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© 2005 by Robert F. Halsey, all rights reserved
Ratio Analysis and Valuation Valuation theory
Discounted free cash flows Residual income
ROE disaggregation into RNOA and financial returns
ROE - Identifying and Computing Operating Working Capital and Operating Assets exercise
ROE Disaggregation (P&G) exercise Pfizer (PFE) valuation exercise
Margin and Turnover EVA
© 2005 by Robert F. Halsey, all rights reserved
Approaches to valuation
Dividend discount model:
From the statement of cash flows,
d = NI + depreciation + OperCL - OperCA - OperLTA + Debt
Substitute cash flows for “d” to yield the free cash flow to equity model (FCFE) :
4)ek(14d
3)ek(13d
2)ek(12d
)ek(11d
0P
4)e(14FCFE
3)ek(13FCFE
2)ek(12FCFE
)ek(11FCFE
0Pk
© 2005 by Robert F. Halsey, all rights reserved
RIt It - ke * BVt-1 First, define residual income (RI) as,
BVt = BVt-1 + It - dt Next, assume clean surplus updating of book value of stockholders’ equity:
dt = (1+ke)BVt-1-BVt+RIt Then, we can rewrite dividends as,
Finally, substituting dt in the dividend discount model yields,
Residual income stock price model
Residual income model
4)ek(1
4RI4)ek(1
3RI2)ek(1
2RI)ek(1
1RI0BV0V
© 2005 by Robert F. Halsey, all rights reserved
Source: Parker Center for Investment Research, Cornell Univ.
© 2005 by Robert F. Halsey, all rights reserved
FCF and RI models The FCF and RI models are theoretically
equivalent since both are derived from the dividend discount model. They will, therefore, yield the same valuation in a steady state (constant RNOA)
FCF defines value in terms of cash flows. RI defines value in terms of accrual accounting (earnings and book values)
© 2005 by Robert F. Halsey, all rights reserved
Lower terminal value for ROPI version of RI model vs. DCF
)+)/(1NOA - V( + )+)/(1NOA - OI( + NOA = V 55
51-tt
5
=1t00 w5ww kk*k
5w5
5w k1k1 VFCF = V t
5
=1t0
Source: Prof. Peter D. Easton, Notre Dame University
TV is reduced by NOA in RI model
RI results in less terminal value component. Why?
© 2005 by Robert F. Halsey, all rights reserved
BV *ekROEBV * BVBV*ek
BVIBV * ekIRI
Importance of ROE
So, given a level of book value, the spread of ROE over the cost of capital (ke) is central to the creation of shareholder value.
© 2005 by Robert F. Halsey, all rights reserved
Spreads v. Market-to-Book For Dow Jones Industrials
ROE - Ke
UTX
MRK
MO
PGMMM
T
MCD
GE
BA
C
WMT
XOMHON
GM
JNJ
AXP
EK
MSFT
HPQ
IBM
DD
IP AA
JPM
INTC
KO
SBCDIS
-60 -50 -40 -30 -20 -10 0 10 20 30 40 50 60
HD
0
2
4
6
8
10
CATMar
ket V
alue
/Boo
k Va
lue
© 2005 by Robert F. Halsey, all rights reserved
Source: Nissim and Penman, 2003
© 2005 by Robert F. Halsey, all rights reserved
AvgNOASales * Sales
NOPAT RNOA
= PM * Turnover
ROE Disaggregation
ROE = RNOA + (FLEV * SPREAD)
© 2005 by Robert F. Halsey, all rights reserved
ROE - Identifying and Computing Operating Working Capital and Operating Assets exercise
ROE Disaggregation (P&G) exercise
Pfizer (PFE) valuation exercise
Exercises
Cisco Systems, Inc
© 2005 by Robert F. Halsey, all rights reserved
ROE Disaggregtion – P&G Profitability Ratios
Procter & Gamble 2003 2002 2001 2000
Gross profit margin .............................. 49.0%
($21,236 / $43,377)
47.8% ($19,249 /
$40,238)
43.7% ($17,142 /
$39,244)
46.1% ($18,437 /
$39,951)
Operating expense margin....................................................
30.9% ($13,383 /
$43,377)
31.2% ($12,571 /
$40,238)
31.6% ($12,406 /
$39,244)
31.2% ($12,483 /
$39,951)
Net operating profit margin1...................................................
12.5%
($7,853.689) / $43,377)
11.3%
($6,678.682) / $40,238
7.6%
($4,736.633) / $39,244
9.5%
($5,954.64) / $39,951
1 After-tax %................................................. 1-$2,344/$7,530
= .689) 1-$2,031/$6,383
= .682 1-$1,694/$4,616
= .633 1-$1,994/$5,536
= .64
© 2005 by Robert F. Halsey, all rights reserved
ROE Disaggregtion – P&G Turnover Ratios
Procter & Gamble 2003 2002 2001
Accounts receivable turnover............................................................
14.16 ($43,377 / [($3,038 +
$3,090) / 2]
13.37 ($40,238 / [($3,090 +
$2,931) / 2]
13.44 ($39,244 / [($2,931 +
$2,910) / 2]
Average collection period ...............................................................
25.56 ($3,038/ [$43,377/ 365])
28.03 ($3,090/ [$40,238/ 365])
27.26 ($2,931/ [$39,244/ 365])
Inventory turnover .......................................... 6.24
($22,141 / [$3,640 + $3,456] / 2)
6.14 ($20,989 / [$3,456 +
$3,384] / 2)
6.43 ($22,102 / [$3,384 +
$3,490] / 2)
Average inventory days outstanding ............................................
60.01 ($3,640/ [$22,141/ 365])
60.10 ($3,456/ [$20,989/ 365])
55.88 ($3,384/[$22,102/ 365])
Long-term operating asset turnover 1 ...............................................
1.52 ($43,377/([$28,486 +
$28,610] / 2)
1.46 $40,238 / ([$28,610 +
$26,498] / 2)
1.55 $39,244 / ([$26,498 +
$24,2202] / 2)
Long-term net operating asset turnover 2 .........................................................
1.73 ($43,377/([$24799 +
$25,445] / 2)
1.74 $40,238 / ([$25,445 +
$20,759] / 2)
1.87 $39,244 / ([$20,759 +
$21,2942] / 2)
1 Net long-term operating assets
$43,706 - $15,220 =
$28,486
$40,776 - $12,166 =
$28,610
$34,387 - $10,889 =
$26,498
2 Net long-term net operating assets
$43,706 - $15,220 - $1,396 - $2,291 =
$24,799
$40,776 - $12,166 - $1,077 - $2,088 =
$25,445
$34,387 - $10,889 - $894 - $1,845 =
$20,759
© 2005 by Robert F. Halsey, all rights reserved
ROE Disaggregtion – P&G ROE ComponentsProcter and Gamble 2003 2002 2001
After-tax % ........................................................ 1-($2,344/$7,530) = 0.689
1-($2,031/$6,383) = 0.682
1-($1,694/$4,616) = 0.633
Net operating profit after-tax (NOPAT)...........................................................
$7,853 0.689 = $5,411
$6,678 0.682 = $4,554
$4,736 0.633 = $2,998
Net operating assets (NOA) 1 ..........................
$43,706 - $300 - ($12,358 - $2,172) - $1,396 - $2,291 =
$29,533
$40,776 - $196 -($12,704 - $3,731) - $1,077 - $2,088=
$28,442
$34,387 - 212 -($9,846 - $2,233) - $894 - $1,845 =
$23,823
Net financial obligations (NFO)2 ..................... $2,172 + $11,475 - $300 = $13,347
$3,731 + $11,201 - $196 = $14,736
$2,233 + $9,792 - $212 = $11,813
Stockholders’ equity ....................................... $16,186 $13,706 $12,010
© 2005 by Robert F. Halsey, all rights reserved
ROE Disaggregtion – P&G ROE ComponentsProcter and Gamble 2003 2002 2001 1. Net operating profit margin
(NOPM) 12.474%
($5411 / $43,377) 11.318%
($4,554 / $40,238) 7.639%
($2,998 / $39,244)
2. Return on net operating assets (RNOA)
18.667% $5,411 / ([$29,533 +
$28,442] / 2)
17.427% $4,554 / ([$28,442 +
$23,823] / 2)
12.446% $2,998 / ([$23,823 +
$24,355] / 2)
3. Financial leverage (FLEV) 93.948% ([$13,347 + $14,736 ] / 2) /
([$16,186 + $13,706] / 2)
103.239% ([$14,736 + $11,813] / 2) / ([$13,706 + $12,010] / 2)
98.288% ([$11,813 + $12,068] / 2) / ([$12,010 + $12,287] / 2)
4. Net financial rate (NFR) 1.585% ($561 - $238) .689 /
([$13,347 + $14,736] / 2)
1.516% ($603 - $308) .682 /
([$14,736 + $11,813] / 2)
0.636% ($794 - $674) .633 /
([$11,813 + $12,068] / 2)
5. Spread 17.082% (18.667% - 1.585%)
15.911% (17.427% - 1.516%)
11.810% (12.446% - 0.636%)
6. Return on equity (ROE) 34.698% $5,186 /
([$16,186 + $13,706] / 2)
33.847% $4,352 /
([$13,706 + $12,010] / 2)
24.052% $2,922 /
([$12,010 + $12,287] / 2)
7. ROE formula computation 18.667% + (93.948% x 17.082%) = 34.715%
17.427% + (103.239% x 15.911%) = 33.853%
12.446% + (98.288% x 11.810%) = 24.054%
© 2005 by Robert F. Halsey, all rights reserved
ROE Disaggregtion – P&G Liquidity and Solvency
Procter and Gamble 2003 2002 2001 2000 Current ratio (current assets / current liabilities) 1.23 0.96 1.11 1.00
Quick ratio (quick assets / current liabilities) 0.75 0.53 0.55 0.44
Procter and Gamble 2003 2002 2001 2000 Total liabilities-to-equity...................................... 1.7 2.0 1.9 1.8
Times interest earned .......................................... 14.42 11.59 6.81 8.67
© 2005 by Robert F. Halsey, all rights reserved
ROE Disaggregtion – P&G Altman Z-ScoreThe Altman Z-Score for P&G as of 2003 is:
Z= 0.717 X1 + 0.847 X2 + 3.107 X3 + 0.420 X4 + 0.998 X5 = 2.12 where,
X1 = Working capital/ Total assets X2 = Retained earnings/Total assets X3 = Earnings before interest and taxes /Total assets X4 = Equity/ Total liabilities X5 = Sales/ Total assets
0.717 x 0.065=0.047 0.847 x 0.313=0.265 3.107 x 0.185=0.575 0.420 x 0.588=0.247 0.998 x 0.992=0.990
Z-Score =2.124
P&G’s Z-score is in the gray area—the prediction is inconclusive.
© 2005 by Robert F. Halsey, all rights reserved
PG 5-Year Stock Price Trend
Forecast Horizon Terminal YearYear 2004 2005 2006 2007 2008 2009(in $ Million)Beginning of the Year Balance SheetBeg Net Working Capital 6,084 8,396 9,529 10,816 12,276 12,706 13,150Beg Net Long-Term Assets 87,034 120,107 136,321 154,725 175,613 181,759 188,121Total Assets 93,118 128,503 145,851 165,541 187,889 194,465 201,271
Beg. Net Debt 27,741 38,283 43,451 49,317 55,974 57,933 59,961Beg. Shareholders Equity 65,377 90,220 102,400 116,224 131,914 136,531 141,310Total Net Capital 93,118 128,503 145,851 165,541 187,889 194,465 201,271
Income Statement for the YearSales 54,226 62,359 70,778 80,333 91,178 94,369 97,672Net operating profits after tax (NOPAT) 10,174 11,700 13,280 15,073 17,108 17,706Net interest after tax 1,387 1,914 2,173 2,466 2,799 2,897Net income 8,787 9,786 11,107 12,607 14,309 14,810
ComputationsNOPAT 10,174 11,700 13,280 15,073 17,108 17,706Beginning net operating assets 93,118 128,503 145,851 165,541 187,889 194,465WACC 0.0583 0.0583 0.0583 0.0583 0.0583 0.0583Expected NOPAT 5,427 7,490 8,501 9,648 10,951 11,334ROPI 4,747 4,211 4,779 5,424 6,157 6,372
Discount factor - based on WACC 0.9449 0.8929 0.8437 0.7972 0.7533 0.7118
Residual Oparating Income (ROPI) modelResidual operating income 4,747 4,211 4,779 5,424 6,157 6,372PV of residual operating income 4,486 3,760 4,032 4,325 4,638 4,536Cumulative PV ROPI 4,486 8,245 12,277 16,602 21,240Terminal value of abnormal NOPAT 206,159Beg. book value of assets 93,118Value of the firm - ROPI $320,517Value of debt $27,741Value of equity $292,776
$38.38
ComputationsNOPAT 10,174 11,700 13,280 15,073 17,108 17,706Chg in working capital -2,312 -1,133 -1,286 -1,460 -430 -445Chg in long-term assets -33,073 -16,214 -18,403 -20,888 -6,146 -6,362Free Cash Flow to the Firm (FCFF) -25,211 -5,647 -6,410 -7,275 10,532 10,900
Discounted Cash Flow (DCF) modelPresent value of FCF to the firm (FCFF) -23,822 -5,042 -5,408 -5,800 7,934Cumulative PV FCFF -23,822 -28,865 -34,273 -40,073 -32,139PV of Terminal Value 352,656Value of the firm - FCFF $320,517Value of debt $27,741Value of equity $292,776
$38.38
Pfizer (PFE) valuation exercise
© 2005 by Robert F. Halsey, all rights reserved
ROE DisaggregationEmpirical FindingsDefinition:ROE = RNOA + LEV × SpreadMedian 12.2% ≈ 10.3% + 0.40 × 3.3%
Companies are, on average, conservatively financed (LEV<1.0).
They earn, on average, a positive spread on borrowed monies.
RNOA is, on average, approximately 84% of reported ROE.
All industries that survive must earn a combination of operating and financial returns that meet shareholder expectations.
© 2005 by Robert F. Halsey, all rights reserved
Behavior Over Time(Nissim and Penman 2001)
ROE
RNOA
NBC
1963-1996
© 2005 by Robert F. Halsey, all rights reserved
ROCE v. Ke (Nissim and Penman 2001)
© 2005 by Robert F. Halsey, all rights reserved
Margin vs. Turnover
Margin and Turnover Combinations for a Given RNOA
Entertainment
Printing & Publishing
Agriculture
Beer & LiquorTobacco
Apparel
HealthcarePharmaceuticals
Chemicals
TextilesConstruction Materials
Construction
Electrical Equipment
Autos & Trucks
Aircraft
DefensePrecious Metals
Coal
Petroleumand Natural Gas
UtilitiesCommunication
Computers
Transportation
Retail Restaurants
Banking Real Estate
0.00
0.50
1.00
1.50
2.00
2.50
3.00
3.50
0.00 0.02 0.04 0.06 0.08 0.10 0.12 0.14
Profit Margin
Ass
et T
urno
ver
RNOA=10.3%
© 2005 by Robert F. Halsey, all rights reserved
Margin and Turnover Exercise
NOPAT margin vs. NOA turnover
0.00%2.00%4.00%6.00%8.00%
10.00%12.00%14.00%
0.00 1.00 2.00 3.00 4.00
Net operating asset tunrover rate
NOPA
T m
argi
n
© 2005 by Robert F. Halsey, all rights reserved
Compare RI with Economic Value Added TM (“EVA”)
Under EVA,
MV = capital + PV of future EVA,
where EVA1 = NOPAT1 - kwacc*capital0
© 2005 by Robert F. Halsey, all rights reserved
EVA Exercise Current Year Revenues............................................................. $11,400 Cost of goods sold ............................................... (6,000) Gross profit ......................................................... 5,400 Selling, general and administrative expenses ........ (4,000) Operating profit ................................................... 1,400 Interest expense................................................... (400) Pretax income...................................................... 1,000 Tax expense ........................................................ (350) Net income.......................................................... $ 650
Current Year
Prior Year
Current Year
Prior Year
Cash................................. $ 800 $ 500 Accounts payable.................... $ 800 $ 700 Accounts receivable.......... 1,200 1,000 Accrued liabilities ................... 1,250 1,000 Inventories ....................... 3,000 2,500 Total current liabilities ............ 2,050 1,700 Total current assets ........... 5,000 4,000 Long-term debt ....................... 6,000 5,000 Plant assets, net ................ 10,000 9,000 Total stockholders’ equity ....... 6,950 6,300 Total assets....................... $15,000 $13,000 Total liabilities and equity....... $15,000 $13,000
EVA = $($1,400*[1-0.35]) – ([$13,000-$1,700]×10%) = $910 - $1,130 = ($220)
RNOA = 8.05% ($910/[$13,000-$1,700]) < 10%. The deficit is 1.95% x $(13,000-1,700) = $(220) as above.
© 2005 by Robert F. Halsey, all rights reserved
EVA Exercise – Areas for Improvement
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