Equity Valuation and Analysis
Frank Puskarich: Frank.Puskarich@ttu.edu
Greg Garrison: Greg.Garrison@ttu.edu
JB Richter: Joseph.Richter@ttu.edu
Justin Matthews: Justin.Matthews@ttu.edu
Valued at: November 1, 2007
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
Dow Chemical Analysis Page 2 Executive Summary
Investment Recommendation:
Overvalued, Sell (11/1/07)
DOW-NYSE
Revenue(2006)
Market Cap
Shares Outstanding
Dividend Yield
3-month Avg. Daily Trading Vol.
Percent Institutional Ownership
Book Value per share
ROE
ROA
Cost of Capital
Ke Estimation
5 Yr (3 month)
Published Beta
Kd
WACC(bt)
WACC(at)
Dow Chemical Analysis $44.14
$49,124(M)
39.47(B)
962.3(M)
3.75%
5,632.49(M)
68.20%
$19.13
21.82%
8.11%
R Squared Beta
0.3081
0.8
5.89%
9.23%
7.94%
1.5
Altman's Z-score
2002
2003
1.82
2.12
2004
2.53
Financial Based Valuations
Trailing P/E:
Forward P/E:
P.E.G.:
P/B:
P/EBITDA:
P/FCF:
EV/EBITDA:
10.31
11.22
1.473
2.25
7.14
17.76
8.04
Ke
14.80%
14.80% Intrinsic Valuations
Discounted Dividends
Free Cash Flows
Residual Income
Abnormal Earnings Growth
2005
2.98
2006
3.07
$32.53
$22.95
$24.20
$27.21
Page 3 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).
Dow Chemical Analysis Page 4 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
Dow Chemical Analysis Page 5 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.
Dow Chemical Analysis Page 6 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
Dow Chemical Analysis Page 7 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
Dow Chemical Analysis Page 8 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)
LYO- Lyondell
HUN-Huntsman
DD-DuPont
XOM-Exxon Mobil
DOW- Dow Chemical
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.
Dow Chemical Analysis Page 9 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%
2.03%
18.62%
22.98%
18.03%
7.01%
Industry Sales
Growth
* 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 Chemical Analysis Page 10 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.
Dow Chemical Analysis Page 11 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
Dow Chemical Analysis Page 12 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.
Dow Chemical Analysis Page 13 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
LOW /
MODERATE
Bargaining Power of Suppliers
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
Dow Chemical Analysis Page 14 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
25.00%
20.00%
15.00%
i ndustry growth
10.00%
5.00%
0.00%
1
2
3
4
5
6
5.00%
*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.
Dow Chemical Analysis Page 15 Market Growth in Net Sales (Millions)
$60,000.00
$50,000.00
$40,000.00
DOW
HUN
$30,000.00
LYO
$20,000.00
DD
$10,000.00
$2001
2002
2003
2004
2005
2006
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.
Dow Chemical Analysis Page 16 Market Share within United States
50.00%
45.00%
40.00%
35.00%
30.00%
DOW
25.00%
HUN
20.00%
LYO
15.00%
DD
10.00%
5.00%
0.00%
2001
2002
2003
2004
2005
2006
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
Dow Chemical Analysis Aminoethylethanolamine
Page 17 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
Dow Chemical Analysis Page 18 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
Dow Chemical Analysis Page 19 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
Dow Chemical Analysis Page 20 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
Dow Chemical Analysis Page 21 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
Dow Chemical Analysis Page 22 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
Dow Chemical Analysis Page 23 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
Dow Chemical Analysis Page 24 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
Dow Chemical Analysis Page 25 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
Dow Chemical Analysis Page 26 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
Dow Chemical Analysis Page 27 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
Dow Chemical Analysis Page 28 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
Dow Chemical Analysis Page 29 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
Dow Chemical Analysis Page 30 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: streamlining 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
Dow Chemical Analysis Page 31 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
Dow Chemical Analysis Page 32 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
Dow Chemical Analysis Page 33 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 longheld 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
Dow Chemical Analysis Page 34 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
$’s in millions
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
Dow Chemical Analysis Page 35 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,
Dow Chemical Analysis Page 36 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
Dow Chemical Analysis Page 37 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 topof-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
Dow Chemical Analysis Page 38 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.
Dow Chemical Analysis Page 39 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.
Research and Development
Dow Chemical Analysis Page 40 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
Dow Chemical Analysis Page 41 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
Dow Chemical Analysis Page 42 policies. These variations can account for adjustments in a firms long term liabilities,
and inconsistencies associated with their expenses and net income.
Research and Development
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
Dow Chemical Analysis Page 43 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.
Property
Net Sales
Inventories
2001
2002
2003
2004
2005
2006
$
$
$
$
$
$
35,890
37,934
40,812
41,898
41,934
44,381
$
$
$
$
$
$
28,075
27,609
32,632
40,161
46,307
49,124
$
$
$
$
$
$
4,440
4,208
4,050
4,957
5,319
6,058
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
Dow Chemical Analysis Page 44 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,
Dow Chemical Analysis Page 45 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
Dow Chemical Analysis Page 46 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 longterm 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)
Year
Benefit Obligations at
Net Periodic Costs for the
December 31
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%
Dow Chemical Analysis Page 47 Ultimate health care cost trend
rate (assumed to be reached in
2011)
6%
6%
6%
6%
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
Effect on total of service and interest cost
$6
($3)
Effect on postretirement benefit obligation
$82
($55)
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
Dow Chemical Analysis Page 48 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 Performance Agricultural Basic
Plastics
Chemicals
Sciences
Basic
Hydrocarbons Unallocated
Plastics Chemicals and Energy
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
Dow Chemical Analysis Page 49 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
Dow Chemical Analysis Page 50 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
Dow Chemical Analysis Page 51 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
Dow Chemical Analysis Page 52 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.
DOW
DD
HUN
LYO
Net Sales/Cash from sales
2002
2003
2004
2005
1.01
1.01
1.03
1.01
0.99
1.01
1.03
0.96
0.99
1.34
1.05
0.99
1.01
1.01
1.23
1.01
2006
0.99
1.02
0.98
1.02
DOW
DD
HUN
Net Sales/Net A/R
2003
2004
5.50
5.46
6.40
5.59
6.28
5.99
2006
6.10
6.32
8.48
Dow Chemical Analysis 2002
5.03
6.18
5.26
2005
5.84
6.82
7.17
Page 53 LYO
DOW
DD
HUN
LYO
8.24
2002
6.56
5.45
4.45
9.48
8.42
3.79
11.10
10.25
Net Sales/Inventory
2003
2004
2005
8.06
8.10
8.71
6.57
6.09
5.62
11.61
7.58
8.07
10.89
3.67
11.23
2006
8.11
5.55
6.94
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)
Dow Chemical Analysis Page 54 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
Dow Chemical Analysis Page 55 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
Dow Chemical Analysis Page 56 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.
DOW
DD
HUN
LYO
DOW
DD
HUN
LYO
DOW
DD
HUN
LYO
DOW
DD
LYON
HUNT
Dow Chemical Analysis Asset Turnover
2002 2003 2004 2005
0.69
0.78
0.88 1.01
0.69
0.73
0.77 0.80
0.49
0.79
1.01 1.19
0.44
0.49
0.37 1.23
CFFO/OI
2002 2003 2004 2005
-3.39 2.1588 0.70 0.69
1.04 2.0499 1.18 0.62
0.78 1.2585 0.69 1.35
1.66
-103
3.64 0.83
Pension Expense / SGA
2002 2003 2004 2005
3.54
3.64
3.89 3.08
1.89
1.67
1.39 1.94
1.17
1.08
0.75 0.92
2.69
2.73
0.86 0.39
CFFO / NOA
2002 2003 2004 2005
0.15
0.27
0.19 0.33
0.18
0.26
0.32 0.25
0.12
0.04
0.05 0.24
0.03
0.04
0.02 0.21
2006
1.08
0.86
1.25
1.25
2006
0.84
0.87
1.21
0.76
2006
2.65
1.79
0.83
0.36
2006
0.30
0.36
0.13
0.22
Page 57 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
Dow Chemical Analysis Page 58 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
Dow Chemical Analysis Page 59 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 Ratio
2002
1.28
1.9
1.85
3.37
1.74
DOW
DD
LYO
HUN
Industry
2003
1.38
1.42
1.94
1.49
1.56
2004
1.51
1.92
1.94
1.74
1.78
2005
1.63
1.67
1.68
1.64
1.66
2006
1.62
1.62
1.6
1.61
1.61
Current Ratio
4
3.5
3
DOW
2.5
DD
2
LYO
1.5
HUN
Industry
1
0.5
0
2002
2003
2004
2005
2006
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
Dow Chemical Analysis Page 60 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 RATIO
2002
DOW
0.53
DD
1.13
LYO
1.15
HUN
0.53
INDUSTRY
0.84
Dow Chemical Analysis 2003
0.63
0.58
1.27
0.77
0.81
2004
0.76
1.06
1.04
1.00
0.97
2005
0.84
0.89
0.88
0.86
0.87
2006
0.75
0.89
0.82
0.73
0.80
Page 61 Quick Asset Ratio
1.40
1.20
DOW
1.00
DD
0.80
0.60
LYO
0.40
HUN
0.20
0.00
2002
2003
2004
2005
2006
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
Dow Chemical Analysis Page 62 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 TURNOVER
2002
DOW
5.65
DD
3.79
LYO
8.42
HUN
4.31
INDUSTRY
5.54
2003
6.96
4.27
10.35
6.10
6.92
2004
6.91
4.62
3.37
6.67
5.39
2005
7.20
4.39
9.95
6.92
7.12
2006
6.85
3.98
8.75
5.98
6.39
Inventory Turnover
12.00
10.00
DOW
8.00
DD
LYO
6.00
HUN
4.00
INDUSTRY
2.00
0.00
2002
2003
2004
2005
2006
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
Dow Chemical Analysis Page 63 preferred, in that this ratio shows the number of days a product sits on a company’s
shelf before it is sold.
DAYS SUPPLIES INVENTORY
2002
2003
DOW
64.59
52.46
DD
96.21
85.52
LYO
43.33
35.27
HUN
84.62
59.88
INDUSTRY
72.19
58.28
2004
52.84
78.93
108.15
54.75
73.67
2005
50.72
83.12
36.67
52.73
55.81
2006
53.25
91.63
41.7
61.08
61.92
Days Supplies Inventory
120
100
DOW
80
DD
60
LYO
40
HUN
20
0
2002
2003
2004
2005
2006
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
Dow Chemical Analysis Page 64 how efficient a company is in extending credit to its purchasers, as well as the
effectiveness of asset use.
A/R Turnover
2002
8.86
6.18
9.59
6.1
DOW
DD
LYO
HUN
2003
9.13
6.4
9.77
6.32
2004
8.45
5.59
4
5.99
2005
9.04
5.55
10.82
7.17
2006
9.85
5.28
10.08
8.48
A/R Turnover
12.00
10.00
DOW
8.00
DD
LYO
6.00
HUN
4.00
2.00
2002
2003
2004
2005
2006
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)
Dow Chemical Analysis Page 65 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 Receivables
2002
2003
DOW
41.19
39.98
DD
59.05
57.03
LYO
38.04
37.35
HUN
59.79
57.75
Industry
2004
43.2
65.27
91.19
60.89
2005
40.39
65.78
33.74
50.94
2006
37.06
69.19
36.21
43.04
51.35
Days Supply of Receivables
90.00
80.00
70.00
DOW
DD
60.00
LYO
50.00
HUN
40.00
30.00
2002
2003
2004
2005
2006
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
Dow Chemical Analysis Page 66 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 CYCLE
2002
DOW
105.78
DD
155.26
LYO
81.37
HUN
144.41
INDUSTRY
121.705
2003
92.44
142.55
72.62
117.63
106.31
2004
2005
96.04
91.11
144.2
148.9
199.34
70.41
115.64 103.67
138.805 103.523
2006
90.31
106.82
77.91
104.12
94.79
Cash to Cash Cycle
250
200
DOW
DD
150
LYO
100
HUN
INDUSTRY
50
0
2002
2003
2004
2005
2006
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)
Dow Chemical Analysis Page 67 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 TURNOVER
2002
2003
DOW
10.96
9.12
DD
3.77
4.98
LYO
6.06
5.4
HUN
8.29
8.49
INDUSTRY
7.27
7.00
2004
7.46
3.76
2.69
7.04
5.24
2005
6.87
5.34
9.74
8.84
7.70
2006
7.43
5.56
10.78
8.41
8.05
Working Capital Turnover
12
10
DOW
8
DD
6
LYO
HUN
4
INDUSTRY
2
0
2002
2003
2004
2005
2006
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.
Dow Chemical Analysis Page 68 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
Dow Chemical Analysis Page 69 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
DOW
DD
LYO
HUN
INDUSTRY
2002
13.87%
26.98%
11.16%
9.02%
15.26%
2003
13.65%
23.10%
-0.67%
9.74%
11.46%
2004
14.73%
23.82%
6.18%
12.59%
14.33%
2005
17.34%
26.11%
2.44%
15.13%
15.26%
2006
15.47%
25.46%
5.37%
14.49%
15.20%
Gross Profit Margin
30%
DOW
20%
DD
10%
LYO
0%
HUN
-10%
2002
2003
2004
2005
2006
INDUSTRY
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.
Dow Chemical Analysis Page 70 OPERATING PROFIT MARGIN
2002
0.09
0.10
0.05
0.02
0.07
DOW
DD
LYO
HUN
INDUSTRY
2003
0.08
0.02
-0.01
0.03
0.04
2004
0.11
0.07
0.01
0.03
0.06
2005
0.16
0.15
0.07
0.07
0.11
2006
0.11
0.14
0.05
0.07
0.09
Operating Profit Margin
0.18
0.16
0.14
DOW
0.12
DD
0.10
LYO
0.08
HUN
0.06
INDUSTRY
0.04
0.02
0.00
2002
2003
2004
2005
2006
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
Dow Chemical Analysis Page 71 by improving efficiency within production which would spread a lower cost over the
same sales base.
Operating Expense Ratio
DOW
DD
LYO
HUN
INDUSTRY
2002
0.06
0.12
0.05
0.06
0.07
2003
0.04
0.11
0.05
0.06
0.07
2004
0.04
0.11
0.05
0.07
0.07
2005
0.03
0.12
0.03
0.06
0.06
2006
0.03
0.12
0.03
0.07
0.06
Operating Expense Ratio
0.15
DOW
0.10
DD
0.05
LYO
HUN
0.00
INDUSTRY
2002
2003
2004
2005
2006
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)”.
Dow Chemical Analysis Page 72 Net Profit Margin
DOW
DD
LYO
HUN
INDUSTRY
2002
-1.22%
-4.59%
-4.54%
-0.89%
-2.81%
2003
5.30%
3.60%
-8.47%
-4.62%
-1.04%
2004
2005
2006
6.96% 9.75% 7.58%
6.51% 7.72% 11.48%
0.93% 3.14% 0.89%
-2.40% -0.33% 2.18%
3.00% 5.07% 5.53%
Net Profit Margin
15%
DOW
10%
DD
5%
LYO
0%
-5%
2002 2003 2004 2005 2006
HUN
INDUSTRY
-10%
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.
Dow Chemical Analysis Page 73 Asset Turnover
DOW
DD
LYO
HUN
INDUSTRY
2002
0.7
0.69
0.44
0.49
0.58
2003
0.78
0.73
0.47
0.79
0.69
2004
0.88
0.77
0.36
1.01
0.75
2005
1.01
0.8
1.12
1.19
1.03
2006
1.08
0.86
1.17
1.25
1.09
Asset Turnover
1.50
DOW
1.00
DD
0.50
LYO
HUN
0.00
INDUSTRY
2002
2003
2004
2005
2006
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
DOW
DD
LYO
HUN
INDUSTRY
Dow Chemical Analysis 2002
-0.95%
-2.74%
-1.99%
-0.43%
2.29%
2003
4.37%
2.81%
-3.96%
-3.66%
-1.56%
2004
2005
6.68% 9.84%
4.81% 5.77%
0.34% 3.52%
-2.42% -0.39%
1.83% 4.58%
2006
8.11%
9.46%
1.04%
2.72%
4.59%
Page 74 Return on Assets
15%
DOW
10%
DD
5%
LYO
0%
HUN
-5%
2002 2003 2004 2005 2006
INDUSTRY
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
DOW
DD
LYO
HUN
INDUSTRY
Dow Chemical Analysis 2002
-3.24%
-7.63%
-12.55%
-6.57%
-8.93%
2003
15.17%
10.74%
-26.12%
170.38%
43.26%
2004
20.88%
18.20%
1.92%
59.61%
24.99%
2005
2006
32.61% 25.68%
18.07% 9.46%
17.65% 5.83%
-2.28% 13.23%
16.95% 18.58%
Page 75 Return on Equity
60%
DOW
40%
DD
20%
LYO
0%
HUN
-20%
2002 2003 2004 2005 2006
INDUSTRY
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
Dow Chemical Analysis Page 76 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
4.19
2.55
5.32
14.19
6.56
DOW
DD
LYO
HUN
INDUSTRY
2003
3.57
2.74
5.6
-44.11
3.97
2004
2.74
2.03
4.67
-23.73
3.15
2005
2
2.66
4.04
4.82
3.38
2006
1.67
2.33
4.6
3.85
3.11
Debt to Equity
7
6
DOW
5
DD
4
LYO
3
HUN
2
INDUSTRY
1
0
2002
2003
2004
2005
2006
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
Dow Chemical Analysis Page 77 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 stockholders for the reason that if income from operations cannot cover the required interest
charges, than there can be no profits.
Times Interest Earned
DOW
DD
LYO
HUN
Industry
3.53
2002
3.14
6.92
0.45
0.34
2003
3.19
1.41
-0.04
0.42
2004
6.16
4.98
0.2
0.43
2005
10.36
7.88
1.95
1.68
2006
9.07
8.24
1.69
2.1
Times Interest Earned
9.00
7.00
DOW
5.00
DD
LYO
3.00
HUN
1.00
-1.00
2002
2003
2004
2005
2006
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
Dow Chemical Analysis Page 78 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
Z-score
2002
2003
2004
2005
2006
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
Dow Chemical Analysis Page 79 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.
Debt Service Margin
0.70
0.60
0.50
DOW
0.40
DD
0.30
LYO
0.20
HUN
0.10
0.00
-0.10
2002
DOW
DD
LYO
HUN
Industry
2003
2004
2005
2002
-0.04
0.43
0.07
0.03
2006
2003
0.05
0.58
0.02
0.04
2004
0.23
0.58
0.05
0.03
2005
0.49
0.37
0.27
0.22
2006
0.52
0.62
0.15
0.26
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
Dow Chemical Analysis Page 80 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.
IGR
DOW
DD
LYO
HUN
INDUSTRY
2004
3.55%
1.02%
-0.96%
0.00%
2.28%
2005
6.88%
1.73%
1.94%
-0.49%
3.51%
2006
4.93%
5.32%
-0.24%
2.43%
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
Dow Chemical Analysis Page 81 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.
Sustainable Growth Rate
2002
4%
2003
15%
2004
24%
2005
33%
2006
25%
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.
Dow Chemical Analysis Page 82 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 Analysis Page 83 Forecasted
Dow Chemical
(In mil ions, except per share amounts)
2001 2002 2003 2004 2005
2006 Assumed 2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
Income Statement
% increase % increase% increase % increase % increase
Sales 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 50
Purchased in-process research and development charges
Restructuring charges
543 114 591
Gain on asset divestitures
563
Total 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
280
Asbestos-related credit
828
177
Equity in earnings of nonconsolidated affiliates
40 322 923 964 959
Sundry income net
54 146 136 755 137
Interest income
66 92 86 138 185
Operating 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
774 828 747 702 616
(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)
Income before Income Taxes and Minority Interests
Provision for income taxes
(280) (82) 877 1,782 1,155
Minority interests' share in income
63 94 122 82 93
Income before Cumulative Effect of Change
in Accounting Principle
Cumulative effect of change in accounting
principle
Net Income Available for Common Stockholders
Share Data
Earnings before cumulative effect of change
in accounting
principle per common share basic
Earnings per common share basic
Earnings before cumulative effect of change
in accounting
principle per common share diluted
Earnings per common share diluted
Common stock dividends declared per share
of common stock
Weighted-average common shares outstanding
basic
Weighted-average common shares outstanding
Dow Chemical Analysis (405) 1,739 2,797 4,535 3,724
67
(9)
(20)
($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
($0.44) $1.89 $2.98 $4.71 $3.87
($0.37) $1.88 $2.98 $4.69 $3.87
($0.44) $1.88 $2.93 $4.64 $3.82
($0.37) $1.87 $2.93 $4.62 $3.82
$1.34 $1.34 $1.34 $1.34 $1.50
910.50 918.80 940.10 963.20 962.30
910.50 926.10 953.80 976.80 974.40
Page 84 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.
Dow Chemical Analysis Page 85 Balance Sheet
Assets
Current Assets
Cash and cash equivalents
Marketable securities and interest-bearing
deposits
Accounts and notes receivable:
Trade (net of allowance for doubtful receivables 2006:
$122; 2005: $169)
Other
Inventories
Deferred income tax
$1,484
89
13%
$2,392
42
18%
$3,108
84
20%
$3,806
32
22%
$2,757
153
16%
6.00% $
3,030.86
$
3,116
2,369
4,208
109
0.3699
11,375
3,574
2,356
4,050
698
0.3089
13,112
4,753
2,604
4,957
384
0.3120
15,890
5,124
2,802
5,319
321
0.3056
17,404
4,988
3,060
6,058
193
0.3520
17,209
$
5,903.55
$
6,703.12
35.00% $ 17,680.01
Investments
Investment in nonconsolidated affiliates
Other investments
Noncurrent receivables
1,565
1,689
577
1,878
1,971
230
2,698
2,141
189
2,285
2,156
274
2,735
2,143
288
Total investments
Total current assets
3,303.64
$
3,600.96
$
4,379.53
$
$
6,434.86
$
7,306.40
$
19,271.21
$
3,854.24
4,773.69
$
$
7,014.00
$
7,645.26
$
7,963.98
$
8,680.73
5,203.32
$
$
8,333.34
$
9,462.00
5,671.62
$
$
9,083.34
$
10,313.58
6,182.06
$
$
9,900.84
$
11,241.80
6,738.45
$
$
10,791.91
$
12,253.57
7,344.91
$
11,763.18
$
12,821.87
$
13,356.39
$
14,558.46
$ 21,005.61
$ 25,547.25
$ 27,846.50
$
30,352.69
$
33,084.43
$
36,062.03
$
39,307.61
$
42,845.30
$
$
$
5,569.30
$
6,070.54
$
6,616.89
$
7,212.41
$
7,861.52
$
8,569.06
66,972.34
$
72,999.85
$
79,569.83
3,831
4,079
5,028
4,715
5,166
Property
Property
Less accumulated depreciation
37,934
24,137
40,812
26,595
41,898
28,070
41,934
28,397
44,381
30,659
Net property
13,797
14,217
13,828
13,537
13,722
3,189
613
3,226
579
3,152
535
3,140
443
3,242
457
3,776
1,489
4,113
1,176
4,369
1,028
3,658
818
4,006
725
1,492
10,559
28,187
1,389
10,483
28,779
2,055
11,139
29,995
2,219
10,278
28,530
1,054
9,484
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
$
$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
$580
797
$258
1,088
$104
861
$241
1,279
$219
1,291
2,834
1,789
202
30
326
2,298
2,843
2,041
212
241
331
2,520
3,701
2,194
419
205
342
2,680
3,931
1,829
493
201
347
2,342
3,825
1,849
569
251
382
2,215
8,856
28%
11,659
9,534
29%
11,763
10,506
31%
11,629
10,663
35%
9,186
10,601
37%
8,036
$ 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
994
3,775
1,124
3,572
1,301
3,979
1,395
3,308
999
3,094
2,072
3,214
1,791
3,556
1,549
3,202
1,384
3,338
1,079
3,342
10,055
31%
366
10,043
31%
376
10,031
30%
449
9,425
31%
336
8,514
30%
365
$ 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
1,000
$31,936
1,000
$32,716
1,000
$33,615
1,000
$30,610
1,000
$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
2,453
2,453
2,453
2,453
2,453
(61)
9,520
(2,097)
(2,189)
8
(30)
9,994
(1,491)
(1,759)
274
(12)
11,527
(977)
(995)
661
(1)
14,719
(1,949)
(559)
830
0
16,987
(2,235)
(970)
$ 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
7,626
$39,562
9,175
$41,891
12,270
$45,885
15,324
$45,934
17,065
$45,581
$19,353 $
$ 50,514.30 $
21,919.93
55,060.59
$ 24,793.81
$ 60,016.04
$ 28,005.31
$ 72,992.14
$ 31,587.96
$ 79,561.43
$
$
35,578.47
86,721.96
$
$
40,016.94
94,526.94
$ 44,947.25
$ 103,034.37
Other Assets
Goodwill
Other intangible assets (net of accumulated
amortization 2006: $620; 2005: $552)
Deferred income tax assets noncurrent
Asbestos-related insurance receivables
noncurrent
Deferred charges and other assets
Total other assets
Total Noncurrent Assets
Total Assets
$35,515
7.00% $
3,536.00
4,201.12
5,109.45
Liabilities and Stockholders' Equity
Current Liabilities
Notes payable
Long-term debt due within one year
Accounts payable:
Trade
Other
Income taxes payable
Deferred income tax liabilities current
Dividends payable
Accrued and other current liabilities
Total current liabilities
Long-Term Debt
Other Noncurrent Liabilities
Deferred income tax liabilities noncurrent
Pension and other postretirement benefits
noncurrent
Asbestos-related liabilities noncurrent
Other noncurrent obligations
Total other noncurrent liabilities
Minority Interest in Subsidiaries
Preferred Securities of Subsidiaries
Total Liabilities
Stockholders' Equity
Common stock (authorized 1,500,000,000 shares
of $2.50 par value each; issued 981,377,562 shares)
Additional paid-in capital
Unearned ESOP shares
Retained earnings
Accumulated other comprehensive loss
Treasury stock at cost (2006: 23,326,570 shares;
2005: 14,221,354 shares)
Stockholders' equity
Total Liabilities and Stockholders' Equity
$ 50,417.37
$ 112,307.46
$ 56,479.71
$ 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.
Dow Chemical Analysis Page 88 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.
Dow Chemical Analysis Page 89 Cash Flow Statement
Operating Activities
Net Income Available for Common Stockholders
Adjustments to reconcile net income to
net cash provided by operating
activities:
Cumulative effect of change in accounting
principle
Depreciation and amortization
Provision for deferred income tax
Earnings of nonconsolidated affiliates
in excess of dividends received
Minority interests' share in income
Pension contributions
Net gain on sales of ownership interests
in nonconsolidated affiliates
Net gain on sales of investments
Net gain on sales of property, businesses
and consolidated companies
Other net (gain) loss
Gain on asset divestitures related to formation
of nonconsolidated affiliates
Restructuring charges
Asbestos-related credit
Tax benefit nonqualified stock option
exercises
Excess tax benefits from share-based payment
arrangements
Changes in assets and liabilities:
Accounts and notes receivable
Inventories
Accounts payable
Other assets and liabilities
($338)
$1,730
(67)
9
1,825
(311)
1,903
(378)
63
(180)
63
(4)
94
(235)
4
(60)
(2)
(8)
(65)
168
34
828
31
(299)
223
474
1
(28)
(10)
(102)
8
93
(575)
(34)
(100)
(33)
(56)
(19)
(130)
69
(563)
(29)
(12)
341
41
100
85
586
(177)
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
$
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
$ (2,437.62) $
475.21
$
517.98
$ (5,450.57) $
74.04
$
80.71
$
87.97
$
95.89
$
104.52
$
113.93
(11)
4,154
(1,333)
163
(1,597)
105
(1,775)
296
(263)
(109)
(208)
41
956
(208)
(111)
(103)
6
10
(1,827)
1,661
(1,400)
1,379
(1,405)
1,383
(653)
(1,096)
(1,907)
(152)
(1,285)
658
(15)
706
74
(1,559)
4
(68)
398
23
(1,359)
(57)
(1,252)
(70)
(1,287)
(57)
(1,404)
(1,100)
231
(10)
(533)
(71)
3
(80)
63
53
Cash and cash equivalents at end of year
82
(1,031)
(732)
4,474
(1,623)
79
(1)
Summary
Increase (Decrease) in cash and cash equivalents
Cash and cash equivalents at beginning
of year
122
(399)
(29)
2,670
632
Effect of Exchange Rate Changes on Cash
2,074
104
(343)
$
20
242
(758)
(129)
(515)
3,780
Cash used in financing activities
2,079
740
(469)
(469)
(240)
106
(135)
(448)
Financing Activities
Changes in short-term notes payable
Payments on long-term debt
Proceeds from issuance of long-term debt
Purchases of treasury stock
Proceeds from sales of common stock
Excess tax benefits from share-based payment
arrangements
Distributions to minority interests
Dividends paid to stockholders
2,088
255
(553)
(1,316)
(931)
1,252
(429)
2,108
Cash used in investing activities
$3,724
(322)
95
161
347
Investing Activities
Capital expenditures
Proceeds from sales of property, businesses
and consolidated companies
Acquisitions of businesses
Purchase of previously leased assets
Investments in consolidated companies
Investments in nonconsolidated affiliates
Distributions from nonconsolidated affiliates
Proceeds from sales of ownership interests
in nonconsolidated affiliates
Proceeds from asset divestitures related
to formation of nonconsolidated affiliates
Purchases of investments
Proceeds from sales and maturities of investments
89
$4,515
52
Cash provided by operating activities
39
(98)
$2,797
(149)
(6)
(129)
60
62
845
(1,799)
1,688
(1,732)
1,500
(1,626)
(1,676)
(510)
(472)
2,932
(6)
138
(78)
(1,217)
(285)
(857)
907
(6)
303
(58)
(1,229)
787
(1,225)
(1,397)
(2,508)
(3,302)
(5)
29
96
(172)
6
1,264
220
908
1,484
716
2,392
698
3,108
(1,049)
3,806
$1,484
$2,392
$3,108
$3,806
$2,757
(739)
223
11
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 longterm debt. We then assigned each liability line item a weight in reference to total
liabilities and multiplied them by their respected interest rates.
Dow Chemical Analysis Page 92 Cost of Debt
Liabilities
Source
Current Liabilities
Accounts Payable
Current Maturities of L-T Debt
Accrued Expenses & Liabilities
Income Tax Payable
Total Current Liabilities
Long-term Liabilities
Long-term Debt
Deffered Income Tax Liability
Total L-T Liabilities
Interest Rate(%) Weight
Fed
10_k
Fed
10-K
Estimate
10-K
Fed
Value
4.41
6.7
4.41
35
0.2079
0.0473
0.0811
0.0207
0.00917
0.00317
0.00358
0.00725
5,674
1,291
2,215
569
9,749
4.8
6.7
2.9
0.312
0.2944
0.0366
0.01498
0.01972
0.00106
8,514
8,036
999
17,549
0.05893
27,298
1
Total Liabilities
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.
72 month
60 month
48 month
36 month
24 month
72 month
60 month
48 month
36 month
24 month
X
1.0918
1.5005
0.9629
0.8015
0.2973
X
1.0817
1.4923
0.9503
0.8009
0.3058
3 month
adj r2
t-stat
0.2628 5.1288
0.3081 5.2226
0.1240 2.7660
0.0654 1.8569
-0.0244 0.6725
Ke
0.1480
X
1.0895
1.4985
0.9602
0.8023
0.3015
1 year
adj r2
t-stat
0.2624 5.1246
0.3080 5.2212
0.1235 2.7608
0.0657 1.8609
-0.0238 0.6829
5 year
7 year
2
2
adj r
t-stat
0.2601 5.0948
0.3047 5.1826
0.1208 2.7309
0.0656 1.8596
-0.0231 0.6939
X
1.0800
1.4897
0.9471
0.7996
0.3058
adj r
t-stat
0.2593 5.0853
0.3032 5.1651
0.1198 2.7201
0.0652 1.8556
-0.0231 0.6939
2 year
X
1.0859
1.4960
0.9570
0.8023
0.3045
3 year
adj r2
t-stat
0.2617 5.1156
0.3072 5.2121
0.1228 2.7534
0.0660 1.8638
-0.0233 0.6909
X
1.0841
1.4949
0.9548
0.8023
0.3056
10 year
X
1.0792
1.4882
0.9445
0.7986
0.3060
adj r2
t-stat
0.2611 5.1081
0.3065 5.2033
0.1222 2.7460
0.0660 1.8640
-0.0231 0.6936
20 year
2
adj r
t-stat
0.2588 5.0787
0.3022 5.1532
0.1190 2.7113
0.0650 1.8524
-0.0231 0.6941
X
1.0772
1.4844
0.9402
0.7968
0.3065
adj r2
t-stat
0.2577 5.0644
0.3000 5.1270
0.1177 2.6965
0.0644 1.8465
-0.0230 0.6947
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
Dow Chemical Analysis Page 93 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
Dow Chemical Analysis Page 94 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”.
Dow Chemical Analysis Page 95 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.
P/EEPS
PPS
Trailing
HUN
0.986
18.97
19.25
DD
3.39
48.71
14.73
LYO
0.711
25.57
35.94
INDUSTRY
AVERAGE
DOW
23.19
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
Dow Chemical Analysis Page 96 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.
P/EEPS
PPS
Forecasted
HUN
2.19
18.97
8.65
DD
4.22
48.71
11.55
LYO
N/A
INDUSTRY
AVERAGE
DOW
10.1
3.56
39.9
EXPECTED
35.96
ACTUAL
39.9
11.22
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).
Dow Chemical Analysis Page 97 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
3.15
AVERAGE
DOW
17.73
39.9
EXPECTED
55.86
ACTUAL
39.9
2.25
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.
Dow Chemical Analysis Page 98 DIVIDEND
PPS
HUN
D/P
N/A
DD
1.48
48.71
0.0303
LYO
0.9
25.57
0.0352
INDUSTRY
AVERAGE
DOW
0.0328
1.5
39.9
EXPECTED
45.73
ACTUAL
39.9
0.0375
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.
Dow Chemical Analysis Page 99 GROWTH
RATE
P/E
HUN
DD
N/A
18%
14.73
LYO
0.8183
N/A
INDUSTRY AVERAGE
DOW
PEG
0.8183
7%
10.31
EXPECTED
22.16
ACTUAL
39.9
1.473
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.
Dow Chemical Analysis Page 100 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
INDUSTRY AVERAGE
DOW
EXPECTED
ACTUAL
20.85
5.588
39.9
7.14
116.51
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).
Dow Chemical Analysis Page 101 FCF
PPS
P/FCF
HUN
1.067
18.97
17.78
DD
2.391
48.71
20.372
LYO
N/A
INDUSTRY AVERAGE
DOW
19.076
2.247
39.9
EXPECTED
42.86
ACTUAL
39.9
17.757
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.
Dow Chemical Analysis Page 102 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
INDUSTRY AVERAGE
DOW
8.749
5.588
44.9
EXPECTED
48.89
ACTUAL
39.9
8.035
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
Relative to the
Market Value
Price
($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
Dow Chemical Analysis Page 103 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
Dow Chemical Analysis Page 104 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.
Ke
11.00%
13.00%
14.80%
17.00%
19.00%
$
$
$
$
$
ub
lb
0
39.72
35.47
32.53
29.70
27.65
Growth Rate
0.03
$
49.80
$
42.52
$
37.94
$
33.83
$
31.00
$43.89
$
0.05
$
62.12
$
50.17
$
43.40
$
37.73
$
34.02
Undervalued
35.91 Overvalued
$
$
$
$
$
0.07
86.76
62.91
51.65
43.18
38.06
$
$
$
$
$
0.1
308.52
113.89
76.92
57.22
47.47
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
Dow Chemical Analysis Page 105 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.
WACC BT
0.05
0.07
0.09
0.0923
0.1
0.12
$
$
$
$
$
$
ub
lb
0
80.72
44.32
24.64
22.95
17.90
8.03
Growth Rate
0.02
0.03
$
135.16 $
203.21
$
63.64 $
80.54
$
33.55 $
40.24
$
31.19 $
37.30
$
24.31 $
28.89
$
11.60 $
13.98
$43.89 Undervalued
$
35.91 Overvalued
$
$
$
$
$
$
0.04
407.36
108.71
49.61
45.74
35.00
16.96
$
$
$
$
$
0.05
N/A
165.06
63.66
58.18
43.55
20.78
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
Dow Chemical Analysis Page 106 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
Cost of Equity
11.0%
13.0%
14.8%
17.0%
19.0%
$
$
$
$
$
ub
lb
0%
39.36
30.02
24.20
19.15
15.85
Negative Growth Rate
-10%
-15%
$
35.40 $
34.00
$
28.62 $
28.29
$
23.95 $
23.89
$
19.57 $
19.69
$
16.52 $
16.71
$43.89 Undervalued
$
35.91
$
$
$
$
$
-30%
33.28
27.77
23.79
19.88
17.04
-50%
32.55
27.46
23.72
20.00
17.26
$
$
$
$
$
Overvalued
outstanding, which we found to be 962.3 million on November 1, 2007.
Dow Chemical Analysis Page 107 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.
Cost of Equity
0.11
0.13
0.148
0.17
0.19
Sensitivity Analysis
Growth Rate
0%
-10%
$
45.48 $
44.21
$
33.86 $
33.81
$
27.21 $
27.54
$
21.81 $
22.26
$
18.46 $
18.90
ub
$43.89
lb
Dow Chemical Analysis $
-20%
$
43.90
$
33.78
$
27.68
$
22.47
$
19.11
Undervalued
35.91 Overvalued
$
$
$
$
$
-30%
43.54
33.77
27.76
22.59
19.24
$
$
$
$
$
-40%
43.40
33.77
27.80
22.66
19.31
Page 108 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.
ROE =.187
0.125
0.135
0.148
0.155
0.165
Ke
$
$
$
$
$
ub
lb
Ke = .148
$
0.11
62.83
52.36
41.88
31.41
20.94
0.23
0.21
0.19
0.17
0.15
ROE
Growth Rate
0.12
$ 262.14
$
88.03
$
47.61
$
38.28
$
29.99
Undervalued
35.91 Overvalued
0.11
100.42
60.70
40.31
34.22
28.20
$43.89
ub
lb
0.13
N/A
$ 224.66
$ 63.00
$ 45.59
$ 32.80
0.14
N/A
N/A
$ 116.88
$ 62.65
$ 37.86
Growth Rate
0.12
0.13
78.16
110.53
63.95
88.42
49.74
66.32
35.53
44.21
21.32
22.11
$43.89 Undervalued
$
35.91 Overvalued
0.15
N/A
N/A
N/A
$ 147.97
$ 49.68
0.14
223.82
174.08
124.34
74.61
24.87
0.15
N/A
N/A
N/A
N/A
N/A
ROE
0.15
Growth = .13
0.125
0.135
0.148
0.155
0.165
Ke
ub
lb
Dow Chemical Analysis 0.17
N/A
N/A
$ 70.93 $ 157.66
$ 22.11 $
44.21
$ 16.00 $
31.99
$ 11.51 $
23.02
$43.89 Undervalued
$ 35.91 Overvalued
0.19
N/A
$ 236.48
$
66.32
$
47.99
$
34.53
0.21
N/A
$ 315.32
$ 88.42
$ 63.98
$ 46.04
0.23
N/A
$ 394.14
$ 110.53
$ 79.98
$ 57.54
Page 109 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.
Book Value of Equity
19353 21919.9 24793.8 28005.3
31588 35578.5
40017 44947.3 50417.4 56479.7
Ending BVE = Beginning BVE + Earning – Dividend
ROE= Net Income current / BVE of the previous year
ROE
0.2196
0.2111
0.2032
0.1958 0.1889
0.1826
0.1767
0.1712
0.1662
0.1615
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
Growth of Equity
13.26% 13.11%
12.95% 12.79%
12.63% 12.48%
12.32% 12.17%
12.02%
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
Dow Chemical Analysis Page 110 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
Dow Chemical Analysis Page 111 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.
Dow Chemical Analysis Page 112 Net
2002
DOW 1.0091
DD
0.9992
HUN 0.9934
LYO 1.0137
2006
0.9972
1.0159
0.9785
1.0226
2002
DOW 5.0335
DD
6.1807
HUN 5.2644
LYO 8.2374
2006
6.1039
6.3255
8.4811
10.253
DOW
DD
HUN
LYO
2002
6.5611
5.4448
4.4447
9.4823
Sales/Cash from sales
2003
2004
2005
1.0142 1.0302 1.0081
1.0141 1.0252 0.9644
1.337 1.0536 0.9896
1.0142 1.2321 1.0058
Net Sales/Net A/R
2003
2004
2005
5.5029 5.4589 5.8424
6.4002 5.5921 6.8183
6.2827 5.9943 7.1656
8.4209 3.7897 11.095
Net Sales/Inventory
2003
2004
2005
8.0573 8.1019 8.706
6.5732 6.0904 5.6165
11.606 7.5819 8.0742
10.896 3.6726 11.229
Dow Chemical Analysis Appendix
Screening Ratio’s
2006
8.1089
5.5497
6.9362
9.8398
Asset Turnover
2002
2003
2004
2005
DOW 0.6979 0.779 0.8753 1.0081
DD
0.6934 0.7289 0.7673 0.8002
HUN 0.4946 0.7929 1.0089 1.1917
LYO
0.438 0.4953 0.3733 1.2331
CFFO/OI
2002
2003
2004
2005
DOW -3.389 2.1588 0.7034 0.6992
DD
1.0396 2.0499 1.1814 0.6149
HUN 0.7808 1.2585 0.6877 1.3547
LYO 1.6609 -103 3.6381 0.8257
Pension Expense / SGA
2002
2003
2004
2005
DOW 3.5413 3.6412 3.8933 3.0829
DD
1.8921 1.6658 1.391 1.9358
HUN 1.1662 1.0878 0.7454 0.9232
LYO 2.6875 2.7294 0.8571 0.3849
CFFO/NOI
2002
2003
2004
2005
DOW 0.1528 0.2659 0.1931 0.3305
DD
0.1836 0.2617 0.316 0.2466
LYON 0.1219 0.0375 0.0491 0.2441
HUNT 0.0288 0.0444 0.0211 0.2086
2006
1.0777
0.8629
1.2485
1.2455
2006
0.8355
0.8723
1.2126
0.7549
2006
2.6581
1.7869
0.834
0.3613
2006
0.3027
0.3559
0.1336
0.22
Page 113 Core Financial Ratios
2002
2003
2004
2005
2006 Average
2.10
0.83
7.68
49.52
5.55
72.19
7.14
1.56
0.81
7.91
48.03
6.92
58.28
6.97
1.78
0.96
6.01
65.14
5.39
73.67
5.23
1.65
0.87
8.14
47.71
7.12
55.81
7.67
1.61
0.79
8.42
46.38
6.39
61.91
8.03
1.74
0.85
7.63
51.35
6.27
64.37
7.01
15.26%
0.07
-2.81%
0.58
2.29%
-8.93%
11.46%
0.07
-1.04%
0.69
-0.78%
43.26%
14.33%
0.07
3.00%
0.75
2.40%
24.99%
15.26%
0.06
5.07%
1.03
4.64%
16.95%
15.20%
0.06
5.53%
1.09
5.35%
18.58%
0.14
0.07
0.02
0.83
0.03
0.19
6.56
2.71
0.12
-8.05
1.25
0.17
-3.57
2.94
0.22
2.28%
3.38
5.47
0.34
3.51%
3.11
5.28
0.39
4.22%
0.29
3.53
0.25
1.28
0.53
8.86
41.19
5.65
64.59
10.96
1.38
0.63
9.13
39.98
6.96
52.46
9.12
1.51
0.76
8.45
43.20
6.91
52.84
7.46
1.63
0.84
9.04
40.39
7.20
50.72
6.87
1.62
0.75
9.85
37.06
6.85
53.25
7.43
1.49
0.70
9.07
40.36
6.71
54.77
8.37
13.87%
0.06
-1.22%
0.70
-0.95%
-4.43%
13.65%
0.04
5.30%
0.78
4.37%
18.86%
14.73%
0.04
6.96%
0.88
6.68%
22.80%
17.34%
0.03
9.75%
1.01
9.84%
29.46%
15.47%
0.03
7.58%
1.08
8.11%
21.82%
0.15
0.04
0.06
0.89
0.06
0.18
4.19
3.14
-0.04
3.57
3.19
0.05
0.15
2.00
10.36
0.49
6.88%
0.33
1.67
9.07
0.52
4.93%
0.25
2.83
6.39
0.25
0.04
2.74
6.16
0.23
3.55%
0.24
1.90
1.13
6.18
59.05
3.79
96.21
3.77
1.42
0.58
6.40
57.03
4.27
85.52
4.98
1.92
1.06
5.59
65.27
4.62
78.93
3.76
1.67
0.89
5.55
65.78
4.39
83.12
5.34
1.62
0.89
5.28
69.19
3.98
91.63
5.56
1.70
0.91
5.80
63.27
4.21
87.08
4.68
26.98%
0.12
-4.59%
0.69
-12.17%
23.10%
0.11
3.60%
0.73
2.81%
9.95%
23.82%
0.11
6.51%
0.77
4.81%
15.65%
26.11%
0.12
7.72%
0.80
5.77%
22.94%
25.46%
0.12
11.48%
0.86
9.46%
33.41%
0.25
0.12
0.05
0.77
0.04
0.14
2.55
6.92
0.43
2.74
1.41
0.58
2.03
4.98
0.58
1.02%
2.66
7.88
0.37
1.73%
2.33
8.24
0.62
5.32%
2.46
5.89
0.52
1.85
1.15
9.59
38.04
8.42
43.33
6.06
1.94
1.27
9.77
37.35
10.35
35.27
5.40
1.94
1.04
4.00
91.19
3.37
108.15
2.69
1.68
0.88
10.82
33.74
9.95
36.67
9.74
1.60
0.82
10.08
36.21
8.75
41.70
10.78
1.80
1.03
8.85
47.31
8.17
53.02
6.94
11.16%
0.05
-4.54%
0.44
-2.21%
-12.55%
-0.67%
0.05
-8.47%
0.47
-4.05%
-26.12%
6.18%
0.05
0.93%
0.36
0.71%
1.92%
2.44%
0.03
3.14%
1.12
3.33%
17.65%
5.37%
0.03
0.89%
1.17
1.23%
5.83%
0.05
0.04
-0.02
0.71
0.00
-0.03
5.32
0.45
0.07
5.60
-0.04
0.02
4.67
0.20
0.05
-0.96%
4.04
1.95
0.27
1.94%
4.60
1.69
0.15
-0.24%
4.85
0.85
0.11
Industry
LIQUIDITY
Current Ratio
Quick Asset Ratio
A/R Turnover
A/R Days
Inventory Turnover
Inventory Days
Working Capital Turnover
PROFITABILITY
Gross Profit Margin
Operating Expense Ratio
Net Profit Margin
Asset Turnover
Return on Assets
Return on Equity
CAPITAL STRUCTURE
Debt to equity ratio
Times interest earned
Debt service margin
IGR
Dow Chemical
LIQUIDITY
Current Ratio
Quick Asset Ratio
A/R Turnover
A/R Days
Inventory Turnover
Inventory Days
Working Capital Turnover
PROFITABILITY
Gross Profit Margin
Operating Expense Ratio
Net Profit Margin
Asset Turnover
Return on Assets
Return on Equity
CAPITAL STRUCTURE
Debt to equity ratio
Times interest earned
Debt service margin
IGR
SGR
0.20
Dupont
LIQUIDITY
Current Ratio
Quick Asset Ratio
A/R Turnover
A/R Days
Inventory Turnover
Inventory Days
Working Capital Turnover
PROFITABILITY
Gross Profit Margin
Operating Expense Ratio
Net Profit Margin
Asset Turnover
Return on Assets
Return on Equity
CAPITAL STRUCTURE
Debt to equity ratio
Times interest earned
Debt service margin
IGR
-2.74%
Lyondell
LIQUIDITY
Current Ratio
Quick Asset Ratio
A/R Turnover
A/R Days
Inventory Turnover
Inventory Days
Working Capital Turnover
PROFITABILITY
Gross Profit Margin
Operating Expense Ratio
Net Profit Margin
Asset Turnover
Return on Assets
Return on Equity
CAPITAL STRUCTURE
Debt to equity ratio
Times interest earned
Debt service margin
IGR
Huntsman
LIQUIDITY
Current Ratio
Quick Asset Ratio
A/R Turnover
A/R Days
Inventory Turnover
Inventory Days
Working Capital Turnover
PROFITABILITY
Gross Profit Margin
Operating Expense Ratio
Net Profit Margin
Asset Turnover
Return on Assets
Return on Equity
CAPITAL STRUCTURE
Debt to equity ratio
Times interest earned
Debt service margin
IGR
Dow Chemical Analysis 3.37
1.49
1.74
1.64
1.61
0.53
6.10
59.79
4.31
84.62
7.77
0.77
6.32
57.75
6.10
59.88
8.38
1.00
5.99
60.89
6.67
54.75
7.00
0.86
7.17
50.94
6.92
52.73
8.75
0.73
8.48
43.04
5.98
61.08
8.34
1.97
0.78
6.81
54.48
5.99
62.61
8.05
9.02%
0.06
-0.89%
0.49
-6.57%
9.74%
0.06
-4.62%
0.79
-6.23%
170.38%
12.59%
0.07
-2.40%
1.01
-2.61%
59.61%
15.13%
0.06
-0.33%
1.19
-0.37%
-2.28%
14.49%
0.07
2.18%
1.25
2.59%
13.23%
0.12
0.06
-0.01
0.95
-0.01
0.47
14.19
0.34
0.03
-44.11
0.42
0.04
-23.73
0.43
0.03
0.00%
4.82
1.68
0.22
-0.49%
3.85
2.10
0.26
2.43%
-9.00
0.99
0.11
-0.43%
Page 114 Altman Z-score
Z-score =
2002
2519
39,562
2003
3,578
41,891
2004
5,384
45,885
2005
6,741
43,934
2006
6,608
45,581
9,994
41,891
11,527
45,885
14,719
43,934
16,987
45,581
2,642
41,891
4,604
45,885
7,270
43,934
5,588
45,581
38,194.5
32,716
46,544.4
33,615
42,207.4
30,610
42,273.8
28,516
32,632
41,891
40,161
45,885
46,307
43,934
49,124
45,581
2002
0.0764
2003
0.1025
2004
0.1408
2005
0.1761
2006
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
2002
2003
2004
2005
2006
1.2 Working Capital
Total Assets
(+)
1.4Retained Earnings 9,520
Total Assets
39,562
(+)
3.3
EBIT
2,433
Total Assets
39,562
(+)
0.6 MV of Equity 27,041.9
BV of Liabilities 31,936
(+)
1
Sales
27,609
Total Assets
39,562
Raw
Weighted
Dow Chemical Analysis 1.82
2.12
2.53
2.98
3.07
Page 115 Regression Analysis
3 Month
SUMMARY OUTPUT
72 month
Regression Statistics
Multiple R
0.522630544
R Square
0.273142686
Adjusted R Square
0.26275901
Standard Error
0.062363058
Observations
72
ANOVA
df
Regression
Residual
Total
Intercept
X Variable 1
1
70
71
SS
MS
0.10230415 0.10230415
0.272240566 0.00388915
0.374544716
Coefficients Standard Error
t Stat
0.00556246
0.007389837
0.7527176
1.091787102
0.212872095 5.12884088
F
Significance F
26.30501
2.48628E-06
P-value
0.454144
2.49E-06
Lower 95%
Upper 95% Lower 95.0% Upper 95.0%
-0.009176104
0.020301 -0.0091761 0.02030102
0.667227102 1.5163471 0.6672271
1.5163471
SUMMARY OUTPUT
60 Month
Regression Statistics
Multiple R
0.565553759
R Square
0.319851054
Adjusted R Square 0.308124348
Standard Error
0.057818637
Observations
60
ANOVA
df
Regression
Residual
Total
Intercept
X Variable 1
1
58
59
SS
MS
0.09118165 0.09118165
0.193893696 0.00334299
0.285075345
Coefficients Standard Error
t Stat
0.003122317
0.007750746 0.40284088
1.500548991
0.287318972 5.22258931
F
Significance F
27.27544
2.49541E-06
P-value
0.688546
2.5E-06
Lower 95%
Upper 95% Lower 95.0% Upper 95.0%
-0.012392486 0.0186371 -0.0123925 0.01863712
0.925417586 2.0756804 0.9254176
2.0756804
SUMMARY OUTPUT
48 Month
Regression Statistics
Multiple R
0.377625976
R Square
0.142601378
Adjusted R Square 0.123962277
Standard Error
0.051023884
Observations
48
ANOVA
df
Regression
Residual
Total
Intercept
X Variable 1
1
46
47
SS
MS
0.019918003
0.019918
0.119758089 0.00260344
0.139676092
Coefficients Standard Error
t Stat
0.002164357
0.00761353 0.28427777
0.962856865
0.34810667 2.76598223
Dow Chemical Analysis F
Significance F
7.650658 0.008143283
P-value
0.777473
0.008143
Lower 95%
Upper 95% Lower 95.0% Upper 95.0%
-0.013160883 0.0174896 -0.0131609
0.0174896
0.262154492 1.6635592 0.2621545 1.66355924
Page 116 SUMMARY OUTPUT
36 Month
Regression Statistics
Multiple R
0.303440599
R Square
0.092076197
Adjusted R Square 0.065372556
Standard Error
0.055256898
Observations
36
ANOVA
df
Regression
Residual
Total
Intercept
X Variable 1
1
34
35
SS
MS
F
Significance F
0.010528097
0.0105281 3.448076 0.072006621
0.103813043 0.00305332
0.11434114
Coefficients Standard Error
t Stat
P-value
Lower 95%
Upper 95% Lower 95.0% Upper 95.0%
-0.00063504
0.009521801 -0.0666936 0.947216
-0.01998567 0.0187156 -0.0199857 0.01871558
0.801510538
0.431639114 1.85689969 0.072007 -0.075685675 1.6787068 -0.0756857 1.67870675
SUMMARY OUTPUT
24 Month
Regression Statistics
Multiple R
0.141919467
R Square
0.020141135
Adjusted R Square
-0.0243979
Standard Error
0.043382824
Observations
24
ANOVA
df
Regression
Residual
Total
Intercept
X Variable 1
1
22
23
SS
MS
F
Significance F
0.000851096
0.0008511 0.452213 0.508287888
0.041405527 0.00188207
0.042256624
Coefficients Standard Error
t Stat
P-value
Lower 95%
Upper 95% Lower 95.0% Upper 95.0%
0.000302795
0.009332888 0.03244382 0.974411 -0.019052431
0.019658 -0.0190524 0.01965802
0.297271458
0.442060452 0.67246789 0.508288 -0.619505803 1.2140487 -0.6195058 1.21404872
Dow Chemical Analysis Page 117 1 Year
SUMMARY OUTPUT
72 Month
Regression Statistics
Multiple R
0.52231823
R Square
0.27281633
Adjusted R Square 0.26242799
Standard Error
0.06237706
Observations
72
ANOVA
df
Regression
Residual
Total
Intercept
X Variable 1
1
70
71
SS
MS
F
Significance F
0.102181915 0.102181915 26.2617877
2.52703E-06
0.272362801 0.003890897
0.374544716
Coefficients Standard Error
t Stat
P-value
0.00582068
0.007386456 0.788021267 0.43334471
1.089495
0.212599921 5.124625612 2.527E-06
Lower 95%
Upper 95% Lower 95.0% Upper 95.0%
-0.008911138 0.02055251 -0.0089111 0.02055251
0.665477832 1.51351216 0.66547783 1.51351216
SUMMARY OUTPUT
60 Month
Regression Statistics
Multiple R
0.56544947
R Square
0.31973311
Adjusted R Square 0.30800437
Standard Error
0.05782365
Observations
60
ANOVA
df
Regression
Residual
Total
Intercept
X Variable 1
1
58
59
SS
MS
F
Significance F
0.091148026 0.091148026 27.2606537
2.50841E-06
0.19392732 0.003343574
0.285075345
Coefficients Standard Error
t Stat
P-value
0.00345008
0.007734848 0.446043594 0.65722651
1.49846148
0.286997062 5.221173593 2.5084E-06
Lower 95%
Upper 95% Lower 95.0% Upper 95.0%
-0.012032901 0.01893306 -0.0120329 0.01893306
0.92397445 2.07294851 0.92397445 2.07294851
SUMMARY OUTPUT
48 Month
Regression Statistics
Multiple R
0.3770192
R Square
0.14214348
Adjusted R Square 0.12349443
Standard Error
0.05103751
Observations
48
ANOVA
df
Regression
Residual
Total
Intercept
X Variable 1
1
46
47
SS
MS
F
Significance F
0.019854046 0.019854046 7.62202062
0.0082546
0.119822046 0.002604827
0.139676092
Coefficients Standard Error
t Stat
P-value
0.00239629
0.007595451 0.315489574 0.75381687
0.96020364
0.347798967 2.760800721 0.0082546
Dow Chemical Analysis Lower 95%
Upper 95% Lower 95.0% Upper 95.0%
-0.012892564 0.01768513 -0.0128926 0.01768513
0.26012064 1.66028664 0.26012064 1.66028664
Page 118 SUMMARY OUTPUT
36 Month
Regression Statistics
Multiple R
0.30403661
R Square
0.09243826
Adjusted R Square 0.06574527
Standard Error
0.05524588
Observations
36
ANOVA
df
Regression
Residual
Total
Intercept
X Variable 1
1
34
35
SS
MS
F
Significance F
0.010569496 0.010569496 3.46301593
0.071421637
0.103771644 0.003052107
0.11434114
Coefficients Standard Error
t Stat
P-value
-0.0005036 0.009501034 -0.05300321 0.95803956
0.80227758 0.431119246 1.860918034 0.07142164
Lower 95%
Upper 95% Lower 95.0% Upper 95.0%
-0.019812009 0.01880484
-0.019812 0.01880484
-0.073862136 1.67841729 -0.0738621 1.67841729
SUMMARY OUTPUT
24 Month
Regression Statistics
Multiple R
0.14407725
R Square
0.02075825
Adjusted R Square -0.0237527
Standard Error
0.04336916
Observations
24
ANOVA
df
Regression
Residual
Total
Intercept
X Variable 1
1
22
23
SS
MS
F
Significance F
0.000877174 0.000877174 0.46636243
0.501794128
0.04137945 0.001880884
0.042256624
Coefficients Standard Error
t Stat
P-value
0.00029837 0.009318134 0.032020152 0.97474471
0.30154821 0.441565345 0.682907333 0.50179413
Dow Chemical Analysis Lower 95%
Upper 95% Lower 95.0% Upper 95.0%
-0.019026259
0.019623 -0.0190263
0.019623
-0.614202261 1.21729869 -0.6142023 1.21729869
Page 119 3 Year
SUMMARY OUTPUT
72 Month
Regression Statistics
Multiple R
0.521091747
R Square
0.271536609
Adjusted R Square 0.261129989
Standard Error
0.062431919
Observations
72
ANOVA
df
Regression
Residual
Total
Intercept
X Variable 1
SS
1 0.101702602
70 0.272842114
71 0.374544716
Significance F
MS
F
0.101703 26.092681 2.693E-06
0.003898
Coefficients Standard Error t Stat
P-value
Lower 95% Upper 95% Lower 95.0% Upper 95.0%
0.006308106 0.007384397 0.854248 0.3958817 -0.0084196 0.0210358 -0.00841961 0.02103582
1.084063661 0.21222446
5.1081 2.693E-06 0.6607953
1.507332 0.66079533 1.50733199
SUMMARY OUTPUT
60 Month
Regression Statistics
Multiple R
0.564132568
R Square
0.318245554
Adjusted R Square 0.306491167
Standard Error
0.057886837
Observations
60
ANOVA
df
Regression
Residual
Total
Intercept
X Variable 1
SS
1 0.090723961
58 0.194351384
59 0.285075345
Significance F
MS
F
0.090724 27.074619 2.678E-06
0.003351
Coefficients Standard Error t Stat
P-value
Lower 95% Upper 95% Lower 95.0% Upper 95.0%
0.003956358 0.00771958
0.51251 0.6102408 -0.0114961 0.0194088 -0.01149606 0.01940878
1.494857376 0.287288723 5.203328 2.678E-06 0.9197865 2.0699282 0.91978652 2.06992823
SUMMARY OUTPUT
48 Month
Regression Statistics
Multiple R
0.3752868
R Square
0.140840182
Adjusted R Square 0.122162795
Standard Error
0.051076261
Observations
48
ANOVA
df
Regression
Residual
Total
Intercept
X Variable 1
SS
1 0.019672006
46 0.120004086
47 0.139676092
MS
0.019672
0.002609
F
Significance F
7.540679 0.0085797
Coefficients Standard Error t Stat
P-value
Lower 95% Upper 95% Lower 95.0% Upper 95.0%
0.002654832 0.007580819 0.350204 0.7277843 -0.0126046 0.0179142 -0.01260456 0.01791423
0.954757536 0.347686532
2.74603 0.0085797 0.2549009 1.6546142 0.25490086 1.65461422
Dow Chemical Analysis Page 120 SUMMARY OUTPUT
36 Month
Regression Statistics
Multiple R
0.304487347
R Square
0.092712545
Adjusted R Square 0.066027619
Standard Error
0.05523753
Observations
36
ANOVA
SS
1 0.010600858
34 0.103740282
35 0.11434114
MS
0.010601
0.003051
Significance F
F
3.4743416 0.0709817
Coefficients Standard Error
-0.0004737 0.009494807
0.80234831 0.430453939
t Stat
-0.04989
1.863959
P-value
Lower 95% Upper 95% Lower 95.0% Upper 95.0%
0.960502 -0.0197695 0.0188221 -0.01976947 0.01882207
0.0709817 -0.0724393
1.677136 -0.07243934 1.67713596
SS
1 0.000904153
22 0.041352471
23 0.042256624
MS
0.000904
0.00188
F
Significance F
0.4810198 0.4952189
Coefficients Standard Error
0.000234007 0.009330535
0.305600924 0.440629126
t Stat
0.02508
0.693556
P-value
Lower 95% Upper 95% Lower 95.0% Upper 95.0%
0.9802175 -0.0191163 0.0195844 -0.01911634 0.01958435
0.4952189 -0.6082079 1.2194098 -0.60820795
1.2194098
df
Regression
Residual
Total
Intercept
X Variable 1
SUMMARY OUTPUT
24 Month
Regression Statistics
Multiple R
0.146276129
R Square
0.021396706
Adjusted R Square -0.02308526
Standard Error
0.04335502
Observations
24
ANOVA
df
Regression
Residual
Total
Intercept
X Variable 1
Dow Chemical Analysis Page 121 5 Year
SUMMARY OUTPUT
72 Month
Regression Statistics
Multiple R
0.5200989
R Square
0.2705028
Adjusted R Square 0.2600814
Standard Error
0.0624762
Observations
72
ANOVA
df
Regression
Residual
Total
Intercept
X Variable 1
SS
1 0.101315402
70 0.273229314
71 0.374544716
Coefficients Standard Error
0.006695 0.007383658
1.0816882 0.212314179
MS
F
Significance F
0.10132 25.95651 2.8352E-06
0.0039
t Stat
P-value
Lower 95% Upper 95% Lower 95.0% Upper 95.0%
0.90673 0.367661 -0.0080313 0.0214212 -0.008031 0.021421215
5.09475 2.84E-06 0.65824097 1.5051355
0.658241 1.505135511
SUMMARY OUTPUT
60 Month
Regression Statistics
Multiple R
0.5625978
R Square
0.3165163
Adjusted R Square 0.3047321
Standard Error
0.0579602
Observations
60
ANOVA
df
Regression
Residual
Total
Intercept
X Variable 1
SS
1 0.090230998
58 0.194844347
59 0.285075345
Coefficients Standard Error
0.004423 0.007708555
1.4923465 0.287953058
MS
F
Significance F
0.09023 26.85938 2.8894E-06
0.00336
t Stat
P-value
Lower 95% Upper 95% Lower 95.0% Upper 95.0%
0.57378 0.568332 -0.0110073 0.0198534 -0.011007 0.019853395
5.1826 2.89E-06 0.91594582 2.0687472 0.9159458 2.068747159
SUMMARY OUTPUT
48 Month
Regression Statistics
Multiple R
0.373504
R Square
0.1395052
Adjusted R Square 0.1207988
Standard Error
0.0511159
Observations
48
ANOVA
df
Regression
Residual
Total
Intercept
X Variable 1
SS
1 0.019485547
46 0.120190545
47 0.139676092
Coefficients Standard Error
0.0028711 0.007570536
0.950284 0.347979257
Dow Chemical Analysis MS
F
Significance F
0.01949 7.457618 0.00892574
0.00261
t Stat
P-value
Lower 95% Upper 95% Lower 95.0% Upper 95.0%
0.37924 0.706252 -0.0123676 0.0181098 -0.012368 0.018109776
2.73086 0.008926
0.2498381 1.6507299 0.2498381 1.650729909
Page 122 SUMMARY OUTPUT
36 Month
Regression Statistics
Multiple R
0.3038443
R Square
0.0923214
Adjusted R Square 0.0656249
Standard Error
0.0552494
Observations
36
ANOVA
df
Regression
Residual
Total
Intercept
X Variable 1
1
34
35
SS
0.01055613
0.10378501
0.11434114
Significance F
MS
F
0.01056 3.458191 0.07160997
0.00305
P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0%
Coefficients Standard Error t Stat
-0.000416 0.009490546 -0.04387 0.965265 -0.0197035 0.0188708 -0.019703 0.018870758
0.8008947 0.430676224 1.85962 0.07161 -0.0743447 1.6761341 -0.074345 1.676134068
SUMMARY OUTPUT
24 Month
Regression Statistics
Multiple R
0.0086847
R Square
7.542E-05
Adjusted R Square -0.041588
Standard Error
0.0477816
Observations
26
ANOVA
df
Regression
Residual
Total
Intercept
X Variable 1
SS
1 4.13308E-06
24 0.054793994
25 0.054798127
Coefficients Standard Error
0.0048132 0.009720153
0.0199105 0.467956588
Dow Chemical Analysis MS
4.1E-06
0.00228
F
Significance F
0.00181 0.96641409
t Stat
P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0%
0.49518 0.62498 -0.0152482 0.0248746 -0.015248 0.024874588
0.04255 0.966414 -0.9459044 0.9857254 -0.945904 0.985725402
Page 123 7 Year
SUMMARY OUTPUT
72 Month
Regression Statistics
Multiple R
0.5193968
R Square
0.269773
Adjusted R Square 0.2593412
Standard Error
0.0625074
Observations
72
ANOVA
df
Regression
Residual
Total
Intercept
X Variable 1
1
70
71
SS
MS
0.101042058 0.101042
0.273502658 0.003907
0.374544716
F
Significance F
25.8606 2.93977E-06
Coefficients Standard Error
t Stat
P-value
Lower 95% Upper 95% Lower 95.0% Upper 95.0%
0.0069602 0.007383676 0.942643 0.349105 -0.007766104 0.0216864 -0.0077661 0.02168645
1.0800329 0.212381966 5.085332 2.94E-06 0.656450399 1.5036153 0.656450399 1.50361534
SUMMARY OUTPUT
60 Month
Regression Statistics
Multiple R
0.5612943
R Square
0.3150513
Adjusted R Square 0.3032418
Standard Error
0.0580223
Observations
60
ANOVA
df
Regression
Residual
Total
Intercept
X Variable 1
1
58
59
SS
MS
F
Significance F
0.089813345 0.089813 26.67787 3.08102E-06
0.195262 0.003367
0.285075345
Coefficients Standard Error
t Stat
P-value
Lower 95% Upper 95% Lower 95.0% Upper 95.0%
0.0047599 0.007702401 0.617976 0.53901 -0.010658133 0.0201779 -0.01065813 0.02017793
1.4897076 0.288420056 5.165062 3.08E-06 0.912372103
2.067043 0.912372103 2.06704303
SUMMARY OUTPUT
48 Month
Regression Statistics
Multiple R
0.3722344
R Square
0.1385584
Adjusted R Square 0.1198314
Standard Error
0.051144
Observations
48
ANOVA
df
Regression
Residual
Total
Intercept
X Variable 1
1
46
47
SS
MS
F
Significance F
0.019353298 0.019353 7.398862
0.00917947
0.120322794 0.002616
0.139676092
Coefficients Standard Error
t Stat
P-value
Lower 95% Upper 95% Lower 95.0% Upper 95.0%
0.0030284 0.007563207 0.40041 0.690708 -0.012195564 0.0182523 -0.01219556 0.01825233
0.9471257 0.348197103 2.720085 0.009179 0.246241271 1.6480101 0.246241271 1.64801008
Dow Chemical Analysis Page 124 SUMMARY OUTPUT
36 Month
Regression Statistics
Multiple R
0.303242
R Square
0.0919557
Adjusted R Square 0.0652485
Standard Error
0.0552606
Observations
36
ANOVA
df
Regression
Residual
Total
Intercept
X Variable 1
1
34
35
SS
MS
F
Significance F
0.010514323 0.010514 3.443108
0.07220234
0.103826817 0.003054
0.11434114
Coefficients Standard Error
t Stat
P-value
Lower 95% Upper 95% Lower 95.0% Upper 95.0%
-0.0003568 0.009485825 -0.03761 0.970219 -0.019634279 0.0189208 -0.01963428 0.01892075
0.7995779 0.430908874 1.855562 0.072202 -0.076134271 1.6752901 -0.07613427 1.67529011
SUMMARY OUTPUT
24 Month
Regression Statistics
Multiple R
0.1463393
R Square
0.0214152
Adjusted R Square -0.0230659
Standard Error
0.0433546
Observations
24
ANOVA
df
Regression
Residual
Total
Intercept
X Variable 1
1
22
23
SS
MS
F
Significance F
0.000904933 0.000905 0.481444 0.495030778
0.041351691 0.00188
0.042256624
Coefficients Standard Error
t Stat
P-value
Lower 95% Upper 95% Lower 95.0% Upper 95.0%
0.0002383 0.009328079 0.025548 0.979848 -0.019106936 0.0195836 -0.01910694 0.01958357
0.3058135 0.440741187 0.693862 0.495031 -0.608227795 1.2198548 -0.6082278 1.21985475
Dow Chemical Analysis Page 125 10 Year
SUMMARY OUTPUT
72 Month
Regression Statistics
Multiple R
0.5188987
R Square
0.2692558
Adjusted R Square
0.2588166
Standard Error
0.0625296
Observations
72
ANOVA
df
Regression
Residual
Total
Intercept
X Variable 1
1
70
71
SS
MS
F
Significance F
0.100848348 0.100848 25.79276 3.01617E-06
0.273696369 0.00391
0.374544716
Coefficients Standard Error
t Stat
P-value
Lower 95% Upper 95% Lower 95.0% Upper 95.0%
0.0071862
0.007383426 0.973282 0.333765 -0.00753962 0.0219119 -0.0075396 0.02191194
1.0792325
0.212503519 5.078657 3.02E-06 0.655407618 1.5030574 0.65540762 1.50305742
SUMMARY OUTPUT
60 Month
Regression Statistics
Multiple R
0.5604099
R Square
0.3140593
Adjusted R Square
0.3022327
Standard Error
0.0580643
Observations
60
ANOVA
df
Regression
Residual
Total
Intercept
X Variable 1
1
58
59
SS
MS
F
Significance F
0.089530553 0.089531 26.55541 3.21769E-06
0.195544793 0.003371
0.285075345
Coefficients Standard Error
t Stat
P-value
Lower 95% Upper 95% Lower 95.0% Upper 95.0%
0.0050739
0.007694653 0.659407 0.512244 -0.01032861 0.0204764 -0.0103286 0.02047643
1.488239
0.288799337 5.153194 3.22E-06 0.910144365 2.0663337 0.91014436 2.06633372
SUMMARY OUTPUT
48 Month
Regression Statistics
Multiple R
0.3711964
R Square
0.1377868
Adjusted R Square
0.119043
Standard Error
0.0511669
Observations
48
ANOVA
df
Regression
Residual
Total
Intercept
X Variable 1
1
46
47
SS
MS
F
Significance F
0.019245519 0.019246 7.351072 0.009391495
0.120430573 0.002618
0.139676092
Coefficients Standard Error
t Stat
P-value
Lower 95% Upper 95% Lower 95.0% Upper 95.0%
0.0031905
0.007554773 0.422322 0.674757 -0.01201642 0.0183975 -0.0120164 0.01839752
0.9445255
0.348368082 2.711286 0.009391 0.243296976 1.6457541 0.24329698 1.64575411
Dow Chemical Analysis Page 126 SUMMARY OUTPUT
36 Month
Regression Statistics
Multiple R
R Square
Adjusted R Square
Standard Error
Observations
0.3027736
0.0916718
0.0649563
0.0552692
36
ANOVA
df
Regression
Residual
Total
Intercept
X Variable 1
1
34
35
SS
MS
F
Significance F
0.010481862 0.010482 3.431406 0.072665753
0.103859278 0.003055
0.11434114
Coefficients Standard Error t Stat
P-value
Lower 95%
Upper 95% Lower 95.0%Upper 95.0%
-0.0002829
0.009478665 -0.02984 0.976368 -0.01954582 0.0189801 -0.0195458 0.01898011
0.7986022
0.431116346 1.852405 0.072666
-0.0775316
1.674736 -0.0775316 1.67473604
SUMMARY OUTPUT
24 Month
Regression Statistics
Multiple R
0.1463834
R Square
0.0214281
Adjusted R Square -0.0230525
Standard Error
0.0433543
Observations
24
ANOVA
df
Regression
Residual
Total
Intercept
X Variable 1
1
22
23
SS
MS
F
Significance F
0.000905479 0.000905 0.481741 0.494899387
0.041351145 0.00188
0.042256624
Coefficients Standard Error
t Stat
P-value
Lower 95% Upper 95% Lower 95.0% Upper 95.0%
0.0002507
0.009322103 0.026895 0.978786 -0.01908214 0.0195836 -0.0190821 0.01958358
0.3060237
0.440908438 0.694075 0.494899
-0.6083644 1.2204119 -0.6083644 1.22041186
Dow Chemical Analysis Page 127 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)
Dow Chemical Analysis Page 128