M3 PPT

Module 3
Profitability Analysis and

Interpretation
Return on Equity (ROE)

• ROE measures return from the perspective of the
company’s stockholders.
• The majority of the S&P 500 companies report

noncontrolling interest
• ROE focuses on a company’s common shareholders
1
Return on Equity (ROE)
• For companies with noncontrolling interest
ROE for S&P 500 firms ranged from 13.7% to 17.3% from 2018‐22. 3
Disaggregation of Return on Equity

• To uncover the drivers of ROE, we apply DuPont
disaggregation of ROE. There are two methods for
disaggregation:
1. The traditional DuPont analysis that disaggregates ROE
into components of profitability, productivity, and
leverage.
2. The second method extends the traditional DuPont
analysis by taking an operating focus that separates
operating and nonoperating activities.
• Operating activities are the drivers of shareholder value.
4
2
DuPont Disaggregation of ROE
NCIR = 1 for
firms with NO
noncontrolling
interest
• ROE reflects both company performance (as measured by return on assets), and
how assets are financed (as measured by Financial Leverage).
• To earn a high return on assets, the company must be profitable and manage
assets to minimize the assets invested to the level necessary to achieve its profit.
• ROE is higher when there is more debt and less equity for a given level of assets.
However, as financial leverage increases so does the level of debt payments,
which increases the probability of default and possible bankruptcy.
Noncontrolling Interest Ratio

• For companies with noncontrolling interest, must add a third
term to the ROE computation to account for both shareholder
groups.
• For firms with NCIR = 1, ROE = ROA × FL is often a close

approximation
3
DuPont Disaggregation of ROE
‐‐ Pfizer
Median ROA for S&P 500 firms ranged from 4.4% to 6.4%
Median FL ranged from 2.5 to 2.6 from 2018 ‐ 2022
NCIR at Pfizer
4
Disaggregation of Return on Assets
What the firm Sales generated

earns on each from each dollar
sales dollar invested in assets
Managers can increase ROA by

• Increasing PM: increase profitability for a given level of sales
• Increasing AT: reduce assets while still generating same sales level
Putting It All Together
• ROE increases with each component

• The disaggregation of ROE into ROA and financial leverage (FL)
represents a first level of analysis
• A second level analysis seeks to identify factors driving profitability
(profit margin) and productivity (asset turnover)
10
5
Analysis of Profitability and Productivity
11
Disaggregation of ROE with Operating Focus

• The balance sheet and income statement include both
operating and nonoperating items.
• Return on assets in the traditional DuPont method, reflects
a blend of the return on a company’s operating assets and
its nonoperating return.
• Companies create value mainly through core operations of
the business.
• Accordingly, analysis of a company can be improved if we
separately identify the operating and nonoperating
components of the business and their separate returns.
12
6
ROE with Operating Focus
ROE consists of two returns:
 Return from operating  Return from financing and

activities investing activities
 Earned from operating  Earned from nonoperating
assets & liabilities assets & liabilities
13
Return on Net Operating Assets

(RNOA)
• Operating returns are measured by return on net
operating assets (RNOA)
14
7
Net Operating Assets (NOA)
15
Pfizer’s Net Operating Assets
Operating Assets
2022: $170,437
2021: $145,353
Operating Liabilities
2022: $59,939
2021: $60,370
Net Operating Assets

2022: $110,498
2021: $84,983
16
8
Operating Profit
17
Pfizer’s Net Operating Profit BEFORE

Tax (NOPBT)
NOPBT =
Revenue
‐ Cost of sales
‐ Operating expenses
NOPBT =
$100,330
‐ $34,344
‐ $31,267
NOPBT = $34,719
18
9
Net operating Profit After Tax
(NOPAT)
NOPBT = Sales – Operating expenses
Tax shield: taxes a company saves by having tax‐deductible nonoperating

expenses.
The taxes saved (by the tax shield) do not relate to operating profits. We add
back the tax shield to total tax expense to compute the tax on operating profit.
19
Nonoperating Items on the Income Statement

• Nonoperating items on the income statement include:
– Interest expense on debt and lease obligations
– Loss or income relating to discontinued operations
– Debt issuance and retirement costs
– Interest and dividend income on marketable securities
– Gains or losses on the sale of nonstrategic investments
– “Other” income or expense if reported separately from operating
income
• For most companies, nonoperating activities create a pretax net
nonoperating “expense”
• When the reverse is true the net nonoperating item is “income”
20
10
Pfizer’s NOPAT
Net nonoperating expense before tax = Nonoperating expenses – Nonoperating income
Net nonoperating expense before tax = $987 – $997 = $(10)
21
Pfizer’s NOPAT
Assume a 22% statutory tax rate for Pfizer’s tax shield.
22
11
Statutory versus Effective Tax Rates
• We compute the tax shield on nonoperating income using 22%,
which is the estimate of combined federal and state statutory tax
rate
• Effective rate is typically much lower
23
Return on Net Operating Assets (RNOA)

• RNOA measures operating returns
• RNOA for Pfizer for 2022:
• Median S&P 500 RNOA ranged 10.2% to 13.5% from 2018 to 2022
24
12
Nonoperating Return
• Pfizer for 2022: – Approximate Estimation

36.3% = 32.1% (RNOA) + 4.2% (NCIR = 1.00188)
25
Disaggregation of RNOA
26
13
Net Operating Profit Margin (NOPM)
• Net operating profit margin (NOPM) reveals how much
operating profit the company earns from each sales dollar.
• Pfizer’s 2022 NOPM:
• For each dollar of sales, the company earns nearly 31₵ of

operating profit after all expenses including tax
• Median S&P 500 NOPM was 15₵ in 2022
• NOPM affected by gross profit (Revenue – COGS) and by
SG&A
27
Net Operating Asset Turnover (NOAT)

• Net operating asset turnover (NOAT) measures the
productivity of the company’s net operating assets.
• Pfizer’s NOAT:
• For every dollar of net operating assets, Pfizer earns $1.03 of

Revenue
• Median S&P 500 NOAT was $1.08 in 2022
• Companies can increase net operating asset turnover by
– Increasing sales for a given level of investment in operating assets
– Reducing the amount of operating assets needed to generate $1
of Revenue
28
14
Trade‐Off Between Margin and Turnover
29
In‐Class Exercises
• P3‐44
• P3‐47
30
15

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Module 3

Profitability Analysis and

Return on Equity (ROE)

• The majority of the S&P 500 companies report

Disaggregation of Return on Equity

Noncontrolling Interest Ratio

• For firms with NCIR = 1, ROE = ROA × FL is often a close

Median FL ranged from 2.5 to 2.6 from 2018 ‐ 2022

What the firm Sales generated

Managers can increase ROA by

Putting It All Together

• ROE increases with each component

Disaggregation of ROE with Operating Focus

 Return from operating  Return from financing and

Return on Net Operating Assets

Pfizer’s Net Operating Assets

Net Operating Assets

Pfizer’s Net Operating Profit BEFORE

NOPBT = Sales – Operating expenses

Tax shield: taxes a company saves by having tax‐deductible nonoperating

Nonoperating Items on the Income Statement

Net nonoperating expense before tax = Nonoperating expenses – Nonoperating income

Net nonoperating expense before tax = $987 – $997 = $(10)

Assume a 22% statutory tax rate for Pfizer’s tax shield.

Return on Net Operating Assets (RNOA)

• RNOA for Pfizer for 2022:

• Pfizer for 2022: – Approximate Estimation

• For each dollar of sales, the company earns nearly 31₵ of

Net Operating Asset Turnover (NOAT)

• For every dollar of net operating assets, Pfizer earns $1.03 of

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