Procter & Gamble

Equity Valuation & Analysis

As of November 1, 2007

Raider Investments Group

Brian Hooper

Tyler Yenzer

Nathan Yosten

Dustin Bradford

Brian.D.Hooper@ttu.edu

Phillip.T.Yenzer@ttu.edu

Nathan.Yosten@ttu.edu

Dustin.Bradford@ttu.edu

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Table of Contents

Executive Summary

Business & Industry Analysis

Company Overview

Industry Overview

Five Forces Model

Rivalry Among Existing Firms

Threat of New Entrants

Threat of Substitute Products

Bargaining Power of Buyers

Bargaining Power of Suppliers

Key Success Factors

Firm Competitive Advantage Analysis

Future Competitive Analysis

Accounting Analysis

Key Accounting Policies

Potential Accounting Flexibility

Actual Accounting Strategy

Quality of Disclosure

Qualitative Analysis of Disclosure

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Quantitative Analysis of Disclosure

Sales Manipulation Diagnostics

Expense Manipulation Diagnostics

Potential Red Flags

Undo Accounting Distortions

Financial Analysis

Liquidity Analysis

Profitability Analysis

Capital Structure Analysis

IGR/SGR Analysis

Financial Statement Forecasting

Cost of Equity Estimation

Valuation Analysis

Multiples Valuation

Discounted Free Cash Flow Model

Discounted Dividends Model

Residual Income Model

Long-Run Return on Equity Residual Income Model

Abnormal Earnings Growth Model

Credit Analysis

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Analyst Recommendation

Appendix

Regression Analysis

Income Statement

Balance Sheet

Statement of Cash Flows

Cost of Equity/WACC

Multiples Valuation

Discounted Dividends Model

Discounted Free Cash Flows Model

Residual Income Model

Long-Run Return on Equity Residual Income Model

Abnormal Earnings Growth Model

Altman Z-Score

References

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Executive Summary

Share data Observed NYSE:PG share price as of 11/1/2007 52-week range Shares Outstanding Market Capitalization Percent owned by insiders Percent owned by

institutions Book value per share Key 2007 financial data: Revenue Net Earnings Return on Equity Return on Assets

$68.59$61.03-$71.83

3,159 m$216.7 b

3.83%

58.7%$21.13

$76,476 m$10,340 m

15%7%

Valuation estimates Multiples valuation Trailing P/E Forward P/E P/B D/P PEG P/EBITDA P/FCF EV/EBITDA Intrinsic Valuations Discounted Dividend Discounted FCF Residual Income LR ROE AEG

$69.01$56.47

$307.10$37.55$89.49

$469.93$69.39$65.79

$126.83N/A

$41.87$33.11

$118.34

Published beta 0.92 Kd 6.26 WACCbt 8.61%

Altmans Z-Score

2003 2004 2005 2006 2007

4.6 3.76 3.44 2.67 2.89

Cost of Capital Estimation r2 Beta Ke 3-month 0.2862 0.9358 11.15% 1-year 0.2854 0.9337 11.20% 2-year 0.2847 0.9313 11.08% 5-year 0.2839 0.9305 11.03% 7-year 0.2838 0.9306 11.10% 10-year 0.2839 0.931 11.24

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Industry Analysis

Procter & Gamble (NYSE: PG) started from humble beginnings as a small soap

and candle company in 1837, and has since grown into a multinational corporation with

hundreds of product lines. The company is the largest firm in the personal products

industry of the consumer goods sector. Top competitors for Procter & Gamble include

Johnson & Johnson (NYSE: JNJ), Kimberly-Clark Corp. (NYSE: KMB), Colgate-Palmolive

Co. (NYSE: CL), Avon Products, Inc. (NYSE: AVP), and Unilever (LSE: ULVER.L).

The personal products industry is highly competitive. Top companies must rely

on brand recognition and product innovation to gain market share. The industry is

analyzed thoroughly using the five factor model. The first factor in the model evaluates

rivalry of existing firms. The collective result is that rivalry is high. The next factor

looks at the threat of new entrants, and reveals that substantial barriers exist which

keep the threat of new entrants low. Next is threat of substitute products, which shows

that brand recognition will keep customers loyal, but readily available comparable

products make the threat moderate. Analysis of the bargaining power of buyers reveals

that buyers have moderate power because retailers need to carry certain products at

certain prices to draw customers, in other words, the buyers (retailers) and suppliers

(personal products firms) are equally reliant on each other. Bargaining power of

suppliers reveals that suppliers have less power the bigger the buying firm is.

Certain key success factors must be present to be successful in creating value in

the personal products industry. While these factors vary from firm to firm, none of the

top companies rely on a pure cost leadership or pure differentiation strategy.

Prevalent cost leadership strategies include economies of scale and lowering the costs

of inputs. Differentiation strategies include superior product variety, brand building,

innovation, and superior customer service. Analysis of Procter & Gambles ability to

achieve a competitive advantage reveals that they have been very successful and can

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remain successful if they stay on top of research and development and maintains good

relationships with buyers.

Accounting Analysis

Procter & Gamble has six parts that sums up their companies accounting

analysis. These six parts are: key accounting policies, accounting flexibility, accounting

strategy, disclosure, potential red flags, and accounting distortions. Its main job is to

help an investor see if its company is doing well or if there is a potential problem in the

near future. Most of the accounting information came from Procter & Gamble as well

as other competitors in the industrys 10Ks.

Procter & Gamble is considered a flexible company because of the amount of

judgment decisions they allow their management to make. One of the main reasons

they are flexible is because they allow their companies management to make their

decisions on goodwill. This is a potential red flag area because goodwill is a huge part

of P&Gs company every since the Gillette acquisition. They are keeping it constant

instead of over or understating it so there was no manipulation. They are also a

company who is very transparent. This means they disclose more information than

most public companies. In their 10ks they have a detailed analysis of each section of

their company. This means they have a break up of different categories (cash & credit

sales), and segmented reporting (Baby care, Beauty, Household, etc.) for investors or

auditors to see. Due to their high disclosure, their flexibility through GAAP would be

obvious if there was a red flag. There were three ratios in the analysis that were a

concern when analyzing for potential red flags. However each of the three were

examined carefully, and it was determined there was no manipulation in the companies

accounting analysis.

Valuations

After all of the analysis of the industry, the firm, its accounting policies, and

financials, we can now do a valuation of Procter & Gamble. Several different valuations

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will be used to compute the per share price of the company. This per share price

compared to the actual per share price will advocate if the company is fairly valued,

overvalued, or undervalued.

The earnings multiples valuation is the quickest and easiest way to value a

company. Eight different ratios were used to determine the value. There was no

dominant valuation in this model to tell if it was fairly valued, overvalued, or

undervalued. There was a big variance in the per share prices, which made this method

of valuation very inaccurate and shows that it should not be the only form of valuation

for a firm.

Several different valuations were used to value Procter & Gamble. The

discounted free cash flow model uses expected future free cash flow models to arrive at

a per share price of -$274.17. Since this number is negative it is invalid and cannot be

used to value the company.

The discount dividend model calculates the price per share as the sum of each

of the next ten years expected dividends discounted back to the present value, added

to the terminal value of the perpetuity. This method gives us an undervalued per share

price of $126.83.

The residual income valuation model discounts residual earnings, which are

earnings in excess of normal earnings. The estimated share price of this model was

$41.87, overvalued.

The abnormal earnings growth model values a firm using forecasted earnings,

dividends, dividend reinvestment plan (DRIP), core earnings and normal earnings. Tying

these numbers together gives us a per share price of $118.34, which suggests that

Procter & Gamble is undervalued.

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Financial Analysis, Forecast Financials, and Cost of Capital Estimation

Liquidity, profitability, and capital structure ratios are all tools used by analysts

when looking at a firm. A firms performance can be assessed when the ratios are

compared against ratios from previous years and ratios of other firms in the industry.

Then, analysts will utilize the ratios in forecasted the firms future financial performance.

Regressions are used to estimate a Beta for the firm which is then used to find a cost of

equity using the capital asset pricing (CAPM) model. The weighted average cost of

capital (WACC) is then used to determine an appropriate cost of capital for the firm.

Procter & Gamble is a fairly liquid company. All of their liquidity ratios, except

the current ratio, quick ratio, and working capital turnover, are in line with or above the

industry average. They actually lead the industry in accounts receivable days. They

have good profitability as well despite being below the industry average. All profitability

analysis shows either steady or growing profitability. Although they are below the

industry average, Procter & Gamble is gaining on their competition year by year.

However, capital structure analysis shows that Procter & Gambles ability to pay debt is

has declined. Their debt service margin has experienced a downward trend in recent

years. As a matter of fact, there were not enough cash flows last year to support the

current portion of debt due.

Financial forecasts were then developed for the next ten years using a basic

assumption of a ten percent growth rate in sales per year. The assumption was also

made that past ratios would be a good indicator of future ratios. The ratios discussed

above were utilized in this process to develop a reasonable estimate of Procter &

Gambles future performance.

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Company Overview

In 1837, Procter & Gamble (NYSE: PG) was started as a soap and candle

company out of Cincinnati, OH. Procter & Gamble has since grown to become the

largest consumer goods product company in the world, with $68 billion in sales

worldwide for fiscal year 2006. Corporate headquarters are still in Cincinnati, and they

maintain 39 manufacturing facilities in 23 states, as well as 105 manufacturing facilities

in 41 other countries (P&G 2007 10-K). Procter & Gamble manufacturing facilities

produce personal health care products, house and home care products, health and

wellness products, baby and family care products, and pet care and nutrition products.

These products have made Procter & Gamble a recognized global leader in the

development, manufacture and marketing of some of the worlds most trusted, quality,

leadership brands including Pampers, Tide, Ariel, Always, Whisper,

Pantene, Mach3, Bounty, Dawn, Pringles, Folgers, Charmin, Downy,

Lenor, Iams, Crest, Oral-B, Actonel, Duracell, Olay, Head & Shoulders,

Wella, Gillette, and Braun (www.pg.com). Procter & Gamble boasts over 300

brands being sold in as many as 160 countries (P&G 2007 10-K). Procter & Gamble

acquired many of these brands because of a preexisting solid consumer base.

With global operations employing 138,000 worldwide, it has been necessary for

Procter & Gamble to develop two training schools for senior managers (P&G 2007 10-

K). One is an advanced leadership school for senior managers. It targets the 135

general managers from different branches of the Procter & Gamble global division.

The other is an executive leadership program aimed at the highest-level managers in

the company.

Procter & Gamble strives to provide branded products and services of superior

quality and value that improve the lives of the worlds consumers (www.pg.com). This

commitment would not be possible without progressive breakthroughs in research and

development. Each year, Procter & Gamble increases funding on research and

development, currently around $2 billion total expenditure for fiscal year 2007. The

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company employs more than 7,500 scientists and holds more than 24,000 active

patents worldwide (P&G 2007 10-K). This focus on innovation and technology has put

Procter & Gamble as an industry leader.

Procter & Gambles vast customer base spans drug stores, high-frequency

stores, membership stores, grocery stores, and mass merchandisers. Because of the

broad array of products through a wide customer base, Procter & Gamble benefits with

being industry leader in sales and market capitalization. Figure 1 shows total assets

grew significantly, helped especially by the Gillette merger in 2005. Net sales received

a bump also, but adjusted sales growth shows no significant gains from the acquisition.

Fig. 1: Total Assets, Net Sales, Sales Growth, and Stock Prices (*In Millions)

2003 2004 2005 2006 2007

Total Assets* $43,706 $57,048 $61,527 $135,695 $138,014

Net Sales* $43,377 $51,407 $56,741 $68,222 $76,476

Sales Growth 6% 6% 6% 6% 5%

Procter & Gamble is categorized in the household and personal products industry of the

consumer goods sector. Procter & Gambles major competitors, also in the personal

products industry, include Kimberly-Clark Corp., Colgate-Palmolive Co., Avon Products,

Inc, and Unilever. Another major competitor, although not primarily in the personal

products industry, is Johnson & Johnson .

Industry Overview

The household and personal products industry is a highly competitive industry.

Most companies in competition with Procter & Gamble are focused to only one or two

different sub-industries of the personal products industry. Procter & Gambles major

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competitors, such as Kimberly-Clark Corp, Colgate-Palmolive Co., Johnson & Johnson,

Avon Products Co., and Unilever, are also diversified into many sub-sectors. Most of

these sub-sectors of the personal products industry are largely made up of

manufacturing through chemical processing or paper processing. Suppliers of the

chemicals are numerous, although price fluctuation may occur if availability is limited.

According to Procter & Gambles 10K filing, we may or may not pass on the change,

depending on the magnitude and expected duration of the change.

The companies in the personal products industry rely on brand recognition and

product innovation to build their customer base. Product innovation is a key step to the

corporate strategy for long-term growth of Procter & Gamble. This core philosophy is

what has caused Procter & Gambles stock climbing 65 percent higher today than it was

five years ago (See Fig. 2). The top competitors stock prices have only gained

between 14 and 60 percent. Not shown in the chart is Unilever, with a 17 percent gain

over the same period.

Fig. 2: Stock prices for P&G and top competitors over the last 5 years

Moneycentral.msn.com

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The Five Forces Model

In every industry, there is a model that can be used to identify the strategy,

profitability, and power of particular companies. This model is called the five forces

model. This gives an analysis of companies for competing and personal uses. The five

forces model consists of two major parts. The first part of the model consists of rivalry

among existing firms, threat of new entrants, and threat of substitute products. This

part measures how much actual and potential competition there is. The second major

part is between the bargaining power of buyers and the bargaining power of suppliers.

These two measure the power a company has or does not have over the buyers and

suppliers. In using this model, we will be able to identify these valuable parts of

Procter & Gamble.

Personal Products Industry

Rivalry Among Existing Firms High

Threat of New Entrants Low

Threat of Substitute Products Moderate

Bargaining Power of Buyers Moderate

Bargaining Power of Suppliers Low

Rivalry Among Existing Firms

Industry Growth

The growth in this industry has been moving up on a yearly average. Every

year, the industry seems to steadily increase its annual sales revenue (see figure 3).

Given this information, price wars are expected to happen. To be able to survive, these

companies have to manage decisions by getting rid of every expense that is not

needed. In 2005, the industry grew 8.14 percent. In 2006, the industry grew 11.87

percent. That is a 3.73 percent change in industry growth from 2005 to 2006. A major

portion of that was from Procter & Gambles purchase of Gillette. Because of Procter &

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Gambles purchase of Gillette in 2006 sales grew by 20.23 percent. This is a 9.85

percent increase from the 2005 sales growth of 10.37 percent. A companys historical

growth rate can be used when trying to forecast future sales. The industrys growth is

due to the rise in demand over the last five years. There has been a demand and will

always be a demand for these types of products. The consumers have to use these

products because they are a part of everyday life, which leads to the reason for the

sales growth.

Figure 3: Sales Growth Over the Past Five Years

Concentration

There is a high amount of concentration in this industry. All of the companies in

the personal products industry have to compete on price. Since most of these goods

are not commodities, it allows them to compete less on the price. This industry has

some specific goods people are willing to pay for, and other goods that they are only

willing to pay for the cheaper product. It is in these companies best interest to focus

on the specialty products by putting as much quality in them as possible. Companies

Source: PG, JNJ, KMB, CL, and AVP 10k's; Unilever financials

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also need to focus less on quality and more on price reduction when looking at non-

brand specific products.

Differentiation and Switching Costs

Many of the products offered in the personal products industry are of the same

quality and price, meaning that switching costs are relatively low. A switching cost is

the cost that the consumer encounters while changing from one product to another.

Many consumers will buy similar products based on which one is the cheapest, giving

them a low switching cost. For a company to be successful, it must differentiate its

products from its competitors products. A company can do this by creating brand

names and slogans that consumers will become familiar with, much like Procter &

Gamble has done with Duracell, Crest, and many of its other brand name products

(www.pg.com).

Scale/ Learning Economies

Fig. 4: Total Assets over the Last Five Years

In order for a company to be competitive and profitable, it must be a giant in the

personal products industry. The size of a firm can determine how successful it is going

to be. Having a large firm allows a company to attract more customers than a small

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firm would by name recognition and perceived value. In addition, large companies

have the ability to reduce costs and bring down prices, making it difficult for new

entrants to compete. To facilitate, figure 4 shows Procter & Gamble (PG) and Johnson

& Johnson (JNJ) have the largest number of assets, making them the biggest

companies in the consumer goods market. Therefore, these companies are also the

leaders in this market.

Ratio of Fixed to Variable Costs

Analysis of the ratio of fixed to variable costs gives insight into how well a

company is utilizing its facilities. A firm with a high ratio of fixed to variable costs is

either not making efficient use of its existing capacities, or is having trouble selling

product. A firm with a low ratio of fixed to variable costs is making more efficient use

of its existing capacities. Different industries have different normal fixed-variable

costs ratios, so a ratio close to 1:1 may not be desirable or even achievable. In order

to calculate the ratio, fixed costs, which are general, selling, and administrative

expenses, are divided by variable costs, which are the costs of products sold.

Fig. 5: Ratios of Fixed to Variable Costs over the Past Five Years.

Figure 5 shows the average ratio of fixed to variable costs for Procter & Gamble over 5

years is 0.64. Johnson & Johnsons ratio over the same period averages 1.18, while

Kimberly-Clarks is only 0.25. Colgate-Palmolive averaged 0.75. The industry average

2002 2003 2004 2005 2006 Avg.

Procter & Gamble 0.60 0.60 0.66 0.66 0.66 0.64

Johnson & Johnson 1.17 1.16 1.20 1.23 1.16 1.18

Kimberly-Clark 0.26 0.25 0.25 0.25 0.25 0.25

Colgate-Palmolive 0.72 0.74 0.76 0.76 0.79 0.75

Avon Products 1.17 1.20 1.22 1.23 1.33 1.23

Unilever 0.75 0.70 0.60 0.63 0.64 0.67

Industry Average 0.79

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is 0.79, but since historical figures do not vary much suggests that firms either find it

difficult to change or it is not financially detrimental to keep the current state.

Objective interpretation of the averages would suggest Kimberly-Clark is making the

most efficient use of its resources, while Avon is making the least efficient use.

Excess Capacity

Excess capacity occurs when a firm is not producing as much as it could be

producing. This results in wasted money due to fixed costs. In this situation, a firm

would decrease price to spark demand. This effectively solves the problem of excess

capacity by increasing production. Figure 5 also allows for the interpretation of excess

capacity. Without investigating into alternate causes for the high ratio, Avon would be

a candidate for decreasing price to increase demand. Procter & Gamble and Colgate-

Palmolive would probably be considered to be at an acceptable capacity. Kimberly-

Clark may be considered to be at a very efficient capacity.

Exit Barriers

When a firms operating costs exceed revenue for a long enough period, the firm

may go out of business. In certain industries, barriers may make exiting the market

difficult and often they are forced to stay in business. Contract cancellation costs with

suppliers, asset write-off expenses, or regulations that must be followed are all costly

exit barriers. One large potential barrier to exit for the personal products industry is the

expense of writing-off assets. Much of the equipment is highly specialized chemical

processing equipment which may be difficult to sell or remove. The costs associated

may be more than the company wants to put on its balance sheet.

Conclusion

With a high industry concentration, relatively low switching costs, large

economies of scale benefits, and possible high exit costs, rivalry among existing firms in

the personal products industry tends to be high.

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Threat of New Entrants

The personal products market is a relatively difficult market to penetrate due to

the high degree of concentration. A highly concentrated market makes it difficult for

new entrants to succeed because there are only a few major companies in the industry

that are very competitive. Large companies in the personal products industry have a

huge competitive advantage over new entrants because of their size and experience.

The first companies entered the personal products industry as early as the 1830s,

giving them many years of experience and knowledge to be able to create barriers that

a new entrant would have to overcome to be successful. These barriers include

economies of scale, distribution access, and legal issues.

Economies of Scale and First Mover Advantage

A firms economy of scale can also give them a competitive advantage over new

entrants. The ability to increase production can drive down input costs, giving you

economies of scale. Increasing production is something that can only be done if your

firm is large enough to do so. A firm must have large amounts of assets to be able to

produce goods on a larger scale, making it hard for new entrants to compete with

production costs and price. For example, Procter & Gamble (PG) and Johnson &

Johnson (JNJ) have to highest amount of total assets in the industry with amounts of

$138 Billion and $75 Billion (PG and JNJ 10-K). This allows these two companies to

dominate the consumer goods market, giving new entrants a disadvantage at

competing on cost, quantity produced, and price. Large firms in the consumer goods

market also have the first mover advantage. The first mover advantage lets the first

companies in the industry create different standards and agreements. The first ones in

the industry can regulate it; make it extremely difficult for a firm to enter their market.

For example, a first mover in the personal products industry would have an advantage

because they would be able to register patents, develop market share, get over the

learning curve, and gain reputation over companies that would enter the industry later.

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Distribution Access and Relationships

Access to existing distribution channels can be a substantial barrier that new

entrants would have to face in order to enter the industry. Supermarkets and other

retail stores have a limited amount of shelf space available for consumer goods. This

shelf space is usually used up by the big firms that have existing relationships with the

customer, making it difficult for new entrants to obtain the required room for their

products. A preexisting relationship is important in the personal products industry

because it allows the producer to negotiate pricing and discounts with the buyer. Brand

recognition is also a factor. If a company does not have brand recognition, they will not

be able to get their product distributed as well as a large company would. Without

distributor relationships and brand recognition, a new company will not have much

success upon entering the consumer goods market.

Legal Barriers

Legal barriers can also make it hard to enter the personal products industry. A

new entrant has many regulations, laws, patents, and copyrights that they have to

abide by when they are entering into an industry. The personal products industry is

Fig. 6: Intangible Assets for 2006 Source: PG, JNJ, KMB, CL, ULVR, & AVP Balance Sheets

very research-intensive. This produces many patented products that cannot be copied

by newcomers. For example, as figure 6 shows, market leaders Procter & Gamble (PG)

and Johnson & Johnson (JNJ) have $33.6 billion and $15.4 billion in intangible assets,

Firm Intangible Assets (in millions) (2006)

Procter & Gamble $33,626

Johnson & Johnson $15,412

Kimberly-Clark $821

Colgate-Palmolive $0

Avon $80.4

Unilever $6,312.21(Converted from Euros)

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which includes copyrights, patents, trademarks, and goodwill (PG and JNJ balance

sheets). This much money invested in intangible assets shows that these two industry

leaders have many innovative ideas that they are protecting from being used by any

other company that wants to enter their market.

Conclusion

There are many different barriers in the personal products industry that a new

entrant would have to overcome to enter. The large companies have a huge

competitive advantage over new entrants that leave new entrants with little success in

gaining any market share. With established economies of scale, access to distribution,

relationships, and legal barriers in the favor of existing firms in the industry, a new

entrant would little success in competing. This almost eliminates the threat of a new

entrant in the personal products industry.

Threat of Substitute Products

The threat of substitute products is the customers (retail stores) willingness to

switch to a different product that is similar to yours. In the personal products market,

the threat of substitute products is always present. There are always substitutes

available for every different kind of product in the personal products industry, creating a

mild threat of substitute products. However, there are some factors in considering a

product to be a substitute. The relative price and performance of the substitute product

must be close to the original product to be considered as a substitute. In addition,

customers willingness to switch is a factor in considering a substitute for a product.

Relative Price and Performance

In the personal products industry, price is usually perceived as value. Many of

the name brand items, like Tide laundry detergent, Crest toothpaste, and Bounty paper

towels are often at a higher price than a generic brand of the same items would be.

This is because customers believe these name brands have more value than a lesser-

known brand, allowing them to pay a premium on these items. Often, the brand names

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also have a higher performance than a generic or lesser-known brand would, due to

research and design on brand name products. Many hours are spent on research and

design in big companies so that they can make their products even better for the

customer. This usually results in an increase in performance so that the customer will

benefit more from buying their product. Therefore, the threat of substitute products

depends on the customers wants and needs. If they want better performance at a little

higher price, they can buy the brand names; or, if a customer is willing to give up a

little performance for a lesser price, generic and lesser known brands are what they

choose.

Buyers Willingness to Switch

Buyers willingness to switch is a critical part of the threat of substitute products.

In the personal products market, the buyers willingness to switch is usually low. A

buyer (retail store) of personal products usually has good relationships with their

suppliers, making them partial to their products. For example, Wal-Mart sells all of the

products from companies in the personal products industry, which means that they

have a good buyer/seller relationship. This relationship developed by the popular and

well-known brand names that come out of the companies in the industry. If a company

in this industry did not have familiar names, they would not have much shelf space, if

any, in retail stores like Wal-Mart. Since the buyers (retail stores) have good

relationships with the well-known companies in the personal products industry, they are

unlikely to switch to a different product offered by someone else trying to compete in

this industry.

Conclusion

Substitute products in the personal products industry are readily available by

much smaller and different firms, but due to brand name recognition and developed

relationships, it is not likely that a buyer will switch products. The added benefit, due to

the higher price, is usually enough to keep customers happy with the brand name

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products. Therefore, the threat of substitute products in the personal products market

is low, due to the high concentration of the industry.

Bargaining power of Buyers

Bargaining power is the ability to influence the setting of prices

(http://www.photopla.net/wwp0503/buyer.php). It is based on the relationship

between the firm and the buyer. The main question in this part of the five factor model

is who has the power over whom? In this case, the retailers are the buyers and

Procter & Gamble is the firm. Obviously, the source with the most power will be able to

control the other. If the company has the most power then they will be able to raise

prices and most likely be the only source around. If the buyer has the most power then

the company will have to lower its costs and add a lot more expenses to its list.

Switching costs

The cost of these customers switching from Procter & Gamble to Johnson &

Johnson would be low in certain products. This is because most of these products on

the shelf are close to the same price. However, the quality they would receive would

be less in most cases. Johnson & Johnson would have similar quality to Procter &

Gamble, but the other smaller competitors could not compete with the price and

quality. This is not an industry to get started in if you are small because these huge

companies already have a major head start on you. A large company in this industry

could switch to another large company if it was the last resort.

Differentiation

There is a lot of differentiation when comparing Procter & Gamble products and

the products of other competitors in the industry. According to their 10k, Procter &

Gamble has narrowed their range to three different subjects; these subjects are beauty,

household care, and health and well-being. All of these areas have been differentiated

accordingly. Procter & Gamble has some of the best product names and quality in

retailer stores and pharmacies around the world. With new ideas coming up every

23

year, it gives them an advantage when dealing with retailers. Recently, they had a

breakthrough with Crest toothpaste. The new product was called Crest Pro Health and

was a huge success. It had more than $100 million in sales in the first year. Most of

Procter & Gambles brands have different product lines to offer, much like this one.

This product differentiation gives them more power when dealing with retailers.

Johnson & Johnson is very similar in the way that they have a lot of brand power and

quality in their products.

Price Sensitivity

Procter & Gamble is very differentiated, and because of this, it has to be less

price sensitive. In this industry, like most, the best option is to sell at the price desired.

If companies can do this then they have power when dealing with buyers (retailers).

Some of these retailers are Wal-Mart, HEB, Walgreen, etc. Buyers want the best

products on their shelves. These large retailers are forced to keep their own costs

down. Compromising with them more will help to put more products on the shelf. The

companys brand image can also help your business in a competitive industry. With the

advertising and high quality expected in Procter & Gambles brands, retailers will be

convinced that these products will create profits for them. If the product is a small part

of the buyers costs, they are less likely to look elsewhere for a better price.

Importance of Product for Costs and Quality

In the personal products industry, it is very important to have brand power and

quality. If one is lacking it will be very difficult to start a new company and compete

with others. All of the top companies in the personal products industry are greatly

helped by already having the best brand names. These companies have more

bargaining power with customers because their superior products demand a premium

price.

24

Bargaining Power of Suppliers

Our suppliers are valued partners in the success of our business. Our

relationships with them must be characterized by honesty and fairness. Suppliers are

selected on a competitive basis based on total value, which includes quality, service,

technology, and price (Sustainability guidelines for Supplier Relations, 2007 P&G 10-K).

Bargaining power of suppliers involves the relationship between the firm and the

suppliers. When there are fewer companies, the supplier is able to have more control

over a firm in this industry. Procter & Gamble has many sustainability guidelines that

must be followed in order to be involved with their suppliers. Some of these guidelines

are legal compliance, human rights, employment practices, forced labor, and child

labor. Most of the companies in this industry have guidelines like these because they

are ethical companies who want to do the right thing. Supplier diversity is a

fundamental business strategy at P&G (www.pg.com). Since Procter & Gamble has

this option, this allows them to be more diversified. This also allows them to have

some power over their suppliers. If one of the suppliers is trying to raise prices, they

can just go to another. A great portion of a companys success in this industry depends

on brand name. These suppliers know this, which leaves them with some power.

Suppliers have to provide good materials for people to see the quality. There are a few

companies in this industry that can manage and compromise with suppliers like Procter

& Gamble. Because of their large size and name, these companies are not only able to

get whom they want, but they can also control prices. This is a big plus for these

companies in this industry.

Key Success Factors for Value Creation

In order to be successful in the personal products industry, a company must

employ a mix between differentiation and cost leadership strategies. Customers in the

industry have come to expect high quality products at relatively low prices; therefore, a

company will not survive in the industry with a straight cost leadership or a strait

differentiation approach. According to Procter & Gamble, there are five areas that are

25

critical to winning in consumer products (www.pg.com). These five areas are

consumer understanding, brand building, innovation, go-to-market capability, and scale.

Colgate-Palmolive Co., one of Procter & Gambles major competitors, also cites strength

of brand, innovation, and cost control as factors for success in the personal products

industry (www.colgate.com). Neither strategy outlined here is true differentiation or

cost-leadership; however, more emphasis is placed on the differentiation strategies.

Cost Leadership Elements

The personal products industry has high rivalry among existing firms and a low

threat of new entrants. Therefore, companies in the personal products industry must

be able to utilize economies of scale in order to be successful. The manufacturing

process incurs high fixed costs that need to spread out over as many units as possible.

By driving down per unit costs, the final products can be sold at lower prices in the

market enabling firms to compete on price. Beating competitors on price is a common

tool in gaining market share against the existing firms. In addition, having such a

large-scale production process makes it difficult for new entrants to succeed. In order

to compete effectively in the industry on price, a new firm would have to jump straight

in with a huge capital investment that would allow them to mass-produce. This is

difficult for new firms to do; therefore, a new firms costs tend to be higher than an old

firms costs. This will result in higher selling prices making it less attractive to

consumers. If a firm is not large enough to increase production to a level that will

facilitate low per unit costs, it simply will not survive.

Firms must also be able to lower their input costs. Colgate-Palmolive Co.

expressed concern over rising input costs in their 2006 10-K. Increases in the prices of

their raw material commodities can have an adverse affect on their profit margins

especially when they are unable to pass these expenses on to consumers by increasing

prices (www.colgate.com). If a company were to try to pass these expenses on to

consumers through price increases, customers would simply switch to a competitors

product. There is a good degree of brand loyalty in the personal products industry;

26

however, even consumers who prefer one brand to another can only tolerate small

price increases. Therefore, effective management of input costs will allow a company

to maintain low prices and a good competitive advantage in the personal products

industry.

Differentiation Elements

Despite using a mix of cost-leadership and differentiation methods, the personal

products industry does lean more heavily towards differentiation. Firms spend a lot of

time and money trying to make their products stand out from the rest. Consumer

understanding is key in order to differentiate a product. The first thing a firm must do

is figure out exactly what it is that the consumer wants. Firms do this through the

utilization of market research and tests. The results of these tests will let firms know

where demand lies. They will then gear their research and development to satisfy

these consumer demands.

Personal products companies must also provide a superior product variety. Firms

in this industry have numerous products and product lines. The main reason for this is

that different consumers want different results out of the same product. For example,

some toothpastes are aimed at cavity protection while others are targeted for

whitening. Most personal products have different varieties in order to satisfy different

needs. If a firm cannot match a product with a customers need, the customer will turn

to a competing firms product that does address their need.

Brand building in the personal products industry plays a big role in a companys

success. Brand building seeks to increase the product's perceived value to the

customer and thereby increase brand franchise and brand equity

(www.wikipedia.com). When a company is able to deliver a consistent product for an

extended period, they begin to develop a trust with consumers. At this point, a

companys brand itself will increase in value allowing a premium to be charged for its

brand. This increases margins that eventually lead to higher profits.

27

Innovation is the single most important strategy in the personal products

industry. Personal products companies are constantly announcing new products and

improvements, and consumers have come to expect them. When these new products

are released, older products may be rendered obsolete. If a company cannot innovate

and keep up with competitors, their own products will quickly become outdated.

Demand for such products will drop until they eventually become extinct. An example

of product evolution can be seen with razors. Razors were originally single blade

instruments. Now they have evolved into instruments with upwards of four blades.

There are also electric razors. Razors are just one example of a personal product that

has changed through innovation. Successful personal products companies must have

the innovative capabilities to improve upon all their existing products. Figure 7 shows

an overall increase in research and development spending over the last two years by

the four major players in the personal products industry.

Figure 7: Research and development expenses

02000400060008000

1000012000

Millions of Dollars

2004 2005 2006Year

Research and Development Expenses

Johnson & JohnsonProctor and GambleColgate-PalmoliveKimberly ClarkAvonUnileverIndustry

Competitors in the personal products industry must also be successful at getting

their product to market. They must effectively manage their products supply chains

and distribution channels. In order to accomplish this, they need to have some power

over buyers. This gives them the ability to distribute their products to wherever they

see fit at the price they see fit. If a retail store has the power to dictate which of a

Figures, in millions of dollars, obtained from

2006 financial statements for each company.

28

firms products will ultimately get shelf space and at what price, the firm is not able to

manage the exposure of its own products. In such a case, the retail store is not acting

in the best interests of the firm. Therefore, companies in the personal products

industry need to have some bargaining power over buyers in order to move their

products through the supply chain at a profitable price.

The final element of the differentiation strategy that companies in the personal

products industry must utilize is superior customer service. Products provided in this

industry are indeed personal. Therefore, companies must make every effort to

maximize the satisfaction of their customers. People use these products everyday, and

in doing so, develop an attachment to them. A trust is then formed between the

manufacturer and the consumer. It is the responsibility of the manufacturer to

maintain that trust. If firms do not effectively manage relationships with consumers,

consumers will then turn to another firm. At this point, it is very difficult to regain the

trust of a consumer.

Conclusion

Creating the right mix between cost-leadership and differentiation strategies is

essential to last in the personal products industry and to create value for the firm. Most

firms will favor differentiation; however, cost-leadership must be addressed as well.

Consumers in this industry do desire a certain quality of products, but they will switch

to a lower cost provider if prices are too high. The personal products industry is very

research intensive; therefore, constant innovation is necessary in order to survive.

Finally, firms in the industry must offer a good variety of products while building a good

brand image and maintaining good customer service.

Competitive Advantage Analysis

The personal products industry, as stated above, contains many entrance, exit,

and legal barriers. This allows established firms to look forward into the future instead

of constantly worrying about new entrants into the industry. This has also allowed them

29

to be more efficient in the research and development aspect of the firm. It has been

shown that in the personal products industry it is necessary to perform intense research

and development in order to stay ahead of the competitors. For example, Procter &

Gamble steadily increased their research and development investment from year to

year. In addition, they have also made many acquisitions, such as The Gillette

Company in 2005, in order to provide a global advantage in the personal grooming

sector of the personal products industry. Research and development is extremely

important in the personal grooming sector. This can be seen when thinking how just

ten years ago there was no such thing as the Gillette Mach 4, or such high

performance shaving gels and creams as the ones being produced today by Procter &

Gamble. The personal products industry is technologically advanced; therefore, major

players in the industry have had to become extremely efficient and competitive while

keeping the prices low and new entrants virtually non-existent. In addition, Procter &

Gamble has been able to rely heavily on feedback from their consumers, in order to

provide them with functional, yet aesthetically pleasing products. Providing better

customer service is just one way Procter & Gamble has implemented and succeeded

with their differentiation strategies in the industry.

Through maintaining strong relationships with their retailers, Procter & Gamble

has also been able to hold on to vital shelf space, and prime brand recognition. These

intangible assets are extremely important, and if lost, could be detrimental to the firm.

In the personal products industry, it is often noted that the brand sells itself. For

example, consumers often times will automatically buy a certain brand due to history

and satisfaction with that particular brand or product. This is the case only if the

product is reasonably priced. This is where solid relationships with buyers come in to

play. In the personal products industry, the connection between the consumer and

manufacturer is the retailer whom sells the product. Therefore, as long as Procter &

Gamble can maintain their firm relationships with its buyers, they can continue to

dominate the market share in the personal products industry by producing quality,

differentiated products at a reasonably low price.

30

Future Competitive Advantage

Procter & Gamble has long been known for their expansion and global research.

In fact, P & G now sells its products in more than 13,000 cities and towns in China

alone, and that number is sure to grow even larger in the years to come

(CNN.Money.com). Procter & Gamble was even recently named the #10 most admired

company in the world by Fortune Magazine, as well as being placed in the top ten in

total sales from the time period of 1999 2007. Although corporate segment net sales

decreased $235 million in 2007, this can be attributed to high transaction costs from

the acquisition of The Gillette Company, and higher interest expenses (P&G.com). Yet,

Procter & Gamble recorded an increase of 18% in their operating cash flows in 2007

and this can be attributed to higher net earnings as well as the acquisition of The

Gillette Company (P&G.com). Since Procter & Gamble acquired Gillette, it has seen an

increase in their Razors and Blades net sales by 49%. This is shown in figure 8 below.

Figure 8: Sales growth of Procter & Gamble by segment

Beauty Health

Care

Fabric &

Homecare

Family

Care

Razors &

Blades Net Sales Growth 9% 14% 11% 6% 49%

Overall, in the future you can look for Procter & Gamble to make huge strides. Due to

their enormous size and ability to turn profits (12% increase in 2007), it is almost a

given that Procter & Gamble will do well in this industry for years to come

(Fortune.com). Also, the constant dedication to research and development continues to

be a high priority for Procter & Gamble. Though many of these activities and costs will

not be realized in the coming year, Procter & Gamble believe this to be a demonstration

of their commitment to the future and the satisfaction of its consumers. With their long

history of achievements and dedication to the factors presented above, success is sure

to come for Procter & Gamble.

31

Identification of Key Accounting Policies

Analysis of a companys formal accounting practices starts with identifying key

accounting policies. These key accounting policies are those that help achieve a

companys key success factors discussed previously. The degree of success a company

enjoys directly relates to their ability to successfully implement certain key accounting

policies. Procter & Gamble cites its key success factors as being consumer

understanding, brand building, innovation, go-to-market capability, and scale (2007

P&G 10-K). Analysis of key accounting policies involves assessing the amount of

disclosure the company is willing to give about how they achieve their key success

factors.

Five years ago, Procter & Gamble reportedly owned 12 brands earnings over a

billion dollars in revenue each (2002 P&G 10-K). This number has grown to 23 billion-

dollar brands, with 18 expected to hit the billion-dollar mark in revenue within the next

few years (2007 P&G 10-K). Nearly doubling the amount of billion-dollar brands owned

was not accomplished just by building these brands from the ground-up, many were

acquired through the Gillette, Wella, and Hutchison acquisisions. Focus on brand

building through acquisitions may result in increases to the Goodwill line item on the

balance sheet. Purchased goodwill is the difference between the fair market value of

the net tangible and identifiable intangible assets and the purchase price of the

acquired business (Kieso, Weygandt, &Warfield, 2007). Procter & Gambles purchase

of Gillette resulted in $35.3 billion in goodwill recorded on the balance sheet. As stated

in their 2007 10-K filing, Procter & Gamble does not amortize goodwill, management

assesses it yearly and records impairment if they feel it is necessary.

Procter & Gamble invests an increasing amount of money every year in

innovation through research and development. Both the 10-K and the annual report to

shareholders liberally emphasize the amount of research and development required to

keep the firm growing. All research and development expenses are charged to

Research and Development Expense on the income statement as part of selling,

32

general, and administrative expenses. Expensing research and development (instead of

debiting an asset account) is a requirement of GAAP because of the uncertainty of the

results of the research and development (Kieso, Weygandt, & Warfield, 2007). When

research and development results in a useful product and is patented, the legal fees

associated are debited to intangible assets and amortized for the useful life. This is the

procedure Procter & Gamble uses, and states so in their 2007 10-K filing.

With products sold in over 180 countries, 18 of which generated over a billion

dollars in sales last year, Procter & Gamble must be concerned with the risks involved

(2007 P&G 10-K). Procter & Gamble claims to use direct netting to get rid of settlement

risk, risk involving the exchange of currency (2007 P&G 10-K)

(http://www.riskglossary.com/link/netting.htm). Interest rate exposure is lessened

through hedging the interest rates of certain debts in foreign interest rates to reduce

volatility in currency exchange rates. Procter & Gamble uses forward contracts and

options with less than 18-month maturities to curb short-term changes in currency

exchange rates. Since Procter & Gamble also manufactures products in countries

around the world, commodity prices can fluctuate due to economic, political, or

environmental factors. Fixed-price contracts, as well as swaps, options and futures

contracts, are used to reduce exposure to these issues.

Another key accounting policies refers to the disclosure associated with pension

plans and other post-employment benefit plans. Procter & Gamble claims that

contractual commitments associated with pension funding is not currently

determinable (2007 P&G 10-K). They do, however, project near-future expense

variables based on many different assumptions: discount rate; expected salary

increases; certain employee-related factors, such as turnover, retirement age and

mortality; expected return on assets and health care cost trend rates (2007 P&G 10-K).

U.S. GAAP policies are followed in expensing the costs, including a recent addition to

policy, disclosure of under/over funded status.

33

Accounting flexibility

A firms accounting flexibility is based on how a company allows their managers

to make decisions in accordance with GAAP. Procter & Gamble considers three items to

be important. These items are employee benefits, goodwill, and revenue recognition.

Both show how Procter & Gamble illustrates a large or small amount of their flexibility in

its accounting policies. The least flexible is revenue recognition because of the strict

GAAP standards and the required amount of accounting. The other two show a lot of

flexibility by using judgment calls and estimations in their accounting policies.

Goodwill

In 2005, Procter & Gamble purchased Gillette to take their company to the next

level. After they purchased Gillette the companys goodwill skyrocketed from 19.816

billion to 55.306 billion. In 2007, it remained steady at an amount of 56.552 billion. Of

the amount of goodwill in 2007, 35.3 billion were from the purchase of Gillette. The

overall amount of goodwill is expected to remain steady unless there is another huge

purchase or sell. Procter & Gamble does not amortize their goodwill, but they do test it

annually for impairment. They also treat other intangible assets in a similar manner as

they do their goodwill. The reason they are a flexible company is that they allow the

management of their company to make judgment decisions when they are evaluating

economic and operating changes. This is putting a lot of trust in your management by

letting them make decisions outside of what is required. When impairing their goodwill

they use forecasts in growth rates and cost of equity. This causes even more judgment

calls by managers. Other companies in this industry such as Johnson & Johnson and

Kimberly-Clark use similar techniques. Kimberly-Clark recorded goodwill in 2006 of

2860.5 million. That is around 16.7 percent of its total assets. In 2006, Johnson &

Johnson reported goodwill as 18.9 percent. In the previous year, they reported

goodwill at 10.2 percent. Overall Procter & Gamble and other companies in the industry

show that they are flexible through the amount of decisions they allow their

management to make.

34

Employee Benefits

Procter & Gamble has a lot of benefits, most being post-employment. These

benefits are pensions, specific benefit plans, and other post employment benefit plans.

These Other benefit plans are mainly health care and life insurance based. As far as

their accounting decisions, they are very flexible because you have to be able to

estimate expected salary raises, discount rates, and employee related factors. These

factors are all different because not every employee has the same health. Some

employees are obviously going to cost more to insure than others are. There are many

factors that play into employee benefits. All these factors increase a companys

flexibility because it enables them to make independent decisions aside from what is

required. They also comply with GAAP through certain ways. They defer the difference

between the actual results and their own assumptions up to 10%. Anything over 10%

is expensed in the next year. It is evident that Procter & Gambles employee benefits

are flexible because of the assumptions the company allows management to make.

Revenue Recognition

Of these three, revenue recognition is the least flexible and uses more required

accounting than judgment calls. The reason they do this is that there is not much

judgment needed. Everyone follows a basic strategy. Procter & Gamble recognizes its

revenue when the title has been passed to new owner. This is standard procedure for

all companies in this industry. Another procedure that is involved with revenue

recognition is how they deal with product discounts and returns. They use another

standard industry norm of reducing sales in the time the product is purchased. As said

before there is little if any room for flexibility in revenue recognition. It is standard to

follow the industry norm and record at the time of acquisition.

Conclusion

Although Procter & Gamble is reasonably flexible, they also give a lot of

disclosure through their 10k and annual reports. The reason they are reasonably

35

flexible is because of their high flexibility in goodwill and employee benefits and their

low flexibility in revenue recognition. Again, in this industry there is a lot of flexibility

given to the managers. The reason is that their KAPS allow them to make more

judgment calls rather than follow straight out of the book. So not only do they follow

GAAP requirements but also make adjustments when needed.

Accounting Strategy

Companies generally have to follow the GAAP Guidelines while disclosing

financial information in their annual reports. However, it is much better if some

information about results, trends, and insight used by the management could be

provided to the investors. This not only builds trust for the company but also enables

investors to make sound investment decisions. Procter & Gamble uses the Managers

Discussion and Analysis section in the annual report to discuss the financial results

which include several non GAAP financial measures used by them. Along with this, they

have also provided the comparable GAAP measures in their discussion. It is quite clear

that Procter & Gamble is an aggressive company because of excessive amount of

information they provide. By doing this, they are signaling to investors that they are a

high disclosure company that not only show what GAAP requires but they stretch the

limits. For example, Procter & Gamble segment reporting consists of three global

business units which are beauty and health, household care, and Gillette. In each of

these three global business units, Procter & Gamble categorizes their seven reportable

segments under U.S. GAAP. Those are beauty, healthcare, fabric and home care, pet

health, snacks and coffee, baby and family care, blades and razors, and finally Duracell

and Braun. An example of disaggregating is the companys choice to split credit sales

and cash sales. This also allows investors to see a more detailed part of their company.

When compared to a low disclosure firm the roles are completely reversed. A low

disclosure firm on the other hand only provides to investors what GAAP requires of

them. They do not provide any additional information. Procter & Gamble is considered

a very aggressive company not only because of their high disclosure, but also because

they always show an increase in reported earnings. Each year as shown in figure 9,

36

their reported earnings have grown. They are also proud to show that they give a lot of

dividends and pensions. Their companys motto is Procter & Gamble is designed to

grow (P&G Annual Report). Their transparency is just another factor that shows their

aggressiveness. Either Procter & Gamble can manipulate reported earnings to show a

high income, or they can reduce it to pay a smaller amount of taxes. In 2006, they

overstated their assets to possibly make the company look better. However, they will

have to pay a lot more for taxes. As shown this accounting strategy is very aggressive.

Sustaining Growth (FIGURE 9)

P&Gs performance in fiscal 2006 continues the consistent growth

we have delivered in the first half of the decade. Since 2001:

Net sales have increased 12% per year. Organic sales

have increased 6% per year. Total sales have grown from

$39 billion to $68 billion.

Earnings per share have grown an average of 12% per year.

Free cash flow has grown to nearly $9 billion per year,

totaling more than $35 billion over the past five years.

Procter & Gamble is a company which goes to great lengths to disclose its

companys information. Through their disclosure comes their aggressive strategy. After

researching their financial statements and annual reports it was determined their

industrys competitors disclose large amounts of information. It was also determined

that according to their key accounting policies they are considered an aggressive

company. Nevertheless, this leads a potential investor to think that they can be trusted

because of their high transparency.

Qualitative Analysis

Qualitative analysis is a useful tool in determining the overall transparency and

decision usefulness of the reported financial statements. In order to allow outsiders to

37

get a good picture of a companys performance, the company must release adequate

information. However, disclosure must also be at a level that does not harm a firms

competitive advantage. Incentives are always present that tempt managers to bias

company reports; therefore, an in-depth look at those reports must be taken in order to

ensure the accuracy of reported information.

The first area that needs to be evaluated is the companys overall level of

disclosure. Procter & Gamble does a good job disclosing financial information. The

notes to their financial statements give a good explanation for everything put into the

financial statements. They dont leave analysts guessing where the numbers came

from. If anything seems out of the ordinary, it is addressed either in the notes to the

financial statements, or in the management discussion and analysis. For example, in

2006 Procter reported a 19 percent increase in selling, general, and administrative

expenses. In comparison to other years, this is a large jump. If no other disclosure

were given, this increase would signal a red flag to analysts. However, the

management discussion and analysis section of Procter & Gambles 2007 10-K goes on

to explain how this large increase resulted from the acquisition of Gillette

(www.pg.com). This good level of disclosure is also consistent throughout the industry.

Dis-aggregation of financial information is also important in order to obtain an

accurate picture of a companys performance. If a company lumps items on financial

statements together, analysts cannot be sure how to allocate the data to individual

business activities. The line items on Procter & Gambles financial statements are

somewhat aggregated; however, in the notes to their statements, line items are further

broken down. One example of this is Procter & Gambles reporting of long-term debt.

Long-term debt is shown as one line item on the 2007 balance sheet. However, note 5

of the 10-K filing dis-aggregates all the long-term debt into individual liabilities complete

with interest rates and due dates (www.pg.com). Figure 10 shows the dis-aggregation.

38

Figure 10: Dis-aggregation of long-term debt notes

June 30 2007 2006

LONG-TERM DEBT 3.50% USD note due October 2007 $ 500 $ 5006.1 3% USD note due May 2008 500 500Bank credit facility expires July 2008 4,537 19,5554.30% USD note due August 2008 500 5003.50% USD note due December 2008 650 6506.88% USD note due September 2009 1,000 1,000Bank credit facility expires August 2010 1,830 1,8573.38% EUR note due December 2012 1,882 1,7794.50% EUR note due May 2014 2,016 4.95% USD note due August 2014 900 9004.85% USD note due December 2015 700 7004.1 3% EUR note due December 2020 806 7639.36% ESOP debentures due 2007-2021 (1) 968 1,0004.88% EUR note due May 2027 1,344 6.25% GBP note due January 2030 1,001 9175.50% USD note due February 2034 500 5005.80% USD note due August 2034 600 6005.55% USD note due March 2037 1,400 Capital lease obligations 628 632All other long-term debt 3,657 5,553Current portion of long-term debt (2,544) (1,930) 23,37 35,976

(www.pg.com)

This method of reporting is much more transparent than the single line item on the

balance sheet, and it better depicts Procter & Gambles long-term debt. The rest of the

personal products industry practices similar dis-aggregation methods in reporting.

When a company with multiple segments reports financial information, it needs

to be reported by individual segments. This allows analysts to assess the performance

of each segment of the company. Some segments will out perform others; however, if

there is no individual segment disclosure, there is no way to determine which segments

are the strongest and which are the weakest. Procter & Gamble does report their

financial results based on segments. This breakdown can be found in the notes to

financial statements. For instance, note 12 of Procter & Gambles 2007 10-K breaks

down performance by segment (www.pg.com). Figure 11 from note 12 shows global

segment results.

39

Figure 11: Global segment results

Before-Tax Depreciation

&

Capital

Global Segment Results Net

Sales Earnings Net

EarningsAmortization Total

Assets Expenditure

s

BEAUTY AND HEALTH

BEAUTY 2007 $ 22,981 $ 4,794 $ 3,492 $ 577 $ 14,470 $ 641 2006 21,126 4,359 3,106 535 13,498 577 2005 19,721 3,977 2,752 535 11,494 535

HEALTH CARE 2007 8,964 2,148 1,453 279 7,321 189 2006 7,852 1,740 1,167 234 7,644 162 2005 6,078 1,210 811 161 2,536 112

HOUSEHOLD CARE

FABRIC CAREAND

HOMECARE 2007 18,971 4,156 2,793 453 7,649 654

2006 17,149 3,553 2,369 435 6,928 567 2005 15,796 3,186 2,129 391 6,845 647

BABY CARE AND

FAMILY CARE

2007 12,726 2,291 1,440 671 7,731 769

2006 11,972 2,071 1,299 612 7,339 739 2005 11,652 1,924 1,197 580 7,272 684

SNACKS, COFFEE AND

PET CARE 2007 4,537 759 477 164 2,176 141

2006 4,383 627 385 159 2,122 150 2005 4,314 714 444 162 2,197 142

GILLETTE GBU(1)

BLADES AND

RAZORS (1) 2007 5,229 1,664 1,222 657 24,160 210

2006 3,499 1,076 781 489 24,575 271 2005

DURACELL AND

BRAUN (1) 2007 4,031 588 394 194 6,998 135

2006 2,924 400 273 155 7,384 108 2005

CORPORATE 2007 (963) (1,690) (931) 135 67,509 206 2006 (683) (1,413) (696) 8 66,205 93 2005 (820) (1,030) (410) 55 31,183 61

TOTAL COMPANY 2007 76,476 14,710 10,340 3,130 138,014 2,945 2006 68,222 12,413 8,684 2,627 135,695 2,667 2005 56,741 9,981 6,923 1,884 61,527 2,181

(www.pg.com)

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This level of segmentation disclosure is consistent with that the rest of the personal

products industry.

Conclusion

On an absolute basis, Procter & Gamble exercises a high quality of disclosure.

Their 10-K information provides in-depth notes and management discussion and

analysis that discuss any foggy aspects of the reported financial information. This is

done by dis-aggregating single line items found on the financial statements as well as

breaking down results by segments. On a relative basis, Procter & Gamble reports with

about he same disclosure as its competitors. Overall, the personal products industry

practices high disclosure. The tables presented above are not exclusive to Procter &

Gamble. 10-K reports produced by Johnson & Johnson, Kimberly-Clark, and Colgate-

Palmolive all had dis-aggregated reports as well as segmented reports.

Quantitative Analysis

Quantitative Analysis is the financial analysis technique that seeks to understand

behavior by using complex mathematical and statistical modeling, measurement and

research (investopedia.com). This tool will be used to compare sales manipulation

diagnostics and expense manipulation diagnostics. Since there is flexibility in

accounting, a company could manipulate their revenue and expenses in a fiscal year,

which could alter their actual performance. Any inconsistence in a corporations

numbers could throw up a red flag to investors. A thorough analysis of these ratios

can show how accurate or inaccurate the quality of disclosure is from a company. In

the following paragraphs, we will compare sales manipulation diagnostics, which

includes net sales compared to cash from sales, net accounts receivable, unearned

revenues, warranty liabilities, and inventory. We will also compare expense

manipulation diagnostics, which compares sales to assets, changes in operating cash

flows to operating income and net operating assets, and pension and other employment

expenses to selling, general, and administrative expenses.

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Sales Manipulation Diagnostics

Analyzing the sales of a company over a period can show if there are any

distortions to the accounting during those years. Also, comparing these numbers to

their competitors can also show if there are any manipulations of their accounting.

Sales manipulation diagnostics will be used in the following paragraphs for the personal

products industry.

Net Sales/ Cash From Sales

Net sales divided to cash from sales is an important ratio because it shows the

amount inventory sold on credit. An ideal ratio is 1:1. This ideal ratio can be reached,

but it is very hard to maintain due to the high amount of sales on credit. Sales on credit

cause a delay in the amount of cash received, which causes this ratio to be higher than

1:1. It is normal to be slightly higher than a 1:1 ratio in the personal products industry.

Procter & Gambles ratio has fluctuated from around 1:1 to 1.02:1 in the past five

years. This alternating ratio shows that there were higher amounts of sales on credit

one year, but the next year the cash from the sales was received. Therefore, this ratio

shows that the net sales and cash from sales reported are believable.

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Net Sales/ Accounts Receivable

Comparing net sales to net accounts receivable shows us a companys accounts

receivable turnover. Accounts receivable turnover is the effectiveness of a company

collecting debts. As seen in the above graph, all companies have fairly steady net sales

to net accounts receivable ratios. Procter & Gamble has the most fluctuation from 14.28

percent to 11.54 percent, but this number has steadily decreased over the past five

years. The decrease in this ratio, however, is not significant enough to cause a red

flag because there are no sharp increases or decreases over time. A higher ratio

means that the company is more efficient in collecting its accounts receivable. Upon

analyzing this ratio, we believe that net sales are supported by accounts receivable and

that Procter & Gamble are not manipulating their sales.

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Net Sales/ Inventory

Net sales compared to inventory will show how a companys inventory turnover.

Inventory turnover is the measure of how well a company can turn inventory into sales. Each

company in this industry has maintained steady net sales to inventory ratios over the past five

years. From 2003 to 2006, Johnson & Johnsons ratio increased, meaning that more sales were

generated with the inventory that they had. Then in 2007 there was almost a 2 percent

decrease, meaning that fewer sales were generated. Procter & Gamble has had a ratio of

between 11 percent and 12 percent over the past five years. Since there is little fluctuation in

this ratio, there is no reason to believe that Procter & Gamble has manipulated net sales with

respect to inventory.

Conclusion

Using sales manipulation diagnostics for companies in the personal products

industry has shown that some companies have more distortion than others do.

Investors should still be extremely careful in examining a company and be very cautious

if any distortions are found. Procter & Gamble was, overall, consistent in its accounting.

However, this does not mean that Procter & Gamble has no distortion at all. The

financial statements and annual reports should still be examined thoroughly before any

important decisions are made.

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Expense Manipulation Diagnostics

Analyzing the expenses of a company over a period can also show if there are

any distortions to the accounting during those years. Comparing these numbers to their

competitors can show if there are any manipulations of their accounting as well.

Expense manipulation diagnostics will be used in the following paragraphs for the

personal products industry.

Asset Turnover

Asset turnover is generated by comparing sales to total assets. This ratio shows

the amount of sales produced for every dollar of assets produced. All the firms in the

industry, except Procter & Gamble, have maintained a steady asset turnover ratio over

the past five years. The industry leader is Avon, which means that they are efficient in

producing sales with the assets that they have. Procter & Gambles ratio had a

substantial decrease from 2005 to 2006. This would normally raise a red flag for the

company, meaning that assets were understated substantially. However, the sharp

decrease in asset turnover for Procter & Gamble was a result of the acquisition of The

Gillette Company on October 1, 2005. This acquisition increased Procter & Gambles

assets by $74 billion in this year. From 2006 to 2007, Procter & Gambles asset turnover

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ratio rose slightly due to the increase in sales from the Gillette acquisition, and will

continue to increase in years to come.

Cash Flows from Operating Activities/ Operating Income

The ratio of cash flows from operating activities compared to operating income

shows how operating income is supported by cash flows. In the personal products

industry, each company maintained a low and relatively steady ratio with an average of

around one over the past five years, with the exception of Unilevers spike in 2005.

Procter & Gambles ratio fell roughly 0.4 percent from 2003-2005. A drop in cash

caused this decrease in the ratio from operating activities in 2005 while operating

income was steadily increasing. This drop in cash from operations was due to the initial

operating expenses of the Gillette acquisition. Operating cash flows increased in 2006

by 31 percent due to the benefit of acquiring Gillette (PG 10K). This caused the ratio to

become steady for the next two years. Upon analyzing this ratio, it shows us that cash

from operating activities is supported by operating income for Procter & Gamble.

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Cash Flow from Operating Activities/ Net Operating Assets

The ratio of cash flows from operating activities to net operating assets shows how

operating revenue is generated for every dollar in net operating assets that the

company has. The higher the ratio, the more revenue a company has from its fixed

assets. As the graph shows, Johnson & Johnson is the industry leader in this area,

producing $1.05 in revenue, on average, with each dollar in net assets. Procter &

Gamble is on the middle of the industry and has an average ratio of around 0.65 that

has had little fluctuation over the past five years. Even though Procter & Gamble is

among the top in the industry based on cash flow from operations data, they have a

lower CFFO/NOA ratio due to the very large amount of fixed assets that they have

compared to others in the personal products industry.

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Pension Expense/ SG&A

The pension expense to selling, general, and administrative expense ratio shows

how much money is being spent on retirees compared to the rest of SG&A expenses.

Pension expense is a part of SG&A expenses. As a result, this ratio should be relatively

low so that pension expense is only a portion of SG&A expenses. All companies in the

personal products industry have maintained a low ratio over the past five years. Procter

& Gambles ratio has relatively small change, if any, during this time period. This is

because both pension expense and selling, general, and administrative expenses are

increasing at about the same rate.

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Other Employment Expenses/ SG&A

The ratio of other employment expenses to selling, general, and administrative

expenses shows how much is spend on other employee benefits, except for pension

funds, compared to all SG&A expenses. Other employee benefits in a company can

include life, dental and health insurance, retirement programs, and even family

benefits, and is included in SG&A. This ratio should remain relatively stable over time

because the expenses should typically increase or decrease collectively. An increase in

this ratio means that more is being spent on other employment expenses compared to

SG&A. Procter & Gamble has had little fluctuation over the past five years in this ratio.

Conclusion

Using the quantity of disclosure method has shown that some companies in the

personal products industry have more distortion than others. However, these distortions

could be caused by changing their accounting policies, managers, or methods. Even if

these changes explain the distortions in accounting, investors should still be very careful

in examining the company. Procter & Gamble was, overall, consistent in its accounting.

However, this does not mean that Procter & Gamble has no distortion at all. The

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financial statements and annual reports should still be examined thoroughly before any

important decisions are made.

Potential Red Flags

Whenever analysts come across questionable financial reporting, they will red

flag it for further analysis. This is where biased and tampered financial reports will be

exposed. One potential red flag discussed above was with the other employment

expenses to selling general and administrative expenses ratio. Procter & Gamble

reported a small decrease from 2003 to 2005 while the rest of the industry remained

fairly flat. Although the move differed from that of the rest of the industry, it was small

enough to be ignored and is considered to be insignificant. One ratio that displayed a

broad range over the last five years was total accruals to change in sales. However,

the rest of the industry reported very sporadic results here as well. Therefore, there is

no evidence of manipulation here. The last ratio that presented a possible red flag was

cash flows from operations to operating income. This ratio did have a fair decrease

from 2003-2005; however, it never jumped outside the range of the