Earnings Sources and Performance

We consider the acquisition of a minority equity interest in Thunderbird Corporation, a publicly held firm located in the United States. Thunderbird is a leading producer of electronic components used in automotive, aircraft, and marine applications.

Sources of Earnings and Return on Equity

We begin our analysis by identifying the sources of Thunderbird’s earnings and determining whether these sources are sustainable over time.

Return on equity (ROE) can be decomposed using the extended DuPont equation, as follows:

The DuPont decomposition allows us to identify the firm’s performance drivers, allowing us to expose effects of weaker areas of business that are being masked by the effects of other, stronger areas. For example, a firm could offset a declining EBIT margin by increasing asset turnover or increasing leverage.

We must also consider the firm’s sources of income and whether the income is generated internally from operations or externally. For example, the firm has less control over income that is generated by an ownership interest in an associate than over income generated internally. If equity income from associates or joint ventures is a significant source of earnings, we should isolate these effects by removing the equity income from our DuPont analysis to eliminate any bias.

As mentioned before, the equity method is used to account for influential investments (generally an ownership interest of 20% to 50%). Under the equity method, the investor recognizes its pro rata share of the investee’s earnings on the income statement. Eliminating the equity income from the investor’s earnings permits analysis of the investor’s performance resulting exclusively from its own asset base.

Assuming the investee is profitable, this adjustment will decrease both the investor firm’s earnings and net profit margin.

Since, under the equity method, the firm’s investment is reported as a balance sheet asset, total assets should be reduced by the carrying value of investment. This will increase total asset turnover (smaller denominator). We can use the extended DuPont equation to determine the overall effect on ROE.

We begin our extended example using the selected financial data for Thunderbird presented in Figure 12.2. Thunderbird owns a 30% equity interest in one of its suppliers, Eagle Corporation.

Figure 12.2: Selected Financial Data, Thunderbird Corporation

Using these data, we can decompose Thunderbird’s ROE using the extended DuPont equation.

Figure 12.3: Extended DuPont Analysis (As Reported)

Note the slight improvement in ROE over the period, from 19.51% to 21.26%. The decomposition reveals that this is the result of an increasing EBIT margin and decreased effects of taxes and interest, which is offset to some degree by a reduction in financial leverage. Note that an increase in the interest and tax burden ratios indicates that the effective tax rate and impact of interest charges on operating earnings have decreased.

By removing the equity income of Eagle from earnings and the equity investment from total assets, we can examine Thunderbird’s performance on a standalone basis. Another common adjustment made by analysts is to remove the effects of any unusual items (e.g., provisions for restructuring and litigation, goodwill impairment, etc.) from reported operating earnings (EBIT) before computing the EBIT margin and the tax burden ratios.

Figure 12.4: Extended DuPont Analysis (Excluding Equity Income and Investment

Asset)

As compared to the reported ROE (Figure 12.3), adjusted ROE (Figure 12.4) has been decreased by eliminating equity income and the investment asset. Note that EBIT margin did not change because Thunderbird did not include equity income from Eagle as a part of EBIT.