Question

1. When determining a company's cash flow from assets, how is depreciation handled and why is that so?

2. How might deconstructing Return on Equity using the DuPont model be helpful if we discovered that our companys ROE is signigicantly lower than the average ROE of our industry peers?

3. Finance professionals strive to enhance shareholders value. The overall value of a firm is generally more closely related to market value than to the book value presented on financial statements. Why don't financial analysts just work with market values?

Answer 1

Solution:

1. The depreciation is a non-cash item and so when we prepare cash flow by indirect method, then we start from the profit and add the non-cash items (e.g. Depreciation).   So depreciation is added back to the profit because depreciation is not paid in cash but rather it is a non-cash expense.

2. ROE using DuPont model is

ROE = Net profit margin x asset turnover x equity multiplier

        = Net income / Sales x    Sales / Asset x   Asset / Equity = Net Income / Equity

This will help in identifying why the ROE is lesser than other companies, and which factor is actually contributing less e.g. Net profit margin is lower or asset turnover is lower or equity multiplier is lower.

3. When we analyze the company using book value then we actually try to find out the market value using various methods like Discounted Cash Flow method, Dividend Discount method. Market Value is basically the function of the book value and other factors. Analysts don’t take only market value because these value can change very frequently and will be more difficult to do valuations.