- CFA Exams
- 2023 Level II
- Topic 3. Financial Statement Analysis
- Learning Module 16. Integration of Financial Statement Analysis Techniques
- Subject 2. Long-Term Equity Investment
Subject 2. Long-Term Equity Investment PDF Download
An analyst wants to evaluate Nestle, a publicly traded global food company.
ROE = Net Profit Margin x Total Asset Turnover x Leverage
Phase 1. Define a Purpose for the Analysis.
Questions to be answers:
- Which factors have driven Nestle's financial success?
- How sustainable is Nestle's success?
- What are the possible risks?
Phase 2. Collect Input Data.
The main sources are Nestle's financial statements for the past several years.
Phase 3/4: Process Data / Analyze and Interpret Processed Data.
The first thing is to make some adjustments. The assets and income from associates were removed. The analyst also restated a few financial statements due to changes in accounting methods.
DuPont analysis breaks down ROE into three components:
The analyst calculated "Nestle-only" net profit margin and total asset turnover of each year after neutralizing the effect of the associates' earnings and assets. Due to lack of information (how the investment in associates was financed) the financial leverage ratio was not adjusted. The ROE on a Nestle-only basis was then calculated and then compared to the aggregate ROE.
The two ROE series share a similar trend: smooth and steadily increasing. However, the magnitudes of the Nestle-only ROE are lower. This is because a significant part of Nestle's earnings comes from its associates. The investment has not been the primary driver of ROE or margins, and Nestle's performance appears to be sustainable.
Asset Base Composition
The increasing portion of the asset mix in intangibles and reduction in short-term investments indicate that Nestle's success may be due in part to successful acquisitions.
Capital Structure Analysis
A de-leveraging trend was found. For the period from 2005 to 2007:
- Financial leverage decreased from 2.16 to 2.02.
- The portion of more risky long-term liabilities dropped and the portion of the less risky equity financing increased.
- The management of working capital (receivables, inventory and payables) improved.
The capital structure is capable of supporting future operations and strategic plans.
What about the capital allocation decisions? Does the company invest its capital in the most profitable segments? The analyst examined the relationship between capital expenditures and geographic segments, calculated the ratio of capital expenditure proportion to total asset proportion, and then compared the to the current EBIT profitability ranking.
The analysis shows that:
- It seems that Pharma, the segment that has the highest margins, is not getting its proportional capital expenditures.
- The two lowest-ranked product groups (Milk Products, Nutrition, and Ice cream and Confectionery) have been allocated capital expenditures at a "growth mode" rate.
- The amount allocated to Nestle Waters is problematic.
Accruals and Earnings Quality
A manager may increase or decrease the levels of accounting accruals (e.g., accounts receivables, inventory, accounts payable, deferred revenue, accrued liabilities, and prepaid expenses) in order to reach a desired profit. Is this happening at Nestle? The analyst examined the balance-sheet-based accruals and cash-flow-based accruals over the last few years. The result: significant accruals ratio fluctuations. This could indicate the use of accruals to manage earnings.
Cash Flow Relationships
Meaningful insight into a company's financial health can be obtained by analyzing the relationship between earnings growth and growth in operating cash flow. Ideally operating cash flow and earnings should grow more or less evenly over time. When they don't, and one measure exceeds the other by a large margin, there's reason to doubt that a company's performance is as strong as either measure alone may suggest.
After making some financial adjustments and calculations, the analyst concluded that the ratio of the operating cash flow to operating earnings has been fairly consistent. The ratios of the operating cash flow to total assets, reinvestment and debt all indicate very satisfactory financial strength. Nestle has the financial stability to fund growth in its existing operations and carry out its growth-by-acquisition strategy.
Decomposition and Analysis of the Company's Valuation
How does the market value Nestle? To calculate the true P/E ratio the analyst first removed the value and earnings of Nestle's holdings in Alcon and L'Oreal from its market value and total earnings. The P/E multiple for the Nestle-only company should then be 16.3, compared to the actual P/E multiple of 18.4 for Nestle's common shares. The conclusion is that Nestle shares may be undervalued relative to the market.
Phase 5: Develop and Communicate Conclusions and Recommendations
Questions posed in Phase 1 are answered in the analytical report. Refer to the textbook for details for recommendations and causes for concern.
Phase 6: Follow-up
To determine whether changes to holdings or recommendations are necessary, the analyst must periodically repeat the above steps to gather new information and analyze/interpret data.
User Contributed Comments 1
|kajbenpaj||This text is closely unrelated to the basic questions that comes with it.|
I passed! I did not get a chance to tell you before the exam - but your site was excellent. I will definitely take it next year for Level II.
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