Ratio Analysis and Valuation

Valuation theory



ROE disaggregation into RNOA and financial returns





Discounted free cash flows
Residual income
ROE - Identifying and Computing Operating Working Capital
and Operating Assets exercise
ROE Disaggregation (P&G) exercise
Pfizer (PFE) valuation exercise
Margin and Turnover
EVA
© 2005 by Robert F. Halsey, all rights reserved
Approaches to valuation
Dividend discount model:
d3
d
d
d
1
2
4 
P0 



(1ke ) (1k )2 (1k )3 (1k )4
e
e
e
From the statement of cash flows,
d = NI + depreciation + OperCL - OperCA - OperLTA + Debt
Substitute cash flows for “d” to yield the free cash flow to equity
model (FCFE) :
FCFE3 FCFE
FCFE FCFE
1
2
4
P0 



(1ke ) (1k )2 (1k )3 (1k )4
e
e
e
© 2005 by Robert F. Halsey, all rights reserved
Residual income model
First, define residual income (RI) as,
RIt  It - ke * BVt-1
Next, assume clean surplus updating of
book value of stockholders’ equity:
BVt = BVt-1 + It - dt
Then, we can rewrite dividends as,
dt = (1+ke)BVt-1-BVt+RIt
Finally, substituting dt in the dividend discount model yields,
Residual
RI
RI
RI
 RI1

3 
2 
4   income stock
V0  BV0  


(1ke ) (1k )2 (1k )4 (1k )4
e
e
e

 price model
© 2005 by Robert F. Halsey, all rights reserved
Source: Parker Center for Investment Research, Cornell Univ.
© 2005 by Robert F. Halsey, all rights reserved
FCF and RI models


The FCF and RI models are theoretically
equivalent since both are derived from the
dividend discount model. They will, therefore,
yield the same valuation in a steady state
(constant RNOA)
FCF defines value in terms of cash flows. RI
defines value in terms of accrual accounting
(earnings and book values)
© 2005 by Robert F. Halsey, all rights reserved
Lower terminal value for ROPI
version of RI model vs. DCF
5
5
5
=
+
(
)/(1
+
k
+
(
NOA
)/(1
+
k
k
*
NOA
)
)
V 0 NOA0  OI t w
V5
w
5
w
t -1
t=1
5
V 0 =  FCF t 1  k w   V 5 1  k w 
5
5
TV is reduced by
NOA in RI model
t=1
RI results in less terminal value component. Why?
Source: Prof. Peter D. Easton, Notre Dame University
© 2005 by Robert F. Halsey, all rights reserved
Importance of ROE




k * BV 

 * BV  ROE  k * BV
RI  I  k * BV   I  e
e
e
 BV
BV 


So, given a level of book value, the spread
of ROE over the cost of capital (ke) is
central to the creation of shareholder
value.
© 2005 by Robert F. Halsey, all rights reserved
Spreads v. Market-to-Book For
Dow Jones Industrials
Market Value/Book Value
10
KO
PG
MMM
8
MRK
JNJ
WMT
IBM
6
MSFT
GE
DD
4
INTC
HD
AXP
UTX
MO
BA
CAT
HON
IP
AA
2
XOM
EK
C
MCD
DIS
T
GM
JPM
HPQ
SBC
0
-60
-50
-40
-30
-20
-10
0
ROE - Ke
© 2005 by Robert F. Halsey, all rights reserved
10
20
30
40
50
60
Source: Nissim and Penman, 2003
© 2005 by Robert F. Halsey, all rights reserved
ROE Disaggregation
ROE = RNOA + (FLEV * SPREAD)
NOPAT
Sales
RNOA 
*
Sales
AvgNOA
=
© 2005 by Robert F. Halsey, all rights reserved
PM
* Turnover
Exercises
ROE - Identifying and Computing Operating Working
Capital and Operating Assets exercise
ROE Disaggregation (P&G) exercise
Pfizer (PFE) valuation exercise
© 2005 by Robert F. Halsey, all rights reserved
Cisco Systems, Inc
ROE Disaggregtion –
P&G Profitability Ratios
Procter & Gamble
2003
49.0%
Gross profit margin ..............................
($21,236 /
$43,377)
30.9%
Operating expense
($13,383 /
margin....................................................
$43,377)
12.5%
2002
2001
47.8%
43.7%
46.1%
($19,249 /
$40,238)
($17,142 /
$39,244)
($18,437 /
$39,951)
31.2%
31.6%
31.2%
($12,571 /
$40,238)
($12,406 /
$39,244)
($12,483 /
$39,951)
11.3%
7.6%
9.5%
Net operating profit
($7,853.689) ($6,678.682) ($4,736.633)
margin1...................................................
/ $43,377)
/ $40,238
/ $39,244
1
1-$2,344/$7,530 1-$2,031/$6,383
After-tax %.................................................
= .689)
= .682
© 2005 by Robert F. Halsey, all rights reserved
2000
1-$1,694/$4,616
= .633
($5,954.64)
/ $39,951
1-$1,994/$5,536
= .64
ROE Disaggregtion –
P&G Turnover Ratios
Procter & Gamble
2003
2002
14.16
Accounts receivable
($43,377 / [($3,038 +
turnover............................................................
2001
13.37
13.44
($40,238 / [($3,090 +
$2,931) / 2]
($39,244 / [($2,931 +
$2,910) / 2]
25.56
28.03
Average collection
period ...............................................................
($3,038/ [$43,377/ 365])
($3,090/ [$40,238/ 365])
27.26
$3,090) / 2]
6.24
($2,931/ [$39,244/ 365])
6.14
6.43
($20,989 / [$3,456 +
$3,384] / 2)
($22,102 / [$3,384 +
$3,490] / 2)
60.01
60.10
Average inventory
days outstanding ............................................
($3,640/ [$22,141/ 365])
($3,456/ [$20,989/ 365])
55.88
Inventory turnover ..........................................
($22,141 / [$3,640 +
$3,456] / 2)
1.52
Long-term operating
($43,377/([$28,486 +
asset turnover 1 ...............................................
1.46
1.55
$40,238 / ([$28,610 +
$26,498] / 2)
$39,244 / ([$26,498 +
2
$24,220 ] / 2)
1.74
1.87
$40,238 / ([$25,445 +
$20,759] / 2)
$39,244 / ([$20,759 +
2
$21,294 ] / 2)
$43,706 - $15,220 =
$40,776 - $12,166 =
$34,387 - $10,889 =
$28,486
$28,610
$26,498
$43,706 - $15,220 $1,396 - $2,291 =
$40,776 - $12,166 $1,077 - $2,088 =
$34,387 - $10,889 $894 - $1,845 =
$24,799
$25,445
$20,759
$28,610] / 2)
Long-term net
1.73
operating asset
($43,377/([$24799 +
turnover 2 .........................................................
$25,445] / 2)
1
2
Net long-term operating
assets
Net long-term net operating
assets
© 2005 by Robert F. Halsey, all rights reserved
($3,384/[$22,102/ 365])
ROE Disaggregtion –
P&G ROE Components
Procter and Gamble
2003
1-($2,344/$7,530)
After-tax % ........................................................
= 0.689
2002
1-($2,031/$6,383)
= 0.682
2001
1-($1,694/$4,616)
= 0.633
Net operating profit after-tax
$7,853  0.689 =
(NOPAT)...........................................................
$5,411
$43,706 - $300 ($12,358 - $2,172) Net operating assets (NOA) 1 ..........................
$1,396 - $2,291 =
$29,533
$6,678  0.682 =
$4,554
$4,736  0.633 =
$2,998
$2,172 + $11,475 Net financial obligations (NFO)2 .....................
$300 = $13,347
Stockholders’ equity .......................................
$16,186
© 2005 by Robert F. Halsey, all rights reserved
$40,776 - $196 ($12,704 - $3,731)
- $1,077 - $2,088=
$34,387 - 212 ($9,846 - $2,233)
- $894 - $1,845 =
$28,442
$23,823
$3,731 + $11,201 $196 = $14,736
$2,233 + $9,792 $212 = $11,813
$13,706
$12,010
ROE Disaggregtion –
P&G ROE Components
Procter and Gamble
1. Net operating profit margin
(NOPM)
2. Return on net operating
assets (RNOA)
3. Financial leverage (FLEV)
4. Net financial rate (NFR)
2003
2002
12.474%
11.318%
7.639%
($5411 / $43,377)
($4,554 / $40,238)
($2,998 / $39,244)
18.667%
17.427%
12.446%
$5,411 / ([$29,533 +
$28,442] / 2)
$4,554 / ([$28,442 +
$23,823] / 2)
$2,998 / ([$23,823 +
$24,355] / 2)
93.948%
103.239%
98.288%
([$13,347 + $14,736 ] / 2) /
([$16,186 + $13,706] / 2)
([$14,736 + $11,813] / 2) /
([$13,706 + $12,010] / 2)
([$11,813 + $12,068] / 2) /
([$12,010 + $12,287] / 2)
1.516%
0.636%
([$13,347 + $14,736] / 2)
($603 - $308)  .682 /
([$14,736 + $11,813] / 2)
($794 - $674)  .633 /
([$11,813 + $12,068] / 2)
17.082%
15.911%
11.810%
(18.667% - 1.585%)
(17.427% - 1.516%)
(12.446% - 0.636%)
34.698%
33.847%
24.052%
$5,186 /
$4,352 /
$2,922 /
([$16,186 + $13,706] / 2)
([$13,706 + $12,010] / 2)
([$12,010 + $12,287] / 2)
18.667% + (93.948% x
17.082%) = 34.715%
17.427% + (103.239% x
15.911%) = 33.853%
12.446% + (98.288% x
11.810%) = 24.054%
1.585%
($561 - $238)  .689 /
5. Spread
6. Return on equity (ROE)
7. ROE formula computation
© 2005 by Robert F. Halsey, all rights reserved
2001
ROE Disaggregtion –
P&G Liquidity and Solvency
Procter and Gamble
2003
2002
2001
2000
Current ratio (current
assets / current liabilities)
1.23
0.96
1.11
1.00
Quick ratio (quick assets /
current liabilities)
0.75
0.53
0.55
0.44
2003
2002
2001
2000
1.9
1.8
Procter and Gamble
Total liabilities-to-equity......................................
1.7
2.0
Times interest earned ..........................................
14.42
11.59
© 2005 by Robert F. Halsey, all rights reserved
6.81
8.67
ROE Disaggregtion –
P&G Altman Z-Score
The Altman Z-Score for P&G as of 2003 is:
Z= 0.717  X1 + 0.847  X2 + 3.107  X3 + 0.420
 X4 + 0.998  X5 = 2.12
where,
X1
X2
X3
X4
X5
=
=
=
=
=
Working capital/ Total assets
Retained earnings/Total assets
Earnings before interest and taxes /Total assets
Equity/ Total liabilities
Sales/ Total assets
0.717
0.847
3.107
0.420
0.998
x
x
x
x
x
0.065=0.047
0.313=0.265
0.185=0.575
0.588=0.247
0.992=0.990
Z-Score =2.124
P&G’s Z-score is in the gray area—the prediction is inconclusive.
© 2005 by Robert F. Halsey, all rights reserved
PG 5-Year Stock Price Trend
© 2005 by Robert F. Halsey, all rights reserved
Pfizer (PFE)
valuation exercise
Year
(in $ Million)
Beginning of the Year Balance Sheet
Beg Net Working Capital
Beg Net Long-Term Assets
Total Assets
Forecast Horizon
2004
2005
2006
2007
2008
Terminal Year
2009
6,084
87,034
93,118
8,396
120,107
128,503
9,529
136,321
145,851
10,816
154,725
165,541
12,276
175,613
187,889
12,706
181,759
194,465
13,150
188,121
201,271
Beg. Net Debt
Beg. Shareholders Equity
Total Net Capital
27,741
65,377
93,118
38,283
90,220
128,503
43,451
102,400
145,851
49,317
116,224
165,541
55,974
131,914
187,889
57,933
136,531
194,465
59,961
141,310
201,271
Income Statement for the Year
Sales
Net operating profits after tax (NOPAT)
Net interest after tax
Net income
54,226
10,174
1,387
8,787
62,359
11,700
1,914
9,786
70,778
13,280
2,173
11,107
80,333
15,073
2,466
12,607
91,178
17,108
2,799
14,309
94,369
17,706
2,897
14,810
97,672
Computations
NOPAT
Beginning net operating assets
WACC
Expected NOPAT
ROPI
10,174
93,118
0.0583
5,427
4,747
11,700
128,503
0.0583
7,490
4,211
13,280
145,851
0.0583
8,501
4,779
15,073
165,541
0.0583
9,648
5,424
17,108
187,889
0.0583
10,951
6,157
17,706
194,465
0.0583
11,334
6,372
Discount factor - based on WACC
0.9449
0.8929
0.8437
0.7972
0.7533
0.7118
4,747
4,486
4,486
206,159
93,118
$320,517
$27,741
$292,776
$38.38
4,211
3,760
8,245
4,779
4,032
12,277
5,424
4,325
16,602
6,157
4,638
21,240
6,372
4,536
10,174
-2,312
-33,073
-25,211
11,700
-1,133
-16,214
-5,647
13,280
-1,286
-18,403
-6,410
15,073
-1,460
-20,888
-7,275
17,108
-430
-6,146
10,532
17,706
-445
-6,362
10,900
-23,822
-23,822
352,656
$320,517
$27,741
$292,776
$38.38
-5,042
-28,865
-5,408
-34,273
-5,800
-40,073
7,934
-32,139
Residual Oparating Income (ROPI) model
Residual operating income
PV of residual operating income
Cumulative PV ROPI
Terminal value of abnormal NOPAT
Beg. book value of assets
Value of the firm - ROPI
Value of debt
Value of equity
Computations
NOPAT
Chg in working capital
Chg in long-term assets
Free Cash Flow to the Firm (FCFF)
Discounted Cash Flow (DCF) model
Present value of FCF to the firm (FCFF)
Cumulative PV FCFF
PV of Terminal Value
Value of the firm - FCFF
Value of debt
Value of equity
ROE Disaggregation
Empirical Findings
Definition:ROE = RNOA + LEV × Spread
Median
12.2% ≈ 10.3% + 0.40 × 3.3%




Companies are, on average, conservatively financed
(LEV<1.0).
They earn, on average, a positive spread on
borrowed monies.
RNOA is, on average, approximately 84% of reported
ROE.
All industries that survive must earn a combination of
operating and financial returns that meet shareholder
expectations.
© 2005 by Robert F. Halsey, all rights reserved
Behavior Over Time
(Nissim and Penman 2001)
ROE
RNOA
NBC
© 2005 by Robert F. Halsey, all rights reserved
1963-1996
ROCE v. Ke (Nissim and Penman 2001)
© 2005 by Robert F. Halsey, all rights reserved
Margin vs. Turnover
Margin and Turnover Combinations for a Given RNOA
3.50
Retail
Restaurants
3.00
2.50
Aircraft
Apparel
Asset Turnover
Agriculture
2.00
Defense
Precious Metals
Electrical Equipment
Computers
Textiles
Construction
Construction Materials
Chemicals
Transportation
Banking
Healthcare
Autos & Trucks
Petroleum
1.50
Real Estate
Printing & Publishing
and Natural Gas
1.00
Tobacco
Beer & Liquor
Pharmaceuticals
Coal
Entertainment
RNOA=10.3%
Utilities
Communication
0.50
0.00
0.00
0.02
0.04
0.06
0.08
Profit Margin
© 2005 by Robert F. Halsey, all rights reserved
0.10
0.12
0.14
Margin and Turnover Exercise
NOPAT margin
NOPAT margin vs. NOA turnover
14.00%
12.00%
10.00%
8.00%
6.00%
4.00%
2.00%
0.00%
0.00
1.00
2.00
3.00
4.00
Net operating asset tunrover rate
© 2005 by Robert F. Halsey, all rights reserved
Compare RI with
Economic Value Added
TM
(“EVA”)
Under EVA,
MV = capital + PV of future EVA,
where EVA1 = NOPAT1 - kwacc*capital0
© 2005 by Robert F. Halsey, all rights reserved
EVA Exercise
Current Year
Revenues............................................................. $11,400
Cost of goods sold ............................................... (6,000)
Gross profit .........................................................
5,400
Selling, general and administrative expenses ........ (4,000)
Operating profit ...................................................
1,400
Interest expense...................................................
(400)
Pretax income......................................................
1,000
Tax expense ........................................................
(350)
Net income.......................................................... $ 650
Current
Year
Cash.................................$ 800
Accounts receivable.......... 1,200
Inventories ....................... 3,000
Total current assets ........... 5,000
Prior
Year
$ 500
1,000
2,500
4,000
Plant assets, net ................10,000
9,000
Total assets.......................
$15,000 $13,000
Current
Year
Accounts payable....................$ 800
Accrued liabilities................... 1,250
Total current liabilities ............ 2,050
Prior
Year
$ 700
1,000
1,700
Long-term debt ....................... 6,000
5,000
Total stockholders’ equity ....... 6,950
6,300
Total liabilities and equity.......$15,000 $13,000
EVA = $($1,400*[1-0.35]) – ([$13,000-$1,700]×10%) = $910 - $1,130 = ($220)
RNOA = 8.05% ($910/[$13,000-$1,700]) < 10%.
The deficit is 1.95% x $(13,000-1,700) = $(220) as above.
© 2005 by Robert F. Halsey, all rights reserved
EVA Exercise –
Areas for Improvement
© 2005 by Robert F. Halsey, all rights reserved