Ratio Analysis and Valuation.ppt

8/14/2019 Ratio Analysis and Valuation.ppt

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© 2005 by Robert F. Halsey, all rights reserved

Ratio Analysis and Valuation Valuation theory

Discounted free cash flows

Residual income

ROE disaggregation into RNOA and financial returns ROE - Identifying and Computing Operating Working Capital

and Operating Assets exercise

ROE Disaggregation (P&G) exercise

Pfizer (PFE) valuation exercise

Margin and Turnover

EVA




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




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




Source: Parker Center for Investment Research, Cornell Univ.




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)




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.



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



Source: Nissim and Penman, 2003





ROE - Identifying and Computing Operating Working

Capital and Operating Assets exercise

ROE Disaggregation (P&G) exercise

Pfizer (PFE) valuation exercise

Exercises



Cisco Systems, Inc



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




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




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




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%




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




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.



PG 5-Year Stock Price Trend

Forecast Horizon Terminal Year



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




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.






ROCE v. Ke (Nissim and Penman 2001)




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%




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




Compare RI withEconomic Value Added TM (“EVA”)

Under EVA,

MV = capital + PV of future EVA,

where EVA 1 = NOPAT1 - k wacc*capital0




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



EVA Exercise –

Areas for Improvement

Documents

Ratio Analysis and Valuation.ppt