTRODUCTION

• Financial modeling usually starts with the income statement.

• The first step in forecasting revenue is to analyze / decompose the
components of a company’s revenues:
- Trends and growth rates.
- Sources of revenues:
• Product or services segments.
• Business segments.
• Geographic segments.
• Other relevant segmentation.

66
REVENUE MODELING BY SEGMENTS

• Novo Nordisk is a Denmark-based biopharmaceutical company with a focus on

diabetes drugs. The company provides detailed disclosure of revenue along
geographic, business segment, and product lines.
• In its 2011 annual report, Novo Nordisk provided the following geographic
breakdown of sales for the previous three years. The company also classified
revenue into business segments: diabetes care and biopharmaceuticals, with
additional disclosure on several individual product lines.

67
REVENUE MODELING BY SEGMENTS

Source : CFA curriculum

68
REVENUE MODELING BY SEGMENTS

Questions:
• 1. Determine the percentage of Novo Nordisk’s sales that came from each
geographic region in 2011.
• 2. Management only began breaking out revenue for China in 2011 (restated
for previous years). Previously, China had been included in the “International”
region. Over the past two years, revenue from China has increased 41%,
compared with 37% growth for the remainder of the International region.
Describe at least two alternative interpretations of why management
decided to increase disclosure about China.

69
REVENUE MODELING BY SEGMENTS

Solution to 1:
• North America: (3,569/8,905) = 0.401 or 40.1%
• Europe: (2,573/8,905) = 0.289 or 28.9%
• International: (1,257/8,905) = 0.141 or 14.1%
• Japan and Korea: (835/8,905) = 0.094 or 9.4%
• Region China: (671/8,905) = 0.075 or 7.5%

70
REVENUE MODELING BY SEGMENTS

Solution to 2:
• Two possible explanations for management’s decision to enhance
disclosure are:
- China is a relatively fast-growing market, so management believes investors
will see the company in a more favorable light with this geography broken
out.
- China is an area of particular interest to investors and management
simply wants to improve investors’ understanding of the business by
providing extra detail. Because the International region grew almost as
quickly as China, the second explanation seems more likely.

71
REVENUE MODELING BY SEGMENTS

Source : CFA curriculum

72
REVENUE MODELING BY SEGMENTS

Questions:
• 3. Modern insulins provide certain advantages over human insulins, such as
having a faster or longer-lasting effect on blood sugar levels. Compare Novo
Nordisk’s recent sales growth rate of modern insulins with that of human
insulins.
• 4. Which segment was the larger contributor to Novo Nordisk’s sales growth
over the past two years: diabetes care or biopharmaceuticals?

73
REVENUE MODELING BY SEGMENTS

Solution to 3:
• Between 2009 and 2011, Novo Nordisk’s sales of modern insulins increased
3,861/2,883 – 1 ≈ 0.339 or 33.9%, although year-over-year growth has slowed.
• Compound annual growth rate: (3,861/2,883)1/2 – 1 = 0.157 or 15.7%.
• In contrast, sales of human insulins declined modestly. This decline may be
explained by the advantages of modern insulins mentioned in the question.

74
REVENUE MODELING BY SEGMENTS

Solution to 4:
• In the past two years, Novo Nordisk’s total sales increased by €2,045 million
(from €6,860 million to €8,905 million). During the same time, diabetes care
sales increased by €1,733 million and biopharmaceuticals sales increased by
€312 million.
• The diabetes care segment thus accounted for about 85% (≈ 1,733/2,045) of
Novo Nordisk’s sales growth between 2009 and 2011 (delta sales diabetes
care segment 6’769 – 5’036 over total sales segment 8’905-6’860).

75
REVENUE MODELING – TRENDS AND GROWTH

Questions:
• 5. Xia Wutran is an equity analyst covering European pharmaceutical
companies. Wutran projects that global nominal GDP will grow 5% annually
over the long run (2% real growth and 3% inflation). The incidence of diabetes
is escalating globally because of increasingly unhealthy diets and sedentary
lifestyles. As a result, Wutran believes global sales of diabetes drugs will
grow 100 bps faster than nominal GDP over the long run. However, Wutran
believes the revenue growth rate of Novo Nordisk’s diabetes care segment
will decline linearly over the next four years from its growth rate in 2011 to
the projected long-run growth rate of the diabetes drug market.
- A. Is Wutran using a top-down, bottom-up, or hybrid approach to modeling
Novo Nordisk’s revenue?
- B. Based on Wutran’s projections for revenue growth, calculate the
estimated revenue growth rate for the diabetes care segment in 2013.

76
REVENUE MODELING – TRENDS AND GROWTH

Solution to 5A:
• Wutran’s long-run revenue projections are based on Novo Nordisk’s growth
relative to nominal GDP growth, which is a top-down approach.
• His estimated growth rate is applied to only one of Novo Nordisk’s segments
(diabetes care), indicating a hybrid approach.
• Wutran’s four-year forecasts are also based in part on the historical growth rate
of the diabetes care segment, which is a bottom-up approach.
=>Globally, Wutran is thus using a hybrid approach.

77
REVENUE MODELING – TRENDS AND GROWTH

Solution to 5B:
• The data indicates that Novo Nordisk’s diabetes care segment grew
approximately 10% in 2011 (= 6,769/6,137 – 1 ≈ 0.103).
• Wutran projects the long-run growth rate to be in line with the diabetes drug
market growth at 6% (100 bps faster than GDP growth of 5%). The difference
between the 2011 growth rate and projected long-run growth rate is 4% (=
10% – 6%).
• Wutran expects the deceleration in growth to occur linearly over four years,
implying a reduction of 100 bps per year in the growth rate. The estimated
growth rates by year are thus:
- 2012 = 9% / 2013 = 8% / 2014 = 7% / 2015 = 6% / Thereafter, 6%
• The estimated revenue growth rate for 2013 is 8%.

78
REVENUE MODELING – TRENDS AND
GROWTH: UPDATED GROWTH DATA

79
INCOME STATEMENT MODELING: REVENUE

80
REVENUE MODELING – TRENDS AND GROWTH

• Helga Hansen is a buy-side analyst in Denmark. In early 2011, Hansen was

investigating Victoza, a recently launched compound in a new class of
diabetes drugs called GLP-1 analogs. As of 2011, Victoza has only one
direct competitor in its class: Byetta, a drug that is co-marketed by two US-
based pharmaceutical companies, Amylin Pharmaceuticals and Eli Lilly.
• Victoza had a few advantages over Byetta; most notably, it is delivered by
injection once a day, rather than twice a day.
• Eli Lilly reported global sales of Byetta in US dollars. Hansen converted these
figures to euro using the annual average USD/EUR exchange rate and
compiled the following table comparing sales of Victoza with sales of
Byetta, measured in millions of euros.
2008 2009 2010
Byetta 513 573 536
Victoza 0 12 311

Source : CFA curriculum

81
REVENUE MODELING – TRENDS AND GROWTH

Questions:
• 1. What was the growth rate in total GLP-1 analog sales in 2010?
• 2. What percentage of GLP-1 analog sales growth in 2010 was caused by
Victoza?
• 3. Hansen projected that the growth rate of the GLP-1 analog market would
slow to 28% in 2011. She also expected Victoza to improve its market share
by 25 percentage points. What was Hansen’s estimate of 2011 Victoza
sales? How close was she to the actual result?
• 4. Is Hansen’s approach to modeling Novo Nordisk’s sales best described as
bottom-up, top-down, or hybrid?

82
REVENUE MODELING – TRENDS AND GROWTH

Solution to 1:
• Total sales of GLP-1 analogs in 2010 were €847 million (= 536 + 311),
compared with total sales of €585 million (= 573 + 12) in 2009.
• The growth rate was thus around 45% (= 847/585 – 1 ≈ 0.448).

83
REVENUE MODELING – TRENDS AND GROWTH

Solution to 2:
• From 2010 to 2011, total GLP-1 analog sales increased by €262 million (from
€585 million to €847 million), whereas Victoza sales increased by €299 million
(from €12 million to €311 million).
• As a result, Victoza accounted for approximately 114% of the growth in sales of
this drug class (= 299/262 ≈ 1.14, or 114%).
• Victoza accounted for more than 100% of the total growth in sales of this drug
class because the other drug in the class had a decline in sales.

84
REVENUE MODELING – TRENDS AND GROWTH

Solution to 3:
• Based on 2010 sales of €847 million and a projected growth rate of 28%,
Hansen projected the total GLP-1 analog market to be worth about €1,084
million in 2011 (= 847 x 1.28 ≈ 1,084.2).
• Victoza’s market share in 2010 was around 37%, which Hansen projected to
improve by 25 percentage points, resulting in a 62% market share in 2011.
• Hansen thus projected 2011 Victoza sales to be around €672 million (= 1,084
x 0.62 ≈ 672). Actual Victoza sales in 2011 were €804 million, so Hansen’s
estimate was too low by €132 million (= 804 – 672 = 132).

85
REVENUE MODELING – TRENDS AND GROWTH

Solution to 4:
• Hansen bases her estimates on market growth and market share, which would
normally imply a top-down approach.
• The analysis, however, is applied to an individual product line, implying a
bottom-up approach.
• Therefore, Hansen is using a hybrid approach.

86
REVENUE MODELING – TRENDS AND
GROWTH: UPDATED MARKET SHARE DATA

87
FORECASTING OPERATING PROFIT BASED ON
HISTORICAL MARGINS

88
FORECASTING OPERATING PROFIT BASED ON
HISTORICAL MARGINS
Johnson & Johnson Baidu
(NYSE: JNJ) (NASDAQ: BIDU)
• U.S. health care conglomerate, • Chinese language internet search
founded in 1887. engine, established in 2000 and
• 2009 sales of around $61.9 billion went public on NASDAQ in 2005.
from its three main businesses: • Revenues for 2009 were 4.4 billion
pharmaceuticals, medical devices renminbi (RMB), an increase of
and diagnostics, and consumer 40% from 2008 and more than 14
products. times greater than revenues in
• For the four years prior to 2009, 2005.
average operating profit margin • For the four years prior to 2009,
was approximately 25.0%. average operating profit margin
was approximately 27.1%.

89
FORECASTING OPERATING PROFIT BASED ON
HISTORICAL MARGINS

• For relatively mature companies operating in nonvolatile product markets,

historical information on operating profit margins can provide a useful
starting point for forecasting future operating profits (at least over short
forecasting horizons).
• Historical operating profit margins are typically less reliable for projecting
future margins for a new or relatively volatile business or one with significant
fixed costs (which can magnify the volatility of operating margins).

Question:
• From previous slide data (slide compares JNJ and BIDU), based solely on this
description, would a forecasting method of applying the average operating
profit over the previous several years to a forecast of sales be a
reasonable starting point for projecting future operating profit?

90
FORECASTING OPERATING PROFIT BASED ON
HISTORICAL MARGINS

Solutions:
• JNJ:
- Because JNJ is an established company with diversified operations in
relatively stable businesses, the suggested approach to projecting the
company’s operating profit would arguably be a reasonable starting point.
• BIDU:
- A relatively new company, such as Baidu, has limited operating history on
which to judge stability of margins. The company appears to have been in a
period of rapid growth and is in an industry that has been changing rapidly in
recent years. This important aspect of the company suggests that the broad
approach to projecting operating profit would not be a useful starting point.

91
FORECASTING OPERATING PROFIT BASED ON
HISTORICAL MARGINS

Source: Baidu’s annual report (20-F)

92
FORECASTING OPERATING PROFIT BASED ON
HISTORICAL MARGINS

• JNJ:
- JNJ’s actual operating profit margin for 2009 was 25.2%, which is very close
to the company’s four-year average operating profit margin of approx. 25.0%.
- If the average operating profit margin had been applied to forecast 2009
sales to obtain forecasted operating profit, the forecasting error would have
been minimal.
• BIDU:
- Baidu’s actual operating profit margin for 2009 was 36.4% (RMB1.6 billion
divided by sales of RMB4.4 billion).
- If the average profit margin of 27.1% had been applied to forecast sales, the
forecasted operating profit would have been approximately RMB1.2 billion, or
around 25% below Baidu’s actual operating profit.

93
FORECASTING – FINANCIAL MODELING

• Sales Forecast

• Expenses
• Gross Profit
• Operating Profit

• Assets
• Liabilities

• Cash Flow

94
OPERATING COSTS MODELING –
INTRODUCTION

• After developing a revenue forecast, an analyst can use ratios expressing

the relationship between revenues and various items on the income
statement to forecast income. An analyst may use historical common-size
data as an input to developing expectations about specific expense line
items.
- The gross profit margin could be used to forecast gross profit directly
and/or to forecast cost of goods sold.
- The operating profit margin could be used to forecast operating profit
directly.

95
OPERATING COSTS MODELING –
INTRODUCTION

• Analyst can take a top-down, bottom-up, or hybrid approach to analyzing and

forecasting costs. Fixed and variable cost components of operating costs are
considered.
• Economies of scale is present if the average cost per unit falls as revenues
increase (indicative of economics of scale: operating margins positively
correlated with revenues).
• Costs are challenging to estimate based on reported accounts. For example,
companies reserve against losses are based on estimates, but the actual
losses may differ from the estimates.

96
OPERATING COSTS MODELING –
INTRODUCTION

• Approaches are similar to that of forecasting revenues. Variable costs vary

with revenues and can be modeled as a percentage of revenues or in terms
of growth of unit sales.
• Fixed costs are related to property, plant, and equipment (PP&E), future
PP&E, and capacity growth. Economies of scale relates to the coverage of
fixed costs: the per unit cost decreases with higher levels of output if there is
economies of scale.
• There are uncertainties with regard to costs, including in particular the
estimation of:
- Fixed versus variable costs.
- Costs considering reserves.
- Costs of future inputs.

97
OPERATING COSTS MODELING –
INTRODUCTION

Cost of goods sold: focus on gross margins.

- Percentage of sales with a break-down by product / segment.
- Hedging activity may affect costs of raw materials.
- Comparison with competitors’ gross margins.
• Selling, general, & administrative (SG&A) expenses: focus on type of expense.
- Some SG&A expenses vary with cost of goods sold, whereas other SG&A
expenses are relatively fixed (e.g. overhead).
- Benchmarking against competitors may be useful.
• Non-operating costs: depends on the type of cost.
- Interest income varies with cash and investments, whereas interest expense
varies with debt.
- Taxes are affected by the jurisdiction and the type of business.

98
OPERATING COSTS MODELING – GLOBAL
APPROACH

99
OPERATING COSTS MODELING – GLOBAL
APPROACH

• Walgreens and Rite Aid are two of the largest retail drugstore chains in the
United States. For both companies, around two-thirds of sales come from
prescription pharmaceuticals, with the remaining third coming from front-of-
store categories (e.g. beauty products, over-the-counter drugs, convenience
foods, and greeting cards).
• Walgreens and Rite Aid have very different operating margins. There is
reason to believe that economies of scale exist in the drugstore business (i.e.
larger drugstore companies have greater bargaining leverage with suppliers
and ability to negotiate better reimbursement rates with third-party payers).
• Customer service is one driver of revenue for the retail drug business. A
combination of qualitative (personal store visits, customer surveys) and
quantitative (metrics such as selling, general, and administrative (SG&A)
expense per square foot) evidence is used to assess customer service.

100
OPERATING COSTS MODELING – GLOBAL
APPROACH

Source : CFA curriculum

101
OPERATING COSTS MODELING – GLOBAL
APPROACH

Rite Aid

Source : CFA curriculum

102
OPERATING COSTS MODELING – GLOBAL
APPROACH

Question:
• 1A. On the basis of the 2011 operating margins for Walgreens and Rite Aid, is
there evidence suggesting that economies of scale exist in the retail
drugstore business?
• 1B. If so, are economies of scale realized in cost of goods sold or SG&A
expenses?

103
OPERATING COSTS MODELING – GLOBAL
APPROACH

Solution to 1:
• 1A. Walgreens’ 2011 operating margin (operating income / revenue) was 5.4%
(= 3,931/72,184 ≈ 0.054). Rite Aid’s operating margin in 2011 was 1.0% (=
262/26,121 ≈ 0.010). Walgreens’ much larger size ($72,184 million in sales
versus $26,121 million for Rite Aid) combined with its much higher
profitability provides evidence suggesting that there are economies of scale
in the drugstore industry.
• 1B. Divide both companies’ expense lines by revenue for 2011. Walgreens’
cost of goods sold consumed 71.6% (≈ 51,692/72,184) of revenue, whereas
Rite Aid’s cost of goods sold consumed 74% (≈ 19,328/26,121). Walgreens’
SG&A consumed 22.9% (≈ 16,561/72,184) of revenue, whereas Rite Aid’s
SG&A consumed 25% (≈ 6,531/26,121). The results indicate that there are
economies of scale in both cost of goods sold and SG&A (i.e. lower
percentage for Walgreen vs. Rite Aid).

104
OPERATING COSTS MODELING – GLOBAL
APPROACH

Question:
• 2. Marco Benitez is a US-based equity analyst with an independent research
firm. Benitez is researching service levels in the US drugstore industry.
- A. Calculate and interpret Walgreens’ and Rite Aid’s SG&A per average
square foot over the past three years.
- B. Assuming that customer satisfaction is a driver of sales growth, which
company appears to have a more satisfied customer base over the period
examined?

105
OPERATING COSTS MODELING – GLOBAL
APPROACH

Solution to 2A:
• Walgreen’s average SG&A per square foot in 2011 and 2009 were $196 (≈
16,561/84.7) and $191 (≈ 14,366/75.1), respectively. This is an increase of
approximately 2.6%.
• The same figures for Rite Aid were $139 in 2011 and $136 in 2009, for an
increase of 2.2%.
• This might be evidence of higher service levels at Walgreens. Although Rite
Aid spends much less than Walgreen on SG&A per square foot, the trend of
the past three years provides little indication that Rite Aid’s possible customer
service gap relative to Walgreens is increasing.

106
OPERATING COSTS MODELING – GLOBAL
APPROACH

Solution to 2B:
• Walgreens appears to have the more satisfied customer base, considering
just same-store sales.
• Comparing same-store sales growth for the two companies, Walgreens has
consistently outperformed Rite Aid in the past three years. This result supports
the hypothesis that Rite Aid’s customers may be less satisfied than
Walgreens’ customers over the time period examined.

107
OPERATING COSTS MODELING – GLOBAL
APPROACH

Question:
• 3. Jason Lewis is another US-based equity analyst covering the retail
drugstore industry. He is considering several approaches to forecasting
Walgreens’ and Rite Aid’s’ future costs. Classify each of the following as a
bottom-up, top-down, or hybrid approach.
- A. Lewis believes government insurance programs in the United States will
face budgetary pressures in the future, which will result in lower
reimbursements across the retail drugstore industry. He thinks this will lower
all drugstores’ gross margins.
- B. Lewis projects that Walgreens’ historical rate of growth in SG&A
expenses will continue for the next five years. In the long-run, he projects
SG&A to grow at the rate of inflation.
- C. To estimate Rite Aid’s future lease expense, Lewis makes assumptions
about square footage growth and average rent per square foot, based on
past experience.

108
OPERATING COSTS MODELING – GLOBAL
APPROACH

Solution to 3A:
• This case describes a top-down approach as Lewis considers the overall
industry environment before individual companies.

Solution to 3B:
• Lewis combines a bottom-up approach (projecting the historical rate of growth
to continue) with a top-down approach (basing his long-run assumptions on the
overall rate of inflation). Hence, this is a hybrid approach.

Solution to 3C:
• This case describes a bottom-up approach because Lewis bases his
forecasts on Rite Aid’s historical experience.

109
OPERATING COSTS MODELING – GLOBAL
APPROACH

Source : Walgreens (upper table) respectively Rite Aid (lower table) financials
110
OPERATING COSTS
MODELING – GLOBAL
APPROACH

111
OPERATING COSTS MODELING – OPERATING
MARGIN

112
OPERATING COSTS MODELING – OPERATING
MARGIN

• L’Oréal reported an operating margin (EBIT) of 16% in 2011, one of the most
profitable company among beauty companies. However, the average
operating margin of 18% for home and personal goods companies operating
in mass markets is even greater than that of L’Oréal.
• L’Oréal costs are similar to a luxury goods company with high gross margin of
71% that is offset by high costs for advertising and promotion (A&P)
expenditures. With the exception of Avon, the business model of which is
based on direct selling, A&P is substantially greater at the beauty
companies than at the mass market producers.
• L’Oréal is often considered to be a pure beauty company. However, the
company’s operations can be split 50/50 between a luxury beauty high-end
part and a general consumer part. In the general consumer part, L’Oréal’s
products compete with such players as Colgate, Procter & Gamble, and
Henkel in the mass market.

113
INCOME STATEMENT MODELING: OPERATING
COSTS.

Source : CFA curriculum

114
OPERATING COSTS MODELING – OPERATING
MARGIN

Question:
• 1. Assuming the following information, what will L’Oréal’s new operating
margin be?
- L’Oréal’s beauty and mass market operations each represent half of
revenues.
- L’Oréal will be able to bring the overall costs structure of its mass market
operations in line with the average of mass market companies (EBIT = 18%).
- The cost structure of L’Oréal’s beauty operations will remain stable (EBIT =
16%).

115
OPERATING COSTS MODELING – OPERATING
MARGIN

Solution to 1:
• Operating margin will increase from 16% to 17%, which is 50% of 18% (mass
market EBIT) plus 50% of 16% (L’Oréal EBIT).

116
OPERATING COSTS MODELING – OPERATING
MARGIN

Question:
• 2. What will happen to L’Oréal’s operating margin if the company is able to
adjust the operating cost structure of its mass market segment (50% of
revenues) partly toward the average of its mass markets peers, but at the
same time keep its high gross margin?
• Assume the following:
- The cost structure of half of the business (i.e. the beauty operations) will
remain stable (EBIT = 16%).
- L’Oréal’s mass market operations will have a gross margin of 61% (the
average of the current gross margin of 71% and the 51% reported by its
mass market peers).
- L’Oréal’s A&P costs will fall half from 31% of sales to 15% of sales (close to
market average) and other costs will remain stable.

117
OPERATING COSTS MODELING – OPERATING
MARGIN

Solution to 2:
• Operating margin will increase from 16% to 19%. The operating margin of the
mass market operations will improve by 600bps to 22% because a 10%
decline in gross margin (from 71% to 61%) will more than offset the 16% of
decline in A&P expenditures (from 31% of sales to 15% of sales). The average
of the EBIT for beauty (16%) and the new EBIT for mass market operations
(22%) is 19%.

Source : CFA curriculum

118
OPERATING COSTS MODELING – SALES,
OPERATING MARGIN, AND PROFIT MARGIN

Source : Unilever internet site

119
OPERATING COSTS MODELING – SALES,
OPERATING MARGIN, AND PROFIT MARGIN

• The consumer goods company Unilever reported an overall operating margin

of 14.9% in 2011.
• The operating margin is higher in the slower growing Western European
and Americas regions than in the faster growing Asia, Africa, and Central and
Eastern Europe region.

Source : CFA curriculum

120
OPERATING COSTS MODELING – SALES,
OPERATING MARGIN, AND PROFIT MARGIN

Adjustments
for one-time
items

Source : Unilever annual report 2011

121
OPERATING COSTS MODELING – SALES,
OPERATING MARGIN, AND PROFIT MARGIN

122

Source : CFA curriculum

OPERATING COSTS MODELING – SALES,
OPERATING MARGIN, AND PROFIT MARGIN

Question:
• 1. Determine the estimated sales, operating profit, and operating profit
margin by using the following two approaches / methods:
- (Method A) Assume consolidated sales growth of 6.5% and overall stable
operating margin of 14.85% for the next five years.
- (Method B) Assume each individual region’s sales growth and operating
margin continue at the same rate reported in 2011.
- Which approach will result in a higher estimated operating profit after five
years?

123
OPERATING COSTS MODELING – SALES,
OPERATING MARGIN, AND PROFIT MARGIN

Solution to 1:
• Under approach A, using 2011 underlying operating profit figure of
€6,901,000,000, constant sales growth of 6.5% with stable 14.85% margins
generates an operating profit of €9,454,968,000 = €6,901,000,000 x (1.065)5.
Same calculation method applies for sales figures.

Source : CFA curriculum

124
 2011 Data from
previous slide
(Exhibit 7)

Example 2012E:
2’664 = 2’411 x (1.105)

Example 2016E:
3’972 = 2’411 x (1.105)5

Source : CFA curriculum

125
OPERATING COSTS MODELING – SALES,
OPERATING MARGIN, AND PROFIT MARGIN

Method A:
- Revenues €63,664
- Operating profit €9,455
- Operating margin 14.85% (constant)

Method B:
- Revenues €64,618
- Operating profit €9,388
- Operating margin 14.53% (last year)

126
OPERATING COSTS MODELING – SALES,
OPERATING MARGIN, AND PROFIT MARGIN

Question:
• 2. Compare and explain the results under the two alternative approaches
described in Question 1 (A and B) with reference to:
- The yearly growth rate in estimated total sales.
- The yearly growth rate in total operating profit
- The yearly profit margin.

127
Solution to 2:
• First approach (A): a constant 6.5% sales growth rate and a stable 14.85%
operating margin are assumed => the operating profit growth rate is in line with
the revenue growth rate and constant at 6.5% (Panel A on following slide).
• Second approach (Panel B on following slide): the high sales growth of
10.5% in the region with the largest amount of sales (Asia, Africa, and Central
and Eastern Europe) results in accelerating revenue growth from 6.5% in
2012 to 7.1% in 2016. Because the operating margin in the largest and fastest
growing region is less than the overall average, operating margin falls from
14.85% in 2011 to 14.53% in 2016.
• The higher sales growth in a lower margin region puts the company’s
operating margin under structural pressure: the rate of operating profit
growth continues to be less than the rate of sales growth but gradually
improves from 6.1% in 2012 to 6.6% in 2016. In 2016, the rate of profit growth
under method B (6.6%) exceeds the rate under method A (6.5%) as the
negative operating profit mix effect is offset by the positive sales growth
mix effect.

128
Source : CFA curriculum
129
OPERATING COSTS MODELING – SALES,
OPERATING MARGIN, AND PROFIT MARGIN

Question:
• 3. Assume Unilever is able to grow revenues the next five years in each
region in line with 2011 (Asia, Africa, Central and Eastern Europe 10.5%;
Americas 6.3%; Western Europe 0.7%).
• However, operating profit margins in Western Europe will fall 50 bps
annually for the next five years (as a result of high competition and limited
growth) and operating profit margins in Asia, Africa, and Central and
Eastern Europe region will increase 50 bps annually for the next five years
(helped by increasing demand for the company’s products and better utilization
of its factories).
• Using approach (B), calculate the overall operating profit margin.

130
OPERATING COSTS MODELING – SALES,
OPERATING MARGIN, AND PROFIT MARGIN

Solution to 3
• The overall underlying operating profit margin improves from 14.85% in 2011
to 15.24% in 2016 because the margin decline in Western Europe is offset by
the margin increase in the larger and faster growing region of Asia, Africa, and
Central and Eastern Europe.
• Because of the faster revenue growth in Asia, Africa, and Central and Eastern
Europe, the trend for the overall margin enhancement is also positive from 2
bps in 2012 (14.87% − 14.85%) to 13 bps in 2016 (15.24% − 15.11%).

131
Same data
as for
previous
example

Updated
operating
profit
figures
(revenue x
updated
profit
margins)
and resulting
profit growth

Increasing /
decreasing
profit
margins (+/-
0.5%)
132
OPERATING COSTS MODELING – SALES,
OPERATING MARGIN, AND PROFIT MARGIN

Source : Unilever annual report 2016

133
OPERATING COSTS MODELING – SALES,
OPERATING MARGIN, AND PROFIT MARGIN

Source : Unilever website

134
OPERATING COSTS MODELING – SALES,
OPERATING MARGIN, AND PROFIT MARGIN

Source : Unilever website

135
OPERATING COSTS MODELING – SALES,
OPERATING MARGIN, AND PROFIT MARGIN

Source : Unilever website

136
OPERATING COSTS MODELING – SALES,
OPERATING MARGIN, AND PROFIT MARGIN

Source : Unilever website

137
OPERATING COSTS MODELING – INTEREST
RATES

138
OPERATING COSTS MODELING – INTEREST
RATES

Source : CFA curriculum

139
OPERATING COSTS MODELING – INTEREST
RATES

Questions:
• 1. Calculate the interest rate on the average gross debt and interest rate on
the average cash position.
• 2. Calculate the interest rate on the average net debt, assuming the other
financial income and expenses are not related to the debt or cash balances.

140
OPERATING COSTS MODELING – INTEREST
RATES

Solution to 1:
• Interest rate on average gross debt is calculated as interest expense divided
by average gross debt: (€245 million / €3,621 million) = 6.77% or 6.8%.
• The interest rate on average cash position is interest income divided by the
average cash position (€20 million / €2,708 million) = 0.7%.

Solution to 2:
• The interest rate on the average net debt is calculated as net interest expense
divided by average net debt (€225 million / €913 million) = 24.7%.

141
OPERATING COSTS MODELING – TAXES

142
OPERATING COSTS MODELING – TAXES

• ABC, a hypothetical company, operates in Countries A and B.

• The tax rate in Country A is 40%, and the tax rate in Country B is 10%.
• In the first year, the company generates an equal amount of profit before tax in
each country.

Source : CFA curriculum

143
OPERATING COSTS MODELING – TAXES

Questions:
• 1. What will happen to the effective tax rate for the next three years if the
profit in Country A is stable but the profit in Country B grows 15% annually?
• 2. Evaluate the cash tax and effective tax rates for the next three years if the
tax authorities in Country A allow some costs (e.g. accelerated depreciation)
to be taken sooner for tax purposes. The result will be a 50% reduction in taxes
paid in the current year but an increase in taxes paid by the same amount in
the following year (this happens each year). Assume stable profit before tax in
Country A and 15% annual before-tax-profit growth in Country B.
• 3. Now assume that it is Country B not Country A that allows some costs to be
taken sooner for tax purposes and that the tax effect previously described
applies to Country B. Continue to assume stable profit before tax at Country A
and 15% annual profit growth in Country B.

144
Solution to 1:
• The effective tax rate will gradually decline because a higher proportion of
profit will be generated in the country with the lower tax rate. The effective tax
rate declines from 25% in the beginning to 21.9% in the third year.

Source : CFA curriculum

145
Solution to 2:
• The combined cash tax rate will be 15% in the first year and then rebound in
subsequent years. Only the rate for the first year will benefit from a tax deferral;
in subsequent years the deferral for a given year will be offset by the addition
of the amount postponed from the previous year.
• The combined effective tax rate will be unaffected by the deferral. Beginning
with the second year, the combined cash tax and effective tax rates decline
over time but remain identical to each other.

Source : CFA curriculum

146
Solution to 3:
• The combined effective tax rate remains unchanged from previous exhibits.
Because of the growth assumed for Country B, however, the annual tax
postponement will result in a lower cash tax rate in Country B than the effective
tax rate in Country B. Consequently, the combined cash tax rate will be less
than the effective tax rate.

Source : CFA curriculum

147
FORECASTING – FINANCIAL MODELING

• Sales Forecast

• Expenses
• Gross Profit
• Operating Profit

• Assets
• Liabilities

• Cash Flow

148
BALANCE SHEET MODELING

• Forecasts of the balance sheet can be based on relationships of given items

with sales from specific forecasts and/or from ratios.
• Example:
- To forecast the amount of receivables, an analyst can use the days
receivable data from prior periods’ ratio analysis;
- To forecast the amount of inventory, an analyst can use the days inventory
data from prior periods’ ratio analysis;
- To forecast the amount of property, plant and equipment (PPE), an
analyst can use PPE turnover data from prior periods’ ratio analysis and/or
specific forecasts for capital expenditures.

149
BALANCE SHEET MODELING

• Balance sheet modeling is the process of forecasting a company’s balance

sheet based on the following:
- Items that flow from the income statement (e.g. retained earnings).
- Items that vary with revenues (e.g. accounts receivable).
- Items that are the result of investment or financing decisions (e.g. gross
plant, property, and equipment).
• Items affected by the level of revenues can often be forecasted by using
historical or projected efficiency (e.g. turnover) ratios.
• Forecasts of long-term assets are a function of forecasted capital
expenditures and depreciation. Capital expenditures include:
- Maintenance capital expenditures (needed to sustain the business).
- Growth capital expenditures (needed to expand the business).

150
BALANCE SHEET MODELING

• Income statement modeling is the starting point for balance sheet and cash
flow statement modeling. Generally, if an analyst models the income statement
and either the balance sheet or cash flow statements, the third statement
results directly from the first two statements.
• Using forecasted income statement and balance sheet accounts, one can
evaluate the company’s forecasted profitability. Useful measures of
profitability include:
- Return on invested capital (ROIC).
- Return on capital employed (ROCE).
• Because of the uncertainty associated with forecasting, analysts can use
sensitivity analysis or scenario analysis to evaluate the forecasted
profitability.

151
BALANCE SHEET MODELING

Question:
• 1. The management at a restaurant chain intends to maintain a 40% debt-to-
capital ratio. The management has a track record of meeting its capital
structure targets. The restaurant chain is solidly profitable, but earnings are
expected to decline 2% annually over the next five years because of
increasing competitive pressure. The company does not pay a dividend or
repurchase shares, and all earnings are expected to be retained for the next
five years. What is most likely to happen to the restaurant chain’s total debt
over this period?
- A. Total debt will increase.
- B. Total debt will decrease.
- C. Total debt will remain the same.

152
BALANCE SHEET MODELING

Solution to 1:
• A is correct. The restaurant chain is profitable and retains all of its earnings.
These facts will lead to rising equity on the balance sheet. To maintain a
constant debt-to capital ratio, management will have to increase its debt (n.b.
the 2% earnings decline is not relevant for this question).

153
BALANCE SHEET MODELING

Question:
• 2. Sophie Moreau, a buy-side analyst, is analyzing a French manufacturing
company. Working capital (CA - CL) and PP&E segments account for almost all
of the company’s assets. Moreau believes that the depreciation schedule used
by the company is not reflective of economic reality. Rather, she expects PP&E
to last twice as long as what is implied by the depreciation schedule, and as
such, she projects capital expenditures (CapEx) to be significantly less
than depreciation for the next five years. Moreau projects that both earnings
and net working capital will grow at a low single-digit rate during this time.
What do Moreau’s assumptions most likely imply for returns on invested
capital during the next five years?
- A. ROIC will increase.
- B. ROIC will decrease.
- C. ROIC will stay the same.

154
BALANCE SHEET MODELING

Solution to 2:
• A is correct.
• Earnings are expected to grow over the next five years. Working capital is
expected to grow in line with earnings, which would imply a stable ROIC.
• Net PP&E is expected to decline because depreciation is expected to exceed
capital expenditures. Total invested capital (i.e. no need to invest as much) will
thus grow more slowly than earnings or even shrink, implying improving
returns on invested capital.

155
FORECASTING – FINANCIAL MODELING

• Sales Forecast

• Expenses
• Gross Profit
• Operating Profit

• Assets
• Liabilities

• Cash Flow

156
FORECASTING CASH FLOWS – AN
INTRODUCTION

• The amount of forecast liabilities would typically be a result of cash flow

requirements (financing needs) determined after projecting cash flow from
operations minus cash needed for working capital and fixed capital (PPE).
• The level of operating cash (i.e. an amount of cash needed for day-to-day
operations) is usually an input to forecasts, but change in cash is an output.
Change in cash can be an interim output because the amount of borrowing is
determined by the amount of cash flow before incremental borrowing.
• Forecasts typically involve iterations (circularity) because the amount of
borrowing is a function of cash flow requirements, which are a function of
earnings and taxes, which depend on income net of interest expense, and
interest expense is a function of the amount of borrowing.

157
COURSE PROGRESSION
Applicable laws and professional standards ✓ Weeks
Economic analysis ✓ 1-4
Market analysis ✓
Industry analysis ✓
Financial statements and information outside of f/s ✓
Weeks
Analytical tools and techniques for financial analysis ✓ 5-8
Strategic financial modeling and forecasting
Quality of earnings and financial statements
Analysis of industrial companies Weeks
Analysis of insurances and pension funds 9-11

Analysis of banks and financial companies

Sustainable analysis – ESG, SRI and Governance Weeks
Technical analysis and investment timing 12-14

Behavioral analysis and investment biases

158