Overview Analysis

Notional Business Value

Definition

Notional business value is defined as the expected fair market value of a business before considering the individual circumstances (including tax considerations) of any potential buyer or seller. Notional business value represents the sum of three components: the equity invested in the business by the owners/shareholders (commonly known as the book value of equity); a notional goodwill value based on the past performance of the business (which can be positive or negative and will include any intangible assets, such as patents, that are not recognised on the balance sheet); and the business's net debt (borrowings less any cash on hand).

Implications

When examining movements in the notional value of a business the focus should be on movements in the value of notional goodwill as this is determined by the operating performance of the business. Movements in the book value of equity and movements in net debt are not driven by a business's operating performance, but are the result of decisions made by the owners/management (for example, to pay out a dividend or to increase borrowings).

Notional Goodwill

Definition

Notional goodwill represents the value associated with the operating profit being generated by a business that is either above or below the required level of operating profit based on the value of the owner's/shareholder's investment in the business and the nature (riskiness) of the business. Note that notional goodwill can be positive or negative depending on whether a business is generating an operating profit that is greater, or less, than its required (expected) operating profit. The difference between a business's actual operating profit and its required operating profit is referred to as abnormal profit. Notional goodwill is then calculated as the present value of abnormal profits assuming the current period's abnormal profit continues into perpetuity.

Implications

Positive/negative notional goodwill indicates that a business is performing better/worse than could reasonably be expected given the owner's/shareholder's investment in the business and the business's risk profile. Note, however, that a positive notional goodwill value may also indicate that the value of some of the business's assets is either understated or not recorded (for example, the value of patents). Similarly, a negative goodwill value may indicate that some of the business's assets are overstated as they are not producing a reasonable return (profit) for the owners/shareholders.

Abnormal Profit

Definition

Abnormal profit is defined as the value of a business's operating profit that is above/below the required operating profit the business could be expected to generate given the owner's/shareholder's investment in the business and the business's risk profile.

Implications

If a business generates an operating profit above its required (expected) level then it has generated an additional asset referred to as goodwill. Or alternatively, it could indicate that the value of the business's assets is understated on the balance sheet. If a business generates an operating profit below the required (expected) level this will result in a negative goodwill value. A negative goodwill value could also indicate that the value of the business's assets is overstated on the balance sheet.

Return on Equity

Definition

Return on equity is defined as the operating profit currently being earned by a business for every dollar of funds invested in the business by the owners/shareholders.

Implications

Investing in a business is like any other investment; you invest money in order to make a return. Note that if part of the profit earned by a business is not paid out to the owners/shareholders this will result in an increase in the owners' equity in the business which, in turn, will require a proportionately higher operating profit to be earned in the subsequent period for the current rate of return on equity to be maintained.

This can sometimes be misleading for owners/shareholders who focus on a business's profit ('the bottom line') rather than its return on equity. Owners/shareholders may view an increase in profits (compared to the previous period) as being the result of better performance when, in fact, this might not be the case (if return on equity has not improved). This is why return on equity is a far better measure of business performance compared to just focusing on a business's 'bottom line'.

Another area to watch out for is the potential impact of increasing debt levels on a business's return on equity. Provided a business can earn a return on borrowed funds that exceeds the cost of those borrowings then every additional dollar of borrowings will increase the business's return on equity. However, while taking on additional debt may increase a business's return on equity this does not reflect an improvement in the business's operating performance and, indeed, it can potentially mask a deterioration in a business's operating performance.

Operating Return on Assets

Definition

Operating return on assets is defined as the operating profit (return) generated for every dollar invested in net operating assets.

Implications

The operating profit a business generates from its asset base is dependent on two key factors: the operating margin (the operating profit earned for every dollar in sales revenue); and the operating asset turnover (the revenue generated from every dollar invested in net operating assets). Note that these two factors typically work in opposite directions and it is getting the right balance that is important. For example, if a business reduces its prices (and, therefore, its profit margin) it can expect to generate higher revenues with a resulting increase in operating asset turnover. Conversely, increasing prices (margins) will typically result in reduced revenues with a resulting decrease in operating asset turnover.

Operating Margin

Definition

Operating margin is defined as the operating profit earned for every dollar of revenue generated.

Implications

This ratio provides an indication of how much operating profit is being earned from every dollar of revenue generated by the business, and it is impacted by two key factors: sales mark-up (i.e. gross profit margin) and operating expenses. Businesses need to monitor both these operational areas.

Any one-off items (extraordinary items) that are not part of the standard operations of a business should be removed from operating profit as they will distort the true performance and value of the business. One-off transactions include, for example, prior-year adjustments made in the current year, the sale of a division, and one-off large superannuation payments. Most other costs are generally part of normal business operations.

Note that increasing the business's operating margin by increasing prices will typically result in less sales in terms of units sold but might result in more sales revenue.

Operating Asset Turnover

Definition

Operating asset turnover is defined as the revenue generated for every dollar invested in a business's net operating assets; which is defined as operating assets less operating liabilities (excluding interest-bearing debt and net of any cash on hand).

Implications

Businesses invest in assets with the expectation that such investments will provide a future benefit by generating additional revenue (either directly or indirectly). Therefore, it is important to monitor the return a business’s operating assets are providing to ensure they are being utilised effectively and are not sitting idle for extended periods. The more revenue derived from each dollar invested in assets the more effectively those assets are being utilised.

Note that because assets are required to be depreciated (and, therefore, their value declines) the operating asset turnover ratio will increase without there necessarily being any improvement in the business's operating performance. Similarly, when new assets are acquired the operating asset turnover ratio will decrease unless there is a commensurate (and immediate) increase in revenue. This highlights the importance of having a regular asset replacement schedule in place to ensure a steady level of operating assets is maintained (this is particularly important for construction and manufacturing businesses).

Financial Leverage Gain

Definition

Financial leverage gain is defined as the benefit provided to a business when a portion of its operating assets are acquired using debt financing rather than funds contributed by the owners (shareholders).

Implications

The level of benefit provided to a business by the use of debt financing is dependent on two factors: the difference between the business's operating return on assets and its cost of debt (referred to as the spread); and the amount of debt/gearing (net financial leverage) the business has. When examining the impact of debt financing, the focus should be on the spread as this is determined by the business's operating performance. Provided the spread is positive (that is, the business's operating return on assets exceeds its cost of debt) any increase in debt will increase the financial leverage gain and, ultimately, the notional value of the business. Note that if the spread is negative (that is, the business's operating return on assets is less than its cost of debt) any increase in debt will decrease the financial leverage gain and, ultimately, the notional value of the business.

Spread

Definition

Spread is defined as the difference between a business's operating return on assets and the cost of debt used to acquire any of those assets.

Implications

If the return being generated by a business's operating assets is greater than the cost of debt used to acquire any of those assets (i.e. there is a positive spread) then the debt owed by a business will have a beneficial impact on its notional value. Conversely, if the return being generated by a business's operating assets is less than the cost of debt used to acquire any of those assets (i.e. there is a negative spread), then the debt owed by a business will have a detrimental impact on its notional value.

A negative spread provides a significant warning sign that there is potentially an operational issue that needs to be addressed immediately. This may involve: trying to re-finance debt at a lower interest rate; selling off under-utilised assets; and/or trying to improve the business's operating performance by increasing sales margins or implementing cost reductions.

Net Financial Leverage

Definition

Net financial leverage is defined as the proportion of net debt (interest-bearing debt less any cash/cash equivalents) relative to the funds invested in the business by the owners/shareholders.

Implications

It is not possible to determine an optimum level of debt for any given business because this will vary with changes in the business's operating performance, the cost of debt and the economic outlook. While some level of debt is usually beneficial for a business (because the cost of debt is typically less than the required rate of return expected by owners/shareholders) too much debt may substantially increase the risk of financial distress. It is important, therefore, to monitor a business's debt level; particularly when there are significant changes in the economic outlook.