COURSE PROGRESSION

Week Analysis of industrial companies

9 ASSIGNMENT : CASE STUDY NO 3

Week
Analysis of insurances and pension funds
10

Week Analysis of banks and financial companies

11 ASSIGNMENT : CASE STUDY NO 4

1
ANALYSIS OF INDUSTRIAL COMPANIES

Sources:
• CFA Institute curriculum
• Extracts from broker research and financial press
• Author’s documentation

2
COURSE CONTENT

1. Introduction
2. Framework for analysis
3. Class case study – Evaluating a company as long-term equity investment
4. Graded case study – Perform follow-up evaluation

3
PUBLIC INFORMATION – INDUSTRY /
COMPETITION

4
STOCK PRICE

5
ANALYSTS CONSENSUS

6
PRICE TARGET

7
PERCENTAGE OF LOCAL INDEX

8
COURSE CONTENT

1. Introduction

2. Framework for analysis

3. Class case study – Evaluating a company as long-term equity investment
4. Graded case study – Perform follow-up evaluation

9
Source : CFA curriculum
10
STEPS IN FINANCIAL STATEMENT ANALYSIS

1. Articulate the Purpose and Context of the Analysis.

2. Collect Data (including company analysis).

3. Process Data.

4. Analyze/Interpret the Processed Data.

5. Develop and Communicate Conclusions and Recommendations.

6. Follow-Up.

11
STEP 1: ARTICULATE THE PURPOSE AND
CONTEXT OF ANALYSIS

• Prior to undertaking any analysis, it is essential to understand the purpose of

the analysis, for instance:
- Evaluate the historical performance of a company.
- Prepare a forecast of future performance.
- Value a company’s equity or debt securities.
- Prepare a rating or an investment recommendation.
• The purpose of an analysis guides further decisions about the approach, the
tools, the data sources, the format in which to report the results of the
analysis, and the relative importance of different aspects of the analysis.

12
STEP 1: ARTICULATE THE PURPOSE AND
CONTEXT OF ANALYSIS

• When facing a substantial amount of data, a less experienced analyst may

be tempted to just start making calculations and generating financial ratios
without considering what is relevant for the decision at hand. Hence:
- Resist this temptation.
- Avoid unnecessary / pointless efforts.
- Focus on key questions.
• If you could have all the calculations and ratios completed instantly:
- What conclusion would you be able to draw?
- What question would you be able to answer?
- What decision would your answer support?

13
STEP 1: ARTICULATE THE PURPOSE AND
CONTEXT OF ANALYSIS

• The analyst should also define the context of the analysis at this stage.
- Who is the intended audience?
- What is the end product (e.g. a final report with conclusions and
recommendations?
- What is the time frame (i.e. when is the report due)?
- What resources and resource constraints are relevant to completion of the
analysis?

14
STEP 2: COLLECT DATA

• A key part of this step is obtaining an understanding of the company’s

business, financial performance, and financial position (including trends
over time and in comparison with peer companies).
• For historical analyses, financial statement data alone are adequate in some
cases. For example, to screen a large number of alternative companies to find
those with a minimum level of profitability, financial statement data alone would
be adequate.
• To address more in-depth questions, such as why and how one company
performed better or worse than its competitors, additional information would
be required.

15
STEP 2: COLLECT DATA

• Information on the economy and industry is necessary to understand the

environment in which the company operates.
• Analysts often take a top-down approach whereby they:
- Gain an understanding of the macroeconomic environment, such as
prospects for growth in the economy and inflation.
- Analyze the prospects of the industry in which the subject company
operates based on the expected macroeconomic environment.
- Determine the prospects for the company in the expected industry and
macroeconomic environments.

16
STEP 2: COLLECT DATA

• A more detailed company analysis framework may include the following

variables:
- Provide a company profile.
- Explain relevant industry characteristics.
- Analyze demand.
- Analyze supply and input costs.
- Explain the pricing environment.
- Present and interpret relevant financial ratios.

17
STEP 3: PROCESS DATA

• A comprehensive financial analysis at this stage would clearly include:

- Reading and evaluating financial statements (and management
commentary, notes and other disclosures) for each company being analyzed.
- Making any needed adjustments to the financial statements to facilitate
comparison when the unadjusted statements reflect differences in accounting
standards, accounting choices, or operating decisions.
- Using relevant analytical tools such as:
- Computing ratios or growth rates.
- Preparing common-size financial statements.
- Creating charts.
- Performing statistical analyses (regressions, Monte Carlo simulations).
- Performing equity valuation.
- Performing sensitivity analyses.
18
STEP 4: ANALYZE/INTERPRET PROCESSED
DATA

• The next step - critical to any analysis - is to interpret the output.

- The answer to a specific financial analysis question is seldom the
numerical answer alone.
- The answer to the analytical question relies on the analyst’s interpretation
of the output and the use of this output to support a recommendation.
• Financial statement analysis typically involves assessing a number of
company’s data, relative to its own past (trend analysis) and relative to
peer/benchmark companies, including (but not limited to):
- Profitability.
- Liquidity.
- Leverage.
- Efficiency.
- Valuation.

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STEP 5: DEVELOP AND COMMUNICATE
CONCLUSIONS AND RECOMMENDATIONS

• Communicate the conclusion or recommendation in an appropriate format.

Appropriate format will vary by analytical task, by institution, and/or by
audience.
• An equity analyst’s report would typically include the following components:
- Summary and investment conclusion.
- Earnings projections.
- Valuation.
- Business summary.
- Risk, industry, and competitive analysis.
- Historical performance.
- Forecasts.

20
STEP 6: FOLLOW-UP

• If an equity investment is made or a credit rating is assigned, periodic review

is required to determine whether the original conclusions and
recommendations are still valid.
• Follow-up may involve repeating all the previous steps in the process on a
periodic basis.

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COURSE CONTENT

1. Introduction
2. Framework for analysis

3. Class case study – Evaluating a company as

long-term equity investment
4. Graded case study

22
COURSE CONTENT

Class case study – evaluating a company as long-term equity investment

- Introduction
- Conduct a DuPont analysis
- Analyze the composition of Nestlé’s asset base and capital structure
- Study the company’s segments and the allocation of capital among them
- Examine the company’s earnings quality
- Study the company’s cash flows and their adequacy for the company’s
continued operations and strategies
- Decompose the company’s valuation
- Write a report
- Follow-up

23
PURPOSE OF THE ANALYSIS

• Capitalizing on your growing knowledge, you have recently joined

DummDumm Alpha Brokerage Inc., a Zug-based company specialized in
buy-side analysis of large European caps. As a part-time junior buy-side
analyst, you attempt to gather knowledge and experience from older peers in
the company. While sharing a coffee with your new colleague Albert Roestli,
you learned that he performed an extensive study of Nestlé in previous
years.
• You have a chance to review his paper notes, tables, and previous in-depth
analysis from the year 2014 when Albert was attending all analysts’ meetings
in Nestlé’s Headquarters in Vevey. The following pages are taken from Abert
Roestli’s archives from 2014.
• The analysis performed at that time related to a request for a potential
investment in the shares of Nestlé for a large pension fund, at the time a
large client of DummDumm Alpha Brokerage Inc.

24
• At the time, James Ivory, the main portfolio manager for the food sector of a
large public employee pension fund wanted to take a long-term equity
position in a publicly traded food company and had become interested in
Nestlé S.A.
• In its 2014 annual report, the company’s management report indicated the
following general strategic direction:
- “Our ambition is not just to be the leader but the industry reference for
Nutrition, Health and Wellness. In recent years we have built on the strong
foundations of our unrivalled food and beverage portfolio, exploring the
benefits of nutrition’s therapeutic role with Nestlé Health Science.”
• James Ivory asked then Albert Roestli – one of the most senior analyst of
DummDumm Alpha Brokerage Inc. - to evaluate Nestlé for consideration
as a large core holding.

Note from the reviewer:

The analysis and tables included thereafter are taken from an internal risk
report from 2015 whereby an internal risk manager of DummDumm Alpha
Brokerage Inc. reviewed the work performed by Albert Roestli (thereafter “the
analyst” in the notes).

25
PURPOSE OF THE ANALYSIS

• There are many key questions the analyst should ask in order to issue a
proper recommendation, for instance:
- What are Nestlé’s sources of earnings growth? How sustainable is Nestlé’s
performance?
- Do the company’s reported earnings represent its economic reality?
- If Nestlé’s performance is fairly reported, will it be sustainable for an
extended period, such as 5 to 10 years?
- How well does Nestlé’s balance sheet take into account the company’s full
rights and obligations.
- Is the capital structure of the company able to support future operations
and strategic plans?

26
FRAMEWORK – PHASE 1 AND 2

Phase 1: Define a Purpose for the Analysis.

• The analyst states the purpose and context of the analysis as:
- “Identifying the factors that have driven the company’s financial success
and assessing their sustainability.”
- “Understanding the risks that may affect the sustainability of returns.”
- “Performing an evaluation in order to consider investment as a large core
holding.

Phase 2: Collect Input Data.

• The analyst finds that Nestlé has an extensive collection of financial
statements on its website. After gathering several years of annual reports, he
is ready to begin processing the data. He is also able to collect additional
information regarding the industry and peers of Nestlé.

27
FRAMEWORK – PHASES 3 AND 4

Phase 3: Process Data and Phase 4: Analyze/Interpret the Processed Data.

• The analyst intends to accomplish the objectives stated in Phase 1 through a
series of financial analyses, consisting of:
- A DuPont analysis.
- An analysis of the composition of Nestlé’s asset base and capital
structure.
- A study the company’s segments and the allocation of capital among them.
- An examination of the company’s accruals in reporting as they affect
earnings quality.
- A study of the company’s cash flows and their adequacy for the company’s
continued operations and strategies.
- A decomposition and analysis of the company’s valuation.

28
FRAMEWORK – PHASE 5 AND 6

Phase 5: Develop and Communicate Conclusions.

• After processing the input data consistent with the needs of these analyses,
the analyst plans to simultaneously interpret and analyze the resulting
data (Framework Phases 3 and 4 jointly).
• He will sum up his results in a short report to the attention of the portfolio
manager originally interested in Nestlé as a potential core investment.

Phase 6: Follow-up.

29
COURSE CONTENT

Class case study – evaluating a company as long-term equity investment

- Introduction

- Conduct a DuPont analysis

- Analyze the composition of Nestlé’s asset base and capital structure
- Study the company’s segments and the allocation of capital among them
- Examine the company’s earnings quality
- Study the company’s cash flows and their adequacy for the company’s
continued operations and strategies
- Decompose the company’s valuation
- Write a report
- Follow-up

30
DUPONT ANALYSIS – PURPOSE

• The analyst decides to start the assessment of Nestlé with a DuPont analysis.
• The potential investment is expected to be in the company’s common stock.
Ultimately, the DuPont analysis separates the components affecting the
return on common equity. The disaggregation of return on equity (ROE)
components leads to more trails to follow in assessing the drivers of
Nestlé’s performance.
• The analyst also intends to investigate the quality of earnings and
underlying cash flows. He also desires to understand the common
shareholders’ standing in the Nestlé capital structure. DuPont analysis helps
the analyst discover a company’s strengths and allows the analyst to assess
their sustainability. Seeking granularity also helps the analyst find potential
operational flaws and provides an opening for dialogue with management
about possible problems.

31
DUPONT ANALYSIS – INCOME FROM
ASSOCIATES

• The analyst begins to process the data gathered in order to assemble the
information required for the DuPont analysis.
- Exhibit 2 shows the last three years of income statements for Nestlé.
- Exhibit 3 shows the last four years of Nestlé balance sheets.
• The analyst notes that Nestlé has a significant amount of “income from
associates and joint ventures” in three years.
- In 2014, this income amounted to CHF 8,003 million, or 53.7% of Nestlé’s net
income (or profit for the year).
- The income from associates is a pure net income figure, presented after
taxes and with no related revenues in the income statement.
• Much of the income from associates relates to Nestlé’s 23.4% stock
ownership of L’Oréal.

32
Source : CFA curriculum
33
Source : CFA curriculum
34
35
DUPONT ANALYSIS – INCOME FROM
ASSOCIATES

• In 2014, L’Oréal affected income from associates in a variety of ways:

- Nestlé reduced its L’Oréal ownership by selling 48.5 million shares of its
holding back to L’Oréal.
- Nestlé gained full ownership of Galderma (joint venture with L’Oréal).
- The partial disposal of L’Oréal shares netted a gain of CHF4,569 million.
• Income from associates included a revaluation gain of CHF2,817 million
from the increase in ownership of Galderma. Nestlé had owned 50% of
Galderma (L’Oréal holding the other 50%). When Nestlé bought the remaining
ownership from L’Oréal, its original 50% ownership position was revalued at
current fair value, which was based on the price paid. As of July 2014,
Galderma became an affiliated company that was fully consolidated.
• Because of its L’Oréal stock ownership, Nestlé recognizes a share of
L’Oréal’s net income. The share of results at other companies that Nestlé
included in income from associates was CHF828 million in 2014.

36
DUPONT ANALYSIS – INCOME FROM
ASSOCIATES

• The analyst wants to decompose the company’s financial results as much

as possible in order to identify any problem / find hidden opportunities.
• Including the net investments and returns of associates with the full
reported value of Nestlé’s own assets and income would introduce noise into
the analytical signals produced by the DuPont analysis: the returns earned
by associates are not under the direct control of Nestlé’s management.
• Hence, the analyst wants to remove the effects of the investments in
associates from the balance sheet and income statement. Otherwise, such
DuPont analysis components as net profit margin and total asset turnover
would combine the impact of pure Nestlé operations with that of the operations
of associated companies. Conclusions about Nestlé-only business would be
flawed because they would be based on commingled information.

37
DUPONT ANALYSIS – INCOME FROM
ASSOCIATES

• The five-way decomposition of ROE is expanded to isolate the effects of

the investment in associates in Nestlé’s asset base and earnings.
• The necessary modifications to the reported financial data to isolate these
effects are shown in Exhibit 5:
- Subtracting income from associates from the net income (profit for the
year) gives the profits generated by Nestlé’s own asset base.
- Subtracting the amount of investment in associates from total assets
results in a figure that more closely represents Nestlé’s own asset base.
• With this information, the analyst can assess the profitability and returns of the
most relevant part of the entire Nestlé entity: the core Nestlé company.

38
 From
Exhibit
2

From
Exhibit
3

Source : CFA curriculum

39
DUPONT ANALYSIS – INCOME FROM
ASSOCIATES

• Exhibit 6 shows the results of expanding the DuPont analysis on:

- Net profit margin.
- Asset turnover.
• The net profit margin component and the asset turnover component require
adjustments to remove the impact of the associates on the return on
assets.
- To adjust the net profit margin component, the analyst subtracts the
associates’ income from the net income and divides the result by sales.
- For 2014, the Nestlé-only net profit margin was 7.53% (= Profit excluding
income from associates / Sales = 6,901/91,612) vs. 16.27% with associates.

40
DUPONT ANALYSIS – INCOME FROM
ASSOCIATES

- To adjust the asset turnover, the analyst subtracts the investment in

associates from total assets to arrive at the assets used by the core Nestlé
company. Sales divided by the average of the beginning and ending assets
(excluding investment in associates) gives the Nestlé-only asset turnover.
- For 2014, the Nestlé-only asset turnover was 0.787 {= 91,612 / [(108,127 +
124,801) / 2] = 91,612 / 116,464}. Including the investment in associates in
total assets, the asset turnover was 0.722 {= 91,612 / [(120,442 + 133,450) /
2] = 91,612 / 126,946}.
- The difference between the asset turnover based on unadjusted financial
statement amounts and the Nestlé-only asset turnover gives the effect on
total asset turnover of the investment in associates: a decrease of 0.065
in 2014.

41
DUPONT ANALYSIS – INCOME FROM
ASSOCIATES

• The net profit margin can be decomposed into three components:

EBIT margin x Tax burden x Interest burden

• To adjust the tax burden component, the analyst divides profit (excluding
income from associates) by profit before taxes and income from associates
(EBT). For 2014, the tax burden was 67.21% (= 6,901 / 10,268).
• Interest burden is calculated by dividing the profit before taxes, associates,
and joint ventures (EBT) by operating profit (EBIT). For 2014, the interest
burden was 94.16% (= 10,268 / 10,905).
• EBIT margin is earnings before interest and taxes (operating profit) divided by
revenue (sales). For 2014, the EBIT margin was 11.90% (= 10,905 / 91,612).
• Multiplying the three components yields the Nestlé-only net profit margin.

42
DUPONT ANALYSIS – INCOME FROM
ASSOCIATES

• In 2014, the Nestlé-only net profit margin was 7.53% (= 67.21% x 94.16% x
11.90%).
• Calculating the net profit margin without excluding income from associates
gives 16.27% (= Net income / Revenue = Profit for the year / Sales = 14,904 /
91,612), which is not representative of the Nestlé-only operations.
• Dividing the net profit margin by the net profit margin without the associates’
income (16.27% / 7.53% = 216.07%) quantifies the magnifying effect of the
associates’ income on Nestlé’s own margins.
- The “Nestlé-only” entity earned 7.53% on every sale, but including the
associates’ income in net profit increases the net profit margins by 116.07%
[(100.00% + 116.07%) x 7.53% = 16.27%].
- A 16.27% level of profitability is not representative of what Nestlé’s core
operations can generate.

43
 Used on
Exhibit 8

Rounded

Source : CFA curriculum 44

DUPONT ANALYSIS – INCOME FROM
ASSOCIATES

• In 2012 and 2013, the net profit margin (including income from associates)
was fairly stable at 11.90% and 11.33%, respectively. However, it increased
significantly in 2014 to 16.27% as a result of the increase in income from
associates attributable to the L’Oréal disposal and Galderma revaluation.
• The analyst is interested in the ongoing operations of Nestlé, unaffected by
such non-repeating types of gains.
• The net profit margin excluding income from associates shows a
disturbing trend: it decreased each year in the 2012-2014 period:
10.50% => 9.96% => 7.53% (excluding associates)
11.9% => 11.33% => 16.27% (including associates)
• This finding prompts the analyst to try to identify a reason for the declining
profitability of the Nestlé-only business.

45
DUPONT ANALYSIS - IMPACT OF ACQUISITIONS

• Searching the income statements and notes in the annual reports, the analyst
notices that Nestlé has recorded goodwill impairments over the period under
study, with a particularly large one of CHF1,908 million occurring in 2014. This
impairment was related to Nestlé’s acquisitions of ice cream and pizza
businesses in the United States.
• He also notices that Nestlé has recorded provisions each year for
restructuring activities, environmental liabilities, litigation reserves, and other
activities. To see how much these events affected the Nestlé-only profitability,
he constructs the table shown in Exhibit 7.
• He call these events “unusual charges” for convenience of presentations.

46
 From
Exhibit 6

Used in
* Exhibit 8

* Net profit margin excluding associates and unusual charges: 9,729 / 91,612 = 10.62%

Source : CFA curriculum 47

DUPONT ANALYSIS – ADJUSTMENTS

• The analyst notices that adjusted profits / adjusted profit margins were
more stable over the three-year period than profits / profit margins excluding
associates. However, the adjusted profits and profit margins and the profits and
profit margins excluding associates decreased over the same period.
• Although the provisions and impairment charges potentially explain the
significant decrease in the Nestlé-only profit margins, the analyst decides not
to adjust the remaining DuPont analysis to exclude these charges:
- They involve decisions by management.
- They recur regularly.
- They affect the returns to shareholders.
• In assessing the company’s prospects, he believes that these charges are
important variables that should not be ignored.

48
DUPONT ANALYSIS – RETURN FROM
ASSOCIATES

• Going back to the DuPont analysis, the analyst now realizes the significance of
the associates’ earnings to the entire Nestlé entity.
- The margin is greater in each year if the associates’ earnings are included
in net profit as opposed to looking at Nestlé alone.
- Consistently, the company’s profit margins are smaller without the boost
from associates’ earnings.
- Asset turnover is consistently lower when assets include the investment in
associates.

49
DUPONT ANALYSIS – RETURN FROM
ASSOCIATES

• From Exhibit 6, multiplying the three conventionally calculated components of

ROE (net profit margin, total asset turnover, and leverage) yields the ROE
when the effect of associates is included (top row of Exhibit 8). The ROE
exhibits an overall increasing trend when examined without adjusting for
investment in associates. The analyst wants to compare the ROE for Nestlé
alone with the ROE including associates.
• The difference between the two sets of ROE figures reveals the amount of
ROE contribution from the associates. The trend in the ROE including
associates, which shows a significant increase in 2014, is largely the result of
the gains in 2014 from the transactions involving the investments in
associates (exchange of L’Oréal shares for Galderma full ownership). Nestlé
only shows a different trend: decreasing in each of the last two years.

50
DUPONT ANALYSIS – RETURN FROM
ASSOCIATES

From
Exhibit
* 6

* Nestlé only ROE =

Net profit margin excluding associates x total asset turnover excluding associates x financial leverage
(from Exhibit 6), hence
7.53% x .787 x 1.87 = 11.08

Source : CFA curriculum

51
DUPONT ANALYSIS – ADJUSTMENTS

• The analyst is particularly troubled by the sharp drop-off in the Nestlé-only

ROE in 2014. He knows that there was an unusually large goodwill
impairment charge in 2014, which may explain the sudden decrease.
• To see the role played by such unusual charges in the ROE trend, he reworks
the Nestlé-only ROE figures on the basis of revised net profit margins
(excluding associates and unusual charges) as shown in Exhibit 7.
• For 2014, the Nestlé-only ROE was 15.63% (10.62% x 0.787 x 1.87 =
15.63%) as shown in Exhibit 8A.

52
DUPONT ANALYSIS – ADJUSTMENTS

• Without the unusual charges, the magnitude of the Nestlé-only ROE

improved significantly, but the trend remained on a downward slope.
Underscoring the significance of the investment in associates is the
increasing spread between the as-reported and the Nestlé-only net profit
margins in a with- and without-associates comparison (Exhibit 9).

The profit margins included all the previously identified unusual charges
because as the analyst believes they should not be excluded: they are real
costs of doing business and seem to recur. They were incurred by managers
accountable for their stewardship of the shareholders’ resources.
53
COURSE CONTENT

Class case study – evaluating a company as long-term equity investment

- Introduction
- Conduct a DuPont analysis

- Analyze the composition of Nestlé’s asset base

and capital structure
- Study the company’s segments and the allocation of capital among them
- Examine the company’s earnings quality
- Study the company’s cash flows and their adequacy for the company’s
continued operations and strategies
- Decompose the company’s valuation
- Write a report
- Follow-up

54
ASSET COMPOSITION

• The analyst now examines the composition of the balance sheet over time,
as shown in Exhibit 10.
• Given that Nestlé is a food manufacturer and marketer, he expected significant
investments in current assets, inventory, and physical plant assets. However,
the analyst is surprised to see so much investment in intangible assets,
indicating that Nestlé’s success may depend, in part, on successful
acquisitions. Apparently, the company has been actively acquiring companies
in the last four years.
• Goodwill and intangible assets – hallmarks of a growth-by-acquisition
strategy – composed 40.7% of total assets in 2014. At the end of 2011, they
amounted to 32.9% of total assets.

55
ASSET COMPOSITION

* : rounding

Source : CFA curriculum

56
ASSET COMPOSITION

• The investing section of the statement of cash flows (Exhibit 11) shows
that there have been material acquisitions. Except for a slowdown in 2013,
Nestlé had been very active in devoting resources to acquisitions.
- For the full three-year span, 69.0% of the cash expenditures for investing
activities were devoted to acquisitions.
- The largest single acquisition occurred in 2012, when Nestlé acquired the
nutritional business of Wyeth for CHF10.9 billion. This acquisition was 74.8%
(=10,846 / 14,491) of the cash used for investing activities in 2012.
• From the DuPont analysis, the analyst understands that Nestlé’s overall
financial leverage was rather stable over the last three years, which does not
satisfy the analyst’s curiosity regarding Nestlé’s financing strategies.

One shortcoming of financial leverage as a capital structure metric is that it

says nothing about the nature, or riskiness, of the different financing
instruments used by a company.

57
ASSET COMPOSITION

Source : CFA curriculum

58
CAPITAL STRUCTURE ANALYSIS

• The analyst decides to investigate Nestlé’s capital structure more deeply by

constructing a chart on a common-size basis (Exhibit 12). The DuPont
analysis indicated that the company’s financial leverage remained within a
narrow range over the last three years, from a low of 1.87 to a high of 1.98.
• However, Nestlé has been making its capital structure financially riskier
over the last four years:
- The proportion of equity financing is slowly decreasing (from 74.2% in
2011 to 71.5% in 2014).
- The long-term financial liabilities have become a significantly greater part
of the capital mix, increasing to 12.3% in 2014 (from 7.8% in 2011).
• The “other long-term liabilities” (i.e. primarily employee benefit plan obligations
and provisions) decreased from 17.9% in 2011 to 16.2% in 2014.

59
CAPITAL STRUCTURE

• Given the increased leverage in the long-term capital structure, the analyst
wonders whether there have also been changes in the company’s working
capital accounts. He decides to examine Nestlé’s liquidity situation.
• From the financial statements in Exhibits 2 and 3, he constructs the table
shown in Exhibit 13 displaying working capital accounts and ratios.

* : rounding

Source : CFA curriculum

60
CAPITAL STRUCTURE

• The analyst notices that the current and quick ratios improved slightly in
2014, after three years of relative stability. He also notices that the defensive
interval ratio improved in 2014 after a significant decrease in 2013.
• The improvements were modest: given the increase in long-term leverage,
the analyst was expecting more of a liquidity cushion in the working capital
accounts. He found the cushion in that the speed of cash generation has
been increasing: since 2011, days’ sales outstanding has decreased, as has
days on hand of inventory, and the number of days payables has increased.
• In fact, the management of the working capital accounts has changed so
much that Nestlé now has a negative eight days for its cash conversion
cycle, mostly attributable to its steadily increasing delay in paying its vendors.
In effect, Nestlé has been generating cash from its working capital
accounts eight days before applying the cash to accounts payable.

61
CAPITAL ACCOUNTS AND RATIOS

62
COURSE CONTENT

Class case study – evaluating a company as long-term equity investment

- Introduction
- Conduct a DuPont analysis
- Analyze the composition of Nestlé’s asset base and capital structure

- Study the company’s segments and the allocation

of capital among them
- Examine the company’s earnings quality
- Study the company’s cash flows and their adequacy for the company’s
continued operations and strategies
- Decompose the company’s valuation
- Write a report
- Follow-up

63
SEGMENT ANALYSIS AND CAPITAL ALLOCATION

• The Dupond analysis showed the declining profitability of Nestlé in its core
operations, leading the analyst to subsequently learn more about the
composition of the assets and to study the company‘s financing. He knows
that asset turnover has been slowing Nestlé and that the company has been
looking to acquisitions for growth.
• The analyst still wonders about the health of the different businesses under
Nestlé umbrella and how effectively management has allocated capital to
them.
• To understand any geopolitical investment risks, as well as the economies in
which Nestlé operates, the analyst wants to know which geographic areas are
of the greatest importance to the company.

64
SEGMENT ANALYSIS AND CAPITAL ALLOCATION

• One issue the analyst identifies is that Nestlé reports segment information by
management responsibility and geographic area (hereafter referred to as
“segment”), not by segments based exclusively on geographic areas.
• From the segment information in Exhibit 14, he notes that:
- European segment: the sales and operating profit decreased in absolute
terms and as a percentage of total business in 2014 compared with 2012.
The decrease in profits has been consistent over the period.
- Americas segment: sales have also become a smaller contributor to the
whole company’s revenue base in the same period and have decreased
slightly since 2012. The Americas operating profit has decreased consistently
since 2012, and like the European segment, the Americas contribution to
total operating profit in 2014 is a smaller proportion than in 2012.
- The Asia, Oceania, and Africa segments repeated the pattern: lower sales
and operating profit, with a decrease in each of the two years following 2012.

65
SEGMENT ANALYSIS AND CAPITAL ALLOCATION

• Other findings regarding segments:

- Nestlé Waters is not a true geographic segment. It showed minor growth in
revenues and operating profit between 2012 and 2014 and contributed the
same proportion of sales and operating profit in 2014 as it did in 2012.
- Nestlé Nutrition grew significantly during the period: it contributed 10.5% of
revenues in 2014 (only 8.8% in 2012), and its operating profit contributed
14.2% of revenues in 2014 compared with 11.2% in 2012. The analyst
remembers that Nestlé acquired the Wyeth Nutritionals business in 2012,
which would explain the solid growth.
- “Other businesses” also increased in importance between 2012 and 2014,
accounting for 15.2% of sales in 2014 (13.2% in 2012) and 18.9% of
operating profit (15.3% in 2012). Both measures (sales and operating profit)
grew in 2014, and the analyst attributes that growth to Nestlé’s gaining full
control of Galderama in 2014.

66
Source : CFA curriculum
67
SEGMENT ANALYSIS AND CAPITAL ALLOCATION

• For several reasons, the analyst is somewhat frustrated by the segment

information presented by Nestlé.
• He would like to look at trends over more than just three years, but the
change in accounting principles in 2013 (for IFRS 19) was not carried back in
the segment information prior to 2012. That accounting change eliminated
the proportional consolidation method of accounting for joint ventures and
made the 2011 segment information non-comparable with the figures
presented for 2012 and later.
• The earlier amounts included proportional amounts of sales and operating
profits for the segments, and a comparison with later years would be
flawed.

68
SEGMENT ANALYSIS AND CAPITAL ALLOCATION

• Another problem with the segment information is that it is not defined by

category with fully geographic information or product information.
- The analyst notes that three geographically classified segments
accounted for 66.3% of revenues in 2014 and 70.1% in 2012; the operating
profit for the three segments amounted to 77.4% in 2014 and 83.9% in 2012.
- These segments are declining in importance to Nestlé as a whole, whereas
Nestlé Waters and Other businesses are increasing in importance.
• Both of these segments have geographically different operations as well,
which are not being accounted for in the other three geographic segments.
- Example: the “Other businesses” segment includes a coffee product line,
professional products, health care products, and skin care products.
Together, they amount to almost 19% of operating profit, yet they are unlikely
to have similar distribution channels, profitability levels, and growth potential.

69
SEGMENT ANALYSIS AND CAPITAL ALLOCATION

Source : CFA curriculum

70
SEGMENT ANALYSIS AND CAPITAL ALLOCATION

• The segment information is presented on the basis that management uses

to make decisions.
• The analyst moves on with his segment analysis and evaluation of capital
allocation, gathering the segment information shown in Exhibit 15 regarding
Nestlé’s capital expenditures and assets.
• Using the information from Exhibit 14 to calculate EBIT margins, as well as
the information about the asset and capital expenditure distribution from
Exhibit 15, the analyst constructs the table in Exhibit 16, ranking by
descending order of EBIT profitability in 2014.

71
SEGMENT ANALYSIS AND CAPITAL ALLOCATION

**

* : rounding
** (data from Exhibit 14): trading operating profit / sales = 1’997 / 9’614 = 20.77% EBIT margin

Source : CFA curriculum

72
• Although the segmentation is not purely geographic, the analyst can still
make some judgments about the allocation of capital. On the premise that
the largest investments in assets require a similar proportion of capital
expenditures, he calculates ratios of the capital expenditure proportion to
the total asset proportion for the last three years and compares them with the
current EBIT profitability ranking (Exhibit 17).

Source : CFA curriculum

73
SEGMENT ANALYSIS AND CAPITAL ALLOCATION

• Comparing the ratio with the EBIT margin percentage gives the analyst an
idea of whether the company is investing its capital in the most profitable
segments or not.
- A ratio of greater than 1 indicates the company is growing the segment;
the segment is receiving a “growth allocation” of capital spending.
- A ratio of 1 indicates that the segment’s proportion of capital expenditures
is the same as its proportion of total assets.
- A ratio less than 1 indicates that the segment is being allocated a lesser
proportion of capital expenditures than its proportion of total assets; if a trend
develops, the segment will become less significant over time.
• The analyst is still puzzled by the capital allocation taking place within Nestlé.
He describes his findings for each segment.

74
SEGMENT ANALYSIS AND CAPITAL ALLOCATION

• Nestlé Nutrition: this is the most profitable segment, but over the last three
years, it has received the lowest proportion of capital expenditures. The
company has invested in the nutrition segment by acquisition (e.g. Wyeth
Nutritionals business in 2012). One would expect that a more substantial
operation would require more capital expenditures on maintenance. Capital
expenditures for the nutrition segment have increased only nominally since
2012.
• The “Other businesses” segment is the next most profitable segment in EBIT
margin terms (19.12% in 2014). The analyst has difficulty understanding just
why the profit margins are high in this segment because of the variety of
businesses it contains. It appears that the company’s managers are
allocating capital to it in a significant way. Although it did not receive a
“growth allocation” of capital expenditures in 2014, it received a growth
allocation in the previous two years.

75
SEGMENT ANALYSIS AND CAPITAL ALLOCATION

• The Americas segment and the Asia, Oceania, and Africa segment have
similar EBIT margins, which are in the same range as those of the Nestlé
Nutrition and Other businesses segments. Given their profitability levels and
substantial operations, the analyst is encouraged to see that they are receiving
“growth allocations” of capital spending. Less encouraging is the continuing
significant allocation of capital spending to the European segment.
• Even more questionable is the high proportional allocation of capital
spending to the Nestlé Waters segment, which has had the lowest profit
margins. The analyst is uncomfortable with growth investments in such a low-
return business but notes that the absolute levels of capital expenditures are
the lowest of all the segments in each year.

Worst-case scenario: if the company were to continue making growth

allocations of capital toward the lowest-margined businesses, such as
Europe and Nestlé Waters, the overall Nestlé-only returns might be affected
negatively. Nestlé might become more dependent on its investment in
associates to sustain performance.

76
SEGMENT ANALYSIS AND CAPITAL ALLOCATION

• The analyst decides to deepen his analysis. He knows that accrual

performance measures, such as EBIT, can produce results that do not
indicate an entity’s ability to generate cash flow, and he wonders whether this
limitation has any effect on Nestlé management’s capital allocation
decisions. He also knows that at the segment level, cash flow information is
not publicly available.
• He decides to approximate cash flow by adding depreciation expense to
operating profit and then relate the approximated cash flow to the average
total assets of each segment.
• This approach provides an approximation of cash return relative to the
continued investment in a particular segment.

77
SEGMENT ANALYSIS AND CAPITAL ALLOCATION

• The analyst hence combines the segment operating profit from Exhibit 14
and the segment depreciation and amortisation provided in Exhibit 18 in
order to estimate the segment cash generation shown in Exhibit 18.
• Because he wants to eliminate the effects of any investment peaks or
valleys, he also averages the total assets for each segment in Exhibit 18.
The average total assets in 2012 include the 2011 total assets that were
prepared on a pre-IFRS 19 basis, for which no adjustment is available. The
analyst is aware of the irreconcilable difference but believes that the averaging
of the two years’ amounts will help dilute the difference. He notes that if any
resulting measures based on 2011 data points appear to be outliers, he will
dismiss them.

78
SEGMENT ANALYSIS AND CAPITAL ALLOCATION

**

* From Exhibit 15 (data source, 2011 not displayed)

** From Exhibit 14 (data source) : 2’327 + 473 = 2’800

Source : CFA curriculum

79
SEGMENT ANALYSIS AND CAPITAL ALLOCATION

• In Exhibit 19, the analyst computes each segment’s cash operating return
on total assets and compares the results with the 2014 ranking of capital
expenditures (Exhibit 17) as well as the EBIT margins.
• They are ranked in descending order of the ratio of capital expenditure
percentage to percentage of total assets.
• The lighter shading indicates the highest EBIT margin and cash return on
assets for each year, and the darker shading indicates the lowest EBIT
margin and cash return on assets for each year.

80
SEGMENT ANALYSIS AND CAPITAL ALLOCATION

From
Exhibit 17
* From Exhibit 18: 2’800 / 11’544

Source : CFA curriculum

81
SEGMENT ANALYSIS AND CAPITAL ALLOCATION

• The analyst is surprised to see that the Nestlé Nutrition segment, which has
the highest EBIT profit margin, consistently has the lowest cash return on
total assets. When he looks at the segments with respect to EBIT margins,
he is also disappointed with the allocation of capital spending to Nestlé
Nutrition, thinking that it is too low. However, when he looks at it using the cash
return on total assets measure, the low allocation of spending makes much
more sense.
• He is pleased to see that the segments with the highest cash return on total
assets each year (the Americas and the Asia, Oceania, and Africa segments)
are receiving growth allocations of capital spending.

82
SEGMENT ANALYSIS AND CAPITAL ALLOCATION

• He is also encouraged that the European segment, though a poor performer

with respect to EBIT margin, has cash returns on total assets that are
competitive with the other segments and far ahead of Nestlé Waters and
Nestlé Nutrition.
• Even Nestlé Waters, which had not appeared very attractive with respect to
EBIT margin, is generating strong cash returns on total assets.

This restores the analyst’s confidence that management is allocating

capital in a rational manner.
It makes sense to him that if management makes capital budgeting decisions on
a cash flow basis, they should be evaluated on a cash flow basis also.

83
SEGMENT ANALYSIS AND CAPITAL ALLOCATION

• The analyst then decides to look at Nestlé’s capital allocation process from a
product group standpoint. The sales and EBIT information is shown in
Exhibit 20.
• From the table, he notes that the Nutrition and Health Science product
group is the only one with significant growth in either sales or EBIT, and
that is the segment in which the company has been making its acquisitions in
the last few years. He also notes that the EBIT margin for the Nutrition and
Health Science product group has increased in each of the last two years.
• Although it is among the highest over the last three years, the Powdered and
Liquid Beverages product group has consistently shown higher EBIT
margins. The Powdered and Liquid Beverages product group EBIT margins
far exceed the lowest-ranking EBIT margins of the Water product group.

84
SEGMENT ANALYSIS AND CAPITAL ALLOCATION

Source : CFA curriculum

85
SEGMENT ANALYSIS AND CAPITAL ALLOCATION

Source : CFA curriculum

87
86
SEGMENT ANALYSIS AND CAPITAL ALLOCATION

* From Exhibit 20: 2’723 / 13’046 = 20.9%

Source : CFA curriculum

87
SEGMENT ANALYSIS AND CAPITAL ALLOCATION

• Nestlé does not provide capital expenditure information by product

group. Compared with the segment analysis performed, the analyst’s scope is
limited in examining product groups. He decides to look at the return on
assets with respect to EBIT rather than on a cash-generated basis.
• To further examine capital allocation decisions, he gathers the asset
information by product group (Exhibit 21). The reported total assets differ by
segment and product group presentation because Nestlé reports its assets on
an average basis for product groups and on a year-end basis for segments. A
significant amount of assets is unallocated to segments, but there is no
unallocated amount by product group.
• The analyst calculates the EBIT return on assets as EBIT divided by average
assets and determines the proportion of total average assets devoted to
each product group. The highest EBIT percentage, EBIT return on assets,
and percentage of total assets each year are lightly shaded, and the lowest
are shaded darker. He then uses this information to make some important
observations related to each product group.

88
SEGMENT ANALYSIS AND CAPITAL ALLOCATION

**

From Exhibit 15 From Exhibit 20 (recap)

* From Exhibit 20/21: EBIT / Average assets = 4’685 / 11’599 = 40.4%

** average asset per product / total average asset
Source : CFA curriculum
89
SEGMENT ANALYSIS AND CAPITAL ALLOCATION

• The Nutrition and Health Science product group (which the company has
been investing in over the last several years) has the lowest EBIT return on
assets in each of the last three years and makes up the greatest portion of
total assets. The EBIT return on assets for the Nutrition and Health Science
product group is even lower than that of the Water product group, which has
the lowest EBIT margin. The Nutrition and Health Science product group’s
EBIT return on assets is well below the total company’s EBIT return on assets
(8.4% versus 14.1% in 2014, 7.8% versus 14.6% in 2013, and 9.1% versus
15.4% in 2012). The Nutrition and Health Science product group drags down
the overall return in each year as it becomes a bigger part of the whole.
• The EBIT return on assets is highest for the Powdered and Liquid
Beverages product group, possibly because it might not need much in the
way of assets or capital spending: it is one of the lesser components of total
assets. Furthermore, it has the highest EBIT margin of all the product groups.

90
SEGMENT ANALYSIS AND CAPITAL ALLOCATION
– PRE CONCLUSIONS

• Given the high EBIT margin, the high EBIT return on assets, and the low
dedication of total assets, the analyst wonders whether the company is
allocating capital among its product offerings effectively. It would make
sense to devote as many resources as possible to where returns are
best.
• He also wonders about management’s capital allocation skills regarding
acquisitions. The EBIT return on assets in the Nutrition and Health Science
product group is weak, and the company has been making acquisitions in that
group.
• He finds it troubling that Nestlé took a goodwill impairment charge of
CHF1,908 million in 2014 - something directly related to management’s skill in
making past acquisitions.

91
COURSE CONTENT

Class case study – evaluating a company as long-term equity investment

- Introduction
- Conduct a DuPont analysis
- Analyze the composition of Nestlé’s asset base and capital structure
- Study the company’s segments and the allocation of capital among them

- Examine the company’s earnings quality

- Study the company’s cash flows and their adequacy for the company’s
continued operations and strategies
- Decompose the company’s valuation
- Write a report
- Follow-up

92
ACCRUALS AND EARNINGS QUALITY

• At this point, the information reviewed by the analyst has not increased his
enthusiasm for Nestlé’s operating and capital allocation prowess.
• He considers a worst-case possibility:
- Could the company try to make up for weak operating performance by
manipulating accounting inputs? He makes it a point to understand
whether accruals play a role in the company’s performance.
• The analyst decides to examine the balance-sheet-based accruals and the
cash-flow-based accruals over the last few years. From the Nestlé financial
statements, he assembles the information and intermediate calculations shown
in Exhibit 22.

93
 From
Exhibit
3

From Exhibit 5
From Exhibit 24
From Exhibit 11

* Aggregate accruals: (84’209 – 78’829) = 5’380

Source : CFA curriculum

94
ACCRUALS AND EARNINGS QUALITY

• The analyst calculates the balance-sheet-based and cash-flow-based accruals

ratios, which are measures of financial reporting quality. The ratios are
calculated as follows:

Balance sheet accruals ratio for time t = (NOAt − NOAt −1) / [(NOAt + NOAt−1) / 2]
Cash flow accruals ratio for time t = [NIt − (CFOt + CFIt)] / [(NOAt + NOAt−1) / 2]

- where NOA is net operating assets, NI is net income, CFO is cash flow
from operations, and CFI is cash flow from investing.

• The accruals ratios for the last three years are shown in Exhibit 23.

95
ACCRUALS AND EARNINGS QUALITY

From
Exhibit
22

From
Exhibit
22

Source : CFA curriculum

96
ACCRUALS AND EARNINGS QUALITY

• The analyst notes that the absolute level of accruals on the balance sheet
is minor relative to the size of the operating assets, on either an ending
balance basis or an average basis. Similarly, the fluctuation in the balance-
sheet-based accruals ratio is low. The analyst would have been more
concerned if the absolute levels of the accruals ratio were high; even more
worrisome would have been if they were consistently trending higher. That was
not the case.
• The cash-flow-based accruals ratio exhibits a similar pattern. For the most
recent two years, both ratios are lower than in 2012 and indicate that accruals
are not a large factor in the financial results.
• The analyst still decides to examine the quality of Nestlé’s cash flow and its
relationship to net income.

97
COURSE CONTENT

Class case study – evaluating a company as long-term equity investment

- Introduction
- Conduct a DuPont analysis
- Analyze the composition of Nestlé’s asset base and capital structure
- Study the company’s segments and the allocation of capital among them
- Examine the company’s earnings quality

- Study the company’s cash flows and their

adequacy for the company’s continued operations
and strategies
- Decompose the company’s valuation
- Write a report
- Follow-up

98
CASH FLOW RELATIONSHIPS

• The analyst begins his analysis with the compilation of Nestlé’s statements of
cash flows shown in Exhibit 24.The analyst’s most pressing concerns include
the following:
- Are Nestlé’s operating earnings backed by cash flow?
- Are the accrual measures telling the whole story?
- Are the operating earnings the result of accounting choices?

99
Source : CFA curriculum 100
CASH FLOW RELATIONSHIPS

Source : CFA curriculum

101
 From
Exhibit 24
From
Exhibit 2

• To convince himself of the representativeness of the Nestlé earnings, the

analyst first compares the cash generated by operations with the
operating profit (Exhibit 25).
• The cash generated from operations is comparable to accrual basis
operating income but on a cash flow basis. If the cash flow generated by
operations was significantly or consistently less than operating profit, one
would have reason to be suspicious about the quality of the operating profit.
The analyst is encouraged by the fact that the cash generated from
operations substantially exceeded the operating profit in each of the last
three years.

Source : CFA curriculum

102
CASH FLOW RELATIONSHIPS

• Knowing that Nestlé has made a number of acquisitions, the analyst decides to
examine the relationship between operating cash flow and total assets.
- Cash flow is a measure of the operational success of the company’s
investment projects: successful investments generate cash rather than
absorbing it.
- Total assets reflect the total of management’s resource allocations over
time.
- Cash generated by total assets indicates the kind of cash return that is
generated by all investments.
• The relationship is shown in Exhibit 26.

103
CASH FLOW RELATIONSHIPS

From
Exhibit 24
*

• The analyst finds himself again concerned about the effectiveness of

management’s asset allocation decisions. Although the 13.5% cash return
on total assets is a high return on investment, the trend is declining.

* Source of data from Exhibit 22 – example: Avg total assets 2014 = (assets 2014 + assets 2013) / 2

Source : CFA curriculum

104
CASH FLOW RELATIONSHIPS

• The analyst thinks back to the 2014 goodwill impairment and the poor EBIT
return on assets in the Nutrition and Health Science product group, in
which acquisitions have been occurring lately.
• Given the negative trend in asset returns, the analyst looks at Nestlé’s
liquidity and funding ability relative to cash flow.
• He decides to compare cash flow with reinvestment, debt, and debt-
servicing capacity, as shown in Exhibit 27.

105
106
CASH FLOW RELATIONSHIPS

• The analyst sees that reinvestment needs have been covered by cash flow
by a factor of 3.89 in 2014, 3.42 in 2013, and 3.31 in 2012. Even better, the
trend is improving.
• He also sees that based on the relationship of cash flow to total debt, the
company is not highly leveraged, with cash generated from operations at
78.3% of total debt at the end of 2014. The ratio is high enough to indicate that
additional borrowing could be arranged should an investment
opportunity arise. In addition, the analyst notes that Nestlé has the capacity
to pay off its debt in approximately two years even while maintaining its current
reinvestment policy*.
• The cash flow interest coverage ratio indicates more than satisfactory
financial strength in the current year, with cash flow 33.2 times the interest
paid. This indicates that the company has sufficient financial capacity to add
more debt if there is an investment opportunity.

* Total debt divided by operating cash flow minus reinvestment needs : [21,963 / (17,199 – 4,423)]
107
COURSE CONTENT

Class case study – evaluating a company as long-term equity investment

- Introduction
- Conduct a DuPont analysis
- Analyze the composition of Nestlé’s asset base and capital structure
- Study the company’s segments and the allocation of capital among them
- Examine the company’s earnings quality
- Study the company’s cash flows and their adequacy for the company’s
continued operations and strategies

- Decompose the company’s valuation

- Write a report
- Follow-up

108
DECOMPOSITION AND ANALYSIS OF THE
COMPANY'S VALUATION

• At this point, the analyst believes he has obtained sufficient information about
the company’s sources of earnings, returns on shareholders’ equity, capital
structure, capital allocation decisions, and earnings quality.
• The analyst wants to study the company’s market valuation. During his
reading of the annual reports, he noted that Nestlé has a significant equity
position (23.4%) in L’Oréal, a French cosmetics company. L’Oréal is accounted
for in the financial statements as an investment in associates as Nestlé’s
ownership position does not give it control.
• Although L’Oréal contributes to the earnings of Nestlé as a whole, it is also
valued separately in the public markets, and its discrete valuations may be
different from its embedded Nestlé valuation. To determine the value that the
market places solely on Nestlé operations, the analyst first removes the value
of the L’Oréal holding from the Nestlé market value, as shown in Exhibit 28.

109
DECOMPOSITION AND ANALYSIS OF THE
COMPANY'S VALUATION

Source : CFA curriculum

110
DECOMPOSITION AND ANALYSIS OF THE
COMPANY'S VALUATION

• The value of the L’Oréal holding is slightly less than 10% of the value of
Nestlé’s market capitalization. The analyst now wants to remove the
earnings of L’Oréal from the earnings of the combined entity (Exhibit 29) to
make a price-earnings comparison for Nestlé earnings alone.

111
• For L’Oréal, this comparison is quite simple: Nestlé discloses in its annual report
that L’Oréal has contributed CHF934 million to current year earnings. The analyst
prepares the table shown in Exhibit 30, which compares the different market
values and price-earnings ratios (with data from Exhibits 28 and 29).

112
DECOMPOSITION AND ANALYSIS OF THE
COMPANY'S VALUATION

• At the time of the current analysis (author’s note: early 2015), Nestlé’s
common stock traded at a price-earnings multiple of 16.0 based on its
year-end market value of CHF231,135 million and trailing earnings (attributable
to controlling interests) of CHF14,456 million, representing a discount of 20%
to the price-earnings multiple of 19.9 for the S&P 500 Index at year-end 2014.
• Once the earnings and available market value of the L’Oréal holding are taken
out of the price-earnings valuation, the shares of the Nestlé-only company
are selling at a slightly higher discount: at 15.5 times earnings, the discount
to the overall market’s price-earnings multiple was a steeper 22%.

113
DECOMPOSITION AND ANALYSIS OF THE
COMPANY'S VALUATION

• At first, the analyst is surprised by Nestlé’s discount to the market multiple,

given that the company has consistently demonstrated meaningful cash flows
and earnings and possesses low financial leverage.
• He considers whether the discount might be attributable to Nestlé’s slipping
core profitability.
• The analyst concludes that Nestlé shares may be discounted by the
market because investors may be developing a skeptical attitude toward
the company.

114
COURSE CONTENT

Class case study – evaluating a company as long-term equity investment

- Introduction
- Conduct a DuPont analysis
- Analyze the composition of Nestlé’s asset base and capital structure
- Study the company’s segments and the allocation of capital among them
- Examine the company’s earnings quality
- Study the company’s cash flows and their adequacy for the company’s
continued operations and strategies
- Decompose the company’s valuation

- Write a report
- Follow-up

115
WRITE A REPORT

• The analyst prepares a report to sum up his findings for the portfolio
manager of the food sector of a large public employee pension fund.
• He sums up his key findings regrouping them into three main categories:
- Support for an investment decision in Nestlé’s shares.
- Cause of concerns.
- Recommendation.

116
SUPPORT FOR AN INVESTMENT IN NESTLE’S
SHARES

• Nestlé has the financial stability to fund growth in its existing operations and
carry out its growth-by-acquisition strategy. The company’s current liquidity
and cash flows are more than adequate for future operating and investment
purposes. The company has low leverage, and the capital structure is capable
of supporting future operations and strategic plans.
• The operating cash flows have consistently exceeded the operating earnings.
The ratio of operating cash to operating profit has been consistently favorable,
providing confidence in the quality of the earnings. Measures comparing
cash flow with reinvestment, debt, and debt-servicing capacity indicate
strength in financial capacity.
• Decomposing earnings into Nestlé-only and L’Oreal and considering the
respective price-to-earnings ratios, it appears that the implied Nestlé-only
portion is undervalued. The implied Nestlé-only portion has a far lower price-
to-earnings ratio than L’Oréal or the market.

117
CAUSES FOR CONCERN

• Although Nestlé has significant, world-class brands and global reach, its core
business has deteriorated in profitability in the last several years, as shown
by the decomposition of the ROE. Even when taking into account the unusual
items affecting profit margins, core operations still show decreases in
profitability. The negative trend also shows in the cash returns on total assets.
They have decreased each year since 2012.
• The acquisition activities in the Nutrition and Health Science product group
do not appear to build on the company’s traditional strengths. They do not
seem to provide a remedy for the deterioration in the core profitability.

118
CAUSES FOR CONCERN

• The company’s priorities in the allocation of capital in making acquisitions

are of some concern. Although the Nutrition and Health Science product group
and the Nestlé Nutrition segment show excellent EBIT margins, they rank very
low in return on assets. This finding raises the question of whether
management is overpaying for acquired companies.
• The company’s write-down of goodwill from earlier acquisitions may signal
ineffective allocation of capital. It is troubling that Nestlé has taken write-
downs on previous acquisitions while actively making new ones.

119
INVESTMENT RECOMMENDATION – DECISION

• The analyst concludes that:

- Nestlé is not a good investment opportunity at this time.
- He recommends waiting to see whether a further discount makes it more
attractive or whether company’s operations improve to change his
recommendation.

120
COURSE CONTENT

Class case study – evaluating a company as long-term equity investment

- Introduction
- Conduct a DuPont analysis
- Analyze the composition of Nestlé’s asset base and capital structure
- Study the company’s segments and the allocation of capital among them
- Examine the company’s earnings quality
- Study the company’s cash flows and their adequacy for the company’s
continued operations and strategies
- Decompose the company’s valuation
- Write a report

- Follow-up

121
FOLLOW-UP

• The portfolio manager is surprised by the analyst’s findings and

recommendations. The portfolio manager is convinced that the purchase of
shares is justified because of the discount and because, in her opinion, Nestlé
is experiencing only temporary issues. She commits the pension fund to a
cautious, less-than-core investment holding of Nestlé common stock.
• The size of the holding is less than originally anticipated because, despite
her enthusiasm for the company, the portfolio manager is troubled by the
analyst’s observations about the resource allocation within the company. She
wants him to continually re-evaluate the holding. Unproductive capital spending
may be a trigger for eliminating the holding.
• The analyst is asked to update his findings in the initial research report at
each reporting period, emphasizing the quality measures expressed by the
accruals tests and the cash flow support of earnings, with particular regard to
return on assets.

122
COURSE CONTENT

1. Introduction
2. Framework for analysis
3. Class case study – Evaluating a company as long-term equity investment

4. Graded case study – Perform follow-up

evaluation

123
CASE STUDY

• Both Albert Roestli (your former colleague) and James Ivory have now retired,
They both enjoyed the Golden visa opportunities available in Portugal and
have relocated there.
• In the meantime, you have been promoted as head of research for
DummDumm Alpha Brokerage Inc. You are now your own boss, just
reporting to the company’s CEO.
• Regarding the analysis of Nestlé, you are somehow worried about both current
external and internal factors, including:
- Changes in top management of Nestlé.
- The role of activists such as Thirdpoint pushing for internal reforms – you
feel the company might not be ready for such changes.
- The sale of many companies previously acquired for a lot of money.

124
• You are now in touch with most of the major anglo-saxon institutional
investors. Based on your previous research and newly acquired experience,
you want to demonstrate that the company has taken significant steps since
the previous in-depth analysis of 2015.
• You decide to write a short but comprehensive report on Nestlé covering a
full cycle of 7 years while providing at the same time a clean strategic view
for future years. Your report should include the following sections:
1. A short review of the quality of previous forecasts performed in 2015
vs. real numbers for those years.
2. A short analysis of key events and related impact on company strategy
for the years 2015 to 2019.
3. An updated investment recommendation (UW / N / OW) aimed at
institutional investors (including relevant background information to justify
your recommendation, using the approach presented on Week 9 of the
course – i.e. this week – i.e. not the Remy Martin approach from week 7).
Please make sure that the basis for your recommendation includes a “best
estimate” assessment of the impact of Covid-19 on sales and revenues of
Nestlé.

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CASE STUDY

Source : CNN – April 3, 2020 (remember – financial institutions can hold shares on a fiduciary basis)
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CASE STUDY

Source : CNN – April 3, 2020

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CASE STUDY

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CASE STUDY

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Source : Nestlé internet site
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Source : Nestlé internet site
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Source : Nestlé internet site
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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

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