Equity Valuation and Analysismmoore.ba.ttu.edu/ValuationReports/Fall2007/DowChemicals.pdf5 Yr (3 month) 0.3081 1.5 14.80% Intrinsic Valuations Discounted Dividends $32.53 Published

Equity Valuation and Analysis

Valued at: November 1, 2007

Frank Puskarich: [email protected]

Greg Garrison: [email protected]

JB Richter: [email protected]

Justin Matthews: [email protected]

Dow Chemical Analysis Page 2

Table of Contents

Executive Summary 3

Business/Industry Analysis 7

Firm Overview 10

Industry Overview 12

Five Forces Model 14

Rivalry among against firms 14

Threat of new entrants 20

Threat of substitutes 22

Bargaining Power’s 22

Value Chain Analysis 26

Firms Competitive Advantage 30

Accounting Analysis 36

Key Accounting Policies 37

Accounting Flexibility 42

Evaluating Accounting strategy 44

Quantitative Analysis 49

Manipulation Diagnostics 50

Financial Analysis 58

Credit Analysis/Z-score 78

Forecasting Analysis 82

Cost of Capital 90

Methods of Comparables 94

Intrinsic Model Valuation 103

Analysis Recommendation 109

Appendix 112

Reference 128


Investment Recommendation: Overvalued, Sell (11/1/07)

DOW-NYSE $44.14 Altman's Z-scoreRevenue(2006) $49,124(M) 2002 2003 2004 2005 2006Market Cap 39.47(B) 1.82 2.12 2.53 2.98 3.07Shares Outstanding 962.3(M)Dividend Yield 3.75% Financial Based Valuations3-month Avg. Daily Trading Vol. 5,632.49(M) Trailing P/E: 10.31Percent Institutional Ownership 68.20% Forward P/E: 11.22Book Value per share $19.13 P.E.G.: 1.473ROE 21.82% P/B: 2.25ROA 8.11% P/EBITDA: 7.14

P/FCF: 17.76Cost of Capital R Squared Beta Ke EV/EBITDA: 8.04Ke Estimation 14.80%5 Yr (3 month) 0.3081 1.5 14.80% Intrinsic Valuations

Discounted Dividends $32.53Published Beta 0.8 Free Cash Flows $22.95Kd 5.89% Residual Income $24.20WACC(bt) 9.23% Abnormal Earnings Growth $27.21WACC(at) 7.94%

Executive Summary


Industry Analysis

In 1897, chemist Herbert Henry Dow began the Dow Process Company in

Midland, Michigan where he exclusively sold bleach and potassium bromine. In the

course of just under a century, the Dow Chemical Co. (DOW) is the largest American

chemical manufacturer and the second largest the world. With over 43,000 employees

located in over 175 production facilities worldwide, Dow continues to be an innovative

producer of chemical products that range anywhere from plastics, chemicals (both basic

and performance grade), agricultural chemicals and even hydrocarbon energies.

Dow competes in the chemical manufacturing industry which comprises of nearly

26 major competitors and countless numbers of small to mid-sized firms. Despite facing

competition from numerous firms around the globe, Dow maintains a commanding

market share over its top domestic competitors such as DuPont, Lyondell, Huntsman,

and Exxon Mobil.

To remain successful in the chemical business, we identified several key success

factors that will ultimately determine how well the company is performing in this

industry. This industry is characterized as have vast economies of scale, high barriers to

entry, and low levels of competition between competitors. This industry also has a

heavy emphasis on continuing innovation and therefore carries a low level of product

differentiation while still requiring high expenditures both fixed assets and Research and

Development expenses.

By following its key success factors and maintaining its cost-leadership business

strategy, Dow Chemical can continue its success as being one of the largest chemical

manufacturing company and, most importantly, to accomplish its stated goal as

“constantly improving what is essential to human progress by mastering science and

technology with the vision to be the largest, most profitable, and most respected

chemical company in the world” (Dow Mission Statement).


Accounting Analysis

When analyzing a company’s annual reports, it is important to measure the

overall transparency of the financial statements and to evaluate the level of disclosure

for significant line items that correspond to the firm’s key success factors. Due to the

varying degrees of flexibility that the General Accepted Accounting Principles (GAAP)

allow in financial reporting, it is imperative that we recognize these significant line

items, identify and remove potential “red flags”, and asses a true economic value to the

firm.

By having numerous opportunities at their disposal to influence the method of

computing financial data, managers of firms are often tempted to hide or withhold

various information from financial statements for the purpose of disguising results and

therefore inflating the true economic value of the company. By identifying the numbers

that relate to firm’s key success factors such as economies of scale, cost leadership,

and high investments in Research and Development, we were able to locate any item

that could potentially distort the true performance of the company. An example would

be Dow’s policy of not capitalizing their operating leases, which we all know can

significantly alter Dow’s income statement and balance sheet.

Despite the questionable strategy of their operating leases, we found Dow to

considerably conservative in their accounting policies and therefore gave us some

degree of confidence in the disclosure of their information.

Financial Analysis/Forecasting Analysis/Cost of Capital Estimates

When analyzing a firm’s financial statements, analysts use various financial ratios

to compare performance with that of its given industry. Some of the more relevant

ratios used, were measuring Dow’s liquidity, profitability, operating efficiency as well as

Dow’s capital structure, in reference to the chemical industry. Also, we forecasted

Dow’s financial statements to show where Dow is heading in the future, and to where


they may stand against their competition. The last financial ratio tool we used in

valuing Dow Chemical Co, was regression analysis which allowed us to understand what

costs were being put into the company.

In referring to Dow’s liquidity ratios, they show the ability to covert their assets

into readily available cash in a timely manner. Although Dow extends the opportunity

for purchasers to buy on credit, their ratios show that they are able to collect on their

receivables quickly. This is shown in Dow’s day’s supply of receivables ratio where they

collect on their receivables in a substantially lower number of days compared to their

competition and industry as a whole. Their profitability ratios illustrate how Dow has

become much more profitable in their earnings as well as expanding their growth

strategy. With this expansion in the past couple of years, Dow has been able to

balance out their overload of liabilities. Dow has shown progress of improvement in

each of the 8 liquidity ratios throughout the five year span, with the exception of

Working Capital, which still averages out higher than the industry average of 7.01.

The profitability ratios were also a great tool in showing that Dow’s structure and

commitment to profitability are strong. Dow has consistently shown to outperform its

competitors in operating efficiency and productivity. These ratios were extremely

helpful in that efficiency and productivity are both key success factors of Dow. With

these consistencies, Dow has begun to emerge as the primary holder of this industry

market share.

After computing these financial ratios, we used them to forecast our financial

statements out to 10 years in the future. By doing so, we were able to identify Dow’s

growth trends and possible room for improvement. Our growth rate showed to be

consistent with historical prices, which can look positive in the eyes of investors.


Valuations

In determining Dow’s current state, we used several valuation models that were

precisely weighted to conclude if Dow’s stock price is overvalued, undervalued, or

priced fairly. We had to base our valuation on the intrinsic models, because the

method of comparables had too many inconsistencies within the industry. Although

these comparables were not completely relevant in our valuation, they showed that

Dow’s stock price was slightly undervalued. Once again, these ratios did not carry a

heavy weight in our decision of valuing our company, because the 8 different valuation

ratios were scattered with a wide range of prices.

In shaping our final estimates of Dow’s value, we looked closely at the five

intrinsic models that include: Residual Income Model, Free Cash Flow Model,

Discounted Dividend Model, Abnormal Growth Model, and Long-Run Return on Equity.

The least accurate model within our valuation was the Discounted Dividends model

because it is extremely difficult to forecast dividends, growth, and treasury re-purchases

and issuances. This model yielded the highest price ($32.53) of any other model due to

these fallacies. The Residual Income model was the most precise and held the largest

bias for our estimation of Dow’s stock price due to the accurate estimations of expected

returns and earnings. This model valued our price per share to be $24.20. Although

Residual Income was the most accurate model, Free Cash Flows and the Abnormal

Earnings Growth models were also both consistent. This isn’t surprising because of the

tie between the Residual Income Model and AEG. These models contributed to our

valuation that Dow is overvalued.

Business & Industry Analysis

Company Overview

Dow Chemical Co. (DOW) is the top American based chemical company and the

second largest in the world. Dow is well diversified, leaning heavily on innovation and


research and development. In addition, Dow is the single largest concentration of

PhD’s as well as Engineers in the entire United States. Dow’s headquarters reside in

small Midland, MI where a wide range of products and services are distributed

worldwide.

When the company was started in 1897 by chemist Herbert Henry Dow, it was

limited to selling bleach and potassium bromide. Later, Dow Chemical Company was

incorporated in 1947 under Delaware law taking over the rights of the former Michigan

Company. Today, Dow operates in six major segments producing everything from food

and fresh water, to pharmaceuticals and paints, to packaging and personal care

products. Dow’s current workforce is composed of over 43,000 employees worldwide

driving towards the common goal of innovation. With 175 plants and facilities

worldwide, Dow is able to control their overhead costs by reducing transportation costs

and controlling various markets (Dow.com).

With Dow’s primary focus on innovation and Research and Development, they

can solely concentrate on expanding the growth of their company. On February 6,

2001, Union Carbide Corporation became a wholly owned subsidiary of The Dow

Chemical Company. Bought for $11.6 billion by Dow, Union Carbide Corporation sells

most of its products to Dow for cheaper prices and has become one of the top

performers in the Dow family (Dow Chemical 10-K).

While Dow only has a few major competitors, there are 26 other main companies

in the chemical industry. Dow’s major competitors consist of: DuPont (DD), Exxon

Mobil (XOM), Lyondell (LYO), and Huntsman (HUN). Dow’s current market cap is at

39.77B, which puts them within 10% of the highest competitor, DuPont (excluding XOM

who only competes on a limited basis). For this reason and reasons of inability to

separate the different factions of XOM, they will not be considered in this report. In

addition, Dow’s stock performance throughout the past five years has been on a

rollercoaster ride pricing out at as high as $56.24 in February 2005, to as low as $33.54


in July of 2006. Comparing Dow’s stock price with fellow competitors, Dow’s growth

was right alongside fellow competitors, until late last year where they saw a decline.

The decline in Dow’s stock price was an example of rough market conditions as well as

an extreme fluctuation in energy costs.

Stock Price’s of Industry (5 Year)

According to Dow’s statement of commitments and goals, they plan on pursuing

a business strategy of sustainability and innovation. In order for Dow to achieve these

goals of growth, they must retain financial order while increasing investments in

positive opportunities, especially in emerging geographies abroad as well as business

performance. With expectations of increases in capital expenditures, Dow looks to

maintain safety and reliability of the company. Dow has stated that they will continue

their policy of reducing debt by either using a portion of its cash, or by issuing new

debt. With economic conditions remaining healthy and the costs of energy prices

staying stable, Dow looks to dominate the chemical industry in 2007.

LYO- Lyondell

HUN-Huntsman

DD-DuPont

XOM-Exxon Mobil

DOW- Dow Chemical


2002 2003 2004 2005 2006

Net Sales $27,609 $32,632 $40,161 $46,307 $49,124

Total Assets $39,562 $41,891 $45,885 $45,934 $45,581

Sales Growth

(DOW) 0.70% 18% 23% 15.30% 6.10%

Industry Sales

Growth 2.03% 18.62% 22.98% 18.03% 7.01%

* Net sales and Total Assets measured in millions of dollars

According to the growth chart provided above, Dow shows consistency with the

industries average growth. This allows for confidence within Dow’s company because it

illustrates their ability to maintain a realistic and sustainable growth rate. The industry

average might be slightly higher due to the fact that Exxon Mobile’s entire enterprise

growth rate is factored into this average.

Firm Overview

Dow is a highly diversified company with six major operating segments. Their

six segments consist of products such as: Performance plastics, performance chemicals,

agricultural sciences, basic plastics, basic chemicals and hydrocarbons and energy.

Listed below are a few of the many products produced in plants by Dow.

Plastics are Dow’s overall top product and top seller according to earnings. “In

2006, Dow’s EBIT (Earnings before Interest/Income Tax) was $1,629 million and shows

signs of continual growth” (Dow Chemical 10-K). Offering a large range of high

performance plastics, Dow is a world-leading provider in electrical performance using

specialized plastic wire and cable compounds. Dow also sells a high performance

plastic that makes automobiles more fuel efficient and safer by using the formula of

Styrene-Acrylonitrile to bond the glass and control outside sound (Dow.com).


Dow provides consumers with specialized chemical products that meet an

assortment of needs. Their basic core chemicals serve as vital raw materials for the

industry. They play a big role in making various products more durable and reliable as

well as making household cleaning materials more successful. Dow also uses

polyacrylic acid compounds, which are used in detergents and put into waste water

plants for cleansing.

Dow’s Agrosciences department manufactures and promotes products that

develop and maintain crop production, by killing insects, weeds and protecting crops

from diseases. This segment is also in the research of producing bio-technology, such

as seeds and healthy oils for plants. Although the smallest segment now, Dow looks to

put emphasis on its Agrosciences for the future in hoping that further research will form

a break-through product.

“Dow’s Hydrocarbons and Energy business is the world leader in the production

of olefins and aromatics, and is at the forefront of efforts to secure advantaged

feedstock positions in emerging geographies as well as new potential energy and

feedstock sources to create long-term competitive advantage for Dow”

(www.Dow.com). With the energy business at a current boom, Dow has the potential

to secure and entire market segment. Although energy prices have been high, Dow is

in the process of researching alternate materials to produce high amounts of energy.

The world is moving into a direction of a “cleaner environment” where new demands

will start to grow and sources of supply will be vacant.

With the diversification and wide range of products, Dow is able to gain a

competitive advantage over its competitors.


2006 Sales to External Customers

Industry Overview

The chemical industry is composed of companies that produce specialized

chemicals that are converted into vital raw materials that are dominant throughout the

world economy. Polymers and plastics represent about 80% of the 70,000 somewhat

products produced in this industry (Wikipedia.org). With chemicals consisting of around

$2 trillion of global enterprise, the US companies control most of the output by

employing over a million employees. The chemical industry is one of the fastest

growing industries in the world, and with the increasing technological advances, it

seems that it will continue to expand.

Dow Chemical Company ranks second in the world only behind Baden Aniline

and Soda Factory (BASF) of Germany, according to total chemical sales. These two

companies are near monopolies in the industry by their dominating total sales, along

with their name recognition. Although BASF is in competition with Dow for world

ranking, they however don’t compete over customers. Dow dominates the United


States as well as some smaller areas of Europe while BASF swallows up Europe with

fewer few top competitors.

With the dominance of BASF in Europe, the window of competition within the US

opens up to Dow and its domestic rivals. The four major competitors in this segment

include DuPont, Exxon Mobil, Lyondell Chemical and Huntsman Corp. Research and

Development is the main push for all five of these companies where competition is

fierce for the most cutting-edge material or solution.

2006 R&D Expenses

*Numbers represented in millions of dollars

Exxon Mobil’s company as a whole is valued at a much higher dollar amount than

any of the other competitors. However, Exxon Mobil states that only 11% of its 2006

earnings came from the chemical segment.

The chemical industry is highly interdependent with the sale and purchase of

fellow competitors materials and products. “The chemical industry itself consumes 26

percent of its own output” (Wikipedia.org). For instance, it is common for a company

like Dow to buy a competitors material for cheap, to later combine that material with its

own. By doing this, Dow is cutting down on various expendetures and time, which in

the long-run, shaves down overhead costs.


Five Forces Model

In ordered to evaluate a given industries foundation of profitability and structure,

an important evaluation tool, The Five Forces Model, can be implemented to assess that

industry. The Five Forces Model identifies the key success factors that a company can

pursue in order to become profitable. This model identifies sources of competition that

include: rivalry among existing firms, threat of new entrants, and the threat of

substitute products. This model also conveys the relationship of power that both the

buyer and supplier possess. These relationships are identified in the last two

components of the Five Forces Model, bargaining power of buyers and bargaining

power of suppliers. In order to evaluate how successful a company is within a given

industry, it is crucial that they follow their identified success factors within this model.

Chemical Industry

Rivalry Among Existing Firms MODERATE

Threat of New Entrants LOW

Threat of Substitute Products LOW

Bargaining Power of Buyers LOW

Bargaining Power of Suppliers LOW /

MODERATE

Rivalry among Existing Firms

In the business of chemical manufacturing, the firms that comprise this industry

engage in low to moderate levels of competition. This industry is characterized as

having high levels of growth, low concentration of competitors, very adaptive learning

curves, many barriers to entry and exit, and also large economies of scale with an


ample amount of excess capacity. Given the circumstances that this firm competes in,

the Dow Corporation has become the largest supplier of chemicals in the United States

and continues to be a major innovator.

Industry Growth

Industry Growth Rate

5.00%

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

1 2 3 4 5 6

industry growth

*Vertical axis periods are represented by: 2001(1), 2002(2), 2003(3), ect.

As the graph above clearly illustrates, the chemical manufacturing industry is an

enterprise that has experienced a surge in net sales in 2003 following the 2002

recession and the September 11th attacks that preceded it, proving that this industry

operates in a business environment that is sustainable. Because of the rise in industrial

growth, firms that compete in this industry do not spend excessively on advertisements

and other marketing campaigns in order to capture market share from one another.

Despite the fact that the industry has experienced above average growth, the threat of

new entrants is set off by the initial high cost of capital; therefore, assuring that firms in

this industry can successfully maintain the current market share.


Market Growth in Net Sales (Millions)

$-

$10,000.00

$20,000.00

$30,000.00

$40,000.00

$50,000.00

$60,000.00

2001 2002 2003 2004 2005 2006

DOW

HUN

LYO

DD

Global Market Share

In the United States alone, there exist 170 major chemical companies along with

countless other small to medium sized chemical manufacturing facilities. With the

addition of foreign competition, there is an estimated 4,500 facilities worldwide. “By

controlling nearly 46% American market share, Dow is by far the largest chemical

manufacturing firm in the United States and the second largest in the world”

(Wikipedia.org). This industry is characterized as having low to moderate levels of

competition amongst contending firms.


Market Share within United States

0.00%

5.00%10.00%

15.00%20.00%

25.00%

30.00%35.00%

40.00%45.00%

50.00%

2001 2002 2003 2004 2005 2006

DOW

HUN

LYO

DD

Differentiation

Because product-line’s follow the same chemical formula and production process

amongst all competitors, the industry competes in a manufacturing environment that

sells very homogenous products. Therefore, not much differentiation can be made

between its products and the competition. However, several firms have made numerous

advancements in the field of chemistry and now offer synthetically made chemicals that

seek to differentiate between competitors. The following table provides the recently

acquired advancements in the chemical manufacturing industry.

Scale Inhibitors Aminoethylethanolamine


Chlorine Diethylenetraimine

Ethylcellulose Glutaradehyde

Hydroxyethylcellulose Hydroxypropyl Methycellulose

Methyl Cellulose Methyl Chloride

Methylene Chloride Methy Glucosidederatives

Perchlorethylene Polypropylene Glycols

Thioglycolic Acid Trichlorethyene

(www.chemweek.com/bluebook.pdf)

Economies of Scale/ Learning Economies

In order for it to maintain its leverage over the competition, a company must

employ a larger, more specialized workforce than its rivals. “The scope of production

encompasses nearly 12% of European manufacturing’s added value” (Wikipedia.org).

With sales forecast predicting stable levels of growth over the next few years, many

firms in this industry have made plans to expand their operations in hopes of capturing

more market share from competitors.

Total Assets

(in millions) 2001 2002 2003 2004 2005 2006

DOW 35,515 39,562 41,891 45,885 45,934 45,581

HUN 4,827 5,044 8,737 9,437 8,871 8,445

LYO 6,703 7,448 7,633 15,928 15,089 17,846

DD 40,319 34,621 37,039 35,632 33,291 31,777


It is also important to note that this industry is identified with having a very

adaptive learning curve. Essentially what this means is that as soon as a company

introduces a new and innovative product on the market, the competitors in that

industry are quick to copy the design and exploit it. This process ensures that any form

of differentiation is avoided.

Fixed assets to Variable Costs ratio:

FA/VC Ratio 2001 2002 2003 2004 2005 2006

DOW 0.5683 0.5802 0.5046 0.4038 0.3537 0.3304

HUN 0.7118 0.7868 0.8052 0.6163 0.5124 0.4468

LYO 1.2945 0.8175 0.7335 1.3205 0.3959 0.4626

DD 0.7943 0.758 0.4763 0.5194 0.495 0.5136

The fixed asset to variable costs ratio serves as an excellent tool to help measure

the degree of competition within an industry. If a company was to have a high FA/VC

ratio, then that would indicate that the firm is committed to the industry and must

continue its operations rather than temporarily cease production. As the graph above

indicates, the industry is very liquid, especially for all competitors. The reason this might

be, is attributable to the constant acquisitions and sale of property, plant, and

equipment by companies such as Lyondell, who openly trade fixed assets on the open

market.

Excess Capacity


Because the industry that the companies compete in contains more providers

than buyers, the industry participates in an ample excess capacity market. Since a

couple of firms produce completely homogenous products, it must keep prices low or at

least on par with competitors in order to effectively participate in the market. This

information is reflected in the industry growth rate graph listed above.

Barriers to Exit

Since the facilities of a chemical manufacturing firm are tailored made to

specialty products, this business is faced with extremely difficult and very costly barrier

to exit. Due to the fact that many other industries have no practical use for other

company’s facilities, the only plausible scenario that the companies could pursue in the

case of an exit would be through an acquisition from a competitor.

Conclusion

Since the chemical companies participate in an industry with low levels of

competitor concentration, costly barriers to entry, and consistently high levels of

industrial growth with ample amounts of excess capacity, our firm would classify the

chemical manufacturing industry that Dow competes in as having low to moderate

levels of competition.

Threat of New Entrants

Determining the threat of new entrants into the industry is vital for valuing the

company. To do this there are certain things that have to be taken into consideration.

These are scale of economies, first mover advantage, distribution and relationship

access and legal barriers. Once each of these have been considered and evaluated it

can be determined the threat level established by the possibility of new entrants.

Scale of Economies


First we must consider scale of economies. Scale of economies is the

determination of whether or not size will make a significant difference in market

entrance. As for the chemical industry, we have determined that size is a large factor.

The customers are usually in manufacturing and need to buy large quantities to fulfill

their needs. Also, the suppliers of the raw materials are large corporations that deal in

bulk amounts and are not scaled to sell to small, startup firms. Scale of economies

plays a large role in entering the chemical manufacturing industry.

First Mover Advantage

The second consideration is first mover advantage. This is the advantage

created by being first in the industry. For example, already having the government

licenses, the technical staff, and have developed the standard for the industry. Due to

the nature of chemical manufacturing, we must consider emission licenses and

standards set by the EPA, environmental protection agency. Since Dow is in the top ten

on highest levels of emissions, it is reasonable to assume that the EPA is not going to

grant more licenses easily. Dow has an extreme advantage over new entrance in the

learning economies since they have a full arsenal of chemists and chemical engineers.

After being in business for over 60 years Dow has created a high standard for new

entrants to meet. First mover advantage plays a critical role in hampering new entrants

into the industry.

Channels of Distribution

Next, we must consider the channels of distribution and relationships. These

are the networks between suppliers, manufactures, and customers. For example, a

new entrant would face the possibility of having to build a reputation with customers on

the quality of their products or with suppliers on their ability to purchase in the

quantities that they are set up the deal in. These existing channels and manufacturing

locations can easily impede new companies from becoming major players in the


industry. Dow has manufacturing facilities worldwide as well as distribution centers

that make it hard to compete in purchasing supplies and selling products.

Research and Development

Because this is such an intense research and development industry the legal

barriers make it hard for entrance for any company to start up in. Furthermore, because

of the nature of this industry, a firm has limited entry through the use of patents and

copyrights. Not to mention state and national regulations that controls the use of these

chemicals.

The overall threat of new entrants into the Chemical Manufacturing industry is

low. It can be concluded based on the economies to scale, the first mover advantage,

the access to channels of distribution and relationships, and the legal barriers that the

threat of a new entrances into this market is highly unlikely.

Threat of Substitute Products

No matter the industry, there is always some level of threat of substitute

products. This threat comes in the form of comparable products for comparable prices.

If there is a comparable product that performs exactly as another product pricing will

play a large role in overall market performance.

As in the case of the chemical manufacturing industry, the overall threat of

substitute products is very low. They manufacture a series of very specialized products

that have very specific uses in the manufacturing of end user products. For example,

Dow manufactures the plastic compound that containers for cleaning products are

made from, but they do not make the end user container or cleaning product.

Therefore, this is more of a niche market segment that is small enough to avoid the

threat of both substitutes and new products.

Bargaining Power of Customers


The bargaining power of buyers can best be split in to two categories: price

sensitivity and relative bargaining power. Firms with high price sensitivity incorporate

a low cost strategy. Where as a firm with a low cost sensitivity rely on differentiation of

their products. In addition, industries with high relative bargaining power cause firms

to compete on price because of the undifferentiated product selection. This means that

there a low switching cost for the buyer between competing products, which allows

them to choose the lowest price possible. In contrast, buyers in a low relative

bargaining power industry are susceptible to the price of doing business. This means

that operating expenses are not an issue to the firm because it can raise its prices to

compensate for the added expenses.

The chemical industry as a whole is a low price sensitive market due to the lack

of competition. The Dow chemical company in itself is a leader in this industry, and in

certain market segments it is the only producer of these specialized products. A few of

these products are: scale inhibitors, aminoethylethanolamine, aminohydroxy compound,

and chlorine.

In addition, the bargaining power in the chemical industry is very high in most

marketing segments due to the lack of differentiation between products. This gives the

buyer the advantage of getting the same product at the lowest price.

Price Sensitivity

Price sensitivity is very important in this industry because products in this

industry are undifferentiated. Thus, an increase in price will cause consumers to seek

the same product from other companies. The chemical industry as a whole consumes

26% of its own product. Therefore, firms will buy products from their competitors if it

will reduce cost, while maintaining efficiency. Furthermore, the chemical industry relies

on some of its own products to manufacture other products.(www.wikipedia.org)

Bargaining Power


Throughout the chemical industry bargaining power for buyers is very high

because of price sensitivity and the low levels of switching cost. Buyers can obtain the

same product from competitors with low switching cost, which is a big advantage to

them. However, in certain specialized products that Dow manufactures, there are no

competitors. Therefore, the bargaining power of the buyer in these market segments is

very low due to the fact that these products are only produced by Dow.

Conclusion

There are many factors in dealing with the bargaining power of buyers in the

chemical industry. Two of the main factors are price sensitivity and relative bargaining

power. In dealing with this industry, each firm must consider these two ideas in

assessing the degree of competition. While the industry focuses on cost leadership, it

becomes imperative that they lower as many input costs as possible in order to increase

profits. If a company can hold bargaining power over a supplier, they can purchase

materials at a cheaper price which in effect would increase a companies bottom-line.

Bargaining Power of Suppliers

The bargaining power of suppliers is very important in determining how a

company can go about pricing its own product. Industries with high bargaining power

for suppliers can dictate the market price to firms that need their product. This allows

the supplier to be in control of pricing decisions that the firm must incur to obtain the

needed product. On the other hand, industries with low bargaining power are under

the control of the firm, and must compete on the bases of price. Firms in this case

have the power to make suppliers compete for their business. If the firm is dissatisfied

with the services provided by the supplier, they can look for alternative suppliers to

obtain the same product.

Price sensitivity


Price sensitivity of suppliers in the industry is a key to how the company runs.

In the chemical industry there is a large variety of similar products. Therefore,

suppliers must compete on the basis of price. If both products are of the same quality,

then price is the only factor in choosing which firm to purchase from. As previously

stated, switching prices in this industry are low for the buyer, which puts pressure on

the supplier to maintain the lowest cost in order keep their customer. Since the

switching costs are low the supplier is at a disadvantage in terms of their bargaining

power. However, in the case of specialty products the suppliers themselves control the

price sensitivity of the product. Thus, Dow has numerous examples of relative

bargaining power because they are the only manufacturers of certain products. This is

essentially a monopoly with these products because there are no competitors.

Relative Bargaining Power

The relative bargaining power of suppliers in the chemical industry is moderately

low. Since most of the products are so similar there are plenty of substitutes that a

firm can choose from. One of the key factors that help Dow, is their brand recognition.

In some instances, firms may choose Dow on the basis of their good name rather than

buy another product at a cheaper cost. Dow has been an industry leader for years and

has proven its reliable quality, which has set them apart from their competition.

Conclusion

The competitive advantage of this industry is strongly tied in with the bargaining

power of both buyers and suppliers. Other things to consider are product

differentiation and switching cost, which can hurt a firm if these factors are not taken

into consideration. It is for this reason that there is a low level of bargaining power for

the supplier in this industry.

The Five Forces Model Conclusion


According to Alfred D. Chandler, the author of the book titled Shaping the

Industrial Century, Chandler characterizes the chemical manufacturing industry as

having “successful chemical firms followed definite "paths of learning" whereby first

movers and close followers created entry barriers to would-be rivals by building

"integrated learning bases" (or organizational capabilities) which enabled them to

develop, produce, distribute, and sell in local and then worldwide markets. Also they

followed a "virtuous strategy" of reinvestment of retained earnings and growth through

diversification, particularly to utilize "dynamic" scale and scope economies relating to

new learning in launching "next generation" products” (wikipedia.org). This industry is

characterized has having moderate levels of competition among existing firms, low

threat levels of new entrants, substitute products, and bargaining power of buyers while

bargaining power of suppliers ranges to levels of low to moderate.

Value Chain Analysis

Overall Classifications of the Industry

To summarize the industry as a whole it can be broken down to the following

categories: low to moderate rivalry amongst existing firms, low threat of new entrants,

and a low threat of substitutes. In relation to the bargaining power of the buyer and

supplier there is a mixture of both low and high bargaining power in this industry.

There are several aspects that will now be discussed to support these conclusions. To

begin with, the most important factors are a mix of constant research and development

in this ever evolving market, high levels of economies of scale and scope, and

established distributor relationships. In addition, efficient production, lower input costs,

superior products variety, and are the final key factors in this industry.

To begin the breakdown of this industries competitive strategy, one must first

break it down between cost leadership and product differentiation. It is clear that firms

in this industry must compete based on cost leadership; however, differentiation of

products is necessary in order to be successful in certain market segments. In most


cases, firms will choose to implement either cost leadership or differentiation of

products, but in this industry both strategies are required to be successful.

Through the evaluation of the value chain, one can get a better understanding of

how firms in this industry are able to turn a profit. In general, this process begins with

the supplier to firm relationship. This relationship involves the exchange of goods and

services for money. Then the firm turns the raw materials into the final products, which

are then sold to other firms or consumers. “Chemicals are used to make a wide variety

of consumer goods, as well as thousands inputs to agriculture, manufacturing,

construction, and service industries” (www.wikipedia.org). By understanding the value

chain, the industry can show the relevance of each strategy implemented, and

determine if new strategies must be incorporated. Furthermore, if strategies are not

having the desired effect the firm must choose a new approach to combat these issues

to maintain their competitive advantage.

Competitive strategy

“The profitability of a firm is influenced not only by its industry structure, but also

by the strategic choices it makes in positioning itself in the industry” (Palepu and

Healy). Firms in this industry use the economies of scale and scope, efficient

production, lower input costs to strategize in the cost leadership approach. In addition,

the use of the differentiation approach is carried out through superior product variety,

research and development, and more flexible delivery. In order for firms in the industry

to maintain their competitive advantage, they must not only compete through cost

leadership. It is vital to their survival that they produce superior products and invest in

research and development, so that their competitors do not surpass them.

Economies of Scale and Scope

Another important factor to consider when evaluating a company is examining

the scale of its operations and the scope of the consumer demand. Since the chemical


industry on competes in a low to moderate level of competition amongst rival firms who

produce completely homogeneous products, it is imperative that everyone maintains a

“cost leadership” approach to its business. Therefore, in order to decrease the average

cost of production, the firms emphasized a managerial specialization of production.

Managerial Specialization is a method where a firm examines the production process to

identify and remove inefficiencies in the product assembly and to find new ways to

increase efficiency. By making the production process more efficient, each firm can

lower its long-run average cost and therefore increase profits. The economies of scope

for the chemical industry are very beneficial. Since most of the chemical industry is

based on production of raw chemicals for other industries, for example making the

chemicals that go into hand lotions and other cosmetics. Most of the companies that

buy chemicals to include in their production are more focused on cost than

differentiation; therefore, it is necessary for all firms to work on great scales of

operations to keep its overhead low.

Lower input Cost

In order for firms to make a profit in this industry, it is necessary for them to

lower input costs, which in turn will raise revenues. Globalizing markets are becoming

the most cost effective form for lowering costs. Larger companies that endorse

purchasing power are using their size and money to bully foreign prices. According to

recent research, 50% of chemical companies’ costs are from raw materials. If

companies are not able to lower their input costs, they will be forced to raise the price

of their products to offset high energy costs. This would in turn, allow competitors to

gain an advantage if they were able to produce the same product at a cheaper cost.

Consumers are turned away from price increases and usually look elsewhere to

purchase that same product. As previously shown, firms in this industry will buy each

other’s products in order to maintain a lower input cost. If it is cheaper for a company

to purchase materials from a competitor rather than produce it on their own, most

companies will pursue this option. In conclusion, the leverage of input costs is a key


strategy to gain or maintain market share in the chemical industry. Whether costs are

reduced by purchasing abroad, or product prices are increased to offset costs, chemical

companies are struggling with the high prices of energy.

Efficient Production

Since much of the industry is based on commoditization, it is necessary for all

companies to work towards the most efficient production available. This is

accomplished by reducing waste, energy consumed, and increasing efficiency in

production methods. To identify how efficiency has changed, we compared input costs

per unit before and after we implemented the new/more efficient production process.

Constant research and development is put into creating more efficient means of

producing product and reducing or reusing waste products produced by the production

plants. One way to accomplish this is to reduce gases lost due to leaks in tanks.

Another would be reclaiming and reusing waste products to extract as much of the

usable chemicals as possible.

Investments in Research and Development

In the chemical industry, a strong research and development strategy is crucial

in order to achieve both an effective and efficient product. A firms R&D strategy can be

improved by increasing the number of production plants and facilities, hiring more

qualified chemical engineers, and constantly researching new ways to innovate. These

investments are necessary to not only come up with more efficient ways to make an

existing product, but also to create new and innovative products for the future. In the

year 2006, the industry on average, spent close to $855 million on Research and

Development expenses. Research and development is a major strategy where

competition is fierce for the most cutting edge material and solution. Firms in this

industry spend billions of dollars on research and development, which further illustrates

their desire to gain competitive advantage over each other. Since firms are so

interdependent, if one were to fall behind in research and development they would find


themselves buying products from their competitors instead of producing the same

products themselves. It is for this reason that research and development is mandatory

in the chemical industry.

Flexible Delivery

Due to the globalization of the chemical industry, flexible delivery is an important

strategy that can separate one company from another. For example, if you need

products in the United States and the two firms that produce it are in Europe and the

U.S. it would be more practical to buy your product locally. The nature of the chemical

industry is the process of moving raw materials from one firm to another. Therefore,

the more flexible a supplier can be with a buyer, the greater the chance they have for

continued business. In addition, companies are taking the initiative to hire

transportation services to improve their delivery system. This further illustrates the

industries recognition of the importance of flexible delivery to improve customer

satisfaction.

Superior Product Variety

Since the firms that compete in the chemical industry produce completely

homogeneous products, it becomes imperative that a firm differentiates from its

competitors. In order to achieve a specialty product, a firm can make variations within

the production process to add value to that particular product. It is apparent that firms

who invest heavily in research and development of new and innovative chemicals’ have

consistently shown higher returns. Companies customize their products made-to-order

to meet customer preferences and demands. An example of superior product

differentiation would be the growing sector of performance chemicals and plastics. In

this industry, many firms produce basic chemicals and plastics; however, the companies

that can add variations in the production process can distinguish themselves and add

value to the product. These variations can increase quality, product life, address

environmental concerns, and enhance performance effectiveness. While all firms


cannot compete on a large scale of product inventory, firms that excel in product

specialization can capture a considerable portion of overall market share.

Firm Competitive Advantage Analysis

With the recent internal analysis of Dow Chemical, management has restructured

priorities that will allow Dow to keep an advantage over its competitors. Moving its

primary focus to their niche and market segment, Dow has improved its quality and

services by centralizing their visions. Dow has implemented strategies such as: stream-

lining employment, lowering high energy costs, globalization and investing more into

research and development. In addition to these strategies, Dow has also employed

professional companies to maintain such things as global transportation and plant

productivity. While competing with a strategic mix between cost leadership and

product differentiation, Dow has widened its customer base. By doing this, Dow has

gained an advantage over the competition by improving strategies in: economies of

scale and scope, efficient production, lower input costs, superior product variety, more

flexible delivery and investment in research and development.

Economies of Scale and Scope

Another important factor to consider when evaluating a company is examining

the scale of its operations and the scope of the consumer demand. Since the Dow

Corporation competes in a low to moderate level of competition amongst rival firms

who produce completely homogeneous products, it is imperative that Dow maintains a

“cost leadership” approach to its business. Therefore, in order to decrease the average

cost of production, the Dow Company has emphasized a managerial specialization of

production. By making the production process more efficient by eliminating wasted time

and products, Dow can lower its long-run average cost (i.e. lowering variable cost per

unit), and therefore increase profits. The economies of scope for the chemical industry

are very beneficial to Dow. Since most of Dow’s production is in producing by-products

for other companies, Dow essentially doesn’t have to bother with advertising or any


other costly marketing schemes to attract consumers. Most of the companies that buy

chemicals to include in their production are more focused on cost than differentiation;

therefore, Dow gains an advantage due its vast scales of operation and its ability to

offer the same form of chemicals at a discount price.

Efficient Production

With the implementation of the Six Sigma approach in 1999, Dow has increased

productivity immensely while also cutting back on human labor. Six-Sigma is a set of

practices that improve processes by eliminating defects. This approach allows for Dow

Chemical to reduce variation in like products, control and analyze production, as well as

increase the involvement by upper-management in ensuring product quality. Since

implementing Sigma, Dow has seen an immediate 30% reduction in staffing costs along

with an increase in value creation from reinvested working capital. “Over a five year

period, this equates to nearly $90 million in value creation for our company” (Jon

Walker, Human Resources Information, www.Dow.com). By reducing the amount of

human labor needed as well as over-seeing all production activity, Dow has increased

productivity within its plants. In addition, with the defects of materials being

recognized more quickly by the Six Sigma software, Dow can correct problems more

effectively and assure quality management. In addition to the success of the Six Sigma

process, Dow had also formed an alliance with the leading software company Aspen

Technology. AspenTech is a leading supplier in software designed to analyze and

automate processes in manufacturing plants. Dow’s process manufactures use the

AspenTech software to maintain and operate efficient and safe plants while reducing

various shop expenses such as raw material and energy costs. Dow uses its scale and

scope of economics to increase its production efficiency. Dow is constantly improving

their manufacturing process to reduce waste and cost. This is exhibited in their winning

of the 2007 Chemical Processing Magazine’s Plant innovation award. They were

awarded this for their work in recycling chlorinated organic material

(www.chemicalprocessing.com/bluebook.pdf). This new process saves the company


approximately $600-800M/yr. It is through constant R&D that Dow is able to

streamline their production facilities to create more efficient production.

Lower Input Costs

With energy costs currently at a boom, Dow has made a significant effort to

lower input costs. Dow’s raw material costs (energy costs), account for about 50% of

their total input costs. With newly incorporated joint ventures in the global market,

Dow is now able to purchase feedstock (material in most raw materials) for a third of its

current costs. These cost savings will directly affect Dow’s earnings because of the

sales in global markets don’t affect their end selling price. Dow has not only cut costs

through the recognition of the global market, but has also done so through innovation

techniques. In 2007, Dow won the Chemical Processing Magazine’s Plant Innovation

Award for its efforts in the recycling of wasted materials. Dow recognized that they

were losing revenue on all the wasted material that was being incinerated on a daily

basis. By recycling the material and turning it into useful feedstock, Dow has seen a

$600-$800 million/yr savings as well as a massive reduction in pollution.

Superior Product Variety

By having such a variety of materials and products available for consumers and

manufacturers, Dow has pushed itself even further past the competition. Dow operates

in six major segments that manufacture performance plastics, basic plastics,

performance chemicals, basic chemicals, agricultural sciences as well as hydrocarbons

and energy sources. While the plastics segment makes up over 50% of Dow’s sales,

this segment is also the world’s largest producer of plastics. Along with plastics, Dow is

one of the top producers of chemical products. A majority of Dow’s chemical

production is bought by fellow competitors within the industry. Producing such a wide

variety of specialized products, Dow is able to dip into multiple markets and create a

larger target niche. With the continual studies by some of the top Ph. D’s and

Engineers in the United States, expansion is the only way Dow’s product lines can


move. In addition, Dow has the highest R&D expense of any other competitor in the

industry ($1,164 mill.) and is looking to produce the most cutting-edge products.

Flexible Delivery

As one of the world's leading multi-national manufacturing companies, Dow

increased the efficiency of its global transportation by partnering with one of the lead

logistics provider’s worldwide. BDP International had a long track record of exceptional

global transportation as well a time tested reputation for great customer service. BDP

handles all of Dow’s Marine Packaged Cargo business, as well as their global supply

chain analysis and implementation, through a strategic approach. "It reflects our long-

held belief that there is no 'one-size-fits-all' logistics solution. From the start, the goal

then and now has been to drive value back to Dow through their global supply chain,

through a strategic approach, metrics and metrics analysis initiatives, as well as

transactional order execution functions" (John Bolte, BDP Chief Operating Officer,

www.BDPoint.com). Employees of BDP are what make Dow’s global market succeed.

BDP has appointed a whole team of employees to over-see and operate Dow’s delivery

of products. With the global transportation taken care of, Dow can put primary focus

on the production process. With plants in over 15 states in the U.S., Dow is able to

deliver products in a timely and efficient manner. With the hazard of chemicals being

transported, Dow played a key role in the creation of the American Chemistry Council’s

Responsible Care. With the help of this council, Dow set the standard for security and

safety in the chemical transportation business.

Investment in Research and Development

Like previously mentioned, Dow is an industry leader in Research and

Development. In December 2006, Dow reportedly employed 5,600 people in a variety

of research and development positions. Putting such an emphasis on the development

of new products as well as refining existing ones shows that Dow is looking to expand.

In the chemical industry, the majority of competition is in the R&D department. The


company with the most innovative, cutting-edge product grabs the attention of buyers.

Dow’s Research and Development expenses have slowly gotten higher year after year.

Without the constant development of new products, Dow would lose its competitive

edge. With the construction under progress with the Dow Center in Shanghai, Dow is

placing a state of the art research and development lab that compares to no other.

Housing one of the top research labs in the world, Dow is looking to expand even

further into the global market.

Dow’s R&D Expenses

In comparing the returns from the past three years of Research and

Development expenses relative to the Gross Profit of the proceeding years, Dow shows

on average a 14.48% return on R&D Investments.

Looking Ahead

Dow Chemical has continued to improve in striving to be the industries best.

With their production progress at an all time high, Dow looks to increase sales even

higher with the variety of products offered. With their vast movement into the global

market, Dow looks to keep input costs low by purchasing materials abroad. With

$’s in millions


energy costs looking to come down in the future and with the continual increases in

R&D expenses, Dow’s earnings are consistently continuing to swell.

* From this point on we will no longer consider Exxon Mobile a direct

competitor within this industry. Exxon Mobile only competes in this

industry on a small percentage of products manufactured.

Accounting Analysis

Shareholders and stakeholders, current and potential, of a firm do not have

direct access to the internal accounting information found in the general ledger. For

this reason, they must rely on the information disclosed in the company’s 10-k filings to

get an overview of the health and direction of a company. Unfortunately, the

information found in a company’s financials is not always an accurate view of the

operations of a company. By allowing flexibility to managers for the purpose of

depicting a true representation of a business and industry, GAAP leaves a fair amount

of latitude in how certain thing are reported – leading to the potential for distortion in

expenses, liabilities, assets, and revenues. This brings forth the necessity for

accounting analysis. Accounting analysis not only uses the company and industry

information, but also estimations and assumptions based on research of current

markets to gauge the accuracy and completeness of the statements. The main goal of

accounting analysis is to determine how confident in the numbers presented on a

company’s financial statements an analyst is.

For the most part, financial analysts follow a six step accounting analysis to

determine the quality and accuracy of a firm’s recordings. In the first step,


identification of accounting policies, analysts must weigh the firm’s critical factors and

risks in relevance to the estimations and policies provided in the financials. In an

industry, a firm incorporates its success factors as well as its potential risks within its

competitive strategy. Next, analysts must perform an assessment of a firms accounting

flexibility. Flexibility varies from company to company, in which various policies are

chosen to utilize different components. Flexibility is determined by how much of a

choice managers have in how certain items are reported on their financials. For

example, R&D accounting is very inflexible, while pension plan estimation is very

flexible. Thirdly, analysts evaluate the firm’s actual accounting strategy. This step is

used to determine how the firm’s policies compare to that of its fellow competitors

within the industry. This evaluation also looks into the management’s structure, looking

for significant transactions or changes in policies for the benefit of obtaining accounting

objectives. For the fourth step, analysts evaluate the quality of the firm’s disclosures.

While managers hold a choice in the amount of disclosure they wish to provide, the

more information provided allows for a more transparent look into the firms

performance by investors. If there is too much disclosure, the analyst must consider

the possibility that the company is trying to hide something in plain sight by adding lots

of ‘noise’ to the financial statements. Next, the analysts go through the financials

looking for potential ‘red flags’. A red flag is defined as a questionable accounting

procedure that may lead to distortion of the firm’s value (Business Analysis &

Valuation). Finally, if the analysis reveals a red flag, adjustments are made to the

financial statement to gauge whether or not the distortions would have a significant

impact of the view of the company’s positions.

Key Accounting Policies

A firm should look to its key success factors to add value and gain a competitive

advantage in an industry. Reason being, “That analyst should identify and evaluate the

policies and the estimates the firm uses to measure its critical factors and risks.”

Mentioned previously in the five forces model, Dow and the industry as a whole key


success factors include: tight cost control, economies of scale, and high investment in

research and development. Of all of our key success factors related to DOW we found

it interesting of the amount of money that is disclosed with research and development.

With the flexibility provided by GAAP, firm’s can “dress up” their figures and numbers to

be viewed as more appealing to shareholders and potential investors. Holding these

key success factors, Dow structures its accounting policies as following:

Growth

Dow’s focus on continual growth has allowed them to top the industry in market

share, as well as providing a strategy that makes them competitive in annual net sales.

In 2006, they set an annual company record by recording just over $49 billion in sales;

a 6% increase from 2005. “With energy costs soaring in North America, Dow has

begun to see significant increases in demand in its European, Asian, and Latin American

markets” (2006 Dow 10-K). Dow continues to gain and maintain relationships on the

global level as well. Purchasing materials abroad has lowered their input costs

substantially, assisting in their overall growth. With the construction of numerous top-

of-the-line plants and laboratories in India and China, increased efforts in recruitment,

and the acquisitions and mergers that have taken place in recent years, Dow looks to

capitalize its sales growth in newly opened markets.

By looking at Dow’s balance sheet, it is apparent that the 5.8% growth in

property, plant, and equipment captures the underlying principle of Dow’s growth

strategy. With the 14% increase in inventories for the years 2005 to 2006, Dow

continues to allow for future growth with the selling of more products.

Dow’s Growth in KSF’s


Post-Retirement Benefit Plans

The chemical manufacturing industry is a highly priced competitive market with

multiple suppliers of standardized products. Since it is a struggle to compete on price,

Dow must focus on cost control in order to remain profitable. Retirement plans make

up a majority of a company’s operating expenses. Dow provides a reasonable level of

disclosure on these plans, which allows for outsider interpretation. There was a 52.5%

increase in pension plan liability between 2001 and 2002 that can be attributed to the

acquisition of Union Carbide. Other than this vast increase, there has been a

continuous decrease of, 16.9% and 6.5% respectively, in Dow’s pension liabilities in

2005 and 2006. These changes are due to a change in pension policies that took place

between the years of 2004 and 2005. In addition, Dow is constantly changing their

discount rate, which is able to increase savings for the company that therefore leads to

higher profits. Currently their benefit plans are over-funded, but not by a significant

amount. Most of the over-funding at this point can be accounted for by the exceptional

investment period of 2006. During this period, they experienced almost 2 times their

expected rate of return. Their pension plan accounts for just fewer than 50% of their

total long-term liabilities recorded in 2006. However, these plans account for only 16%

of their total liabilities. Until this past year, Dow’s actual and expected rates of return

have been within .05% respectively.


Operating and Capital Leases

Operating leases are used a great deal in the chemical manufacturing industry.

Dow regularly leases properties for administrative offices, warehouses, railcars,

computers, and equipment under operating leases. Operating leases usually are

expensed on the Income Statement and stay off the balance sheet, which reduces

liabilities and future obligations. “At the termination of these leases, Dow has the

choice of purchasing these properties and equipment based on a fair market value”

(2006 Dow 10-K). According to Dow’s 10-k, they will wait to the maturity date of the

operating lease to purchase the building or equipment once it is paid off. By using this

rent to own method Dow is able to make smaller payments, decrease liabilities, while

maintaining such a large network. Dow doesn’t disclose much information pertaining to

their lease agreements, which may distort areas of their financials. Costs for operating

leases are generally more cost effective and lead to reduced purchasing costs at the

leases termination. The Chemical Industry as a whole uses Operating lease over

Capital leases due to the fact that the industry thrives on innovation. In order to stay

competitive in terms of innovation, firms must constantly upgrade their production

facilities in order to meet new product demands. Therefore, by the use of an Operating

lease, a firm can avoid the risk of holding an obsolete factory, as well as, other cost

associated with it. By classifying these operating leases as rental expense on the

Income Statement, Dow has recorded expenses on these leases (net of sublease rental

income) as follows: 2006, $441 million, 2005, $451 million and in 2004, $456 million.

Even though these operating expenses seem high, the cost to capitalize would be far

greater. Operating leases as well as the way they are disclosed are a key accounting

policy used by Dow. With the non-transparent information on their leases, Dow shows

a potential of distorted expenses and costs.



As seen in previous figures, firms in this industry stress their growth strategy

primarily through intense research and development. By defining high investment in

research and development as one of their key success factors, the proper disclosure

and accounting policy on R&D becomes important. As an industry leader in research

and development expenses, Dow has gained value in the progression of new products,

improvement of existing products, in addition to the newly constructed plants and

laborites. With the addition of a 5,600 member R&D team and a state of the art facility

in Shanghai, Dow seeks to gain market share by increasing their product lines. Many

companies try to take advantage of the flexibility provided by GAAP with regards to the

way they record research and development. Although some firms record R&D as an

asset, this is incorrect because it is impossible to perceive the value added to the firm in

the future. Dow reports the costs as operating expenses along with Selling, General

and Administrative expenses. In 2006, research and development consisted of 41% of

operating expenses. Because Dow has performed at a profitable level shown in their

increases in net income, they do not need to record their R&D as an asset to look better

to investors.

Goodwill

With Dow being as large of a firm as it is goodwill is not a huge factor on their

balance sheet. Back in 2004 when DOW purchased Hampshire Chemical Corporations,

the total write off for the company was only $13 million dollars. Furthermore, on the

consolidated balance sheet in 2006 the total amount of goodwill that year was $3,242

(in millions, when assets totaled $45,581 (in millions). As a group we came to the

conclusion that goodwill for DOW is not one of their key success factors when DOW has

more assets placed elsewhere throughout the company.

Hedging

Through Dow’s business operations they are exposed to market risk. These

include foreign exchange rates, interest rates, equity prices, commodity prices and

other market factors. To protect themselves, Dow has the ability to minimize these


risks through hedging transactions. According to Dow’s 10-k, “entering into these

hedging transactions, pursuant to established guidelines and policies which enable it to

mitigate the adverse effects of financial market risk.” If Dow were not to use these

transactions they would be exposed to all these factors which would effect their

consolidated financial statements in a negative way. Although following these practices

starting in 2006, Dow began the year with an accumulated derivative loss of $127

million.

Conclusion

Firms accounting policies can have a huge impact on investor’s decisions. By

providing high disclosure and proper use of policies, firm’s financial statements appear

transparent and make it much easier to form inferences and set values. The industries

key accounting policies listed above make it easier to translate what their key success

factors are in improving and adding value to the company.

Accounting Flexibility

Throughout the industry, companies that are publicly traded are required to

present numerous reports to the SEC each year. Within these requirements, the

numbers in these reports must follow the guidelines of the General Accepted

Accounting Principles (GAAP). As found in the book, Business Analysis and Valuation

Tools, “managers have the flexibility in deciding their accounting policies as well as their

estimates related to key success factors.” To be more specific, managers have the

flexibility to decide whether to use different methods to be more elastic in this industry.

Most firms use post-retirement benefit plans and research and development as key

areas of flexibility. As previously stated, these numbers can be adjusted by the use of

Operating leases as opposed to Capital leases, or changes in pension obligations

through new pension plans or changes in the discount rates associated with these


policies. These variations can account for adjustments in a firms long term liabilities,

and inconsistencies associated with their expenses and net income.


As mentioned above, GAAP’s flexibility in the way they allow research and

development to be recorded can cause many firms to take advantage of the amount of

disclosure they chose to provide. The reason being that many firms in this industry

want to record research and development as an asset rather an expense because they

perceive the money spent will generate future cash flows. The logic behind reporting

R&D as an asset instead of an expense is that a firm can capitalize the cost over the

useful life of the products/services resulting from R&D. With this in mind, it must be

assumed that the money put into its research and development, and operating

expenses (including general, selling, and administrative expense) may not fully reflect

all the costs associated with R&D. In the industry, it is typical to see anywhere for 40

to 50% of a firms operating expenses to be invested in research and development.

This shows that the industry uses a high degree of the differentiation approach in order

to maintain a competitive advantage. Dow consumes just over 41% of their total

operating expenses in research and development, which in 2006 accounted for 21% of

their income. From these percentages, it can be determined that Dow is placing a

significant amount of its income back into the business that is working toward

generating future cash flows. This is a good indication of their investment into the

future of the company. By applying this much of their income back into the business,

managers are sending the signals that they are confident in the continued success of

the business and industry.

Operating Leases

Many firms in the chemical industry use the recording of “off balance sheet”

assets otherwise known as operating leases quite frequently. The reason being that a

conglomerate like Dow as well as other firms in the chemical industry are able to use a


facility or building without assuming all the risk that comes along if they were to own it.

Because of GAAP’s loose requirements, managers have the flexibility whether to

distinguish it from a capital lease or an operating lease. By choosing to use an

operating lease, firms are able to lower their long term liabilities by simply expensing

these payments each year. However, this makes it hard to determine how much these

expenses actually are because they are consolidated in the category of “Other long

term expenses.” Due to the fact that there are such loose requirements set up by

GAAP, managers have given very low disclosure based around these figures.

Throughout Dow’s 10-k, they have given the figures of the bare minimum yearly

payments of these leases. These payments include (2007) $251 million, (2008) $208

million, (2009) $179 million, (2010) $137 million, (2011) $85 million, and (2012 and

thereafter) $565 million. Thus, it nearly impossible to determine how firms like Dow are

accounting for these expenses.

Evaluating Accounting Strategy

Given a firms accounting flexibility, management have the option of reporting or

omitting key provisions within its financial statement. Through the use of an aggressive

accounting strategy, a firm can choose to exclude imperative information on how

2001 2002 2003 2004 2005 2006

Property

$

35,890

$

37,934

$

40,812

$

41,898

$

41,934

$

44,381

Net Sales

$

28,075

$

27,609

$

32,632

$

40,161

$

46,307

$

49,124

Inventories

$

4,440

$

4,208

$

4,050

$

4,957

$

5,319

$

6,058


certain numbers effecting key success factors where formed. On the other hand, a

conservative accounting strategy would increase the transparency of the company,

which in turn would increase investor confidence. To determine the type of accounting

strategy used, one must focus on the level of disclosure a company provides within

their financial reports.

In the chemical and plastic industries, those which DOW competes in, there is a

mixture of conservative and aggressive accounting. There is a high level of disclosure

in the product segmentation reports, which gives not only an overview of the product

line, but also the sales growth, volume of production, competition, and product

licensing rights for each manufactured goods. In addition, subjects related to the

growth of the company also have high disclosure of their values. In the areas that are

crucial to the growth of the company such as properties, plant and equipment, net

sales, and inventories, we see that Dow has made a considerable investment in all

three sectors.

Aside from the advances in these areas, the firm has also been restructuring

their business model by cutting back on manufacturing labor, ceasing operations from

inefficient production facilities, and increasing the R&D staff. Furthermore, in the areas

of Research and Development, we are able to see a high level of disclosure. DOW has

increased its intellectual capital by hiring 5,600 experienced and knowledgeable

professionals, and built new state-of-the-art production facilities to yield new and

innovative products. This shows that Dow, along with other competitors in this

industry, know the importance of R&D, and seek to gain a competitive advantage by

increasing the amount of funding associated with it in hopes of generating future cash

flows.

On the other hand, there is a low level of disclosure in Capital/Operating leasing.

Firms can choose to capitalize their leases or expense them through Operating Leases.

When using a capital lease, the lease is treated as an asset on the firms Balance Sheet,


and the payment of principle and interest are written as liabilities. In contrast, an

Operating lease is treated as an expense on the Income Statement that is taken out of

revenues, which reduces Net Income and Retained Earnings. A company that chooses

to use an Operating Lease benefits in terms of reducing liabilities because it is

considered an “off Balance Sheet” activity. The information pertaining to Dow’s

Operating Lease provides absolutely no insights on the current state of their lease

agreements. The only information regarding leasing contracts was an annual expense

in 2005 in the amount $451 million and a forecast of expected payments from 2006

through 2012 and beyond. By looking at the table of future expected payments, an

expert can find the net present value of operating leases through computation by using

a 6.65% cost of capital rate and discounting the expected future payments back to their

present values.

Minimum Operating Lease Commitments at December 31, 2006 (in millions)

Years DOW's future value PV Factor Net Present Value

2007 $251 .937 $235

2008 $208 .879 $183

2009 $179 .824 $148

2010 $137 .773 $106

2011 $85 .725 $62

2012 and thereafter $565 .679 $383

Total $1,425 $1117

note: discount rate of 6.65% chosen due to cost of capital rate

Cost of capital rate determined by using average rate of long-term debt disclosed in note K of 2006 10K


Operating leasing is considered a relevant concept of innovation, which is a

significant aspect for this firm. Since the industry is constantly changing and requiring

new and innovative production facilities, it is beneficial for DOW to keep potentially

“obsolete” property, plant, and equipment off their balance sheets. However, it is also

important to note that companies in this industry rely heavily on their Operating Leases,

and the fact that DOW has withheld some information and has barely met the GAAP

requirements of disclosure causes some concern and raises the risk of impairment on

their financial transparency.

Finally, there is a relatively high level of disclosure in the financial statements

regarding Dow’s retirement pension plan. This company’s retirement pension plan plays

a significant role in how well DOW performs in the key success factor of cost leadership.

Since Dow engages in heavy price competition with rivals, it is imperative that this firm

lowers as many expenses as possible in order to obtain an above par industry profit.

The company’s retirement pension package accounts for well over 50% of their long-

term liability and approximately 16% of their total liabilities. DOW provides an in depth

look at the company’s retirement policy and their employee benefit package, however,

it is somewhat difficult to measure the company’s net present value for providing these

services. DOW does an excellent job proving key features of the computations of their

pension-plan expenses such as using a higher discount rate to lower future retirement

obligations.

U.S. Plan Assumptions for Other Postretirement Benefits (in millions)

Benefit Obligations at

December 31

Net Periodic Costs for the

Year

Year 2006 2005 2006 2005

Discount Rate 5.89% 5.60% 5.60% 5.88%

Initial health care cost trend rate 8.79% 9.50% 9.50% 10.16%


In relation to other companies the ultimate health care cost trend does not affect

Lyondell. “The health care cost trend rate assumption does not have a significant effect

on the amounts reported due to limits on Equistar’s maximum contribution level to the

medical plan”( Lyondell 10-k). Equistar being one of the companies that Lyondell had

merged with back in 2002. One of Dow’s other competitor’s however, DuPont will have

an initial health care cost rate of 10%, ultimately reaching its peak through the years

2011-2012. Another point of interest on DuPont’s 10-k was how if a single percentage

point went up or down effected total service, interest cost and also the effect on

postretirement benefit obligation.

1% point Increase 1% Point Decrease

$6 ($3)

$82 ($55)

Effect on total of service and interest cost

Effect on postretirement benefit obligation In conclusion, the DOW corporation overall meets industry standards by giving

relatively high disclosure on key success factors such as growth, Research &

Development, product segmentation, and cost-reducing pension plans. With a few

exceptions (i.e. operating leases) and a wealth of accounting flexibility at their disposal,

DOW as a whole follows a reasonably conservative accounting strategy when

presenting information on their financial statements and therefore has the ability to

increase investor confidence in their firm.

Quality of Disclosure

The quality of information that is disclosed by a company plays an important role

in how financiers look at the information provided by the company in its financial

statements. The higher level of quality disclosure gives investors and lenders a more

Ultimate health care cost trend

rate (assumed to be reached in

2011) 6% 6% 6% 6%


transparent view of how a company operates. The following sections will discuss Dow

Chemical’s level of disclosure and confidence in the transparency that they are

providing. Disclosure is defined as, “the giving out of information, either voluntarily or

to be in compliance with legal regulation or workplace rules” (Wikipedia.org)

Sales Data

One of the ways it is possible to assess the transparency of data is viewing how

well broken down into different segments the sales information is. These segments can

be based on different criteria. A good example of this would be listing sales based on

geographic locations. Dow chemical, breaks their sales down into their 6 main sales and

operating sections based on the types of products produced and sold. Unfortunately,

they do not break their research and development expenses into the same segments

making it hard to attribute the cost of research to each segment, which makes it

difficult to guess how R&D is affecting each of the segments.

Performance

Plastics

Performance

Chemicals

Agricultural

Sciences

Basic

Plastics

Basic

Chemicals

Hydrocarbons

and Energy

Unallocated

and Other

2006 28% 16% 7% 24% 11% 13% 1%

2005 27% 16% 7% 24% 12% 13% 1%

2004 26% 16% 8% 23% 14% 12% 1%

(Dow 10-k)

While information such as the table above seems to provide useful information, in

actuality it is just noise to fill up the 10-k. This is one of the things that a full analysis

helps determine, how relevant is the information?

Quantitative Analysis


An important aspect of financial analysis is to gage the level the performance of

not only other firms but the industry as well. We accomplished this task through the

sales manipulation diagnostics, and expense ratios. Net Sales/Cash from sales, Net

Sales/Accounts Receivables, and Net Sales/Inventory are all considered sales

manipulative diagnostics which will measure the performance of the firm. Asset

turnover, cash flow from operations/Operating income, pension expense/ SG&A, and

cash flow from operations/Net operating assets are all expense ratio diagnostics that

show allocation from revenues to expenses. Drastic changes from year to year can

signal a red flag of accounting discrepancy, and therefore require immediate attention.

Sales Manipulation Diagnostics

Sales manipulation diagnostics are keys to signaling “red flags” or manipulation

in the form of revenues. This can be checked by looking at financial statements from

year to year of not only a single firm but also the industry as a whole. The company’s

diagnostics that will be discussed are: Dow, DuPont, Lyondell, and Huntsman.

Net Sales/Cash from Sales

The ratio of Net Sales/Cash from Sales represents the amount of cash a

company receives from transactions versus transactions made on credit, i.e. credit


cards. In a perfect sales environment, this ratio would be 1:1; where all net sales are

purchased in cash. This perfect ratio is especially hard to meet in the chemical industry

because the amount of materials purchased is usually bought in bulk. Most clients do

not possess enough cash on hand to pay for the products in the full amount. In looking

in the 5 year sales figure, Dow shows the most consistent ratio of direct cash to credit

ratio. Huntsman showed a large peck in 2003 and Lyondell in 2004 indicating that a

large percentage of their sales where on credit. Changes in there allowances for credit

sales can attribute to the decrease in these ratios in the past few years. In relation to

the cash to cash cycle those peaks in 2003, Huntsman, and 2004, Lyondell, clearly

indicate a rise in net sales. However, with their net sales increasing their cash from

sales did not increase which in turn means the majority of their sales in 2003 and 2004

were purchased on credit. Whereas, Dow and DuPont have created stability in not only

their net sales, but the majority of their sales came through the purchases with cash.

Net Sales/Net Accounts Receivable

The receivables turnover ratio is one of the ways an individual is able to assess a

company’s liquidity. “The decrease in receivables turnover is the most negative factor


in the liquidity evaluation” (ratio’s handout). As shown above the three companies

DOW, DuPont, and Huntsman have a steady rate across the board showing a favorable

ratio. This positive trend not only has a positive effect on liquidity, but also current

liabilities have not changed either. Lyondell however, has a clear drop off indicating a

negative impact on liquidity for the company. This diagram shows that when a

company is to purchase on credit from Lyondell that it takes longer for them to convert

that into cash. Furthermore, because of this decrease in the receivables turnover some

companies sometimes have to use short-term debt as a source of cash to be able to

continue into the next period. As Lyondell has shown on their 10-k, in September of

2004 they had to restructure their debt because of the acquisition of a new company

changing their liabilities in 2004-2006, one of the main factors for this decrease in their

receivables turnover.

Net Sales/Inventory


The inventory turnover is key indicator in the firm of how a firm is able to turn

inventory into profits. If a company has low inventory turnover an investor should

assume low sales with an excess of inventory. “High inventory levels are unhealthy

because they represent an investment with a rate of return of zero” (investopedia.com).

Which in turn if prices were to fall, then that company would be in trouble. With Dow

maintaining a consistent inventory turnover along with DuPont there is no real concern.

However, according to Dow’s 10-k because of the recent rises in energy costs and plant

operating rates this turnover has begun to decrease. Lyondell had a huge drop off in

2004, along with a quick turnaround in 2005 possibly due to an overstatement of

inventory. Huntsman had a “red flag” with a sharp rise in 2003 due to a large amount

of inventory with an even larger amount of sales. To control this Huntsman starting in

2004 reduced inventories while liquidating parts of their LIFO inventory to not only cut

inventory but sales cost as well. Overall, in the industry all these companies are using a

LIFO method. With the exception of DuPont though, each one of these companies is

struggling to maintain a solid inventory turnover.

Net Sales/Cash from sales 2002 2003 2004 2005 2006 DOW 1.01 1.01 1.03 1.01 0.99 DD 0.99 1.01 1.03 0.96 1.02 HUN 0.99 1.34 1.05 0.99 0.98 LYO 1.01 1.01 1.23 1.01 1.02

Net Sales/Net A/R 2002 2003 2004 2005 2006 DOW 5.03 5.50 5.46 5.84 6.10 DD 6.18 6.40 5.59 6.82 6.32 HUN 5.26 6.28 5.99 7.17 8.48


LYO 8.24 8.42 3.79 11.10 10.25

Net Sales/Inventory 2002 2003 2004 2005 2006 DOW 6.56 8.06 8.10 8.71 8.11 DD 5.45 6.57 6.09 5.62 5.55 HUN 4.45 11.61 7.58 8.07 6.94 LYO 9.48 10.89 3.67 11.23 9.84

Expense Manipulation Diagnostics

The expense diagnostics that will be discussed are the Asset Turnover, Cash flow

from Operations/ Operating Income, and Pension Expense/SG&A. Similar to the

revenue diagnostics these are ratios that can signal a “red flag” on the year to year

financial statements of not just the firm itself, but the industry as well.

Asset Turnover (Sales/Assets)


The Asset Turnover ratio is one way of determining the possible over-statement

of assets. Ideally, there should be a slight rise over time to compensate for growth in

sales as well as inflation. Dow and DuPont have risen at a steadily increasing rate over

the 5 years reviewed, helping to establish a confidence in their asset statement. In

regards to Lyondell this sharp rise should be a “red flag” of overstated assets. Overall,

the companies starting in 2005 have maintained a steady asset turnover.

CFFO/OI

This ratio compares the cash flow from operations to the income a company

receives from operating activities. For a company to have operating cash flows being

supported by operating income allows for a positive ratio. A firm’s goal is to have a

small ratio which will show investors that firm is generating revenue through

operations. However, when the ratio decreases operating income is not solely

supporting the company thus forces the company to get cash from elsewhere. This

could lead to a potential “red flag” because of the possible manipulation of the numbers

by the manager, and the actual numbers being recorded. The dramatic change in

Dow’s 2002 to 2003 ratio can be explained by the purchase of Union Carbide. In 2004

and beyond this has allowed Dow to maintain a small ratio.

Pension Expense/SG&A


From a financial standpoint, the pension expense ratio allows outsiders or

investors to see how much general expenses are being spent on pension to the retired

employees. Having a large ratio would be bad for a company because it would then

show a majority of expenses going to retired employees. However, if you were to have

a low ratio then a majority of your expenses are not going to the pension plan. The

overall look at the industry is not good. Reason being there is a steady decline in all

the firms which shows no pension responsibility, which is a clear “red flag” indicator.

CFFO/NOA


This ratio is an indication of how effectively the fixed assets produce income.

Preferably, in this industry there will be a rise over time, followed by a decline because

of the fixed assets reaching their peak potential. In order to reverse this process,

companies must invest in new and better property, plant and equipment. With the

increased investment in net operating assets (property, plant and equipment), a

company allows itself for potential growth. From the perspective of the company a

large ratio is ideal. It shows that your net operating assets are able to generate

income. With the exception of Dow and Lyondell, Huntsman and DuPont are able to

maintain an upward sloping ratio.

Asset Turnover 2002 2003 2004 2005 2006

DOW 0.69 0.78 0.88 1.01 1.08 DD 0.69 0.73 0.77 0.80 0.86

HUN 0.49 0.79 1.01 1.19 1.25 LYO 0.44 0.49 0.37 1.23 1.25

CFFO/OI 2002 2003 2004 2005 2006

DOW -3.39 2.1588 0.70 0.69 0.84 DD 1.04 2.0499 1.18 0.62 0.87

HUN 0.78 1.2585 0.69 1.35 1.21 LYO 1.66 -103 3.64 0.83 0.76

Pension Expense / SGA 2002 2003 2004 2005 2006

DOW 3.54 3.64 3.89 3.08 2.65 DD 1.89 1.67 1.39 1.94 1.79

HUN 1.17 1.08 0.75 0.92 0.83 LYO 2.69 2.73 0.86 0.39 0.36

CFFO / NOA 2002 2003 2004 2005 2006

DOW 0.15 0.27 0.19 0.33 0.30 DD 0.18 0.26 0.32 0.25 0.36

LYON 0.12 0.04 0.05 0.24 0.13 HUNT 0.03 0.04 0.02 0.21 0.22


Identifying potential red flags

Identifying potential red flags are an important part of the six step process of

analyzing firms accounting policies and procedures. By reviewing financial data over an

extended period, an analyst can quickly determine if there are practices that raise the

risk of misstating assets or liabilities. Such indicators would be a frequent change in

independent auditing firms, unexplained or often accounting changes; unusual changes

in the relationship between sales and inventories, or large asset write offs to name a

few (Business Analysis & Valuation).

After careful analysis of 5 years worth of accounting data, we have been unable

to find any significant discrepancies in Dow’s reporting. Compared to the industry,

Dow’s SEC reporting had no significant changes in format. While some of the data

presented was difficult to decipher, incomes and expenses being mixed in the income

statement, it was consistent from year to year and not impossible to understand with a

little comparison to the cash flow statement and balance sheet.

Overall disclosure was more than adequate to comply with GAAP and to give the

average investor good information. As an analyst firm, we would have preferred

greater disclosure regarding where the R&D expenses were spent and their operating

leasing obligations, the information was adequate to make a full analysis with very little

estimation. Taken with a grain of salt, the financial statements were adequate to

complete an sufficient analysis.

Undoing Accounting Distortions

With great review and to our great relief, we determined that there were no

distortions that required undoing. We review the operating lease agreements and

found them to change to overall long term liabilities by less that 5% if converted to

capital leases. After review the industry standard and Dow’s pension plan, we


determined that they were easily within the normal range for being over/understated

without it being excessive. We did have some concerns regarding the forecasting for

future obligations, but current and past actual contributions and returns have more

than compensated for our concerns.

Financial Analysis

Financial Analysis is a vital tool in the performance evaluation of a specific

company, as well as competitors in a given industry. These ratios are performed after

analyzing and evaluating a company’s financial statements. The analysis of the

financial statements helps to, “evaluate the financial dimensions of management

performance, detect emerging trends and to help explain relationships contained in the

basic financial statements (Financial Statement Analysis Worksheet, Alamo Co).” There

are 3 different types of basic ratio’s that are put together by viewing the three different

basic financial statements. These three ratios’ include: Liquidity ratios, Profitability

ratios, and Capital Structure ratios. At the conclusion of performing these ratio’s, a

company then begins to set forecasts for the company’s future performance. Usually, a

company will limit its forecasts to the major line items on the Income Statement,

Balance Sheet, and the Statement of Cash Flows.

In the final section of this financial analysis are the financial forecasts of Dow’s

financial statements. Financial forecasts are predictions of a company’s future

performance based on past data. These forecasts simulate growth rates that a

company looks to continue within the coming years. In this section, Dow is forecasted

for the upcoming 10 year span on their Income Statement, Balance Sheet, and

Statement of Cash Flows.

Liquidity Ratios


Liquidity ratios refer to the ability of a company to quickly convert assets into

quick cash in a timely manner in order to pay off current debts. Poor liquidity ratios can

usually point to non-sufficient cash flows throughout the statements.

Current Ratio: (Current Assets/Current Liabilities)

The Current Ratio is calculated by dividing Current Assets over Current Liabilities.

Some basic current assets, which are assets that are readily converted into cash in

short notice, consist of, Cash, Accounts Receivables and Inventories. Current Liabilities

might consist of things such as Accounts Payable, Current Notes Payable and Accrued

Liabilities. A company would like to see a higher ratio number compared to its

competitors, which would signify how well a company can generate a sufficient profit to

cover their debt. It is also important to note that many creditors look at this ratio to get

an idea of the risk and creditworthiness of a firm.

Current Ratio2002 2003 2004 2005 2006

DOW 1.28 1.38 1.51 1.63 1.62DD 1.9 1.42 1.92 1.67 1.62LYO 1.85 1.94 1.94 1.68 1.6HUN 3.37 1.49 1.74 1.64 1.61Industry 1.74 1.56 1.78 1.66 1.61

Current Ratio

0

0.5

1

1.5

2

2.5

3

3.5

4

2002 2003 2004 2005 2006

DOWDDLYOHUNIndustry

The current ratio is the mix of company’s current assets in comparison to its

current liabilities. Although Dow has the lowest ratio, it still is larger than one and has


shown growth approaching just under 1.75:1. This shows that Dow is able to pay off

its debt obligations in a manageable fashion. Dow is also a much larger company than

any of its fellow competitors, so it tends to allow for more holding of liabilities. It should

be noted that this ratio does not give a perspective as to the firms’ capital structure. As

the graph above indicates, Dow and its competitors tend to maintain the same levels of

current assets relative to their current liabilities, especially in 2006 where all of the firms

current ratios where nearly identical.

Quick Asset Ratio:[(Cash+Securities+Accounts Receivable)] / (Current Liabilities)

In calculating a company’s Quick Asset Ratio, Cash, Marketable Securities, and

Accounts Receivables are added together and divided over Current Liabilities. This ratio

can be used to “view the sign of a company’s financial strength or weakness

(Investorwords.com).” A higher ratio usually means better things for a company, but

not always. For example, if a company has a really large Acid ratio then that means the

firm does not control balance and holds too many quick assets relative to its current

liabilities.

QUCIK ASSETS RATIO2002 2003 2004 2005 2006

DOW 0.53 0.63 0.76 0.84 0.75DD 1.13 0.58 1.06 0.89 0.89LYO 1.15 1.27 1.04 0.88 0.82HUN 0.53 0.77 1.00 0.86 0.73INDUSTRY 0.84 0.81 0.97 0.87 0.80


0.00

0.20

0.40

0.60

0.80

1.00

1.20

1.40

2002 2003 2004 2005 2006

Quick Asset Ratio

DOW

DD

LYO

HUN

While DuPont and Lyondell hold up the industry average of just under 1, Dow

struggles to maintain a high quick asset ratio. Like Dow’s current ratio, liabilities bring

down this ratio compared to its current assets such as accounts receivables and readily

available cash. Towards the end of 2005 and the beginning of 2006, Dow moves within

the industry’s ratio. Although Dow has the lowest ratio, it is the only company out of

these 4 competitors that shows a continual increase and improvement in steadying out

its asset and liability bases.

The next 3 ratios measure a sense of liquidity, but also show the efficiency of a

company’s operations. “Operating efficiency results are measured by relating expense

items in the income statement to sales on a percentage basis (Financial Statements

worksheet-Alamo Co).” These three ratios consist of: Inventory Turnover, Receivables

Turnover, and Working Capital Turnover.

Inventory Turnover:(Cost of Goods Sold/Inventory)

Inventory turnover is calculated by taking the Cost of Goods Sold (A.K.A. Cost of

Revenue) and dividing it by the company’s inventory measured at cost. This ratio is

very important in that it shows how many times a company turns over its products or


inventories within a year; therefore with this method, the larger the ratio, the better

the result. This allows for a company to correct inventory methods when necessary.

INVENTORY TURNOVER2002 2003 2004 2005 2006


Inventory Turnover

0.00

2.00

4.00

6.00

8.00

10.00

12.00

2002 2003 2004 2005 2006

DOWDDLYOHUNINDUSTRY

Besides the exception of Lyondell, Dow holds a superior inventory ratio. With a

5 year average of 6.7 turns per fiscal year, Dow allows for a continuous flow of new

inventories into its production process which generates a larger ratio than the industry.

While Lyondell’s ratio of turns looks higher, they make a substantial decline between

the years of 2003 and 2005. With a higher amount of turns per year than its immediate

competitors, Dow gains a competitive advantage in allowing for more products to be

sold.

Days’ Supply of Inventory: (365/Inventory Turnover)

The Days’ Supply of Inventory correlates with the Inventory Ratio, in which the

number of days in a fiscal year is divided by that Inventory Turnover. A low number is


preferred, in that this ratio shows the number of days a product sits on a company’s

shelf before it is sold.

DAYS SUPPLIES INVENTORY2002 2003 2004 2005 2006


0

20

40

60

80

100

120

2002 2003 2004 2005 2006

Days Supplies Inventory

DOW

DD

LYO

HUN

The longer inventory sits on a company’s shelves, the longer it takes for a

company to collect money on those products. Like its days of receivables turnover,

Dow’s time of turns are well under the five year industry average of 64.37 days. With

an overall decrease with inventory on Dow’s shelves, it looks as though Dow is trying to

improve its inventory techniques to try and retain quicker cash and more room for new

inventories.

Receivables Turnover: (Sales/Accounts Receivables)

The Receivables Turnover ratio can be calculated by taking the Net Sales (A.K.A.

Revenue) for that year and dividing it over the Accounts Receivables which can be

located at the top of the balance sheet under current liabilities. This ratio measures


how efficient a company is in extending credit to its purchasers, as well as the

effectiveness of asset use.

A/R Turnover2002 2003 2004 2005 2006

DOW 8.86 9.13 8.45 9.04 9.85DD 6.18 6.4 5.59 5.55 5.28LYO 9.59 9.77 4 10.82 10.08HUN 6.1 6.32 5.99 7.17 8.48

A/R Turnover

2.00

4.00

6.00

8.00

10.00

12.00

2002 2003 2004 2005 2006

DOWDDLYOHUN

Dow’s accounts receivables turnover is relatively higher than what the five year

industry turnover was at 7.63. This shows that Dow’s policies on repayment of its

credits are not competitive with its fellow competitors. If credits are not dealt with

properly, they can build of interest for a company which can lead to unneeded

expenditures that bring down total profitability. Dow’s ratio increases due to their

accounts receivables growing at a higher percentage than the sales they are making.

This is not a huge factor due to the rapid rate at which they collect their receivables in

a timely fashion.

Days’ Supply of Receivables: (365/Receivables Turnover)


This ratio may be calculated by taking the days in a fiscal year, 365, and dividing

it by the receivables Turnover. This ratio shows how long (days) that it takes for a

company to get paid up to full by its creditor buyers.

Days Supply of Receivables2002 2003 2004 2005 2006

DOW 41.19 39.98 43.2 40.39 37.06DD 59.05 57.03 65.27 65.78 69.19LYO 38.04 37.35 91.19 33.74 36.21HUN 59.79 57.75 60.89 50.94 43.04Industry 51.35

Days Supply of Receivables

30.00

40.00

50.00

60.00

70.00

80.00

90.00

2002 2003 2004 2005 2006

DOWDDLYOHUN

While Dow’s account receivables turnover is relatively larger than the industry

average, the number of days in which it takes to collect on those accounts is

substantially less than the industry. This means that Dow extends purchases on

credits, but receives the creditor’s money in a reasonable time span.

Cash-to-Cash Cycle: (Days Supply of Receivables + Days Supply Inventory)

The “Money Mary-go-Round” shows how long it takes for a company’s inventory

to be turned into cash. The concept tracks the number of days by starting with the

company paying for the resources to produce a product, ending with the customer

paying in cash. In this ratio, a smaller number is ideal because the less number of days


inventory sit on the shelves, the less keep-up and operating expenses a company must

pay. A fast cash-to-cash cycle also allows for more room on the shelves for new

inventory.

CASH TO CASH CYCLE2002 2003 2004 2005 2006


Cash to Cash Cycle

0

50

100

150

200

250

2002 2003 2004 2005 2006

DOWDDLYOHUNINDUSTRY

Dow’s Cash-to-Cash cycle is relatively low compared to the chemical industry and

our competitors. With the rapid collections of account receivables as well as the low

number of days Dow’s inventory sit on shelves, contributes to cash being more

accessible. This becomes a big part of overall production in that it allows for Dow to

purchase and operate with more cash. While inventory sits on shelves for days and

days, realistically a company is losing possible profits. Dow has obviously made this a

priority, and has decreased its “Money Mary-go-Round” throughout the past few years.

Working Capital Turnover: (Sales/Working Capital)


This ratio allows for analysis of a company’s upper management, showing how

well they are using their working capital. Working Capital Turnover is calculated by

taking the Net Sales on the Income Statement and dividing them over the company’s

Working Capital (Current Assets – Current Liabilities). The Inventory Turnover and

Receivables Turnover ratios correlate with the Working Capital Turnover, in that a

company usually uses the money within these ratios to purchase inventory.

WORKING CAPITAL TURNOVER2002 2003 2004 2005 2006


Working Capital Turnover

0

2

4

6

8

10

12

2002 2003 2004 2005 2006

DOWDDLYOHUNINDUSTRY

The larger a company’s working capital turnover is, the more sales they are

generating. Aside from providing a picture of firm’s financial position, this method can

also be used to assess the level of operating performance. While Dow’s Working Capital

Turnover decreases over the 5 year span, it still maintains above the industry average.

In 2006, Dow generated $7.43 in sales for ever dollar of working capital contributed.

This ratio is a good measure of showing how much money a company is putting into its

operations, in comparison to how many sales they are generating off that input.


Liquidity Overview

In the overall scheme of things, Dow looks to be just as liquid as its competitors

if not more. Lyondell and Dow hold up the industry average excluding Lyondell’s 2004

year where they saw tremendous decreases in operations, collections, and overall

company stability. While Dow extends the possibility of purchases on credits to its

buyers, their account receivables get paid off in a timely fashion. If Dow were to see

increases in its days of receivables in the near future, they may think to reduce the

amount of credit they extend. Also, Dow has been continuing to incur an abundance of

liabilities, but have shown to balance out their debt through their extreme growth policy

of expansion. With the exception of their working capital turnover, Dow has shown

improvements over the 5 year span in every category. Although their working capital

decreased through 2006, they still maintain a level over the industry average of 7.01.

Profitability Ratios

In order to effectively evaluate the true performance of a company, we must

analyze a firm’s ability to generate a profit. After all, it is the profit bottom line that

investors and others consider when assessing an economic value to a firm. In order to

evaluate a firm’s profitability, we look at “four significant factors that are critical to a

company’s profits which include 1) Operating Efficiency; 2) Asset Productivity; 3) Rate

of Return on Assets; and 4) Rate of Return on Equity” (handout from Financial

Statement Analysis). Gross Profit Margin, Operating Expense Ratio, and Net Profit

Margin all apply to operating efficiency. Asset Turnover is used to evaluate asset

productivity.

Gross Profit Margin: (gross profit / sales)

To determine the Gross Profit Margin for a firm, one must simply take gross

profit (sales – cost of goods sold) and divide it by sales. This ratio assess a company’s

ability to retain a proportion of profit from sales, given that is has covered its variable


costs. A firm can increase this ratio by either increasing its level of sales relative to its

cost (i.e. charging higher prices to customers) or by simply reducing its cost of goods

sold.

Gross Profit 2002 2003 2004 2005 2006DOW 13.87% 13.65% 14.73% 17.34% 15.47%DD 26.98% 23.10% 23.82% 26.11% 25.46%LYO 11.16% -0.67% 6.18% 2.44% 5.37%HUN 9.02% 9.74% 12.59% 15.13% 14.49%INDUSTRY 15.26% 11.46% 14.33% 15.26% 15.20%

Gross Profit Margin

-10%

0%

10%

20%

30%

2002 2003 2004 2005 2006

DOWDDLYOHUNINDUSTRY

In the chart above, we can see that the industry as a whole has stayed on an

even keel for the most part of the last decade. Dow has been persistent with the

industry average of 14%, which would suggest that the company has not made any

real changes to their pricing levels. It is also important to note that the firm has slide

slightly ahead of the industry average, which would indicate that Dow is continuing to

adjust their performance to the market.

Operating Profit Margin: (operating income / sales)

Another profitability tool that is commonly used is the operating profit margin,

which is the operating income divided by the net sales. This ratio provides an

assessment of operating efficiency and how well a firm’s sales are covering its variable

costs. A firm can increase this ratio by either lowering it’s per unit operating costs or

increasing its sales price relative to its variable expenses.


OPERATING PROFIT MARGIN2002 2003 2004 2005 2006

DOW 0.09 0.08 0.11 0.16 0.11DD 0.10 0.02 0.07 0.15 0.14LYO 0.05 -0.01 0.01 0.07 0.05HUN 0.02 0.03 0.03 0.07 0.07INDUSTRY 0.07 0.04 0.06 0.11 0.09

Operating Profit Margin

0.000.020.040.060.080.100.120.140.160.18

2002 2003 2004 2005 2006

DOW

DD

LYO

HUN

INDUSTRY

From the table, we see that Dow held an 11.38% operating profit margin in 2006; this

essentially means that for every dollar of revenue collected from sales, roughly 11 cents

is made available to cover other expenses for items such as interest and taxes. As the

graph above indicates, we see that Dow follows industry pattern closely, while

maintaining a considerable advantage over its competitors.

Operating Expense Ratio: (SGA / sales)

In order to remain competitive in this industry, it is imperative that a firm

reduces as many costs and expenses as humanly possible in order to generate a profit

above industry average. To find the operating expense ratio, you must take the total

selling, general, and administrative expenses and divide them by total revenue. This

ratio identifies how well a company manages expenses and how those expenses are

matched to the revenues they generated. A firm can reduce its operating expense ratios


by improving efficiency within production which would spread a lower cost over the

same sales base.

Operating Expense Ratio 2002 2003 2004 2005 2006DOW 0.06 0.04 0.04 0.03 0.03DD 0.12 0.11 0.11 0.12 0.12LYO 0.05 0.05 0.05 0.03 0.03HUN 0.06 0.06 0.07 0.06 0.07INDUSTRY 0.07 0.07 0.07 0.06 0.06

Operating Expense Ratio

0.00

0.05

0.10

0.15

2002 2003 2004 2005 2006

DOWDDLYOHUNINDUSTRY

As the diagram indicates, we can observe that the industry as a whole does a

decent job of not letting operating expenses get out of hand. Since one of Dow’s key

success factors is competing in a cost leadership industry, we can judge that firm is

performing an exceptional job at keeping operating expenses lower than the industry

average of .07, which gives it a slight advantage over its competitors.

Net Profit Margin: (NI / sales)

The Net Profit Margin (or Return on Sales as it’s more commonly known) consist

of dividing Net Income by Sales. This formula provides “an indicator of a company’s

pricing policies and its ability to control cost (Wikipedia.com)”.


Net Profit Margin 2002 2003 2004 2005 2006DOW -1.22% 5.30% 6.96% 9.75% 7.58%DD -4.59% 3.60% 6.51% 7.72% 11.48%LYO -4.54% -8.47% 0.93% 3.14% 0.89%HUN -0.89% -4.62% -2.40% -0.33% 2.18%INDUSTRY -2.81% -1.04% 3.00% 5.07% 5.53%

Net Profit Margin

-10%

-5%

0%

5%

10%

15%

2002 2003 2004 2005 2006

DOWDDLYOHUNINDUSTRY

Net Profit Margin essentially sums up the two previous formulas, Gross Profit

Margin and the Operating Expense Ratio. The chart above shows the overall

performance level of the industry as a whole, which has been increasing exponentially

since 2003 after suffering a drastic recession that persisted throughout all of the year

before. Dow has been a top performer in the industry with an overall average of 6%;

however, we can see signs of competitors slowly starting to catch up with Dow and

starting to compete on their level.

Asset Turnover: (sales / assets)

Asset turnover is the key formula for determining a firm’s asset productivity, which is

essentially how well a company utilizes its assets in order to generate revenues. The

asset turnover is determined by taking total sales and dividing them by total assets.


Asset Turnover 2002 2003 2004 2005 2006DOW 0.7 0.78 0.88 1.01 1.08DD 0.69 0.73 0.77 0.8 0.86LYO 0.44 0.47 0.36 1.12 1.17HUN 0.49 0.79 1.01 1.19 1.25INDUSTRY 0.58 0.69 0.75 1.03 1.09

Asset Turnover

0.00

0.50

1.00

1.50

2002 2003 2004 2005 2006

DOWDDLYOHUNINDUSTRY

As we can see, the industry as a whole has been steadily increasing productivity

and efficiency, which in turn would increase profitability of the firms. In Dow’s case, we

can conclude that firm has been struggling in this sector and is having difficulty to stay

on par with the industry average which currently stands at .83.

Return on Assets: (NI / assets from previous year)

The return on assets incorporates a company’s operating efficiency and asset

productivity into one comprehensive equation. To compute return on assets, you simply

take a firms profit margin (net income / sales) and multiply it by the asset turnover

(sales / assets). An even easier way to compute the return on assets is to simply take

net income and divide it by total assets.

Return on Assets 2002 2003 2004 2005 2006DOW -0.95% 4.37% 6.68% 9.84% 8.11%DD -2.74% 2.81% 4.81% 5.77% 9.46%LYO -1.99% -3.96% 0.34% 3.52% 1.04%HUN -0.43% -3.66% -2.42% -0.39% 2.72%INDUSTRY 2.29% -1.56% 1.83% 4.58% 4.59%


Return on Assets

-5%

0%

5%

10%

15%

2002 2003 2004 2005 2006

DOWDDLYOHUNINDUSTRY

Much like the Asset Turnover Ratio, the Return on Assets is a measuring tool

used to gage how well the company is performing in the areas of efficiency and

productivity and how well the company is utilizing its assets to generate a profit. By

analyzing the graph above, we can tell how much of an impact the recession of 2002

had on the industry, which hit record lows during the proceeding quarters. However, we

have seen a resurgence in late 2003 that has continued to regain much of its

profitability. In Dow’s case, we can tell that the firm has consistently held a

commanding advantage over its competitors with an overall average of 6%.

Return on Equity: (NI / equity from previous year)

The return on investment (ROE) “measures the profitability to owner’s interest in

total assets” (Financial Statement Analysis handout). A firm’s return on equity is

subjective to both return on assets and the company’s capital cost structure (debt to

equity relationships). A simple computation of this rate would be net income divided by

total stockholders equity.

Return on Equity 2002 2003 2004 2005 2006DOW -3.24% 15.17% 20.88% 32.61% 25.68%DD -7.63% 10.74% 18.20% 18.07% 9.46%LYO -12.55% -26.12% 1.92% 17.65% 5.83%HUN -6.57% 170.38% 59.61% -2.28% 13.23%INDUSTRY -8.93% 43.26% 24.99% 16.95% 18.58%


Return on Equity

-20%

0%

20%

40%

60%

2002 2003 2004 2005 2006

DOWDDLYOHUNINDUSTRY

Perhaps one of the most important ratio to look at when valuing a company’s

profitability is the Rate of Return on Equity. As the data indicates, Dow began to beat

the industry average beginning mid 2004. However, it is imperative to take into account

the bizarre and dramatic shifts in the ratios for Dow’s competitors. Upon investigating

Huntsman’s 2003 and 2004 annual 10-K reports, we see that the company’s

tremendous growth in the return on equity was attributable a change in accounting

policies.

Profitability Overview

After analyzing the previous ratios and emerging trends in the industry, it is

evident that the Dow Corporation has consistently and continually performed above

average against their competitors in the matters of operating efficiency and

productivity, which are both considered key success factors for this industry. Given its

track record of outperforming the industry averages and its steadily increasing trend in

market share, it becomes apparent to any investor that the Dow Corporation is quite a

profitable company that has much potential for even greater profitability in the future.

Capital Structure Ratio’s

The capital structure of the company allows investors to see how a company

acquires its assets. “In analyzing capital structure, there are two primary concerns: the

amount of debt relative to the owners’ equity; the ability to service the principal and the


interest requirements on debt” (Ratio Analysis Handout). By looking under the liabilities

section of the balance sheet and checking owners’ equity on the income statement an

investor is able to do so by looking for three ratios. These three ratios are debt to

equity, times interest earned, and debt service margin.

Debt to Equity: (Total liabilities/Total Owners’ Equity)

The importance of this ratio is that by taking this figure one is able to judge a

firm based upon how much of the company is threatened by credit risk. By calculating

the percentage of total liabilities and dividing it by total owners’ equity an investor is

able to see how the company is mostly financed. By keeping this number low it shows

how the majority of the business is funded primarily through equity rather than debt.

DEBT TO EQUITY 2002 2003 2004 2005 2006

DOW 4.19 3.57 2.74 2 1.67DD 2.55 2.74 2.03 2.66 2.33LYO 5.32 5.6 4.67 4.04 4.6HUN 14.19 -44.11 -23.73 4.82 3.85INDUSTRY 6.56 3.97 3.15 3.38 3.11

Debt to Equity

0

1

2

3

4

5

6

7

2002 2003 2004 2005 2006

DOWDDLYOHUNINDUSTRY

While the industry average shows to be extremely low, after taking out

Huntsman’s negative numbers, the industry moves to a more respectful 4.03. With this

ratio, you want a lower number, which shows that you are internally funding operations


instead of externally by debt. Dow shows a tremendous decrease in their debt to

equity ratio; where in 2006 it hits 1.67, the total industries lowest mark.

Times Interest Earned: (NIBIT/ Interest Expense)

Times interest earned is net income before interest and taxes (Income from

Operations) divided by interest expense. This is a key indicator to determine if income

from operations is able to cover interest charges. This can be a huge concern to stock-

holders for the reason that if income from operations cannot cover the required interest

charges, than there can be no profits.

Times Interest Earned2002 2003 2004 2005 2006

DOW 3.14 3.19 6.16 10.36 9.07DD 6.92 1.41 4.98 7.88 8.24LYO 0.45 -0.04 0.2 1.95 1.69HUN 0.34 0.42 0.43 1.68 2.1Industry 3.53

Times Interest Earned

-1.00

1.00

3.00

5.00

7.00

9.00

2002 2003 2004 2005 2006

DOWDDLYOHUN

Dow has the strongest ability within the industry, to make their interest

payments within the fiscal year. While the industry average sits at 3.53, in 2005 Dow

pays of $1 of interest, 10.36 times. Allowing interest to pile up is one of the main ways


to fall into debt financing and possibly bankruptcy. Once again, Dow continues to

improve throughout the 5 year span.

Credit Analysis

Using the Altman Z-score model, we computed Dow’s bankruptcy score (Credit score),

based on five different fixed variable ratios. In order to obtain a loan, a lending company will

usually analyze a company’s credit to evaluate if they will be able to pay back their money.

“Studies measuring effectiveness of the Z-score have shown the model is often accurate in

predicting bankruptcy (&2%-80% reliability)” (Valuebasedmanagement.com). If a company’s

Z-score were to fall below 1.8, bankruptcy is very likely. A score between 1.8 and 2.6 is

considered to be in the “grey area”, or borderline of bankruptcy. If a company obtains a credit

score of 3.0 or higher, bankruptcy is not likely and a firm remains strong

(Valuebasedmanagement.com).

The following is the equation we used in calculating Altman’s Z-score:

Z-score=1.2(Working Capital/Total Assets) + 1.4(Retained Earnings/Total Assets) +

3.3(Earnings Before Interest and Taxes/Total Assets) + 0.6(Market Value of Equity/Book Value

of Liabilities) + 1.0(Sales/Total Assets)

The largest weight distributed within this model comes from the (EBIT/Total

Assets) ratio. The smallest weight distribution comes from how the firm is correlated with the

market.

Dow’s Altman Z-Score

2002 2003 2004 2005 2006

Z-score 1.82 2.12 2.53 2.98 3.07

*Z-score work shown in Appendix

Referring to the table above, we came to a conclusion that Dow was barely avoiding

bankruptcy from 2002-2004. While throughout this five year period Dow’s Z-score has

increased, this shows lenders that Dow has improved its default risk. With the acquisition of


Union Carbide in late 2004, Dow’s credit scored increased improved to push out of the “grey

area”, and into a state of a low bankruptcy possibility.

Debt Service Margin: (Operating Cash Flow/ Notes Payable Current)

Debt service margin is measured by taking operating cash flows and dividing it

by notes payable current. It allows an investor to see if the annual installments are

able to be covered by operating cash flows. “Cash provided by operations should be

viewed as a major source of cash used to retire long-term debt” (Ratio Analysis

Handout). By having a high debt service margin it relieves the company of having to

use operating cash flows for debt, and gives it the ability to use it on something else.

2002 2003 2004 2005 2006DOW -0.04 0.05 0.23 0.49 0.52DD 0.43 0.58 0.58 0.37 0.62LYO 0.07 0.02 0.05 0.27 0.15HUN 0.03 0.04 0.03 0.22 0.26Industry 0.25

While analyzing the debt service margin ratio, a larger number is preferred

because generated cash is preferred to be larger than the debt being paid off in notes.

The reason for Dow’s substantial jump from 2002 on, is explained by their purchase of

Union Carbide in late 2002. With this purchase, it opened many doors for new

Debt Service Margin

-0.10

0.00

0.10

0.20

0.30

0.40

0.50

0.60

0.70

2002 2003 2004 2005 2006

DOWDDLYOHUN


endeavors and cash flows. In 2006, Dow cut back on its debt financing and began to

finance through internal operations.

SGR & IGR Analysis

Internal Growth Rate: (ROA (1- DIV/NI)

The IGR ratio can be computed by taking companies Return on Assets ratio, and

multiplying it by 1 minus the Dividend Payout Ratio. The IGR explains the highest

possible growth point a company can obtain without receiving outside funding. It also

shows how a company circulates its retained earnings by accumulating larger total

assets. This is a good growth model to make available to investors, because it shows

the growth of the company excluding any debt financing.

IGR2004 2005 2006

DOW 3.55% 6.88% 4.93%DD 1.02% 1.73% 5.32%LYO -0.96% 1.94% -0.24%HUN 0.00% -0.49% 2.43%INDUSTRY 2.28% 3.51% 4.22%

*Companies did not disclose previous years in their 10K to come up with IGR.

Throughout the years of 2002 to 2005 we saw a persistent growth rate that rose

at a stable basis. However, in 2006 the Internal Growth Rate saw a decline that was

attributed to the decrease in Net Income as well as the increase in dividend payout.

Also, Dow’s plant and factory growth plan began to be implemented around early 2003.

Dow was able to grow using internal funds without having to finance through debt

instruments.

Sustainable Growth Rate: (IGR (1 + (D/E))

The Sustainable Growth Rate is the highest growth rate a company can maintain

without needing to increase its financial leverage (Utilization by a company of its


borrowed monies). In calculating SGR, multiply the company’s Internal Growth Rate by

1 plus Debt divided by Equity. IGR influences this ratio, in which a higher Internal

Growth Rate will produce a higher Sustainable Growth Rate.

2002 2003 2004 2005 20064% 15% 24% 33% 25%

Sustainable Growth Rate

Dow’s Sustainable Growth Rate follows a very similar pattern as their IGR. While

IGR is a component of a company’s SGR, it however is not the only factor. With a slight

decrease in 2006, Dow saw reduced debt alongside with increasing financial equities.

Knowing that these two ratios can draw conclusions of future profits a 8% decline, in

SGR, and a 1.95% decline in IGR. This decrease is primarily a cause of future

obligations that we have because of our operating leases. With the incremental growth

patterns, Dow’s globalization and expansion efforts look to continue to bring continuous

growth for the years to come. However, with this incremental growth Dow will be

forced to take on new debt decreasing both the IGR and SGR. Furthermore, in the long

run it will reduce profits for Dow as well.

Overview

Dow has made increases towards expanding growth potential by both internal

and sustainable approaches. While decreasing the possibility of having to finance

through debt, Dow has increased its asset base as well as overall net income. With

growth being a high priority in Dow’s future outlook, the expansion of plants and

factories globally, have shown to be a major part of the success. Compared to the

chemical industry, Dow has a much lower Cash-to-Cash ratio. This allows for Dow to

receive cash on hand at a much faster basis. This allows for Dow to look more liquid to

investors as well as allowing for easier cash flows and movements.


Financial Statement Forecasting Analysis

In this segment, we will forecast the financial statements for the Dow

Corporation and also disclose the criteria and methodology that were used to develop

our estimates. The three financial statements that we will be examining are the balance

sheets, income statements, and statement of cash flows. By looking at the past

performance of the balance sheets and income statements, we can determine the

historical growth rates for key line items and use those averages to develop a ten year

forecast for those figures. Aside from analyzing Dow’s numbers, we will also calculate

an industry average of Dow’s competitors to establish a benchmark to compare with. It

is also important to note that aside from using historical averages, the balance sheet

analysis will also include averages for liquidity ratios in their forecasts (i.e. inventory

turnover, current ratios, asset turnover, accounts receivable turnover). In the cash flow

analysis section, we will primarily be using two expense manipulation diagnostics, the

Cash Flows from Operations/ Operating Income (CFFO/OI) and the Cash Flows from

Operations / Net Income (CFFO/NI), both of which were discussed earlier in the

accounting analysis section of this report.


Dow Chemical(In millions, except per share amounts) 2001 2002 2003 2004 2005 2006 Assumed 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016Income Statement % increase % increase % increase % increase % increaseSales Increase -1.66% 18.19% 23.07% 15.30% 6.08% 9.00%Net Sales/Net Revenue $28,075 $27,609 $32,632 $40,161 $46,307 $49,124 53,545.16$ 58,364.22$ 63,617.00$ 69,342.54$ 75,583.36$ 82,385.87$ 89,800.59$ 97,882.65$ 106,692.09$ 116,294.37$ COGS 23,780 28,177 34,244 38,276 41,526 84.00% 44,977.93$ 49,025.95$ 53,438.28$ 58,247.73$ 63,490.03$ 69,204.13$ 75,432.50$ 82,221.42$ 89,621.35$ 97,687.27$ Gross Profit 3,829 4,455 5,917 8,031 7,598 8,567.23$ 9,338.28$ 10,178.72$ 11,094.81$ 12,093.34$ 13,181.74$ 14,368.10$ 15,661.22$ 17,070.73$ 18,607.10$ R & D 1,066 981 1,022 1,073 1,164 2.40% 1,285.08$ 1,400.74$ 1,526.81$ 1,664.22$ 1,814.00$ 1,977.26$ 2,155.21$ 2,349.18$ 2,560.61$ 2,791.06$ SG&A 1,598 1,392 1,436 1,545 1,663 3.40% 1,820.54$ 1,984.38$ 2,162.98$ 2,357.65$ 2,569.83$ 2,801.12$ 3,053.22$ 3,328.01$ 3,627.53$ 3,954.01$ Amortization of intangibles 65 63 81 55 50Purchased in-process research and development chargesRestructuring charges 543 114 591Gain on asset divestitures 563Total Operating Expenses 26,444 30,550 36,702 40,894 44,994 89.80% 48,083.55$ 52,411.07$ 57,128.07$ 62,269.60$ 67,873.86$ 73,982.51$ 80,640.93$ 87,898.62$ 95,809.49$ 104,432.35$ Merger-related expenses and restructuring 280Asbestos-related credit 828 177Equity in earnings of nonconsolidated affiliates 40 322 923 964 959Sundry income net 54 146 136 755 137Interest income 66 92 86 138 185Operating Income 2,433 2,642 4,604 7,270 5,588 10.20% 5,461.61$ 5,953.15$ 6,488.93$ 7,072.94$ 7,709.50$ 8,403.36$ 9,159.66$ 9,984.03$ 10,882.59$ 11,862.03$ Interest expense and amortization of debt discount 774 828 747 702 616Income before Income Taxes and Minority Interests (622) (33,254) (39,386) (42,526) (47,620) 11.00% (52,858.20)$ (58,672.60)$ (65,126.59)$ (72,290.51)$ (80,242.47)$ (89,069.14)$ (98,866.75)$ (109,742.09)$ (121,813.72)$ (135,213.23)$ Provision for income taxes (280) (82) 877 1,782 1,155Minority interests' share in income 63 94 122 82 93

Income before Cumulative Effect of Change (405) 1,739 2,797 4,535 3,724in Accounting PrincipleCumulative effect of change in accounting 67 (9) (20)principleNet Income Available for Common Stockholders ($338) $1,730 $2,797 $4,515 $3,724 7.00% 3,748.16$ 4,085.50$ 4,453.19$ 4,853.98$ 5,290.84$ 5,767.01$ 6,286.04$ 6,851.79$ 7,468.45$ 8,140.61$ Share DataEarnings before cumulative effect of change ($0.44) $1.89 $2.98 $4.71 $3.87in accountingprinciple per common share basicEarnings per common share basic ($0.37) $1.88 $2.98 $4.69 $3.87Earnings before cumulative effect of change ($0.44) $1.88 $2.93 $4.64 $3.82in accountingprinciple per common share dilutedEarnings per common share diluted ($0.37) $1.87 $2.93 $4.62 $3.82Common stock dividends declared per share $1.34 $1.34 $1.34 $1.34 $1.50of common stockWeighted-average common shares outstanding 910.50 918.80 940.10 963.20 962.30basicWeighted-average common shares outstanding 910.50 926.10 953.80 976.80 974.40

Forecasted


Income Statement

When forecasting the income statement, the first thing we estimated was the

growth rate of the firm. With the fluctuation in the industry as a whole we knew this

would present a problem with forecasting a constant growth rate. We assumed a 9%

growth rate, which we thought was sufficient for such a conglomerate. In addition, this

growth rate produced numbers that seemed to flow well with Dow’s past performance.

Furthermore, our gross profit margin over the past three years was 15.85%, and our

forecasted gross profit/net sales in any selected year were on par with this figure. The

next step we took was to find our cost of goods sold. Upon looking at our consolidated

income statement, we found that COGS was 85% of net sales. We followed this

process for research and development as well as selling and general administrative

expenses; meaning the estimates of R&D and the SG&A expenses are a direct

percentage of forecasted sales of that year. Next we added these expenses together to

find the total operating expenses. After comparing the growth rates of gross profits

and total operating expenses, we see that operating expenses are increasing at a faster

rate relative to the gross profits growth rate. This can best be explained by the fact

that Dow Chemical is the largest consumer of oil and petroleum-based products. With

the recent surge in oil prices, Dow’s cost of raw materials is increasing dramatically.

This presents a significant dilemma for Dow in the future as there is no way to

determine when or if these raw material prices will ever level out. In conclusion, we

express concern about Dow’s ability to maintain its cost leadership business strategy,

which is the cornerstone of Dow’s key success factors.

Balance SheetAssetsCurrent AssetsCash and cash equivalents $1,484 $2,392 $3,108 $3,806 $2,757 6.00% 3,030.86$ 3,303.64$ 3,600.96$ 4,379.53$ 4,773.69$ 5,203.32$ 5,671.62$ 6,182.06$ 6,738.45$ 7,344.91$ Marketable securities and interest-bearing 89 42 84 32 153deposits 13% 18% 20% 22% 16%Accounts and notes receivable:Trade (net of allowance for doubtful receivables 2006: $122; 2005: $169) 3,116 3,574 4,753 5,124 4,988 5,903.55$ 6,434.86$ 7,014.00$ 7,645.26$ 8,333.34$ 9,083.34$ 9,900.84$ 10,791.91$ 11,763.18$ 12,821.87$ Other 2,369 2,356 2,604 2,802 3,060Inventories 4,208 4,050 4,957 5,319 6,058 6,703.12$ 7,306.40$ 7,963.98$ 8,680.73$ 9,462.00$ 10,313.58$ 11,241.80$ 12,253.57$ 13,356.39$ 14,558.46$ Deferred income tax 109 698 384 321 193

0.3699 0.3089 0.3120 0.3056 0.3520Total current assets 11,375 13,112 15,890 17,404 17,209 35.00% 17,680.01$ 19,271.21$ 21,005.61$ 25,547.25$ 27,846.50$ 30,352.69$ 33,084.43$ 36,062.03$ 39,307.61$ 42,845.30$

InvestmentsInvestment in nonconsolidated affiliates 1,565 1,878 2,698 2,285 2,735Other investments 1,689 1,971 2,141 2,156 2,143Noncurrent receivables 577 230 189 274 288

Total investments 3,831 4,079 5,028 4,715 5,166

PropertyProperty 37,934 40,812 41,898 41,934 44,381Less accumulated depreciation 24,137 26,595 28,070 28,397 30,659

Net property 13,797 14,217 13,828 13,537 13,722

Other AssetsGoodwill 3,189 3,226 3,152 3,140 3,242 7.00% 3,536.00$ 3,854.24$ 4,201.12$ 5,109.45$ 5,569.30$ 6,070.54$ 6,616.89$ 7,212.41$ 7,861.52$ 8,569.06$ Other intangible assets (net of accumulated 613 579 535 443 457amortization 2006: $620; 2005: $552)Deferred income tax assets noncurrent 3,776 4,113 4,369 3,658 4,006Asbestos-related insurance receivables 1,489 1,176 1,028 818 725noncurrentDeferred charges and other assets 1,492 1,389 2,055 2,219 1,054Total other assets 10,559 10,483 11,139 10,278 9,484Total Noncurrent Assets 28,187 28,779 29,995 28,530 28,372 65.00% 32,834.30$ 35,789.38$ 39,010.43$ 47,444.89$ 51,714.93$ 56,369.28$ 61,442.51$ 66,972.34$ 72,999.85$ 79,569.83$

Total Assets $35,515 $39,562 $41,891 $45,885 $45,934 $45,581 50,514.30$ 55,060.59$ 60,016.04$ 72,992.14$ 79,561.43$ 86,721.96$ 94,526.94$ 103,034.37$ 112,307.46$ 122,415.13$

Liabilities and Stockholders' Equity

Current LiabilitiesNotes payable $580 $258 $104 $241 $219Long-term debt due within one year 797 1,088 861 1,279 1,291Accounts payable:Trade 2,834 2,843 3,701 3,931 3,825Other 1,789 2,041 2,194 1,829 1,849Income taxes payable 202 212 419 493 569Deferred income tax liabilities current 30 241 205 201 251Dividends payable 326 331 342 347 382Accrued and other current liabilities 2,298 2,520 2,680 2,342 2,215

Total current liabilities 8,856 9,534 10,506 10,663 10,601 10,400.00$ 11,336.00$ 12,356.24$ 15,027.79$ 16,380.30$ 17,854.52$ 19,461.43$ 21,212.96$ 23,122.12$ 25,203.11$ 28% 29% 31% 35% 37%

Long-Term Debt 11,659 11,763 11,629 9,186 8,036

Other Noncurrent LiabilitiesDeferred income tax liabilities noncurrent 994 1,124 1,301 1,395 999Pension and other postretirement benefits 3,775 3,572 3,979 3,308 3,094noncurrentAsbestos-related liabilities noncurrent 2,072 1,791 1,549 1,384 1,079Other noncurrent obligations 3,214 3,556 3,202 3,338 3,342

Total other noncurrent liabilities 10,055 10,043 10,031 9,425 8,514 20,761.30$ 21,804.65$ 22,865.99$ 29,959.04$ 31,593.18$ 33,288.98$ 35,048.57$ 36,874.15$ 38,767.97$ 40,732.30$ 31% 31% 30% 31% 30%

Minority Interest in Subsidiaries 366 376 449 336 365

Preferred Securities of Subsidiaries 1,000 1,000 1,000 1,000 1,000Total Liabilities $31,936 $32,716 $33,615 $30,610 $28,516 31,161.30$ 33,140.66$ 35,222.23$ 44,986.83$ 47,973.47$ 51,143.50$ 54,510.00$ 58,087.11$ 61,890.09$ 65,935.42$

Stockholders' EquityCommon stock (authorized 1,500,000,000 shares 2,453 2,453 2,453 2,453 2,453of $2.50 par value each; issued 981,377,562 shares)Additional paid-in capital 8 274 661 830Unearned ESOP shares (61) (30) (12) (1) 0Retained earnings 9,520 9,994 11,527 14,719 16,987 19,275.00$ 21,841.93$ 24,715.81$ 27,927.31$ 31,509.96$ 35,500.47$ 39,938.94$ 44,869.25$ 50,339.37$ 56,401.71$ Accumulated other comprehensive loss (2,097) (1,491) (977) (1,949) (2,235)Treasury stock at cost (2006: 23,326,570 shares; (2,189) (1,759) (995) (559) (970)2005: 14,221,354 shares)

Stockholders' equity 7,626 9,175 12,270 15,324 17,065 $19,353 21,919.93$ 24,793.81$ 28,005.31$ 31,587.96$ 35,578.47$ 40,016.94$ 44,947.25$ 50,417.37$ 56,479.71$ Total Liabilities and Stockholders' Equity $39,562 $41,891 $45,885 $45,934 $45,581 50,514.30$ 55,060.59$ 60,016.04$ 72,992.14$ 79,561.43$ 86,721.96$ 94,526.94$ 103,034.37$ 112,307.46$ 122,415.13$

Balance Sheet

To start on the balance sheet, the first step we took was to link it to the income

statement we had already forecasted. This can be achieved by using the asset turnover

rate because it includes net sales from the income statement and total assets from the

balance sheet.

1.06= (net sales/ total assets)

Adjusted

Total assets = (net sales/1.06)

We assumed a 1.06 asset turnover rate after averaging the last two asset

turnovers for the industry. Dow’s past two averaged out to by 1.05, which added

further confidence for our assumed rate. We choose to only use the past two years

because they showed a lower variability than the years 2002 through 2004, which

increased dramatically in both the industry and Dow. Using this 1.06 asset turnover we

had found for Dow in our forecasting analysis, we divided our net sales by this number

to find our total assets for 2007 and beyond.

The next line item that was forecasted was total current assets. The common

sized balance sheet seemed to have a pretty consistent 35% current asset ratio, which

we multiplied by the total assets to find current assets for that year. After formulating

the current assets, we subtracted them from the 10 year forecasted total assets, which

gave us our total non-current assets. By the use of the common sized balance sheet,

we were able to determine the cash and cash equivalents to be 6% of total asset.

Therefore, when we forecasted out our total assets, we maintained a 6% growth rate in

cash and cash equivalent. To forecast inventory, we used the inventory turnover rate,

which we averaged out to be 6.71.

6.71= COGS/Inventory

Adjusted


Inventory = COGS/6.71

This method provides a link between the income statement and the balance

sheet. Dividing our COGS, which were previously found on our income statement by

our inventory turnover rate, we were able to forecast inventory for the next 10 years.

The industry average was 6.27, but this was not the best number to choose because of

the heavy fluctuation that occurred from year to year. Therefore, it was more logical to

choose Dow’s inventory turnover because it was less volatile than the industries.

The final Current Asset that we forecasted was accounts receivable. This is yet

another technique used to link the Income Statement with the balance sheet.

9.07 = Net Sales/Accounts Receivable

Adjusted

Accounts Receivable = Net Sales/9.07

By dividing your forecasted Net Sales by 9.07, we were able to forecast out our

accounts receivable for the next ten years.

The stand-alone non-current asset that we forecasted was Goodwill. Our

common sized balance sheet gave us 7.5%, which we decreased to 7% after removing

the 2002 and 2003 outliers.

Following the forecasts of assets, we computed retained earnings and

stockholders equity. Since Dow is an equity-based firm, it was important to estimate

equity before liabilities were forecasted. Retained earnings were the first step we took

in this process. To forecast them, we took the previous years retained earnings and

added the current year net income minus dividends. To forecast total shareholders

equity, we subtracted the retained earnings from the previous years retained earnings.

Then we added that number to the previous shareholders equity to forecast the future

shareholders equity for the next ten years.


To find the forecast for total liabilities, we subtracted the S/E from our total

liabilities & S/E, which we know equals total assets because balance sheets balance.

Next, we found our current ratio to be 1.5 compared to the industry of 1.74 because of

Dow’s generally higher rate of debt financing. Using the formula provided below, we

were able to calculate our current liabilities by dividing our previously stated current

assets over our current ratio of 1.5. This formula was used to generate the forecasted

current liabilities of the upcoming 10 years ending in 2016.

1.05 = CA/CL

Adjusted

CA/1.05= CL

Finally, to calculate our long-term liabilities, we subtracted current liabilities from the

total liabilities.

Cash Flow StatementOperating ActivitiesNet Income Available for Common Stockholders ($338) $1,730 $2,797 $4,515 $3,724 3,748.16$ 4,085.50$ 4,453.19$ 4,853.98$ 5,290.84$ 5,767.01$ 6,286.04$ 6,851.79$ 7,468.45$ 8,140.61$ Adjustments to reconcile net income tonet cash provided by operatingactivities:Cumulative effect of change in accounting 20principle (67) 9Depreciation and amortization 2,088 2,079 2,074Provision for deferred income tax 1,825 1,903 255 740 104Earnings of nonconsolidated affiliates (311) (378) (553) (469) (343)in excess of dividends receivedMinority interests' share in income 63 (180) 122 82 93Pension contributions (399) (1,031) (575)Net gain on sales of ownership interests 63 94 (29) (732)in nonconsolidated affiliates (4) (235)Net gain on sales of investments 4 (34) (33) (19)Net gain on sales of property, businesses (60) (100) (56) (130)and consolidated companies (2) (28)Other net (gain) loss (8) 69 (29) (12)Gain on asset divestitures related to formation (65) (10) (563)of nonconsolidated affiliates (102)Restructuring charges 8 341 41 586Asbestos-related credit 168 (177)Tax benefit nonqualified stock option 34 100 85exercises 828Excess tax benefits from share-based payment 31 52 (11)arrangementsChanges in assets and liabilities:Accounts and notes receivable (299) (322) (1,316) (469) 242Inventories 223 95 (931) (240) (758)Accounts payable 474 161 1,252 106 (129)Other assets and liabilities 1 347 (429) (135) (515)

Cash provided by operating activities (448) 632 2,670 4,474 4,154 4,819.06$ 5,252.78$ 5,725.53$ 6,240.83$ 6,802.50$ 7,414.73$ 8,082.05$ 8,809.44$ 9,602.29$ 10,466.49$

Investing Activities 2,108 3,780Capital expenditures (1,333) (1,597) (1,775)Proceeds from sales of property, businesses 163 105 296and consolidated companies (1,623) (1,100)Acquisitions of businesses 79 231 (149)Purchase of previously leased assets (1) (10) (263) (208)Investments in consolidated companies (533) (6) (109) (111)Investments in nonconsolidated affiliates (71) (129) (208) (103)Distributions from nonconsolidated affiliates 39 3 60 41 6Proceeds from sales of ownership interests (98) (80) 62 956 10in nonconsolidated affiliates 63Proceeds from asset divestitures related 89 53 845to formation of nonconsolidated affiliatesPurchases of investments (1,827) (1,400) (1,405)Proceeds from sales and maturities of investments 1,661 1,379 1,383

(1,799) (1,732)Cash used in investing activities 1,688 1,500 (653) (1,096) (1,907) (2,437.62)$ 475.21$ 517.98$ (5,450.57)$ 74.04$ 80.71$ 87.97$ 95.89$ 104.52$ 113.93$

Financing Activities (1,626) (1,676)Changes in short-term notes payable (152) 74 23Payments on long-term debt (1,285) (1,559) (1,359)Proceeds from issuance of long-term debt (510) (285) 658 4Purchases of treasury stock (472) (857) (15) (68) (739)Proceeds from sales of common stock 2,932 907 706 398 223Excess tax benefits from share-based payment (6) (6) 11arrangements 138 303Distributions to minority interests (78) (58) (57) (70) (57)Dividends paid to stockholders (1,217) (1,229) (1,252) (1,287) (1,404)

Cash used in financing activities 787 (1,225) (1,397) (2,508) (3,302)

Effect of Exchange Rate Changes on Cash (5) 29 96 (172) 6

SummaryIncrease (Decrease) in cash and cash equivalents 1,264 908 716 698 (1,049)Cash and cash equivalents at beginning 220 1,484 2,392 3,108 3,806of year

Cash and cash equivalents at end of year $1,484 $2,392 $3,108 $3,806 $2,757

Statement of Cash Flows

Seeing as calculating the statement of cash flows is not only the hardest

statement to calculate for a firm, but also critical in terms of operating and investing

activities. Before we can forecast these cash flows we must first determine the net

income for common stockholders. Fortunately we have forecasted net income from

previous financial analysis that has provided us this information needed to forecast cash

flows from operations. By looking at the net income from the current year minus the

previous year and divided by the previous year we came up with a 9% growth rate. By

applying that same 9% growth rate to our sales forecast we were able to forecast cash

from operating activities for the next ten years. We observed that cash flows from

operations remains at a consistent growth which remains on par for the company’s

expansion. To check our estimates from cash flows from operations we applied the

CFFO/OI ratio and came to the conclusion that our original estimates were reasonable.

To calculate cash flows from investing we took the total other noncurrent liabilities from

the previous year and subtracted total other noncurrent liabilities in the current year.

The recent trend shows the company is increasingly investing in itself; which will help

ensure future profitability.

Cost of Capital

In looking at a firm, the cost of capital is necessary for a valuation. The three

essentials that go into this model consist of: the weighted average cost of capital, the

cost of debt, and the cost of equity. The following section takes you through the

process of computing these three elements.

Cost of Equity (CAPM)

In computing the CAPM model we must first find the (Ke), which is an estimation

of a companies expected stock returns. Three other variables are used in calculating

CAPM, and they consist of the risk free rate, beta, and the market risk premium or MRP.


First, to find our risk free rate, we consulted the St. Louis FRED database, where

we matched our regression analysis to the 3 month T-bill interest rate. After computing

our regression analysis, we found that the highest adjusted R^2 were 30.81%, which

was from the 3 month, 5 year T-bill interest rate.

(CAPM) Ke= Rf + B(MRP)

Ke=.043 + 1.5(.07)

Ke=.148

Cost Of Debt

Dow’s cost of debt was computed at 5.89% on a before tax basis. In computing

the cost of debt we consulted Dow’s 10-k, along with the St. Louis Fed (Fred) Database.

In determining our accounts payable and accrued expenses and liabilities, we used a

three-month non-commercial paper rate of 4.41%, taken off the St. Louis Fed. For

current maturities and long term debt we took a 6.7% interest rate straight off Dow’s

10-k. The deferred income-tax liability was taken using the two-year Non-financial

Risk-free government rate from the St. Louis FED, with an interest rate of 2.9%. While

we could not find a compatible rate for long-term liabilities, we took a reasonable

estimate of 4.8% that was assumed from the averages of other line items from long-

term debt. We then assigned each liability line item a weight in reference to total

liabilities and multiplied them by their respected interest rates.


Cost of DebtLiabilities

Source Interest Rate(%) Weight ValueCurrent Liabilities

Accounts Payable Fed 4.41 0.2079 0.00917 5,674Current Maturities of L-T Debt 10_k 6.7 0.0473 0.00317 1,291Accrued Expenses & Liabilities Fed 4.41 0.0811 0.00358 2,215Income Tax Payable 10-K 35 0.0207 0.00725 569

Total Current Liabilities 9,749

Long-term Liabilities Estimate 4.8 0.312 0.01498 8,514Long-term Debt 10-K 6.7 0.2944 0.01972 8,036Deffered Income Tax Liability Fed 2.9 0.0366 0.00106 999

Total L-T Liabilities 17,5491

Total Liabilities 0.05893 27,298

Kd=5.89%

The following regression analysis information comes from using Dow chemical

historic stock prices adjusted for dividends and comparing them to the St. Louis Fed

FRED database information for T-bill interest rates.

X adj r2 t-stat X adj r2 t-stat X adj r2 t-stat X adj r2 t-stat72 month 1.0918 0.2628 5.1288 Ke 1.0895 0.2624 5.1246 1.0859 0.2617 5.1156 1.0841 0.2611 5.108160 month 1.5005 0.3081 5.2226 0.1480 1.4985 0.3080 5.2212 1.4960 0.3072 5.2121 1.4949 0.3065 5.203348 month 0.9629 0.1240 2.7660 0.9602 0.1235 2.7608 0.9570 0.1228 2.7534 0.9548 0.1222 2.746036 month 0.8015 0.0654 1.8569 0.8023 0.0657 1.8609 0.8023 0.0660 1.8638 0.8023 0.0660 1.864024 month 0.2973 -0.0244 0.6725 0.3015 -0.0238 0.6829 0.3045 -0.0233 0.6909 0.3056 -0.0231 0.6936

X adj r2 t-stat X adj r2 t-stat X adj r2 t-stat X adj r2 t-stat72 month 1.0817 0.2601 5.0948 1.0800 0.2593 5.0853 1.0792 0.2588 5.0787 1.0772 0.2577 5.064460 month 1.4923 0.3047 5.1826 1.4897 0.3032 5.1651 1.4882 0.3022 5.1532 1.4844 0.3000 5.127048 month 0.9503 0.1208 2.7309 0.9471 0.1198 2.7201 0.9445 0.1190 2.7113 0.9402 0.1177 2.696536 month 0.8009 0.0656 1.8596 0.7996 0.0652 1.8556 0.7986 0.0650 1.8524 0.7968 0.0644 1.846524 month 0.3058 -0.0231 0.6939 0.3058 -0.0231 0.6939 0.3060 -0.0231 0.6941 0.3065 -0.0230 0.6947

3 month 1 year 2 year 3 year

5 year 7 year 10 year 20 year

After reviewing the above data sets, it has become clear that CAPM analysis for

Dow will not yield reliable results. The 24-72 month regressions are used for a clear

snapshot point in time to show the yield to maturity. While performing the regression


analysis (in appendix), we determined to exclude the two and twenty year data sets.

We excluded year two because the year one data set and the year three data set

showed enough data we needed within that time span. The unreliable results are due

to the instability of the beta calculations and the overall low r2 that is the measure of

how much of the overall risk can be explained by the company. Unfortunately, during

recent years, the stock market has drifted away from high adjusted r2 confidence levels

and the 30.81% that we have for our chosen beta is actually pretty good. The most

reliable beta that we found turned out to be 1.5 based on the 5 year–3 month data set.

This is almost twice of the published beta of .8 found on finance.yahoo.com. In

reviewing the tables, we found that this beta comes from the 3 year–1 year data set.

Looking ahead, the beta shows to stay consistent with possibilities with slight

decreases. Oddly, this correlates with the lowest adjusted r2, above 0, instead of the

highest. This would virtually eliminate all but the market risk, but not give an accurate

view of the true company risk involved.

In recent years, we have begun to see a trend in the stock market of lower

adjusted r2 numbers being found. This leads to the conclusion, that as the financial

world changes and become more global, the individual businesses have less control

over their risk free rates.

After finding Dow’s Ke, we can now plug in the other values to compute WACC. The

weighted average cost of capital is comprised of the weights of both debt and equity

with their respective discount rates.

Weighted Average Cost of Capital

WACC bt= (Vd/Vf) Kd + (Ve/Vf) Ke

The first component, Vd/Vf, is the weight of debt financing that was acquired

outside the firm at a discount rate of Kd. The weight of equity financing, Ve/Vf, is


acquired at a rate of Ke. These 2 separate forms of financing are added together to

form the cost of capital for a firm on a before tax-basis.

WACC bt= (28,516/45,581) .0589 + (17,065/45,581) .148

WACC bt=9.23%

WACC AT= (Vd/Vf) (Kd(1-T)) + (Ve/Vf) Ke

In calculating Dow’s WACC after-tax, we took our weighted average of portion of

debt, and multiplied it by the corporate tax rate of 35%.

WACC AT= (28,516/45,581) (.0589(.65)) + (17,065/45,581) .148

WACC AT= 7.94%

As you can see above we took the total market value of debt of the firm and

divided it by the market value of the firm (Equity + Debt), and then multiplied it by our

Kd of .0589. From there we took the total value of equity over the total market value

of the firm and multiplied it by our Ke of .148. Once we calculated this equation we got

our before tax WACC of 9.23%. After we calculated the before tax WACC we went

ahead and calculated our after tax WACC of 7.49% by subtracting (1-tax rate).

Method of Comparables

A quick screening tool that investors used when assessing whether or not a given

stock is fairly value is the method of comparables. Essentially, this method compiles

various stock value-based ratios of a company’s competitors to obtain an industry

average. Once this average is found, we use that ratio to derive an expected value for

the company. A few of Dow’s competitors that we used in method include Lyondell,

DuPont, and Huntsman. It is important to note that some competitors where left out of

certain ratios due to the fact that their ratios where too extreme in value and therefore

where deemed as “outliers”.


Trailing Price to Earnings

To get this ratio, we first took the most recently reported share price for Dow

and its competitors. When then took those given share prices and divided them by their

respective past twelve-month earnings per share.

EPS PPS

P/E-

Trailing

HUN 0.986 18.97 19.25

DD 3.39 48.71 14.73

LYO 0.711 25.57 35.94

INDUSTRY

AVERAGE 23.19

DOW 3.869 39.9 10.31

EXPECTED

PRICE 89.72

ACTUAL PRICE 39.9

Once an industry average of the competitors was computed (23.19), we

multiplied that value to the Earnings per Share value of Dow and found an estimated

share price of $89.72; an amount that is more than double the actual share price of

$39.90. This led us to believe Dow is considerably undervalued. The reason why there

is such an extraneous difference between the two values is likely attributable to Dow

considerably higher Earnings per Share than its competitors.

Forecasted Price to Earnings

This method is similar to the Trailing Price to Earnings Ratio in the respect that is

uses the currently listed share price. The difference in the two methods is that the


Trailing method divides the given price per share (PPS) by the past twelve-month

earnings while the Forecasted P/E divides the PPS by the expected earnings per share

(which was found when we forecasted the income statement). It is important to note

that Lyondell was not used in the industry average since its past earnings growth rate

were negative for three consecutive years, making impossible to forecast their expected

future earnings.

EPS PPS

P/E-

Forecasted

HUN 2.19 18.97 8.65

DD 4.22 48.71 11.55

LYO N/A

INDUSTRY

AVERAGE 10.1

DOW 3.56 39.9 11.22

EXPECTED 35.96

ACTUAL 39.9

Once we compare the results of both Dow Chemical share price ($39.90) and the

expected price of $35.96, we see that the firm is fairly value due to the fact the

difference between the due values is within 10% of the original stock price.

Price to Book

This method compares the market value of a given firm to its book value. This

ratio is found by taking the currently listed share price and dividing that value by the

company’s book value per share (found on the most recent 10-K).


BVPS PPS P/B

HUN 7.448 18.97 2.55

DD 10.146 48.71 4.8

LYO 12.19 25.57 2.1

INDUSTRY

AVERAGE 3.15

DOW 17.73 39.9 2.25

EXPECTED 55.86

ACTUAL 39.9

Once we derived an industry average of 3.15, we multiplied this value by Dow’s

most recent Book Value per Share of (BVPS) to get an estimated price of $55.86. When

this estimated price is compared with Dow’s most recent price per share of $39.90, we

see that Dow is undervalued in this method.

Dividend Yield

In this ratio, we analyze how much a given share generates dividends relative to

its market value. To find this ratio, we take a share’s dividend payout for a given year

and divide that amount by the current price per share. It should be noted that

Huntsman is a non-dividend paying firm; therefore, we did not include them in the

industry average.


DIVIDEND PPS D/P

HUN N/A

DD 1.48 48.71 0.0303

LYO 0.9 25.57 0.0352

INDUSTRY

AVERAGE 0.0328

DOW 1.5 39.9 0.0375

EXPECTED 45.73

ACTUAL 39.9

Once we found the industry average, we took that value and divided it into

Dow’s Dividend per Share and came up with an estimated value of $45.73. Once we

compared this expected value with the actual share price of $39.90, we see that Dow

Chemical is slightly undervalued according to this method.

P.E.G.

The Price Earnings Growth model (PEG) is used to estimate a given stock value

while taking into account the expected future earnings of that stock. The PEG value is

found by taking the current Price to Earnings Ratio (P/E) and dividing it by the

estimated earnings per share (EPS) growth rate. When we try to apply the PEG to

Dow’s competitors, we found that this method was a bit difficult. Lyondell has

previously had negative earnings growth rate for consecutive years and Huntsman has

(until recently) been operating with negative net income from the years of 2002 till

2005, making it impossible to find the two companies earnings growth rate. Therefore,

we are left with DuPont as the only source to find an industry average for the PEG ratio.


GROWTH

RATE P/E PEG

HUN N/A

DD 18% 14.73 0.8183

LYO N/A

INDUSTRY AVERAGE 0.8183

DOW 7% 10.31 1.473

EXPECTED 22.16

ACTUAL 39.9

We found an industry average (i.e. DuPont) of 0.8183 and multiplied that

amount by Dow’s 7% growth rate. We then took that result and multiplied it by Dow

EPS to get an estimated share price of $22.16. When this value is compared with Dow’s

share price of $39.90, we observe the Dow is overvalued in regards to the PEG ratio

method. However, due to the fact that DuPont is the only firm to represent the entire

industry, this model does not prove to be a credible valuation in this example.

Price to EBITDA

This ratio is found by taking the stated share price of a firm and divide it by the

earnings before interest, taxes, depreciation and amortization expenses to get an

estimated share value of the company. To find Dow’s EBITDA, we used the information

provided on the income statement of the most recent 10-K. To find Dow’s competitors

PPS and EBITDA, we used the content listed on Yahoo! Finance. To simplify the data,

we put all the companies EBITDA in decimals according to billions.


EBITDA PPS P/EBITDA

HUN 0.7365 18.97 25.76

DD 3.789 48.71 12.86

LYO 1.069 25.57 23.92


DOW 5.588 39.9 7.14

EXPECTED 116.51

ACTUAL 39.9

After dividing the prices per share by their respective EBITDA’s, we took the

industry average of 20.85 and multiplied it by Dow’s EBITDA of 5.588 (in billions) to get

an estimated value of $116.51. Clearly, Dow is extremely undervalued. Due to the fact

the Dow seems to be the only firm in the industry that is producing extraordinarily

profits, the P/EBITDA ratio is flawed and therefore should not considered to be a

reliable source of valuation (at least in this example).

Price to Free Cash Flows

This ratio is used to determine an estimated share price by dividing a firm’s price

per share by the firm’s free cash flows of that year. Much like the P/EBITDA ratio

previously mentioned, we put the companies Free Cash Flows (FCF) into decimals

according to billions for simplicity. It is also important to note that Lyondell was not

computed in the industry average since it had an outflow of free cash flows (a negative

balance at years-end).


FCF PPS P/FCF

HUN 1.067 18.97 17.78

DD 2.391 48.71 20.372

LYO N/A


DOW 2.247 39.9 17.757

EXPECTED 42.86

ACTUAL 39.9

Once we found an industry average of 19.076, we took that amount and

multiplied it by Dow’s FCF (2006 net cash provided by operations and investing) to get

a value of $42.86. When we compare this result with Dow’s current market value of

$39.90, we see that the P/FCF ratio list Dow as a fairly valued firm.

Enterprise Value to EBITDA

Our last and final method used to estimate a firms share value is the EV/EBITDA

ratio. The Enterprise Value (EV) of a firm is “calculated as market capitalization plus

debt, minority interest and preferred shares, minus total cash and cash equivalents”

(Investopedia.com). The Enterprise Value’s of Dow’s competitors were found off of

Yahoo! Finance on November 28th, 2007 (note: both EV and EBITDA numbers are in

billions). To find this ratio, we simply took the Enterprise Value of a firm and divided it

by that firms Earnings before Interest, Tax, Depreciation and Amortization.


EBITDA EV EV/EBITDA

HUN 0.7365 7.233 9.821

DD 3.789 36.086 9.524

LYO 1.069 7.377 6.901


DOW 5.588 44.9 8.035

EXPECTED 48.89

ACTUAL 39.9

Once we had found the industry average, we took that amount and multiplied it

by Dow’s EBITDA to get a value of $48.89. When we compare this result with the

stated share price of $39.90, we see that the EV/EBITDA ratio list Dow as an

undervalued firm.

Method of Comparables Overview

Price

Relative to the

Market Value

($39.90/share)

Trailing Price to Earnings $89.72 Under

Forecasted Price to Earnings $35.96 Fair

Price to Book $55.86 Under

Dividend Yield $45.73 Slightly Under

Price Earnings Growth $22.16 Over

Price to EBITDA $116.51 Extremely Under

Price to Free Cash Flows $42.86 Fair

Enterprise Value to EBITDA $48.89 Under


When we averaged out the rankings of the comparable stock prices (excluding

the P/EBITDA outlier), we see that this firm falls between the ranges of undervalued

and slightly undervalued. As the table above indicates, the comparables valuation

method has proven the Dow Corporation as an undervalued firm; therefore, this

appraisal technique would advise any interested party to buy shares of this firm

immediately.

Intrinsic Model Valuations

A significant drawback the Method of Comparables is that they rely on an

industry average to benchmark their valuation. This valuation does not access the true

value of a firm if the company’s performance exceeds or under performs the industry

benchmark: therefore, instead of getting a true value of a firm, we get a number that

would perform on pair with industry standards. It is for this reason that Intrinsic

Valuations give a better overall picture of a single firm’s performance because it ignores

the industry benchmarking principle of the Comparables Method. In addition, these

valuations dissect a company from different angle in order to gain a better perspective

of the true value of the firm. The methods used were the discounted dividends model,

the free cash flows model, the residual income model, and the abnormal growth model.

Now, we will discuss each model used, and their importance in valuing Dow Chemical.

Discounted Dividends

The discounted dividends model values a firm by using the “firm’s equity as the

present value of forecasted future dividends” (Palepu). This means that shareholders

receive payoffs in the form of dividends, and the value of their equity is the present

value of the future dividends. In order to value the firm with this model, we must

discount the future dividends back to the present value. In order to compute this

model, the two essential elements needed are the forecasted dividends from the


financial statement, and a calculated cost of equity. This model, however, does not

prove to be reliable in regards of accurately valuing the equity because it is unknown

how a firm’s dividends will change over time.

To find the present value of dividends on a year-to-year basis, we multiplied

dividends by their corresponding present value factor, which we then totaled to find the

present value annual dividends. The terminal value of the perpetuity was then found

and dividing this number by one plus the cost of equity raised to the ten twelve’s, which

brought it back to its present value. The estimated price was the total present value of

the annual dividends plus the present value of the terminal perpetuity. To make this

value time consistent, the estimated price per share was multiplied by one plus the cost

of equity raised to the ten twelve’s. The sensitivity analysis reveals that the company is

overvalued using the cost of equity of .148 and a growth rate of zero. There are also

growth rates that cause the estimated prices to spike, especially with smaller cost of

equity. Since dividends, growth rates, treasury repurchases, and stock issuances are

impossible to determine, this valuation model losses it explanatory powers.

Discounted Free Cash Flows

The discounted free cash flows model uses the present value of future cash

flows by discounting them using the weighted average cost of debt. Unlike the

Growth Rate0 0.03 0.05 0.07 0.1

11.00% 39.72$ 49.80$ 62.12$ 86.76$ 308.52$ Ke 13.00% 35.47$ 42.52$ 50.17$ 62.91$ 113.89$

14.80% 32.53$ 37.94$ 43.40$ 51.65$ 76.92$ 17.00% 29.70$ 33.83$ 37.73$ 43.18$ 57.22$ 19.00% 27.65$ 31.00$ 34.02$ 38.06$ 47.47$

ub $43.89 Undervaluedlb 35.91$ Overvalued


discounted dividends model, this model uses cash flows instead of dividends to

determine the value of the firm’s equity.

This first step for this evaluation model is to find the free cash flows for the

company. This can be done by taking the forecasted cash from operations and

subtracting them from the cash from investing. Then we found the total present value

of annual free cash flows by multiplying the annual free cash flows by their present

value factor and summing them together. After finding the continuing value of the

perpetuity, we multiplied it by the present value factor to find the terminal value of the

perpetuity. The value of the firm was the present value of the terminal perpetuity that

was just found plus the total present value of the annual free cash flows. Estimated

market value of equity was then found by subtracting total liabilities for the value of the

firm, which was then divided by the number of shares outstanding to get the estimated

price per share.

The sensitivity analysis allows us to look at Dow’s share prices using different

before tax weighted cost of capital and growth rates. This model showed that Dow was

overvalued at their before tax WACC of .0923 with a 0 perpetuity growth. However,

with a .03 growth rate firm is fairly valued.

Residual Income

Growth Rate0 0.02 0.03 0.04 0.05

0.05 80.72$ 135.16$ 203.21$ 407.36$ N/A0.07 44.32$ 63.64$ 80.54$ 108.71$ 165.06$

WACC BT 0.09 24.64$ 33.55$ 40.24$ 49.61$ 63.66$ 0.0923 22.95$ 31.19$ 37.30$ 45.74$ 58.18$

0.1 17.90$ 24.31$ 28.89$ 35.00$ 43.55$ 0.12 8.03$ 11.60$ 13.98$ 16.96$ 20.78$



Out of all of the intrinsic valuation models, the residual income method proves to

be the most accurate and reliable. Due to the fact that its values are based on the

expected rate of return on future earnings, it proves to be a more credible model than

the other methods that base their evaluations on perpetuity amounts. Moreover, this

model places the largest emphasis of its share price on the current book value of

equity. It is for this reason that the residual model has the highest degree of

explanatory values. By forecasting out our net income for the next 10 years, we were

able to calculate our actual earnings per share. We then found our normal earnings per

share by taking our previous year book value of equity and multiplying it out by the cost

of equity. By subtracting our actual earnings by our expected earning, we found our

annual residual income. In order the discount them back to their present value, we

multiplied this number by its related present value factor, and then totaled them up.

The next step was to find the continuing terminal value of the perpetuity, which was

our RI year eleven divided by the cost of equity minus the growth rate. We then took

this number and multiplied it by the present value factor of year ten to find the terminal

value of the perpetuity. Then to find Dow’s estimated price per share, we added the

book value of liabilities plus the present value of the terminal perpetuity plus the total

present value of residual income and divided that number by our number of shares

outstanding, which we found to be 962.3 million on November 1, 2007.

Negative Growth Rate0% -10% -15% -30% -50%

11.0% 39.36$ 35.40$ 34.00$ 33.28$ 32.55$ 13.0% 30.02$ 28.62$ 28.29$ 27.77$ 27.46$

Cost of Equity 14.8% 24.20$ 23.95$ 23.89$ 23.79$ 23.72$ 17.0% 19.15$ 19.57$ 19.69$ 19.88$ 20.00$ 19.0% 15.85$ 16.52$ 16.71$ 17.04$ 17.26$



The above chart shows the sensitivity analysis of Dow’s share price based on the

residual income model. This sensitivity analysis shows how price would change at

various costs of equities and growth rates. This model assumes a negative growth rate

because of the theory that residual income converges to zero. As you can see our firm

is undervalued using this model since our observed share price was 39.90 on November

1, 2007, and there is only one number that is within 10 percent of this value.

Abnormal Earnings Growth

AEG can be found by using forecasted earnings or net income, as well as, annual

dividends paid. The next step would be to find a dividend reinvestment plan (DRIP)

income, which is found by multiplying the previous year’s dividends by the cost of

equity. From here, we added the earnings and DRIP to get cumulative dividend

earnings. Normal earnings were found by multiplying the previous year’s net income

with the cost of equity. By subtracting the cumulative dividends earnings by normal

earning, abnormal earnings were found. We knew these earnings were correct because

they matched the residual income check figures. To find the present value of the AEG,

we multiplied the AEG by the corresponding present value, and later totaled them up

and added them to the present value of the terminal perpetuity. Finally, we added this

number to the core earnings to find the total average earnings. The intrinsic value per

share was then found by dividing this number by the cost of equity, and then

multiplying this number by one plus the cost of equity raised to the ten twelve’s to find

the time consistent price.

Sensitivity AnalysisGrowth Rate

0% -10% -20% -30% -40%0.11 45.48$ 44.21$ 43.90$ 43.54$ 43.40$ 0.13 33.86$ 33.81$ 33.78$ 33.77$ 33.77$

Cost of Equity 0.148 27.21$ 27.54$ 27.68$ 27.76$ 27.80$ 0.17 21.81$ 22.26$ 22.47$ 22.59$ 22.66$ 0.19 18.46$ 18.90$ 19.11$ 19.24$ 19.31$



This sensitivity analysis was used to show how price would change if the cost of

equity and growth rate were altered. AEG is similar to the residual income model in

that it uses a negative growth rate, so it can move towards zero. After viewing the

results, it became clear that Dow Chemical is an overvalued company. By taking a look

at cost of equity and noticing that the smaller the number got, the closer Dow moved to

their actual share price, which further proves that they are overvalued.

Growth Rate0.11 0.12 0.13 0.14 0.15

ROE =.187 0.125 100.42$ 262.14$ N/A N/A N/A0.135 60.70$ 88.03$ 224.66$ N/A N/A

Ke 0.148 40.31$ 47.61$ 63.00$ 116.88$ N/A0.155 34.22$ 38.28$ 45.59$ 62.65$ 147.97$ 0.165 28.20$ 29.99$ 32.80$ 37.86$ 49.68$


Growth Rate0.11 0.12 0.13 0.14 0.15

Ke = .148 0.23 62.83 78.16 110.53 223.82 N/A0.21 52.36 63.95 88.42 174.08 N/A

ROE 0.19 41.88 49.74 66.32 124.34 N/A0.17 31.41 35.53 44.21 74.61 N/A0.15 20.94 21.32 22.11 24.87 N/A


ROE0.15 0.17 0.19 0.21 0.23

Growth = .13 0.125 N/A N/A N/A N/A N/A0.135 70.93$ 157.66$ 236.48$ 315.32$ 394.14$

Ke 0.148 22.11$ 44.21$ 66.32$ 88.42$ 110.53$ 0.155 16.00$ 31.99$ 47.99$ 63.98$ 79.98$ 0.165 11.51$ 23.02$ 34.53$ 46.04$ 57.54$



To find the long run return of equity, we first found the ROE for next ten years

by dividing the net income by the previous year’s book value of equity. We then

averaged this number out, which was the long run return on equity.

Ending BVE = Beginning BVE + Earning – Dividend

ROE= Net Income current / BVE of the previous year

Then to find the growth rate, we simply took the current BVE minus the previous BVE

and then divided by the previous BVE. We assumed that Dow’s ROE would hit a

plateau at around 15%.

Growth Rate = BVE current –BVE previous / BVE Previous

After viewing the results above, we noticed the decreasing growth rates of Dow’s book

value of equity. We assumed that it would on average hit a plateau at 11%.

Now that we had the long run return on equity and the long run growth rate of equity,

we were able to plug these numbers into the following equation

Value of Firm = BVE ( 1 + ((LR Return on Equity – Ke / (Ke – LR Growth Rate)))

Then, we divided this number by the number of shares outstanding (962.3) to

get the price per share. This gave us a share price of $18.64, which we to November 1,

to be $20.94. This shows that Dow is clearly overvalued. The only way Dow could be

ROE 0.2196 0.2111 0.2032 0.1958 0.1889 0.1826 0.1767 0.1712 0.1662 0.1615

Book Value of Equity 19353 21919.9 24793.8 28005.3 31588 35578.5 40017 44947.3 50417.4 56479.7

Growth of Equity 13.26% 13.11% 12.95% 12.79% 12.63% 12.48% 12.32% 12.17% 12.02%


fairly valued would be to have a ROE of 19 percent. Since the trend seems to be

headed to for a much smaller percentage, which does not seem feasible. Overall, the

sensitivity analysis showed that Dow Chemical is an overvalued firm.

Analyst Recommendation

After careful research of Dow Chemical, including a five forces analysis, industry

analysis, accounting analysis, financial analysis, forecasting models, valuation models,

and future financial statements it is in our opinion that we are slightly overvalued. From

this opinion we would advise to sell.

We came to theses conclusions from past financial statements, Dow’s 10-k, along

with three other competitors’ financial statements. These competitors include

Huntsman, DuPont, and Lyondell. Seeing that the chemical industry is highly

concentrated this requires key success factors that each competitor must follow in order

to gain a competitive advantage. Some of these include economies of scale, operating

efficiency, low input cost, efficient production, and most important research and

development.

According to our accounting ratios Dow is one of the leading competitors in the

industry. Besides working capital Dow holds the bar high for any competitor that exists

or chooses to enter the industry. However, where Dow falls short is the disclosure of

their financial information. In effect this created misleading numbers throughout their

financial statements as well as GAP. For Dow their disclosure has become worse where

as their competitors do a fair job of disclosing their financial information. Overall, for

their financial ratios Dow has had a positive outlook in the market when calculating

these.

When we looked at forecasting the statements we took a below average growth

rate of the past five years to determine future values. Looking back at the previous


trends it is in our opinion this was a good rate to use. Overall, we feel this was the best

rate we could get by getting the most accurate look into the company’s future.

Looking back in the past five years of the company there seems to be no real

evidence of any problems that have occurred. However, when looking at our residual

income model and our AEG model we came to the conclusion of the firm being

overvalued. Along with all other models there was a consistency of overvaluations.

Through much research it is in the opinion of the group that anyone holding Dow

stock to sell. As of November 1, 2007 the stated stock price was $39.90. After looking

at our valuation models the stock price stated for Dow should be $20.94. Comparing

these stock prices it is our opinion to sell this stock because of a prime selling

opportunity.


Appendix

Screening Ratio’s

Net Sales/Cash from sales 2002 2003 2004 2005 2006DOW 1.0091 1.0142 1.0302 1.0081 0.9972DD 0.9992 1.0141 1.0252 0.9644 1.0159HUN 0.9934 1.337 1.0536 0.9896 0.9785LYO 1.0137 1.0142 1.2321 1.0058 1.0226

Net Sales/Net A/R 2002 2003 2004 2005 2006DOW 5.0335 5.5029 5.4589 5.8424 6.1039DD 6.1807 6.4002 5.5921 6.8183 6.3255HUN 5.2644 6.2827 5.9943 7.1656 8.4811LYO 8.2374 8.4209 3.7897 11.095 10.253

Net Sales/Inventory 2002 2003 2004 2005 2006DOW 6.5611 8.0573 8.1019 8.706 8.1089DD 5.4448 6.5732 6.0904 5.6165 5.5497HUN 4.4447 11.606 7.5819 8.0742 6.9362LYO 9.4823 10.896 3.6726 11.229 9.8398

Asset Turnover 2002 2003 2004 2005 2006

DOW 0.6979 0.779 0.8753 1.0081 1.0777DD 0.6934 0.7289 0.7673 0.8002 0.8629

HUN 0.4946 0.7929 1.0089 1.1917 1.2485LYO 0.438 0.4953 0.3733 1.2331 1.2455

CFFO/OI 2002 2003 2004 2005 2006

DOW -3.389 2.1588 0.7034 0.6992 0.8355DD 1.0396 2.0499 1.1814 0.6149 0.8723

HUN 0.7808 1.2585 0.6877 1.3547 1.2126LYO 1.6609 -103 3.6381 0.8257 0.7549

Pension Expense / SGA 2002 2003 2004 2005 2006

DOW 3.5413 3.6412 3.8933 3.0829 2.6581DD 1.8921 1.6658 1.391 1.9358 1.7869

HUN 1.1662 1.0878 0.7454 0.9232 0.834 LYO 2.6875 2.7294 0.8571 0.3849 0.3613

CFFO/NOI 2002 2003 2004 2005 2006

DOW 0.1528 0.2659 0.1931 0.3305 0.3027DD 0.1836 0.2617 0.316 0.2466 0.3559

LYON 0.1219 0.0375 0.0491 0.2441 0.1336HUNT 0.0288 0.0444 0.0211 0.2086 0.22


2002 2003 2004 2005 2006 AverageIndustryLIQUIDITYCurrent Ratio 2.10 1.56 1.78 1.65 1.61 1.74Quick Asset Ratio 0.83 0.81 0.96 0.87 0.79 0.85A/R Turnover 7.68 7.91 6.01 8.14 8.42 7.63A/R Days 49.52 48.03 65.14 47.71 46.38 51.35Inventory Turnover 5.55 6.92 5.39 7.12 6.39 6.27Inventory Days 72.19 58.28 73.67 55.81 61.91 64.37Working Capital Turnover 7.14 6.97 5.23 7.67 8.03 7.01PROFITABILITYGross Profit Margin 15.26% 11.46% 14.33% 15.26% 15.20% 0.14Operating Expense Ratio 0.07 0.07 0.07 0.06 0.06 0.07Net Profit Margin -2.81% -1.04% 3.00% 5.07% 5.53% 0.02Asset Turnover 0.58 0.69 0.75 1.03 1.09 0.83Return on Assets 2.29% -0.78% 2.40% 4.64% 5.35% 0.03Return on Equity -8.93% 43.26% 24.99% 16.95% 18.58% 0.19CAPITAL STRUCTUREDebt to equity ratio 6.56 -8.05 -3.57 3.38 3.11 0.29Times interest earned 2.71 1.25 2.94 5.47 5.28 3.53Debt service margin 0.12 0.17 0.22 0.34 0.39 0.25IGR 2.28% 3.51% 4.22%

Dow ChemicalLIQUIDITYCurrent Ratio 1.28 1.38 1.51 1.63 1.62 1.49Quick Asset Ratio 0.53 0.63 0.76 0.84 0.75 0.70A/R Turnover 8.86 9.13 8.45 9.04 9.85 9.07A/R Days 41.19 39.98 43.20 40.39 37.06 40.36Inventory Turnover 5.65 6.96 6.91 7.20 6.85 6.71Inventory Days 64.59 52.46 52.84 50.72 53.25 54.77Working Capital Turnover 10.96 9.12 7.46 6.87 7.43 8.37PROFITABILITYGross Profit Margin 13.87% 13.65% 14.73% 17.34% 15.47% 0.15Operating Expense Ratio 0.06 0.04 0.04 0.03 0.03 0.04Net Profit Margin -1.22% 5.30% 6.96% 9.75% 7.58% 0.06Asset Turnover 0.70 0.78 0.88 1.01 1.08 0.89Return on Assets -0.95% 4.37% 6.68% 9.84% 8.11% 0.06Return on Equity -4.43% 18.86% 22.80% 29.46% 21.82% 0.18CAPITAL STRUCTUREDebt to equity ratio 4.19 3.57 2.74 2.00 1.67 2.83Times interest earned 3.14 3.19 6.16 10.36 9.07 6.39Debt service margin -0.04 0.05 0.23 0.49 0.52 0.25IGR 3.55% 6.88% 4.93%SGR 0.04 0.15 0.24 0.33 0.25 0.20

DupontLIQUIDITYCurrent Ratio 1.90 1.42 1.92 1.67 1.62 1.70Quick Asset Ratio 1.13 0.58 1.06 0.89 0.89 0.91A/R Turnover 6.18 6.40 5.59 5.55 5.28 5.80A/R Days 59.05 57.03 65.27 65.78 69.19 63.27Inventory Turnover 3.79 4.27 4.62 4.39 3.98 4.21Inventory Days 96.21 85.52 78.93 83.12 91.63 87.08Working Capital Turnover 3.77 4.98 3.76 5.34 5.56 4.68PROFITABILITYGross Profit Margin 26.98% 23.10% 23.82% 26.11% 25.46% 0.25Operating Expense Ratio 0.12 0.11 0.11 0.12 0.12 0.12Net Profit Margin -4.59% 3.60% 6.51% 7.72% 11.48% 0.05Asset Turnover 0.69 0.73 0.77 0.80 0.86 0.77Return on Assets -2.74% 2.81% 4.81% 5.77% 9.46% 0.04Return on Equity -12.17% 9.95% 15.65% 22.94% 33.41% 0.14CAPITAL STRUCTUREDebt to equity ratio 2.55 2.74 2.03 2.66 2.33 2.46Times interest earned 6.92 1.41 4.98 7.88 8.24 5.89Debt service margin 0.43 0.58 0.58 0.37 0.62 0.52IGR 1.02% 1.73% 5.32%

LyondellLIQUIDITYCurrent Ratio 1.85 1.94 1.94 1.68 1.60 1.80Quick Asset Ratio 1.15 1.27 1.04 0.88 0.82 1.03A/R Turnover 9.59 9.77 4.00 10.82 10.08 8.85A/R Days 38.04 37.35 91.19 33.74 36.21 47.31Inventory Turnover 8.42 10.35 3.37 9.95 8.75 8.17Inventory Days 43.33 35.27 108.15 36.67 41.70 53.02Working Capital Turnover 6.06 5.40 2.69 9.74 10.78 6.94PROFITABILITYGross Profit Margin 11.16% -0.67% 6.18% 2.44% 5.37% 0.05Operating Expense Ratio 0.05 0.05 0.05 0.03 0.03 0.04Net Profit Margin -4.54% -8.47% 0.93% 3.14% 0.89% -0.02Asset Turnover 0.44 0.47 0.36 1.12 1.17 0.71Return on Assets -2.21% -4.05% 0.71% 3.33% 1.23% 0.00Return on Equity -12.55% -26.12% 1.92% 17.65% 5.83% -0.03CAPITAL STRUCTUREDebt to equity ratio 5.32 5.60 4.67 4.04 4.60 4.85Times interest earned 0.45 -0.04 0.20 1.95 1.69 0.85Debt service margin 0.07 0.02 0.05 0.27 0.15 0.11IGR -0.96% 1.94% -0.24%

HuntsmanLIQUIDITYCurrent Ratio 3.37 1.49 1.74 1.64 1.61 1.97Quick Asset Ratio 0.53 0.77 1.00 0.86 0.73 0.78A/R Turnover 6.10 6.32 5.99 7.17 8.48 6.81A/R Days 59.79 57.75 60.89 50.94 43.04 54.48Inventory Turnover 4.31 6.10 6.67 6.92 5.98 5.99Inventory Days 84.62 59.88 54.75 52.73 61.08 62.61Working Capital Turnover 7.77 8.38 7.00 8.75 8.34 8.05PROFITABILITYGross Profit Margin 9.02% 9.74% 12.59% 15.13% 14.49% 0.12Operating Expense Ratio 0.06 0.06 0.07 0.06 0.07 0.06Net Profit Margin -0.89% -4.62% -2.40% -0.33% 2.18% -0.01Asset Turnover 0.49 0.79 1.01 1.19 1.25 0.95Return on Assets -0.43% -6.23% -2.61% -0.37% 2.59% -0.01Return on Equity -6.57% 170.38% 59.61% -2.28% 13.23% 0.47CAPITAL STRUCTUREDebt to equity ratio 14.19 -44.11 -23.73 4.82 3.85 -9.00Times interest earned 0.34 0.42 0.43 1.68 2.10 0.99Debt service margin 0.03 0.04 0.03 0.22 0.26 0.11IGR 0.00% -0.49% 2.43%

Core Financial Ratios


2002 2003 2004 2005 2006Z-score = 1.2 Working Capital 2519 3,578 5,384 6,741 6,608

Total Assets 39,562 41,891 45,885 43,934 45,581(+)

1.4Retained Earnings 9,520 9,994 11,527 14,719 16,987Total Assets 39,562 41,891 45,885 43,934 45,581

(+)3.3 EBIT 2,433 2,642 4,604 7,270 5,588

Total Assets 39,562 41,891 45,885 43,934 45,581(+)

0.6 MV of Equity 27,041.9 38,194.5 46,544.4 42,207.4 42,273.8BV of Liabilities 31,936 32,716 33,615 30,610 28,516

(+)1 Sales 27,609 32,632 40,161 46,307 49,124

Total Assets 39,562 41,891 45,885 43,934 45,581

2002 2003 2004 2005 2006Raw 0.0764 0.1025 0.1408 0.1761 0.174

0.3369 0.334 0.3517 0.4486 0.5218

0.2029 0.2081 0.3311 0.5223 0.4046

0.5081 0.7005 0.8308 0.8273 0.8895

0.6979 0.779 0.8753 1.008 1.0777

Weighted 2002 2003 2004 2005 20061.82 2.12 2.53 2.98 3.07

Altman Z-score


SUMMARY OUTPUT72 month

Regression StatisticsMultiple R 0.522630544R Square 0.273142686Adjusted R Square 0.26275901Standard Error 0.062363058Observations 72

ANOVAdf SS MS F Significance F

Regression 1 0.10230415 0.10230415 26.30501 2.48628E-06Residual 70 0.272240566 0.00388915Total 71 0.374544716

Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.0%Upper 95.0%Intercept 0.00556246 0.007389837 0.7527176 0.454144 -0.009176104 0.020301 -0.0091761 0.02030102X Variable 1 1.091787102 0.212872095 5.12884088 2.49E-06 0.667227102 1.5163471 0.6672271 1.5163471

SUMMARY OUTPUT60 Month




Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.0%Upper 95.0%Intercept 0.003122317 0.007750746 0.40284088 0.688546 -0.012392486 0.0186371 -0.0123925 0.01863712X Variable 1 1.500548991 0.287318972 5.22258931 2.5E-06 0.925417586 2.0756804 0.9254176 2.0756804




Regression 1 0.019918003 0.019918 7.650658 0.008143283Residual 46 0.119758089 0.00260344Total 47 0.139676092

Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.0%Upper 95.0%Intercept 0.002164357 0.00761353 0.28427777 0.777473 -0.013160883 0.0174896 -0.0131609 0.0174896X Variable 1 0.962856865 0.34810667 2.76598223 0.008143 0.262154492 1.6635592 0.2621545 1.66355924

Regression Analysis

3 Month






Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.0%Upper 95.0%Intercept -0.00063504 0.009521801 -0.0666936 0.947216 -0.01998567 0.0187156 -0.0199857 0.01871558X Variable 1 0.801510538 0.431639114 1.85689969 0.072007 -0.075685675 1.6787068 -0.0756857 1.67870675


Regression StatisticsMultiple R 0.141919467R Square 0.020141135Adjusted R Square -0.0243979Standard Error 0.043382824Observations 24



Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.0%Upper 95.0%Intercept 0.000302795 0.009332888 0.03244382 0.974411 -0.019052431 0.019658 -0.0190524 0.01965802X Variable 1 0.297271458 0.442060452 0.67246789 0.508288 -0.619505803 1.2140487 -0.6195058 1.21404872






Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0%Intercept 0.00582068 0.007386456 0.788021267 0.43334471 -0.008911138 0.02055251 -0.0089111 0.02055251X Variable 1 1.089495 0.212599921 5.124625612 2.527E-06 0.665477832 1.51351216 0.66547783 1.51351216










Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0%Intercept 0.00239629 0.007595451 0.315489574 0.75381687 -0.012892564 0.01768513 -0.0128926 0.01768513X Variable 1 0.96020364 0.347798967 2.760800721 0.0082546 0.26012064 1.66028664 0.26012064 1.66028664

1 Year






Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0%Intercept -0.0005036 0.009501034 -0.05300321 0.95803956 -0.019812009 0.01880484 -0.019812 0.01880484X Variable 1 0.80227758 0.431119246 1.860918034 0.07142164 -0.073862136 1.67841729 -0.0738621 1.67841729





Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0%Intercept 0.00029837 0.009318134 0.032020152 0.97474471 -0.019026259 0.019623 -0.0190263 0.019623X Variable 1 0.30154821 0.441565345 0.682907333 0.50179413 -0.614202261 1.21729869 -0.6142023 1.21729869

















3 Year




























5 Year








Regression StatisticsMultiple R 0.0086847R Square 7.542E-05Adjusted R Square -0.041588Standard Error 0.0477816Observations 26


Regression 1 4.13308E-06 4.1E-06 0.00181 0.96641409Residual 24 0.054793994 0.00228Total 25 0.054798127


















7 Year




























10 Year


SUMMARY OUTPUT36 MonthRegression StatisticsMultiple R 0.3027736R Square 0.0916718Adjusted R Square 0.0649563Standard Error 0.0552692Observations 36



Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.0%Upper 95.0%Intercept -0.0002829 0.009478665 -0.02984 0.976368 -0.01954582 0.0189801 -0.0195458 0.01898011X Variable 1 0.7986022 0.431116346 1.852405 0.072666 -0.0775316 1.674736 -0.0775316 1.67473604







References

1. Yahoo Finance: http://finance.yahoo.com

2. MSN Money: http://moneycentral.msn.com

3. Dow Chemical Website: www.Dow.com

4. Securities and Exchange Commission Website: http://www.sec.gov

5. Wikipedia: www.wikipedia.org

6. Palepu and Healy, Business Analysis and Valuation, Ohio: Thomson

Southwestern, 4th Edition, 2008.

7. Wall Street Journal Online: www.WSJ.com

8. Chemical Processing: www.chemicalprocessing.com/bluebook.pdf

9. John Bolte, BDP Chief Operating Officer: www.BDPoint.com

10. In-Class Ratio’s Handout (Alamo Distributing Co.)

11. InvestoPedia: www.investopedia.com

12. Dow Chemical 10-K (2002,2003,2004,2005,2006)

13. Huntsman Chemical 10-K (2002,2003,2004,2005,2006)

14. DuPont 10-K (2002,2003,2004,2005,2006)

15. Exxon Mobil 10-K (2002,2003,2004,2005,2006)

16. Lyondell Chemical Co. 10-K (2002,2003,2004,2005,2006)

Documents

Equity Valuation and Analysismmoore.ba.ttu.edu/ValuationReports/Fall2007/DowChemicals.pdf5 Yr (3 month) 0.3081 1.5 14.80% Intrinsic Valuations Discounted Dividends $32.53 Published