CORPORATE FINANCE 2

2122_S01_PGE_M2_FIN_0622_E_L_BOD_TEM

Jeanne METIVIER
Professor of Corporate Finance
jeanne.metivier@kedgebs.com

25/02/2019
 References

• Berk J., Demarzo P., (2017). Corporate Finance,

4ème édition, Pearson Education

• Vernimmen P., Dallochio M., Quiry P., (2018).

Corporate Finance: theory and practice, 5th
edition, J Wiley&sons.
 Course structure overview
I. Basic notions

II. Seasoned Equity Offering

III. Valuation of equity and IPO

IV. Internal financing, dividend policy, share buyback

V. Capital budgeting decisions

VI. Mergers and acquisitions

 Grading system

• Final exam (75% of final grade)

Date: December 8th
12PM-3PM

• Collective assignment (25% of final grade)

4-5 students max
Deadline: December 8th, by noon (12PM)

No resit exam
Any questions?
 The three main financial statements of a company
The balance sheet The income statement The cash flow statement
Reports stocks at a Flow statements which measure the flow of transactions
particular moment over a period of time

o The balance sheet shows the current finance position (assets, liabilities, and
stockholders’ equity) of the firm at a single point in time.

o The income statement reports the firm’s revenues and expenses, and it
computes the company’s bottom line of net income over a given time
interval.

o The statement of cash flows reports the sources and uses of the
firm’s cash during a given time period.
 The three main financial statements of a company
The balance sheet The income statement The cash flow statement

What you should know about the balance sheet:

o The two sides must balance:
𝐴𝑠𝑠𝑒𝑡𝑠 = 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 + 𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟 ′ 𝑠 𝑒𝑞𝑢𝑖𝑡𝑦
o There are 2 ways of analysing the balance sheet:
- capital-employed analysis
- solvency-and-liquidity analysis
o The firm’s net operating working capital (NOWC), which is the capital
available in the short term to run the business, is the difference between
the firm’s current assets and current liabilities.
Excluding cash and debt, key components of OWC are accounts receivable,
inventory, and accounts payable.
 The three main financial statements of a company
The balance sheet The income statement The cash flow statement

Capital-employed analysis Solvency-and-liquidity analysis

Equity
All uses All sources
List of assets
of funds of funds
List of all
liabilities

The capital
How this capital Everything that Everything that
employed in the
is financed a company owns it owes
operating cycle
 The three main financial statements of a company
The balance sheet The income statement The cash flow statement

Capital-employed analysis Inventories 5,135

Receivables 6,134
Working capital 11,269
Carrera consolidated balance sheet (thousands of €) - (Payables) (3,931)
2019
The capital
employed in the Fixed assets 2,408 Net Operating Working Capital 7,338
Net Operating Working Capital 7,338
operating cycle
Operating capital 9,746

Shareholder’s equity 6,939

How this capital Net debt 2,807 Debt to banks and other debts 2,812
is financed Operating capital 9,746 (Cash and equivalents) 5

Net debt 2,807

Highlight:
• A company’s net debt can either be positive or negative.
• If it is negative, the company is said to have NET CASH.
 The three main financial statements of a company
The balance sheet The income statement The cash flow statement

Solvency-and-liquidity analysis
Carrera accounting reports (thousands of €) - 2019

Net fixed assets 2,408

What Carrera owns Total inventories 5,135
Receivables 6,134
Cash and equivalents 5
Total assets 13,682
To its stockholders
What Carrera owes Total stockholders’ equity 6,939
To its creditors Total liabilities 6,743
Operating capital 13,682

Highlight:
• The net fixed assets are reflected at cost less accumulated depreciation, hence the
term net.
 The three main financial statements of a company
The balance sheet The income statement The cash flow statement

Solvency-and-liquidity analysis

Assets = Liabilities + Equity

€13,682 = €6,743 + €6,939

The residual What Carrera owes to its

€6,939
shareholders (Equity)
€13,682 Equity
The net book value=Assets-Liabilities reflects the claim
of shareholders
€6,743
Assets Liabilities What Carrera owns
(Liabilities)

Note: the term liabilities and debt are used indifferently

What Carrera owns
(Assets)

Carrera owns €13,682 in assets of which it owes €6,743 to various creditors.

 The three main financial statements of a company
The balance sheet The income statement The cash flow statement

What you should know about the income statement:

• The income statement shows how profitable the firm has been over a
period.
• The firm’s operating income is equal to its revenues less its costs of goods
sold and operating expenses.
• After adjusting for other non-operating income and expenses, we have the
firm’s Earnings before Interest and Taxes (EBIT), also called Operating
Income.
2018 data
Carrera’s income statement at a glance

Gross margin

Net income = Sales - cost of sales - operating costs + financial + exceptional - taxation
income, net income, net
EBIT = Operating Income
Deduced from Net income because
it reflects an exceptional loss
€ 5,515

€ 1,440 = € 9,995 - € 4,480 - € 3,280 + € [9] + € [74] - € 712

€ 2,235
Deduced from Net income because
it reflects a financial loss

Exceptional income 113

Financial income 24 (Sales of assets, see Appendix)
Financial expense [33] Exceptional charge [187]
(Interest paid) (Sales of assets, see Appendix
Financial income, net [€ 9] Exceptional income, net [€ 74]

Note. Brackets indicate a change in sign, financial Note. The terms exceptional and nonrecurrent
expense is deduced from financial income. are used indifferently.
 From Sales to Operating income

These transactions are recorded when the goods and

9,995 Sales services are delivered to the customer and not when
Note. The term revenues, sales and turnover are customers actually pay.
used indifferently

All costs incurred in the factory to convert rawmaterial

4,480 Less: cost of sales to finished goods (also called product costs).

€ 5,515 Gross margin The excess of sales and cost of sales

3,280 Less: operating costs Selling, administrative and other expenses

Reflects the profit attributed

€ 2,235 Operating income
to operating activities before
or EBIT (Earnings Before Interests and Taxes) tax and any financial items.

This measure is unaffected by the way the firm is financed (but its drawback is that it is before tax).

Highlight:
o A measure not reported by companies called EBIAT (Earnings Before Interest After Tax) or
NOPAT (Net Operating Profit After Tax) avoids this problem :
EBIAT or NOPAT = EBIT x (1-T) where T is the corporate tax rate
 The bottom line of the income statement is the Net income
▪ Reflects the net effect of financial transactions on income.
€ [9] Add: Financial income, net
▪ Carrera earned less financial income than it paid interest
during 2018 (negative financial income, net).

€ 2,226 Income before income tax and exceptional items

This represents a sub-total on the income statement which is :
EBIT (Operating Income) 2,235
Add: Financial income, net [9]

Income before taxes and exceptional items € [2,226]

€ [74] Add: Exceptional income, net

712 Less: Income tax

Reflects income after absolutely everything (this amount

€ 1,440 Net income is legally available for distribution as a dividend).
The net income is available to stockholders
 EBITDA is a key indicator in the analysis of income statements

EBITDA stands for Earnings Before Interest, Tax, Depreciation and Amortization.
EBITDA is extensively used by analysts worldwide because it is:
• Not affected by the accounting policies applied to tangible and intangible fixed assets (calculated
before depreciation and amortization)*.
• Not affected by the financial policy of the company (calculated beforeinterests).
• Not affected by the domestic taxation system of the company (calculated beforetax).

Carrera data
2017 2018 2019
EBIT (Operating profit) 1873 2235 2761
Add back: Depreciation and amortization 207 519 653

EBITDA 2080 2754 3414

*Depreciationand amortization reflect arbitrary accounting assessments of a loss in value of fixedassets

This may leave financial analysts rather blind-sighted.
 EBITDA margin

EBITDA margin is a measurement of a company's operating profitability as a

percentage of its total revenue.
A financial analyst should explain why a company’s
EBITDA margin expanded or contracted by x points
between one period and the next.

Carrera’s data
2017 2018 2019 Trend
EBITDA margin 27.6% 27.5% 19.2% An overrun on production costs

Competitive pressure is making it increasingly hard for

Carrera to keep its EBITDA margin moving in the right direction

2017 2018 2019

Operating costs 5,672 7,760 14,976
(Fixed + Variable)
+36.8%
+36.8% +93%
+93%

Note. Operating costs = Cost of goods sold + Distribution and Marketing expenses + Administrative expenses (see Appendix 4)
 The three main financial statements of a company
The balance sheet The income statement The cash flow statement

What you should know about the cash flow statement:

• The statement of cash flows reports transaction that have affected the
cash amount of the firm during the period under review.
• The statement of cash flows shows the cash used (or provided)
from operating, investing, and financing activities.
 2018 data The cash flow statement at a glance

Carrera: Consolidated Statement of cash flows
Cash flow from operations
Less: Investments
Minimum new funding required
Actual new funding
Net increase in cash
Investments of €1,515 far exceeded the cash flow
from operations of €391 which therefore required a
391 net inflow from outside financing of €1,124.
[1,515]
The so-called Free cash flow equals [€1,124]. As it
[1,124]
is negative, it denotes a cash flow shortfall.
1,535
€ 411 It turns out that Carrera acquired new funding of
€1,535 to fund this cash flow shortfall, the excess of
€411 went to increase the cash at the bank.

Where do Investments of €1,515 come from? Where does the actual new funding
of €1,535 come from?
Investment of fixed assets 1,628
Less: Sales of assets 113 Equity issuance 1,975
Net purchase of fixed assets €1,515 Less: Dividends paid [440]
Actual new funding €1,535

€1,515 is the cash amount used for investing activities

• Equity issuance (Additional cash flow raised by issuing new shares) is a

cash inflow to the equity markets.
• Dividends paid are a cash outflow to the equity markets (shareholders)
 2018 Snapshot: The free cash flow equation

Free cash flow = Cash flow generated - Cash flow used

(FCF) from operations for investments
€ [1,124] = € 391 - € 1,515
FUNDING
SHORTFALL More is spent on investments than was
generated in cash from operations

Carrera has had to raise additional capital to fund thisdeficit.

This was all provided by issuing new shares.

Proceeds from equity issuance 1,975 Additional cash flow raised

Less: Dividends paid [440] by issuing new shares

Cash provided by financing activities € 1,535

Highlights:
o “Free” cash flows means those cash flows that are available to equity and debt holders after
consideration for taxes, capital expenditures or CAPEX, and net OWC needs (positive Δ OWC).
 The free cash flow situation is worsening in 2019

Carrera: Statement of Cash Flows

Carrera’s free cash flows becomes highly
2017 2018 2019
negative:
Free cash flow 1,030 -1,124 -3,867 FUNDING SHORTFALL
Financial decision made by Carrera?

In 2018, Carrera raised additional capital to fund a first deficit of €1,124 by issuing
new shares for an amount of €1,975.

o Problem: Not enough to fulfill the increasing need of financial resources.

Carrera goes into debt for a net amount of €2,807 at end of 2019 (see the Net debt at end of
accounting period in the Statement of Cash Flows, 2019)

o This net debt of €2,807 should be compared with the net cash flow of €2,550
generated by Carrera the same year (see the Net cash flow in the Statement of Cash
Flows, 2019).
o Such a net debt of € 2,807 is not a problem if and only if Carrera’s cash flow does
not shoot dramatically in the near future.
 A guide tour of the Cash flow statement in three steps

Core question: Is cash used for or generated from each of

the three following activities?
Cash flow statement

1. Operating activities End result: Net cash provided

by operating activity (Carrera,2018: € 391).

2. Investing activities End result: Net Investing flow

(Carrera, 2018: € 1 515).

3. Financing activities End result: Net change in Cash

(Carrera, 2018: € 411).
 2018 A guide tour of the Cash flow statement (1st step)
Cash flow from operating Cash flow from investing Cash flow from financing
activities activities activities
“Non-cash” items are non-operating items included in the net
Net income 1,440 income but that do not involve any cash transactions.
Add: Non-cash items 593
Carrera: Balance Sheet
Net cash flow 2,033 2017 19199898
2018 Δ
19199797
Less: Change in net working capital [1,642] Netwoworki
NeNett working capitall
rkinngg 602 2,244
capcapitalital +1,642
2,242,2444
606022 +1,6+1,64242
Net cash provided by operating activities € 391 This increase (or investment) in net working
This increase
capital (or investment)
decreases in net
cash flow from working
operations
capital decreases cash flow from operations
This is the cash GENERATED internally
If negative, cash USED by operations

Where do the non-cash items of € 593 come from?

Depreciation and am ortization 519 Depreciation and amortization are ADDED BACK
Add: Loss on sale of fixed asset 74 to net income because they enter into the
determination of net income (they represent a cost
Non-cash item s 593 allocation) but do not require an outflow of cash.

Note. It is quite usual for Depreciation and amortization to be the most significant non-cashitem.
 Snapshot: D&A are NON-CASH subtractions from EBIT
D e p r e c iation Accounting definition
and T h e p r o c e s s w h e r e b y t h e c o s t of a fixed a s s e t is a l l o c a t e d
D&A
to t h e profit a n d l o s s ( i n c o me s t a t e me n t ) o v e r its u s e f u l life
amortization

T h e y e n t e r into t h e d e t e r m i n a t i o n of n e t i n c o m e ( t h e y r e p r e s e n t
non-cash item a c o s t allocation ) b u t d o n o t r e q u i r e a n o u t f l o w o f c a s h

Operating income (EBIT) = € 2,235 C a u s e s i n c o m e ( i n c o me s t a t e me n t ) a n d c a s h f l o w

Operating cash flows = € 391 f r o m o p e r a t i o n s ( c a s h f l o w s t a t e me n t ) to b e different

Carrera’s 2018 data (Consolidated income statement)

Sales 9,995
1 Less: Cost of sales 4,480
D e p r e c ia t i o n
2 Less: Selling a n d marketing costs 961 €519
and
3 Less: Administrative costs 2,319 amortization

Non-cash subtractions from

E B I T (operating income) € 2,2 3 5
operating income (EBIT)

Examples

1 Production machinery
A part of depreciation e x p e n s e for
€519 2 Car used by the sales team
a tangible as s et is allocated to
Accounting department’s
3 computers
 Snapshot: The Gain (Loss) on asset disposal is also a NON-CASH transaction

The +/- Capital losses/gains on sales of fixed assets* accounting rule is the following:

A GAIN must be DEDUCTED from net income and a LOSS must be ADDED Yes, there is a
BACK to net income to determine cash flow from operatingactivities. logic behind!

1- The case of a Gain

Income Statement (toy example )
This NON-CASH transaction increases
Revenues (Sales) 100 000
taxable income and thus the Net Income.
Less: Expenses (all costs incurred) 20 000
Operating profit (EBIT) 80 000
As a result, Net Income is over-stated
Gain by € 2000 by this non-cash transaction.
Other Income/Expenses
Gain (Loss) on asset disposal 2 000
Therefore, you must SUBSTRACT this non-cash
Net Income Before Taxes 82 000 transaction on the Cash Flow Statement to
compensate for the over-statement of Net Income.
Taxes 5 000
Net Income 77 000

*Sales of fixed assets are also called “asset disposal”

 This NON-CASH transaction decreases
taxable income and thus the Net Income.
2- The case of Carrera (2018) Loss
As a result, Net Income is under-stated
Income Statement (Carrera, 2018)
by € 74 by this non-cash transaction.
Revenues (Sales) 9 995
Less: Expenses (all costs incurred) 7 760
Operating profit (EBIT) 2 235 Therefore, you must ADD BACK this non-cash
transaction on the Cash Flow Statement to
Other Income/Expenses compensate for the under-statement of Net Income.
Financial Income, net -9
Loss Cash Flow Statement (Carrera, 2018)
Gain (Loss) on asset disposal - 74 Net Income 1 440
+ Depreciation + 519
*
Net Income Before Taxes 2 152 +/- losses/gains on asset disposal + 74
Taxes 712 Net Cash flow (1) 2 033
Net Income 1 440 Change in working capital (2) 1 642
Net cash provided by operating
activities (1) + (2) 391

Note. The “Net” Cash flow is net of NON-CASH items, i.e., restated for non-cashitems.
*Calculated before tax and AFTER exceptional items.
 Snapshot: From OWC to the change in OWC (Δ OWC)

O W C and net O W C If positive, net working capital needs to be

Inventories
financed
Uses of funds Change
Receivables NOWC If negative, it represents a source of funds
Operating working capital generated by the operating cycle
Less: Payables Sources of funds Highlight: Some sectors benefit from a negative OWC: transport
(you buy your airline ticket in advance), media (subscription to pay
Net operating working capital TV, cable channel provider, or magazine), food retail.

Net balance of operating Reflects the cash required to cover financing

The capital
uses and sources of funds shortfalls arising from day-to-day operations available in the
short term to
Carrera's Balance Sheet run the business
2017 2018 2019
Net OWC 602 2,244 7,338 Refers to an INCREASE in net OWC

Δ net OWC2018= €1,642 Carrera's Cash Δ net OWC2019 = €5,094

Flow Statement

A positive change in net OWC represents a financing requirement

If negative, it represents a source of funds Refers to a REDUCTION in net OWC
 Change in Operating Working Capital and Operating cash flow
Year: 2018
What impact on operational cash flows?
D e c r e a s e s c a s h flow
Cash used € 1, 643
f r om oper at ions
Cash Flow
Δ IInventor
nvent o r iie
ess
Cash flow from
from
€ 688 D e c r e a s e s c a s h flow
Cash used
f r om oper at ions
operating
operations

Δ R
Reecceeiivvaabblleess a c t i vi t i e s
€ 391
Cash provided € 689 I n creases c a s h flow
f r om oper at ions

Δ P
Paayyaabblleess

T o t al c a s h p r o v i d e d bbyy T o t al c a s h u s e d b y c u r r ent
c u r r e nt a s s e t s a n d liabilities a s s e t s a n d liabilities
€ 689 € 2,331

C h a n g e in wor k i ng capital
I n v e s tm e n t i n n e t
T h i s i n c r e a s e in n e t
w o r k i n g c a pi ta l
€ 1,642 w o r k i n g capit al d e c r e a s e s
cash flow from operations
 Snapshot: From Net cash flow to Cash flow from operations
Delivery date Payment date
Carrera's Cash Flow Statement (2018)
Time

Δ Net working capital Cash flow from

Net cash flow
[1,642] operations
2,033
391

Operating cycle
• By that time, SALES are recorded in the
income statement and thus generate an Timing differences
Why are there timing differences between
EARNING and NOT a cash flow. between operating operating outflows and inflows?
outflows and the
• By that time, they represent non-cash corresponding These timing differences are due to the
transactions included in net income. operating inflows time it takes to manufacture and sell
• SALES generate potential cash flows. products or services (inventories), and
the firm’s commercial policy (customer
and supplier credit).
Highlight:
o Since revenues and costs in the income statement are recognized when goods and services
are INVOICED (i.e. delivered to the customers: The delivery date), there is a lag between
a transaction being recognized in the income statement and it passing through the bank as
CASH (i.e. when customers actually pay:The payment date).
 2018 A guided tour of the Cash flow statement (2nd step)
Cash flow from operating Cash flow from investing Cash flow from financing
activities activities activities

Investment in fixed assets 1,628 Purchases: Capital expenditure or Capex

Less: Sale of fixed assets [113] Disposals: the PRICE at which fixed assets are sold

Net investing flow € 1,515 Cash used for investing activities

If negative, the firm has disinvested

Highlight: Where does the Investment in fixed assets of € 1,628 come from?

Year 2017 2018 2018 2018 2018

816 1,628 519 187 1,738

?
Net plant & Depreciation Net plant & 816 + Investment - 519 - 187 = 1,738
equipment Appendix equipment
Balance Investment = 1,628
Balance Sales of
sheet assets sheet
Assets net
book value
Income
statement
 2018 A guided tour of the Cash flow statement (3rd step)
Cash flow from operating Cash flow from investing Cash flow from financing
activities activities activities

• What does this section of the cash flow statement reveal?

It reveals that Carrera has had to raise additional capital to fund its deficit between cash
flow from operations and investments.

• Cash provided by / used for financing activities. How is it calculated?

Balance sheet (Accounting reports)

2018 2017
Proceeds from equity issuance 1,975 1,200 Capital Capital 1,000
Cash inflow from the equity markets + + - + +
2,275 Issuance premium Issuance premium 500
Less: Dividends paid [440]
Cash outflow to the equity markets
Proceeds from equity issuance
Cash provided by financing activities € 1,535
1,975
if negative, cash USED for financing activities
 Snapshot: Explaining the Net change in cash
Carrera: Consolidated Cash Flow Statement
Free cash flows (1,124)

Add: Equity issuance 1,975 Net cash provided by financing

Less: Dividends paid (440) activities
This represents the surplus of finance raised (€1,535) and
Net change in cash €411
finance required (€1,124: Funding shortfall) and is
reflected in an increased cash balance which is similar to
an investment in cash
We can also compute the Net change in cash from the Balance sheet
Carrera’s Consolidated Balance Sheet
Cash and equivalents (2017) 1,095

Cash and equivalents (2018) 2,050

Increase in cash 955

Debts to bank and other debts (2017) 0 Net change in cash: €411

Debts to bank and other debts(2018) 544 Balance sheet: Accounting reports
Short term debt 44
Increase in Debts to bank and other debts 544
Long term debt 500
Debt to banks and other debts €544
 Snapshot: A negative net debt means that the company is cash-rich

Carrera: Consolidated Balance Sheet Consolidated Statement of Cash Flows (2018)

F r e e c a s h flows [1,124]
Net debt (2018) [1,506]
A d d : Equity i s s u a n c e 1,975
Less: Net debt (2017) [1,095]
L e s s : D i vi d e n d s paid [440]
Change in net debt €[411]
€[411] N e t c hNa en tg e
c hin
a ncgaes hin c a s h €€ 441111

If net debt is negative, the Net increase

in cash
firm is said to have net cash
Consolidated Statement of Cash Flows (2018)

Net debt at beginning of accounting period (1,095)

Net debt at end of accounting period
Change in net debt
We can also use the two bottom
(1,506)
lines of the Cash flow statement to
compute the Change in net debt
€(411) *

Highlight:
o The change in net debt and the net change in cash are two sides of the same coin.
They are always equal but of opposite sign.

* € [411] = -1,506 - (- 1,095)

Why is it necessary for you? Because as a global manager, you
must be able to explain how a company can create value and to
determine whether it is solvent.

What is the pedagogical objective? To equip you with the ability to

evaluate a firm in one of two ways:
• Compare the firm with itself by analyzing how the firm has
changed over time.
• Compare the firm to other similar firms using a common set of
financial ratios.
 In short, what is financial analysis?

o Financial analysis consists of uncovering hidden realities.

o The golden rule of financial analysis: Looking behind the numbers.

The four key dimensions of financial analysis

1. Profitability analysis: How profitable is the company?

2. Efficiency analysis: How effective is the company?
3. Liquidity analysis: How liquid is the company?
4. Financing analysis: How is the company financed?
A roadmap of a standard plan for a financial analysis

Source: adapted from Vernimmen, P., Quiry,

P., Dallocchio, M., Le Fur, Y., & Salvi, A.
(2014). Corporate finance: theory and
practice. 4th Ed., John Wiley & Sons.
 What are key indicators of a financial analysis?

Profitability analysis : How profitable is the firm?

• Profit margin
• Gross margin
• Operating margin
• Return on Capital Employed (ROCE)
• Return on Equity (ROE)

Efficiency analysis : How effective is the firm?

• OWC turnover ratio
• Day’s sales in receivables (DSR) or “Receivables”
• Day’s sales in payables (DSP) or “Payables”
• Inventory days

Liquidity analysis : How liquid is the firm?

• Current ratio
• Quick ratio
Financing analysis : How the firm is financed?
• Debt-to-Equity ratio
• Debt ratio
• Leverage effect
 Assessing Carrera’s financial health
Profitability ratios Efficiency ratios Liquidity ratios Financing ratios

Profitability analysis : How profitable is Carrera?

1 Profit margin Gross margin Operating margin
2 Return on capital employed (ROCE) Return on equity (ROE)

• What is the difference between profitability and margins?

The ratio of profits to the capital that had to be invested
PROFITABILITY
to generate the profits, e.g., ROCE and ROE above.
MARGINS The ratio of earnings to business volumes (sales),
e.g., Profit, Gross, and Operating margins above.

Highlight:
o If no capital is invested, there is no profitability to speak of.
 Profitability analysis : How profitable is Carrera?
1 Profit margin Gross margin Operating margin

• The net profit margin shows the fraction of each euro in revenues (sales)
that is available to equity holders after the firm pays interest and taxes.

The net profit margin is the ratio of net income to revenues (sales)

2018 data:
𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒 1,440
𝑁𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 % = = = 14.4%
𝑆𝑎𝑙𝑒𝑠 9,995

• The profit margin measures how profitable the firm has been with respect to sales.
• This shows that for every €100 generated in revenues there remained €14.4 in income.

Highlight:
o The profit margin is based on the bottom line of the income statement and so is
affected by all types of costs (major changes in costs cannot be identified).
 Profitability analysis : How profitable is Carrera?
Profit margin Gross margin Operating margin

• A firm’s gross margin reflects its ability to sell a product for more than
the cost of producing it.

The gross margin is the ratio of gross profit (Sales - Cost of Goods Sold) to revenues (sales)
2018 data
Gross margin € 5,515
Gross margin % = = = 55.2%
Sales € 9,995

• The gross margin reflects the firm’s pricing policy and shows profit margin on sales
over and above the direct cost of sales (i.e., the cost of goods sold).

• It indicates the extent to which the firm is able to charge a mark-up (an increase of
price).
 Profitability analysis : How profitable is Carrera?
Profit margin Gross margin Operating margin
• Because there are additional expenses of operating a business beyond the direct costs
of goods sold, another important ratio is the operating margin:
The operating margin is the ratio of operating income (EBIT) to revenues(sales)
2018 data

EBIT = € 2,235
Operating margin % = = 22.4%
Sales € 9,995

How has Carrera

Operating profit in % of changed over time? 2017 2018 2019
sales for leading listed
European companies Operating margin 24.8% 22.4% 15.6% Why?
(Source: Exane BNP Paribas) Sector : Video game 22.5% 25.6% 21.5%

• Distribution and marketing expenses are booming

+20% in 2018 and +153% in 2019 (See Appendix 4: Breakdown of operating costs).
• The development cost of new products is constantly increasing
€1,5m per product in 2019 (Data displayed in the case study).
 Profitability analysis : How profitable is Carrera?
2 Return on capital employed (ROCE) Return on equity (ROE)

• Investors and managers often are more interested in the profits earned on
capital employed or invested than in the level of profits as a percentage of
sales (margins). The answer is provided by the ROCE or ROIC.

• The return on capital employed (ROCE), also called the return on

invested capital (ROIC) measures the after-tax profit generated by the
business itself, excluding any interest expenses (or interest income), and
compare it to the capital raised from equity (Book value) and debt holders
that has already been deployed (i.e., not held as cash).
 The ROCE measures the profitability of capital employed or invested

Operating profit after tax or After-tax EBIT

2018 data:
𝐸𝐵𝐼𝑇 ∗ (1 − 𝑇𝑎𝑥 𝑟𝑎𝑡𝑒) €1,495
𝑅𝑂𝐶𝐸 = = = 37.5%
𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑 €3,982

Economic profitability

Data from the Income statement Data from the Balance sheet
€1,495 €3,982
Operating profit after tax Total Operating Capital
€2,235*(1-33.1%)
Where does the corporate income tax Tc=33.1% Fixed assets (€1,738) Stockholders’
come from? + equity (€5,489)
Net operating +
Tc=Income taxes/Net income BEFORE taxes Working capital (€2,244) Net debt (€-1,506)

2018: Tc=712/2152=33.1%
where 2,152=1440+712or equivalently 2,226-74 Capital employed (€3,982) Capital invested (€3,982)

ROCE ROIC
 Snapshot: Another way to compute the ROCE

Notes.
(1)The Net operating margin above (14.95%) is very close to the previous Net profit margin (14.4%) simply because the
operating profit after tax or after-tax EBIT (1,495) is almost equal to the Net income (1,440). Of course, tis is not always
the case.
(2) The asset turnover 2.5 is a multiple, i.e., not expressed in monetary units, but the end result of €1 x 2.5 of course is €.
 Snapshot: Two different roads to the same ROCE

ROCE = Net operating margin * Asset turnover

It indicates the amount of total
operating capital required to
generate a given level of sales.
2004 data

Ryanair 17.4% = 24.8% * 0.7

High margins Low asset turnover
High capital intensity

Nestlé 17.6% = 10.0% * 1.8

Smaller margins High asset turnover
Weak capital intensity

Although Ryanair and Nestlé generate a similar ROCE, their net operating
margin and asset turnover are entirely different.
 Profitability analysis : How profitable is Carrera?
Return on capital employed (ROCE) Return on equity (ROE)

• Shareholders are concerned with how profitable the firm is, not per € on the
capital employed (ROCE), but per € of stockholders’ equity (ROE).

• ROE shows how hard stockholders funds are working.

• The trend in ROE is actually the most volatile of any of the other profitability
measures. This increased volatility we will see is caused by leverage.

Highlight:
o The return on equity (ROE) is also called the ‘investor ratio’.
 ROE shows how hard stockholders’ funds are working

2018 data
Net income € 1,440
ROE = = 26.2%
Stockholders’ equity € 5,489
It means that for every €100 of
Financial profitability stockholders’ equity, Carrera made
€ 26.2. Is this adequate?

• It is difficult to answer: 26.2% is certainly better than closing the business

and placing the € 5,489 (stockholders’ equity) in the bank. However, there
are two concerns with this comparison:

1. As a shareholder you will not receive the €26.2 in the €100 but only a smaller
dividend return (the rest will be invested and be available in future dividends).
2. ROE is in book value terms and does not reflect what you would have to pay
for your share of the equity (market value of equity).
 Assessing Carrera’s financial health
Profitability ratios Efficiency ratios Liquidity ratios Financing ratios

Efficiency analysis: How effective is Carrera?

Operating working capital Day’s sales in receivables Day’s sales in payables
turnover ratio (DSR) (DSP)
Inventory days

• We can use the combined information in the firm’s income statement and
balance sheet to gauge how efficiently the firm is utilizing its operating
working capital (OWC).
• The efficiency ratios are measures which attempt to evaluate how effectively
capital is employed within the firm.
• The emphasis is on the scale of business generated off the capital base rather
than on profitability directly.
 2018 data Efficiency analysis : How effective is Carrera?
Operating working capital Day’s sales in receivables Day’s sales in payables
turnover ratio (DSR) (DSP)

Inventory days

Net OWC totals 71 days

of Carrera’s sales
OWC Net OWC € 2,244
turnover = x 365 days = X 365 days = 71 days
ratio Annual sales € 11,494
(inclusive of VAT)

It means that 19.5% of Carrera’s annual sales volume is

A very often used
benchmark is 25% 19.5% “frozen” in inventories and customers receivables not
(high) financed by supplier credit.

Highlight: Interpreting 19.5%

19.5% from a practical point of view
o At any moment, Carrera needs to have on hand funds equal to 19.5% of its annual sales
to pay suppliers and employee salaries for materials and work performed on products that
have not yet been manufactured, sold or paid by customers.
 Snapshot: Sales must be calculated inclusive of value added tax (VAT)

o This rule holds true each time you compute a ratio involving both a component
of OWC and sales. Why?

• The components of OWC (Inventories, Receivables, and Payables)

are shown:

inclusive of VAT in the balance sheet,

but sales are registered exclusive of VAT in the income statement.

To ensure consistency, sales must be computed on the

same basis and thus increased by the applicable VAT rate.

o Average VAT displayed in the Carrera case study = 15%

 The golden rule of OWC management

The OWC turnover ratio should remain stable over time

Carrera 2017 2018 2019

Working capital turnover ratio 25 days 71 days 131 days

Working capital in % of sales 6.9% 19.5% 36%

Sector: Video games -4% 25% 3%

A negative working capital is due to a favorable mismatch (firms receive the proceeds of
their sales before paying for all their production costs)

Contrary to its competitors, Carrera does not benefit from a negative working capital

Carrera 2017 2018 2019

Warning:
Operating working capital Operating working capital 602 2,244 7,338
+273% +227%
increases faster than sales Sales 7,545 9,995 17,738

+33% +78%
 Warning! The OWC increases faster than sales

1 Operating working capital (OWC) increases faster than sales

As a reminder:
Net cash flow
2 Operating cash flow becomes negative
- Δnet OWC
Operating cash flow = Operating cash flow
2017 2018 2019
€1,427 €391 - 2,544

3 The explanation lies in the change in net OWC

Inventory days Day’s’ sales in receivables

2017 2019 2017 2019
109 days 195 days 39 days 100 days

Due to difficulty to sell certain products Due to increasing pressure from distributors
An OWC increasing faster than sales is typical of fast-growing companies

A quick look at Carrera’s growth

Carrera Video game industry
Average annual
+55% rate of growth +20% Data from the
case study
2017 -2019

Carrera is a fast-growing company

Where does +55% come from?

2017 2018 2019
Sales 7,545 9,995 17,738

+32.5% +77.5%
The average annual growth rate of
Carrera over 2017-2019 is 55%
Average = +55%
 2018 data Efficiency analysis : How effective is Carrera?
Operating working capital Day’s sales in receivables Day’s sales in payables
turnover ratio (DSR) (DSP)

Inventory days

• To evaluate the speed at which a company turns sales into cash, analysts often
compute the number of accounts receivable days – that is, the number of days’
worth of sale accounts receivables represents.
• The DSR ratio compares receivables to sales so as to estimate how efficiently
payments are received from customers. It measures the average payment terms
the company grants to its customers.

Highlight: Interpreting the DSR ratio from a practical standpoint

o In 2018, Carrera’s receivables represent 41 days’ worth of sales. In other words, on average,
Carrera takes just over a month to collect payment from its customers.
o The lower the DSR the faster cash is collected
 2018 data Efficiency analysis : How effective is Carrera?
Operating working capital Day’s sales in receivables Day’s sales in payables
turnover ratio (DSR) (DSP)
Inventory days

• Similarly, the DSP ratio estimates the average of day’s credit taken from suppliers.
The average length of time Carrera
takes to pay its suppliers
Payables € 2,025
DSP =  365 days = x 365 days = 95 days
Annual purchase € 7,760
(inclusive of VAT)
€ 2,025 = 603 (Trade payables) + 1,422 (Other payables: loans that
are interest bearing owed to affiliated companies – not consolidated)

Interpreting a DSP ratio:

The 95 days Carrera takes to pay reduces the funding requirement for operating
working capital (OWC) by cushioning the credit extended to customers.

Highlight:
o When the amount of annual purchase is not available (very often), the rule of thumb is to
use the total of operating costs (Fixed + Variable) instead (see Appendix 4):
6,081+ 1,100 + 411 + 168 = € 7,760
 2019 data Efficiency analysis : How effective is Carrera?
Operating working capital Day’s sales in receivables Day’s sales in payables
turnover ratio (DSR) (DSP)
Inventory days

• The day’s inventory ratio is a useful check on the effectiveness of inventory management.

• This ratio measures the average number of day’s capital tied up in inventory.

Total inventories (2,612) = Inventories at manufacturing

stage (2,009) + Finished goods inventories (603)

Inventory = Inventories x365 days € 2,612

days =  365 days = 213 days
Cost of goods € 4,480 Number of
Sold inventories days

Highlights:
o The day’s Inventory ratio operates in a similar way to day’s sales in receivables (DSR ratio):
the lower it is the faster cash is collected.
o Inventory days reflects management effectiveness in managing operating working capital.
 Looking deeper into Carrera’s inventories
Carrera: Consolidated Balance Sheet
2017 2018 2019

Inventories at manufacturing stage 539 +273% 2,009 +113% 4,283

Finished good inventories 430 603 852

+40% +41%

Total inventories 969 2612 5135

+170% +97%

Inventories at manufacturing stage (i.e. for now not finished) are booming
This is worrying because we don’t know whether these products have a real chance to be delivered and
sold on the market.
2017 2018 2019

Net income 1,232 1,440 1,897

+17% +32%
Carrera’s net income and sales increase but
Sales 7,545 9,995 17,738 less quickly than its total inventories.
+32% +77%
(Consolidated Income Statement and Balance Sheet)
Total inventories 969 2612 5135
+169% +97%

o It may mean that Carrera is unable to sell a part of its products on the market.
o It is also the sign that Carrera’s activity is not dynamic.
 Assessing Carrera’s financial health
Profitability ratios Efficiency ratios Liquidity ratios Financing ratios

Liquidity analysis: How liquid is Carrera?

Current ratio Quick ratio
• Financial analysts often use the information in the firm’s balance sheet to
assess its financial solvency or liquidity.

• Specifically, creditors often compare a firm’s current assets and current

liabilities to assess whether the firm has sufficient working capital to meet
its short-term needs.
Current liabilities: Accounting reports (2019)
Current assets: Balance sheet (2019)
Accounts payable 2,327
Total inventories 5,135
Other payables 1,604
Accounts receivable 5,567 Short term debt 2,247
Other receivables 567
Cash and equivalents 5 Current liabilities€ 6,178
Current assets€ 11,274
The item “Debts to banks and other banks” (2,812) reported in the
Balance sheet does not distinguish between short and long-term
debts. Leasing (65) is not defined as a short term debt because its
duration is greater than one year.
 2019 data Liquidity analysis: How liquid is Carrera?
Current ratio Quick ratio

• The current ratio reveals the short term solvency of the business, if above 1
the firm is solvent in the short term.
2019 data

Current assets €11,274

Current ratio = = = 1.82
Current liabilities €6,178

What does it mean?

o It means that Carrera has €1.82 in current assets for every €1 in current liabilities.
o If Carrera has to repay all of its current liabilities overnight, it would have 82c per €1 in
current liabilities as change or € 5,096.
Net current assets
Current assets 11,274
2017 2018 2019 Less: Current liabilities 6,178
Current ratio 2.27 3.05 1.82 Net current assets € 5,096
A ratio higher than 2 may Carrera may have an It may reflect excessive
not be a positive sign excess of working capital inventory or excess idle cash
 2019 data Liquidity analysis : How liquid is Carrera?
The current ratio The quick ratio
• A more stringent test of the firm’s liquidity is the quick ratio, which compares only cash and
“near cash” assets to current liabilities.
• This ratio tests solvency as if the company had to repay all of its current liabilities overnight
assuming it would be unable to sell any inventory.
o A reason to exclude inventory is that it may not be that liquid; indeed an increase in the current ratio that
results from an unusual increase in inventory could be an indicator that the firm is having difficulty
selling its products.
2019 data
Current assets 11,274
Quick assets €6,139 Less: Total inventories 5,135
Quick ratio = = = 0.99
Current liabilities €6,178 Quick assets €6,139

What does it mean?

This means that Carrera’s quick assets are enough to cover current liabilities: at 0.99 this is
very close to the usual benchmark of 1.

Highlight:
o A higher than 1 current or quick ratio implies less risk of the firm experiencing a
cash shortfall in the near future.
 Assessing Carrera’s financial health
Profitability ratios Efficiency ratios Liquidity ratios Financing ratios

Financing analysis: How is Carrera financed?

Debt equity ratio Debt ratio Leverage effect

• The amount and proportion of debt in a company’s capital structure is

extremely important because of the trade-off between risk and return.
• Failure to satisfy the fixed charges associated with debt (interest charges and
principal repayment) will ultimately results in bankruptcy.
• Although debt implies risk, when debt is used successfully, i.e., when
economic profitability (ROCE) is more than sufficient to cover the after tax
cost of debt, we will see that the returns to shareholders (ROE) are magnified
through financial leverage.
 Financing analysis : How is Carrera financed?
Debt-to-equity ratio Debt ratio Leverage effect

• An important piece of information that we can learn from a firm’s balance

sheet is the firm’s leverage (gearing), or the extent to which it relies on
debt as a source of financing.
• The debt-to-equity ratio is a common ratio used to assess a firm’s leverage:

Carrera: Consolidated Balanced Sheet (2019)

Net debt € 2,807

Debt-to-equity ratio = = 0.40
Equity € 6,939

Notes:
o Net debt = Debts to banks and other debts (2,812) i.e., the total amount of short- and
long-term debt - Cash & equivalents (5) = 2,807.
o From the Accounting Reports (Balance Sheet), we have: Short-term debt (2,247) + Long-
term debt (500) + Leasing (65) = 2,812 - Cash & equivalents (5) = 2,807 = Net debt.
 Financing analysis : How is Carrera financed?
Debt-to-equity ratio Debt ratio Leverage effect

• We can also calculate the fraction of the firm financed by debt in terms of its
debt ratio. This simply indicates the percentage of assets financed by debt.

Carrera: Accounting reports (2019)

Total liabilities € 6,743

Debt ratio = = = 49.3%
Total liabilities and equity € 13,682

Note that there is much variation across industries in this ratio

A straightforward interpretation: Carrera is about 49% debt financed

 Snapshot: Don’t forget to look at the company’s net debt
• While leverage increases the risk to the firm’s equity holders, firms may also
hold cash reserves in order to reduce risk.
• Thus, another useful measure to consider when assessing how the firm is
financed is its net debt, or debt in excess of its cash reserves:

Carrera, 2018

Note. Yes, 2000 + 50 = 2,050 regardless the dataused:

From the Consolidated Balance Sheet (Carrera, 2018) - Cash & equivalents = 2,050
From Accounting Reports (Carrera, 2018) - Cash & equivalents (50) + Short-term investments (2,000)= 2,050
Readily marketable securities (stocks and bonds) that are
Highlights: intended to be sold within the time period of current assets.

o To understand why net debt may be a more relevant measure of leverage, consider a firm
with more cash than debt outstanding.
o Because such a firm could pay off its debts immediately using its available cash, it has not
increased its risk and has no effective leverage.
 Snapshot: The (financial) leverage or gearing

• The debt-to-equity ratio denotes the financial leverage or "gearing" in

the leverage effect analysis (as we will see later on).

Carrera: Debt-to-equity ratio

2017 2018 2019

Debt-to-equity - 0.43 - 0.27 0.4

Net debt is negative

Highlights:
o A negative net debt means that debts to banks and other debts are lower
than Cash and equivalents.
o A negative debt-to-equity ratio indicates that the company is cash rich.
 Financing analysis : How is Carrera financed?
Debt-to-equity ratio Debt ratio Leverage effect

The leverage effect sheds light on the origins of ROE

Does it flow from operating performance or from a favorable financing structure?

ROCE Leverage effect

Why is it important?
o Because only an increasing ROCE guarantees a sustainable rise
in a company’s ROE, and not an increasing leverage which
leads to a higher risk.
 Financing analysis : How is Carrera financed?
Debt-to-equity ratio Debt ratio Leverage effect

• The leverage effect explains how it is possible for a company to use debt to
boost its ROE without any change in ROCE.

Debt-to-equity
ratio

Highlight:
o Due to the leverage effect a company can deliver ROE greater than the rate of return
generated by the capital invested or employed in the business, i.e., its ROCE.
 The leverage effect depends on two components

• By definition, the leverage effect is the difference between ROE and ROCE:

The Leverage Effect equation

ROE = ROCE + Leverage effect

1. The leverage effect results from the Net debt

(ROCE - i) x
difference between economic profitability After-tax
Equity
(ROCE) and the after- tax cost of debt (i). cost of debt
Financial leverage
This is the 1st component.
(Gearing)

2. The leverage effect depends on

the debt-to-equity ratio, also
called (financial) leverage or Gearing.
This is the 2nd component
 How does the leverage effect work?

Debt A company raises debt

Investment The funds are invested in its operating activities

Operating
profit It must exceed the interests due on its borrowings. If not, it
generated is not worth investing.

the after-tax cost of debt

The company generates a surplus equal to ROCE - i related to the borrowing

This surplus increases the rate of return generated by the company’s equity (its ROE)

End result: The leverage effect of debt has increased the ROE
 The leverage effect is not a kind of magic

The if and only if condition of the Leverage effect: ROCE > i

•The if and only if condition for the ROE to increase when the company
raises additional debt is that its ROCE must be higher than its cost of
debt (i).

• Otherwise, what happens?

1. When ROCE < i, it means that the company borrows at a higher rate (i) than the
returns it generates by investing the borrowed funds in its capital employed.

2. This gives rise to a deficit that reduces the rate of return generated by the company’s
• equity (its ROE).

3. As a result, its earnings decline, and the ROE dips below its ROCE.

• Highlight: The leverage effect goes into reverse once:

o ROCE falls below the cost of debt (i) ROCE < i.
o The cost of debt (i) was poorly forecast or suddenly increases because the
company’s debt carries a variable rate and interest rates are on the rise, and as a
result ROCE < i.
 Does the leverage effect still apply when the net debt is negative?

If the firm’s net debt is negative, then the Financial

leverage is negative, and so is the leverage effect.

• In such a situation, the leverage effect still applies but the parameter i does no
longer correspond to the cost of debt.
• When the net debt is negative, that means that the company’s short-term financial
investments + cash & equivalents exceed the value of its total debt. In short, the
firm is cash-rich.
• The leverage effect is calculated in exactly the same way as before, where i
denotes the after-tax rate of return on short-term financial investments (mainly
readily marketable securities).
 Some Basic Parameters
Assuming that stockholders receive all of the EPS

Reflects the theoretical value creation over a period of 1 year, as

 EPS net profit belongs to shareholders. Unlike a dividend, EPS is not a
revenue stream.

Earnings per Net attribuable profit

share =
Total number of shares

Are generally paid out from the net earnings for a given year but can
 DPS
be paid out of earnings that have been retained from previous year.

Dividend per share

 Dividend Yield The ratio of the last dividend paid out to the current share price

Dividend per share DPS0 Dividend yield is based on market

= value and never on book value
Share price P0
 The percentage of earnings from a given year that is distributed
Payout ratio = d to shareholders in the form of dividends

Above 100% The company is distributing more than

Cash dividend its earnings it is tapping its reserves
d= d
Net income The company is reinvesting almost all
Close to 0%
its earnings into the business

Fast-growing companies (growth stock) Mature companies (income stock) pay

pay out little or none of their earnings out a higher percentage of their earnings

d is low d is high

Note. Mature companies are said to have moved from the status of a growth stock to that of an income stock.
 In a given year, shareholders receive a return in the
 Shareholder return form of dividends (dividend yield) and the increase
in price or market value (capital gain)
P1 - P0 Div1 Total Shareholder Return (TSR) is calculated
+
P0 in the same way, but over a longer period
P0

Capital gain Dividend yield

The proportion of shares available to purely financial investors,

 Free Float to buy when the price looks low and sell when it looks high

Indicator of a A share price is relevant only if the stock is sufficiently liquid

share’s LIQUIDITY

Liquidity is also measured in terms of volume traded daily

Note 1. Free Float can be measured either in millions of euros or in percentage of total shares.
Note 2. A security is said to be LIQUID when it is possible to buy or sell a large number of shares on the market without
too great an influence on the price.
 The Price to Book ratio (PBR)

 Price to Book ratio It measures the ratio between MARKET value and BOOK value
Note. PBR can be calculated either on a per-share basis or for an entire company

Market capitalization Market value of equity Price per share

Stockholders’ equity Book value of equity Book value per share

• It may seem surprising to compare BOOK value with MARKET value, which results from
a company's FUTURE CASH FLOW.
• There is NO DIRECT LINK between BOOK value and MARKET value. However, there
is an ECONOMIC LINK between book value and market value, as long as book value
CORRECTLY REFLECTS the market value of ASSETS and LIABILITIES.

Carrera
Interpretation of a PBR This reflects the fact that Carrera has
PBR = 2.76
added €2.76 to every € of book equity

PBR is a MULTIPLE of Equity It represents the value MULTIPLIERS applied

(Multiple de capitaux propres) to the book value of equity by the market
 Price to Book ratio and the Market Efficiency Hypothesis

A sector cannot long show equity value

BELOW book value

There will be a sector consolidation

Market capitalization
PBR = The balance will be re-established,
Stockholders’ equity assuming that markets are efficient

A sector cannot long show equity value

HIGHER than book value

New entrants will be attracted to the sector

The abnormally high returns will be brought

down assuming that markets are efficient

In both cases, MARKET EQUILIBRIUM will thus have been re-established
 The Price/Earnings ratio (P/E)

• Most market operators value shares based on EPS multiplied by the P/E ratio. P/E is equal to:

 Price Earnings ratio P/E is the division of equity market value by net profit

Another way to put this is to consider the aggregate values:

Price per share
P/E = P/E = Market capitalization / Net income
EPS P/E is a MULTIPLE of Net Income

• The widespread use of P/E to determine equity value has given rise to the myth of EPS as a financial
criterion to assess a company’s financial strategy.
• Such or such decision might or might not be taken on the basis of its positive or negative impact on EPS.
• This is why P/E is so important, but it also has its limits (see next slide).

• P/E is conceptually similar to the NOPAT multiple (Enterprise value / After-tax operating profit). Hence,
P/E is used in the same way as the NOPAT multiple to value a company.

• P/E reflects a risk that the NOPAT multiple does not, that of financial structure, which comes on top of
the risk presented by the operating assets.

In an efficient market, the greater EPS growth is, the higher the P/E
The greater the perceived risk, the lower the P/E
 Interpretation of the P/E ratio

P/E is a MULTIPLE Crudely, it expresses market value on the basis of the

of Net Income number of years of earnings that are being bought
P/E represents the number of years’ earnings reflected in the share price

• Equity value of 100

P/E = 8
• Earnings of 12.5

What does it mean? This company is valued eight times its earnings

If EPS remains constant, the investor will have to wait 8 years to recover
his investment, while:
• ignoring the residual value of the investment after 8 years,
• omitting the discount and,
• assuming that the investor receives all the EPS.
If the EPS rises (falls), the investor will have to wait less (more) than 8 years.

P/E ignores the growth expected in earnings and the time value of money !
Limits of P/E
In other words, P/E is implicitly assumed to be constant !
 The relationship between P/E and other parameters

 The P/E ratio depends on the payout ratio, d

When the stock market is bullish When the stock market is bearish

Investors are risk-taker Investors are risk-averse

They will buy growth stocks d0 They will buy income stocks d  100%

The price of growth stocks  The price of income stocks 

Their P/E  Their P/E 

 The P/E ratio depends on the expected growth rate of EPS

During the speculative bubble on Internet, tech and media stocks, some
companies from the “new economy”:

• did not pay out dividends d = 0 The market was in the

• did not earn money Net income = 0 mood for growth stocks

However, their P/E ratios were very high!

WHY?

Simply because the EXPECTED growth rates of EPS were very high!

Companies with P/E ratio = 60 was not unusual!

A P/E ratio equal to 60 years
of EPS does not make sense!

It does make sense only if the expected growth rate of EPS is very high
 Be careful when interpreting the P/E ratio

• Let’s take two companies which operates in the same sector of activity and
within the same geographical area.

For these two firms, we observe  P/E firm 1 > P/E firm 2

Do not conclude that Firm 1 is too expensive or overestimated

Look at the expected growth rate of EPS

An example: At this time, high French P/E ratios are between

34 (e.g. Club Méditerrané) and 37 (e.g. Ubisoft)
• In 2007, Alcatel-Lucent had a P/E = 1949!!
• In 2008, its P/E = 13 Why such a P/E which does not make sense?
Another one: Simply because EPS
• 2007, EADS  P/E = 310! was equal to zero

• 2008, EADS  P/E = 12 When EPS is low, do not use the

P/E ratio because it is not relevant
 How to use the P/E ratio in practice

High P/E ratio Means that the company is overestimated

Signal of sell

Low P/E ratio Means that the company is underestimated

Signal of purchase

Except if this high or low P/E ratio is

GOOGLE = growth stock
explained by a company’s specific factor
 Google’s Stock Market Ratios

• Annual growth rate of EPS over 2002-2005e = +32%

• Annual growth rate of EPS over 2005-2008e = + 312%!
Expected growth rate
Reminder. The P/E ratio is a multiple of Net income

Stock price 395.0

2005 P/E ratio = = = 76.2!
EPS 5.18
The stock market values Google 76 times its Net earnings!

• Dividend per share (DPS) over 2003-2005e = 0% • Payout ratio (d) 2004 = 0%
• Dividend per share (DPS) over 2005-2007e = 0% • Payout ratio (d) 2007e = 0%
Google has reinvested all its earnings in the business
Reminder. The PBR ratio is a multiple of Stockholders’ equity

395.0 • Free float November 7, 2005 = 60%

Stock price
2005PBR = = = 12.3 • Free float December 10, 2007 = 100%
Equity per share 32.0
All Google’s shares are available to purely
Google has added 12.3$ to every $ of book equity financial investors (extremely liquid)
 The relationship between ROE, P/E and PBR
Exemple: DaimlerChrysler (1998)

This figure connects the P/E and PBR with the ROE and illustrates that these
metrics are outcomes of the market valuation process rather than inputs

2.8
Market capitalization
Equity (book value)
PBR

15.9% 17.4
Net income Market capitalization
´
Equity Net income
ROE P/E

€ 30,367 € 4,820 € 83,742

 
Market
Equity Net income capitalization
From the balance sheet From the income statement Stock price ´ Number of shares
(Book valueof equity) (Market valueof equity)