256  Analyzing Performance interest coverage ratios artificially high. By using the debt-to-EBITDA ratio, one can build a more comprehensive picture of the risk of leverage. A variation of these debt multiples is the multiple of debt plus leases to EBITDAR. This multiple works best for companies with extensive operating leases, such as airlines and retailers. To better understand the power—and danger—of leverage, consider the relationship between return on equity (ROE) and return on invested capital (ROIC): ROE ROIC ROIC = + − − [ ( ) ] 1 T k D E d As the formula demonstrates, a company’s ROE is a direct function of its ROIC, its spread of ROIC over its after-tax cost of debt (kd), and its book-based debt-to-equity ratio (D/E). Consider a company that is earning an ROIC of 10 percent and has an after-tax cost of debt of 5 percent. To raise its ROE, the company can either increase its ROIC (through operating improvements) or increase its debt-to-equity ratio (by swapping debt for equity). Although each strategy can lead to an identical change in ROE, increasing the debt-to-equity ratio makes the company’s ROE more sensitive to changes in operating per- formance (ROIC). Thus, while increasing the debt-to-equity ratio can increase ROE, it does so by increasing the risks faced by shareholders. To assess leverage, measure the company’s (market) debt-to-equity ratio over time and against peers. Does the leverage ratio compare favorably with the industry? How much risk is the company taking? Chapter 33 offers in- depth answers to these and other questions about the use of debt to finance operations. Payout Ratio The dividend payout ratio equals total common dividends divided by net income available to common shareholders. We can better understand the com- pany’s financial situation by analyzing the payout ratio in relation to its cash flow reinvestment ratio: • If the company has a high dividend payout ratio and a reinvestment ratio greater than 1, then it must be borrowing money to fund negative free cash flow, to pay interest, or to pay dividends. But is this sustainable? • A company with positive free cash flow and low dividend payout is probably paying down debt (or accumulating excess cash). In this situ- ation, is the company passing up the valuable tax benefits of debt or hoarding cash unnecessarily? Credit Health and Capital Structure  257 Applying these questions to Costco, we find that from 2015 to 2019, Costco generated $14.7 billion in NOPAT, paid $1.1 billion in interest, and returned $9.5 billion to shareholders in dividends. Valuation Metrics To conclude your assessment of capital structure, measure the shareholders’ perception of future performance by calculating a market multiple. To build a market multiple, divide core operating value (defined in Chapter 10 as enter- prise value less the market value of nonoperating assets, such as excess cash and nonconsolidated subsidiaries) by a normalizing factor, such as revenue, EBITA, or the book value of invested capital. By comparing the multiple of one company versus another, you can examine how the market perceives the company’s future relative to other companies. Exhibit 12.12 presents the operating-value-to-EBITDA multiples for Costco and its peers between 2005 and 2019. Although Costco traded in line with its peers from 2005 to 2011, its multiple has since increased substantially, while the multiple for its peers remained the same. We infer that Costco’s higher multiple is driven by its stronger revenue growth and enduring higher ROIC. While operating value to EBITDA is the most common measure of valua- tion, other measures, including operating value to EBITA and operating value to NOPAT, often provide helpful insights as well. For more on how to create and interpret valuation multiples, see Chapter 18. EXHIBIT 12.12  Costco versus Peer Group: Operating Value to EBITDA Multiple of EBITDA 0 4 2005 2007 2009 2011 2013 2015 2017 2019 Costco Peer group median 8 12 16 20 Note: Operating value equals enterprise value less the book value of nonoperating assets. 258  Analyzing Performance General Considerations Although it is impossible to provide a comprehensive checklist for analyzing a company’s historical financial performance, here are some guidelines to keep in mind: • Look back as far as possible (at least ten years). Long time horizons will allow you to determine whether the company and industry tend to revert to some normal level of performance and whether short-term trends are likely to be permanent. • Disaggregate value drivers—both ROIC and revenue growth—as far as possible. If possible, link operational performance measures with each key value driver. • If there are any radical changes in performance, identify the source. De- termine whether the change is temporary, permanent, or merely an ac- counting effect. • If possible, perform your analysis on a fine-grained level, not just on the company as a whole. Real insight comes from analysis of individual business units, product lines, and, if the data exist, even customers. With historical analysis complete, we now have the appropriate context to build a robust set of forecasts, a critical ingredient of any valuation.