1. Analyze revenues by segment
2. Calculate EBIT margins for each segment
3. Calculate the proportion of capital expenditures to the proportion of total assets by segment
Many companies engage in more than one business and geographic area. These are accounted for separately in an annual report as distinct operating segments. Segment reporting provides a breakdown of revenue, operating income, and assets by the company’s most important operating units. It is intended to give investors insight into how each business and region contributes to the bottom line of the entire corporation. Segment information is usually toward the end of the footnotes.
1. Revenues by Segment
Begin by examining how much each segment contributes to the company’s total revenue. Pie charts are particularly effective in visualizing revenue distributions for a single period. Be sure to note how the composition of revenues by segment has changed over time. Also be aware of any trends in year-to-year percentage changes across segments. Any notable changes should be followed up with additional research into what is driving the changes. Keep in mind what acquisitions were made in each year.
For illustrative purposes, segment information for Disney (DIS) is presented.
2. EBIT Margins by Segment
Next, calculate EBIT margins (=operating income / revenue) for each segment. It is often helpful to sort the segments in descending order of profitability. Again, be sure to observe any significant changes over time. This may lead to additional threads to follow.
3. Proportion of Capital Expenditures to the Proportion of Total Assets
Lastly, collect data on capital expenditures and total assets by segment for at least the past three years. Translate both tables on a percentage of total basis (as was done with revenues). With this information, calculate the proportion of capital expenditures to the proportion of total assets (=% of total CapEx / % of total assets).
The resulting table provides some insight into the company’s allocation of capital. Ratios above 1.0 indicate that the company is growing the segment. A ratio below 1.0 suggests that the segment will become less significant over time.
The ratio of capital expenditures to total assets should be compared alongside EBIT values and EBIT margin percentages. As a general rule of thumb, the company should be investing in the most profitable segments. Investment ratios above 1.0 coupled with low EBIT margins could indicate a problem (e.g. if it’s an existing line of business) or an opportunity (e.g. if it’s a new business being developed).
Be sure to stay mindful of absolute values. A segment could have a high margin but be insignificant in terms of revenue. Keep in mind furthermore that certain businesses require more assets than others and that recent acquisitions will affect ratios.