Ratio Analysis and Valuation - Babson Collegefaculty.babson.edu/halsey/acc7500/Ratio Analysis and... · PPT file · Web view2005-09-28 · Ratio Analysis and Valuation Valuation

© 2005 by Robert F. Halsey, all rights reserved

Ratio Analysis and Valuation Valuation theory

Discounted free cash flows Residual income

ROE disaggregation into RNOA and financial returns

ROE - Identifying and Computing Operating Working Capital and Operating Assets exercise

ROE Disaggregation (P&G) exercise Pfizer (PFE) valuation exercise

Margin and Turnover EVA


Approaches to valuation

Dividend discount model:

From the statement of cash flows,

d = NI + depreciation + OperCL - OperCA - OperLTA + Debt

Substitute cash flows for “d” to yield the free cash flow to equity model (FCFE) :

4)ek(14d

3)ek(13d

2)ek(12d

)ek(11d

0P

4)e(14FCFE

3)ek(13FCFE

2)ek(12FCFE

)ek(11FCFE

0Pk


RIt It - ke * BVt-1 First, define residual income (RI) as,

BVt = BVt-1 + It - dt Next, assume clean surplus updating of book value of stockholders’ equity:

dt = (1+ke)BVt-1-BVt+RIt Then, we can rewrite dividends as,

Finally, substituting dt in the dividend discount model yields,

Residual income stock price model

Residual income model

4)ek(1

4RI4)ek(1

3RI2)ek(1

2RI)ek(1

1RI0BV0V


Source: Parker Center for Investment Research, Cornell Univ.


FCF and RI models The FCF and RI models are theoretically

equivalent since both are derived from the dividend discount model. They will, therefore, yield the same valuation in a steady state (constant RNOA)

FCF defines value in terms of cash flows. RI defines value in terms of accrual accounting (earnings and book values)


Lower terminal value for ROPI version of RI model vs. DCF

)+)/(1NOA - V( + )+)/(1NOA - OI( + NOA = V 55

51-tt

5

=1t00 w5ww kk*k

5w5

5w k1k1 VFCF = V t

5

=1t0

Source: Prof. Peter D. Easton, Notre Dame University

TV is reduced by NOA in RI model

RI results in less terminal value component. Why?


BV *ekROEBV * BVBV*ek

BVIBV * ekIRI

Importance of ROE

So, given a level of book value, the spread of ROE over the cost of capital (ke) is central to the creation of shareholder value.


Spreads v. Market-to-Book For Dow Jones Industrials

ROE - Ke

UTX

MRK

MO

PGMMM

T

MCD

GE

BA

C

WMT

XOMHON

GM

JNJ

AXP

EK

MSFT

HPQ

IBM

DD

IP AA

JPM

INTC

KO

SBCDIS

-60 -50 -40 -30 -20 -10 0 10 20 30 40 50 60

HD

0

2

4

6

8

10

CATMar

ket V

alue

/Boo

k Va

lue


Source: Nissim and Penman, 2003


AvgNOASales * Sales

NOPAT RNOA

= PM * Turnover

ROE Disaggregation

ROE = RNOA + (FLEV * SPREAD)


ROE - Identifying and Computing Operating Working Capital and Operating Assets exercise

ROE Disaggregation (P&G) exercise

Pfizer (PFE) valuation exercise

Exercises

Cisco Systems, Inc


ROE Disaggregtion – P&G Profitability Ratios

Procter & Gamble 2003 2002 2001 2000

Gross profit margin .............................. 49.0%

($21,236 / $43,377)

47.8% ($19,249 /

$40,238)

43.7% ($17,142 /

$39,244)

46.1% ($18,437 /

$39,951)

Operating expense margin....................................................

30.9% ($13,383 /

$43,377)

31.2% ($12,571 /

$40,238)

31.6% ($12,406 /

$39,244)

31.2% ($12,483 /

$39,951)

Net operating profit margin1...................................................

12.5%

($7,853.689) / $43,377)

11.3%

($6,678.682) / $40,238

7.6%

($4,736.633) / $39,244

9.5%

($5,954.64) / $39,951

1 After-tax %................................................. 1-$2,344/$7,530

= .689) 1-$2,031/$6,383

= .682 1-$1,694/$4,616

= .633 1-$1,994/$5,536

= .64


ROE Disaggregtion – P&G Turnover Ratios

Procter & Gamble 2003 2002 2001

Accounts receivable turnover............................................................

14.16 ($43,377 / [($3,038 +

$3,090) / 2]

13.37 ($40,238 / [($3,090 +

$2,931) / 2]

13.44 ($39,244 / [($2,931 +

$2,910) / 2]

Average collection period ...............................................................

25.56 ($3,038/ [$43,377/ 365])

28.03 ($3,090/ [$40,238/ 365])

27.26 ($2,931/ [$39,244/ 365])

Inventory turnover .......................................... 6.24

($22,141 / [$3,640 + $3,456] / 2)

6.14 ($20,989 / [$3,456 +

$3,384] / 2)

6.43 ($22,102 / [$3,384 +

$3,490] / 2)

Average inventory days outstanding ............................................

60.01 ($3,640/ [$22,141/ 365])

60.10 ($3,456/ [$20,989/ 365])

55.88 ($3,384/[$22,102/ 365])

Long-term operating asset turnover 1 ...............................................

1.52 ($43,377/([$28,486 +

$28,610] / 2)

1.46 $40,238 / ([$28,610 +

$26,498] / 2)

1.55 $39,244 / ([$26,498 +

$24,2202] / 2)

Long-term net operating asset turnover 2 .........................................................

1.73 ($43,377/([$24799 +

$25,445] / 2)

1.74 $40,238 / ([$25,445 +

$20,759] / 2)

1.87 $39,244 / ([$20,759 +

$21,2942] / 2)

1 Net long-term operating assets

$43,706 - $15,220 =

$28,486

$40,776 - $12,166 =

$28,610

$34,387 - $10,889 =

$26,498

2 Net long-term net operating assets

$43,706 - $15,220 - $1,396 - $2,291 =

$24,799

$40,776 - $12,166 - $1,077 - $2,088 =

$25,445

$34,387 - $10,889 - $894 - $1,845 =

$20,759


ROE Disaggregtion – P&G ROE ComponentsProcter and Gamble 2003 2002 2001

After-tax % ........................................................ 1-($2,344/$7,530) = 0.689

1-($2,031/$6,383) = 0.682

1-($1,694/$4,616) = 0.633

Net operating profit after-tax (NOPAT)...........................................................

$7,853 0.689 = $5,411

$6,678 0.682 = $4,554

$4,736 0.633 = $2,998

Net operating assets (NOA) 1 ..........................

$43,706 - $300 - ($12,358 - $2,172) - $1,396 - $2,291 =

$29,533

$40,776 - $196 -($12,704 - $3,731) - $1,077 - $2,088=

$28,442

$34,387 - 212 -($9,846 - $2,233) - $894 - $1,845 =

$23,823

Net financial obligations (NFO)2 ..................... $2,172 + $11,475 - $300 = $13,347

$3,731 + $11,201 - $196 = $14,736

$2,233 + $9,792 - $212 = $11,813

Stockholders’ equity ....................................... $16,186 $13,706 $12,010


ROE Disaggregtion – P&G ROE ComponentsProcter and Gamble 2003 2002 2001 1. Net operating profit margin

(NOPM) 12.474%

($5411 / $43,377) 11.318%

($4,554 / $40,238) 7.639%

($2,998 / $39,244)

2. Return on net operating assets (RNOA)

18.667% $5,411 / ([$29,533 +

$28,442] / 2)

17.427% $4,554 / ([$28,442 +

$23,823] / 2)

12.446% $2,998 / ([$23,823 +

$24,355] / 2)

3. Financial leverage (FLEV) 93.948% ([$13,347 + $14,736 ] / 2) /

([$16,186 + $13,706] / 2)

103.239% ([$14,736 + $11,813] / 2) / ([$13,706 + $12,010] / 2)

98.288% ([$11,813 + $12,068] / 2) / ([$12,010 + $12,287] / 2)

4. Net financial rate (NFR) 1.585% ($561 - $238) .689 /

([$13,347 + $14,736] / 2)

1.516% ($603 - $308) .682 /

([$14,736 + $11,813] / 2)

0.636% ($794 - $674) .633 /

([$11,813 + $12,068] / 2)

5. Spread 17.082% (18.667% - 1.585%)

15.911% (17.427% - 1.516%)

11.810% (12.446% - 0.636%)

6. Return on equity (ROE) 34.698% $5,186 /

([$16,186 + $13,706] / 2)

33.847% $4,352 /

([$13,706 + $12,010] / 2)

24.052% $2,922 /

([$12,010 + $12,287] / 2)

7. ROE formula computation 18.667% + (93.948% x 17.082%) = 34.715%

17.427% + (103.239% x 15.911%) = 33.853%

12.446% + (98.288% x 11.810%) = 24.054%


ROE Disaggregtion – P&G Liquidity and Solvency

Procter and Gamble 2003 2002 2001 2000 Current ratio (current assets / current liabilities) 1.23 0.96 1.11 1.00

Quick ratio (quick assets / current liabilities) 0.75 0.53 0.55 0.44

Procter and Gamble 2003 2002 2001 2000 Total liabilities-to-equity...................................... 1.7 2.0 1.9 1.8

Times interest earned .......................................... 14.42 11.59 6.81 8.67


ROE Disaggregtion – P&G Altman Z-ScoreThe Altman Z-Score for P&G as of 2003 is:

Z= 0.717 X1 + 0.847 X2 + 3.107 X3 + 0.420 X4 + 0.998 X5 = 2.12 where,

X1 = Working capital/ Total assets X2 = Retained earnings/Total assets X3 = Earnings before interest and taxes /Total assets X4 = Equity/ Total liabilities X5 = Sales/ Total assets

0.717 x 0.065=0.047 0.847 x 0.313=0.265 3.107 x 0.185=0.575 0.420 x 0.588=0.247 0.998 x 0.992=0.990

Z-Score =2.124

P&G’s Z-score is in the gray area—the prediction is inconclusive.


PG 5-Year Stock Price Trend

Forecast Horizon Terminal YearYear 2004 2005 2006 2007 2008 2009(in $ Million)Beginning of the Year Balance SheetBeg Net Working Capital 6,084 8,396 9,529 10,816 12,276 12,706 13,150Beg Net Long-Term Assets 87,034 120,107 136,321 154,725 175,613 181,759 188,121Total Assets 93,118 128,503 145,851 165,541 187,889 194,465 201,271

Beg. Net Debt 27,741 38,283 43,451 49,317 55,974 57,933 59,961Beg. Shareholders Equity 65,377 90,220 102,400 116,224 131,914 136,531 141,310Total Net Capital 93,118 128,503 145,851 165,541 187,889 194,465 201,271

Income Statement for the YearSales 54,226 62,359 70,778 80,333 91,178 94,369 97,672Net operating profits after tax (NOPAT) 10,174 11,700 13,280 15,073 17,108 17,706Net interest after tax 1,387 1,914 2,173 2,466 2,799 2,897Net income 8,787 9,786 11,107 12,607 14,309 14,810

ComputationsNOPAT 10,174 11,700 13,280 15,073 17,108 17,706Beginning net operating assets 93,118 128,503 145,851 165,541 187,889 194,465WACC 0.0583 0.0583 0.0583 0.0583 0.0583 0.0583Expected NOPAT 5,427 7,490 8,501 9,648 10,951 11,334ROPI 4,747 4,211 4,779 5,424 6,157 6,372

Discount factor - based on WACC 0.9449 0.8929 0.8437 0.7972 0.7533 0.7118

Residual Oparating Income (ROPI) modelResidual operating income 4,747 4,211 4,779 5,424 6,157 6,372PV of residual operating income 4,486 3,760 4,032 4,325 4,638 4,536Cumulative PV ROPI 4,486 8,245 12,277 16,602 21,240Terminal value of abnormal NOPAT 206,159Beg. book value of assets 93,118Value of the firm - ROPI $320,517Value of debt $27,741Value of equity $292,776

$38.38

ComputationsNOPAT 10,174 11,700 13,280 15,073 17,108 17,706Chg in working capital -2,312 -1,133 -1,286 -1,460 -430 -445Chg in long-term assets -33,073 -16,214 -18,403 -20,888 -6,146 -6,362Free Cash Flow to the Firm (FCFF) -25,211 -5,647 -6,410 -7,275 10,532 10,900

Discounted Cash Flow (DCF) modelPresent value of FCF to the firm (FCFF) -23,822 -5,042 -5,408 -5,800 7,934Cumulative PV FCFF -23,822 -28,865 -34,273 -40,073 -32,139PV of Terminal Value 352,656Value of the firm - FCFF $320,517Value of debt $27,741Value of equity $292,776

$38.38

Pfizer (PFE) valuation exercise


ROE DisaggregationEmpirical FindingsDefinition:ROE = RNOA + LEV × SpreadMedian 12.2% ≈ 10.3% + 0.40 × 3.3%

Companies are, on average, conservatively financed (LEV<1.0).

They earn, on average, a positive spread on borrowed monies.

RNOA is, on average, approximately 84% of reported ROE.

All industries that survive must earn a combination of operating and financial returns that meet shareholder expectations.


Behavior Over Time(Nissim and Penman 2001)

ROE

RNOA

NBC

1963-1996


ROCE v. Ke (Nissim and Penman 2001)


Margin vs. Turnover

Margin and Turnover Combinations for a Given RNOA

Entertainment

Printing & Publishing

Agriculture

Beer & LiquorTobacco

Apparel

HealthcarePharmaceuticals

Chemicals

TextilesConstruction Materials

Construction

Electrical Equipment

Autos & Trucks

Aircraft

DefensePrecious Metals

Coal

Petroleumand Natural Gas

UtilitiesCommunication

Computers

Transportation

Retail Restaurants

Banking Real Estate

0.00

0.50

1.00

1.50

2.00

2.50

3.00

3.50

0.00 0.02 0.04 0.06 0.08 0.10 0.12 0.14

Profit Margin

Ass

et T

urno

ver

RNOA=10.3%


Margin and Turnover Exercise

NOPAT margin vs. NOA turnover

0.00%2.00%4.00%6.00%8.00%

10.00%12.00%14.00%

0.00 1.00 2.00 3.00 4.00

Net operating asset tunrover rate

NOPA

T m

argi

n


Compare RI with Economic Value Added TM (“EVA”)

Under EVA,

MV = capital + PV of future EVA,

where EVA1 = NOPAT1 - kwacc*capital0


EVA Exercise Current Year Revenues............................................................. $11,400 Cost of goods sold ............................................... (6,000) Gross profit ......................................................... 5,400 Selling, general and administrative expenses ........ (4,000) Operating profit ................................................... 1,400 Interest expense................................................... (400) Pretax income...................................................... 1,000 Tax expense ........................................................ (350) Net income.......................................................... $ 650

Current Year

Prior Year

Current Year

Prior Year

Cash................................. $ 800 $ 500 Accounts payable.................... $ 800 $ 700 Accounts receivable.......... 1,200 1,000 Accrued liabilities ................... 1,250 1,000 Inventories ....................... 3,000 2,500 Total current liabilities ............ 2,050 1,700 Total current assets ........... 5,000 4,000 Long-term debt ....................... 6,000 5,000 Plant assets, net ................ 10,000 9,000 Total stockholders’ equity ....... 6,950 6,300 Total assets....................... $15,000 $13,000 Total liabilities and equity....... $15,000 $13,000

EVA = $($1,400*[1-0.35]) – ([$13,000-$1,700]×10%) = $910 - $1,130 = ($220)

RNOA = 8.05% ($910/[$13,000-$1,700]) < 10%. The deficit is 1.95% x $(13,000-1,700) = $(220) as above.


EVA Exercise – Areas for Improvement

Documents

Ratio Analysis and Valuation - Babson Collegefaculty.babson.edu/halsey/acc7500/Ratio Analysis and... · PPT file · Web view2005-09-28 · Ratio Analysis and Valuation Valuation