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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
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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 equitymodel (FCFE) :
4)ek (1
4d
3)ek (1
3d
2)ek (1
2d
)ek (11
d
0P
4)e(14
FCFE
3)ek (1
3FCFE
2)ek (12
FCFE
)ek (11
FCFE
0P
k
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RIt It - k e * BVt-1 First, define residual income (RI) as,
BVt = BV
t-1 + I
t - d
t
Next, assume clean surplus updating of
book value of stockholders’ equity:
dt = (1+k e)BVt-1-BVt+RIt Then, we can rewrite dividends as,
Finally, substituting dt in the dividend discount model yields,
Residualincome stock
price model
Residual income model
4)ek (14
RI
4)ek (1
3RI
2)ek (12
RI
)ek (11
RI
0BV
0V
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Source: Parker Center for Investment Research, Cornell Univ.
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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)
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Lower terminal value for ROPI
version of RI model vs. DCF
)+ )/(1 NOA-V ( + )+ )/(1 NOA-OI ( + NOA=V 5
5
5
1-t t
5
=1t
00 w5ww k k *k
5
w5
5
w k 1k 1 V FCF =V t
5
=1t
0
Source: Prof. Peter D. Easton, Notre Dame University
TV is reduced byNOA in RI model
RI results in less terminal value component. Why?
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BV*e
k ROEBV*BV
BV*e
k
BVIBV*
ek IRI
Importance of ROE
So, given a level of book value, the spread
of ROE over the cost of capital (k e) is
central to the creation of shareholder
value.
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Spreads v. Market-to-Book For
Dow Jones Industrials
ROE - Ke
UTX
MRK
MO
PG MMM
T
MCD
GE
BA
C
WMT
XOM
HON
GM
JNJ
AXP
EK
MSFT
HPQ
IBM
DD
IP AA
JPM
INTC
KO
SBC
DIS
-60 -50 -40 -30 -20 -10 0 10 20 30 40 50 60
HD
0
2
4
6
8
10
CAT M a
r k e t V a l u e / B o o k V a
l u e
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Source: Nissim and Penman, 2003
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ROE - Identifying and Computing Operating Working
Capital and Operating Assets exercise
ROE Disaggregation (P&G) exercise
Pfizer (PFE) valuation exercise
Exercises
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Cisco Systems, Inc
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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 expensemargin.........................
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 profitmargin1........................
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
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ROE Disaggregtion –
P&G Turnover RatiosProcter & Gamble 2003 2002 2001
Accounts receivableturnover.......................
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 collectionperiod ..........................
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 inventorydays outstanding .......
60.01
($3,640/ [$22,141/ 365])
60.10
($3,456/ [$20,989/ 365])
55.88
($3,384/[$22,102/ 365])
Long-term operatingasset 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 +
$24,220
2
] / 2)
Long-term netoperating assetturnover 2 ....................
1.73
($43,377/([$24799 +$25,445] / 2)
1.74
$40,238 / ([$25,445 +$20,759] / 2)
1.87
$39,244 / ([$20,759 +$21,294
2] / 2)
1 Net long-term operatingassets
$43,706 - $15,220 =
$28,486
$40,776 - $12,166 =
$28,610
$34,387 - $10,889 =
$26,498
2 Net long-term net operatingassets
$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
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ROE Disaggregtion –
P&G ROE Components
Procter and Gamble 2003 2002 2001
After-tax %.....................................1-($2,344/$7,530)
= 0.6891-($2,031/$6,383)
= 0.6821-($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
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ROE Disaggregtion –
P&G ROE Components
Procter 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 operatingassets (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% x17.082%) = 34.715%
17.427% + (103.239% x15.911%) = 33.853%
12.446% + (98.288% x11.810%) = 24.054%
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ROE Disaggregtion –
P&G Liquidity and Solvency
Procter and Gamble 2003 2002 2001 2000
Current ratio (currentassets / 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 1.8Times interest earned ............ 14.42 11.59 6.81 8.67
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ROE Disaggregtion –
P&G Altman Z-Score
The Altman Z-Score for P&G as of 2003 is:
Z= 0.717 X 1 + 0.847 X 2 + 3.107 X 3 + 0.420
X 4 + 0.998 X 5 = 2.12
where,X1 = Working capital/ Total assets
X2 = Retained earnings/Total assetsX3 = Earnings before interest and taxes /Total assetsX4 = Equity/ Total liabilitiesX5 = Sales/ Total assets
0.717 x 0.065=0.047
0.847 x 0.313=0.2653.107 x 0.185=0.5750.420 x 0.588=0.2470.998 x 0.992=0.990
Z-Score =2.124
P&G’s Z-score is in the gray area—the prediction is inconclusive.
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PG 5-Year Stock Price Trend
Forecast Horizon Terminal Year
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Year 2004 2005 2006 2007 2008 2009
(in $ Million)
Beginni ng of th e Year Balance Sheet
Beg Net Working Capital 6,084 8,396 9,529 10,816 12,276 12,706 13,150
Beg Net Long-Term Assets 87,034 120,107 136,321 154,725 175,613 181,759 188,121
Total 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 59,961
Beg. Shareholders Equity 65,377 90,220 102,400 116,224 131,914 136,531 141,310
Total Net Capital 93,118 128,503 145,851 165,541 187,889 194,465 201,271
Income Statement for th e Year Sales 54,226 62,359 70,778 80,333 91,178 94,369 97,672
Net operating profits after tax (NOPAT) 10,174 11,700 13,280 15,073 17,108 17,706
Net interest after tax 1,387 1,914 2,173 2,466 2,799 2,897
Net income 8,787 9,786 11,107 12,607 14,309 14,810
Computations
NOPAT 10,174 11,700 13,280 15,073 17,108 17,706
Beginning net operating assets 93,118 128,503 145,851 165,541 187,889 194,465
WACC 0.0583 0.0583 0.0583 0.0583 0.0583 0.0583
Expected NOPAT 5,427 7,490 8,501 9,648 10,951 11,334
ROPI 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 Incom e (ROPI) model
Residual operating income 4,747 4,211 4,779 5,424 6,157 6,372
PV of residual operating income 4,486 3,760 4,032 4,325 4,638 4,536
Cumulative PV ROPI 4,486 8,245 12,277 16,602 21,240
Terminal value of abnormal NOPAT 206,159
Beg. book value of assets 93,118
Value of the firm - ROPI $320,517Value of debt $27,741
Value of equity $292,776
$38.38
ComputationsNOPAT 10,174 11,700 13,280 15,073 17,108 17,706
Chg in working capital -2,312 -1,133 -1,286 -1,460 -430 -445
Chg in long-term assets -33,073 -16,214 -18,403 -20,888 -6,146 -6,362
Free Cash Flow to the Firm (FCFF) -25,211 -5,647 -6,410 -7,275 10,532 10,900
Discounted Cash Flow (DCF) model
Present value of FCF to the f irm (FCFF) -23,822 -5,042 -5,408 -5,800 7,934
Cumulative PV FCFF -23,822 -28,865 -34,273 -40,073 -32,139PV of Terminal Value 352,656
Value of the firm - FCFF $320,517Value of debt $27,741
Value of equity $292,776$38.38
Pfizer (PFE)valuation exercise
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ROE DisaggregationEmpirical Findings
Definition: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 onborrowed 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 shareholderexpectations.
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ROCE v. Ke (Nissim and Penman 2001)
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Margin vs. Turnover
Margin and Turnover Combinations for a Given RNOA
Entertainment
Printing & Publishing
Agriculture
Beer & Liquor Tobacco
Apparel
Healthcare
Pharmaceuticals
Chemicals
Textiles
Construction MaterialsConstruction
Electrical Equipment
Autos & Trucks
Aircraft
DefensePrecious Metals
Coal
Petroleum
and Natural Gas
UtilitiesCommunication
Computers
Transportation
Retail Restaurants
BankingReal 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
A s s e t T u r n o v e r
RNOA=10.3%
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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
N O P A T m a r g i n
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Compare RI withEconomic Value Added TM (“EVA”)
Under EVA,
MV = capital + PV of future EVA,
where EVA 1 = NOPAT1 - k wacc*capital0
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EVA ExerciseCurrent Year
Revenues.......................................................... $11,400Cost of goods sold ............................................ (6,000)Gross profit ...................................................... 5,400
Selling, general and administrative expenses ..... (4,000)Operating profit ................................................ 1,400Interest expense................................................ (400)Pretax income................................................... 1,000Tax expense ..................................................... (350)
Net income....................................................... $ 650
Current
Year
Prior
Year
Current
Year
Prior
YearCash............................ $ 800 $ 500 Accounts payable................ $ 800 $ 700Accounts receivable..... 1,200 1,000 Accrued liabilities............... 1,250 1,000Inventories .................. 3,000 2,500 Total current liabilities........ 2,050 1,700Total current assets...... 5,000 4,000
Long-term debt ................... 6,000 5,000Plant assets, net ........... 10,000 9,000 Total stockholders’ equity ... 6,950 6,300Total 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.
EVA E i
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EVA Exercise –
Areas for Improvement