An Equity Valuation and Analysis of
As of June 1, 2007
Ashley Boaz
a.boaz@yahoo.com
Kristie Lee
kristie.lee@ttu.edu
Robert Tabb
robert.tabb@ttu.edu
Nick Traweek
nick@traweek.net
Robert Durrant
michael.durrant@ttu.edu
Table of Contents
Executive Summary……………………………………………………………..…………….3
Industry Analysis……………………………………………………………………………….4
Accounting Analysis……………………………………………………………………………4
Financial Analysis Forecast Financials and Cost of Capital Estimation…..….6
Valuations…………………………………………………………………………………………6
Industry Analysis……………………………………………………………………………….8
Company Overview………………………………………………………………………..….8
Five Forces Model…………………………………………………………………………….10
Rivalry Among Existing Firms…………………………………………………………….10
Threat of New Entrants………………………………………………………………..…..13
Threat of Substitute Products………………………………………………………..….15
Bargaining Power of Buyers………………………………………………………….…..16
Bargaining Power of Suppliers…………………………………………………………..16
Value Chain Analysis…………………………………………………………………………17
Firm Competitive Advantage Analysis……………………………………….………..18
Accounting Analysis………………………………………………………………………….21
Key Accounting Policies…………………………………………….………………………21
Areas of Accounting Flexibility……………………………………………………….....23
Quality of Disclosure…………………………………………………………………………25
Potential Red Flags…………………………………………………………………………..43
Fixing Accounting Distortions…………………………………………………………….44
Financial Analysis Forecast Financials and Cost of Capital Estimation…….45
Liquidity Analysis……………………………………………………………………………..45
Profitability Analysis…………………………………………………………………………55
Capital Structure Analysis………………………………………………………………….64
Extended Ratio Analysis……………………………………………………………………68
Forecasting Analysis…………………………………………………………………………72
Cost of Capital Estimation…………………………………………………………………80
Weighted Average Cost of Capital……………………………………………………..83
Method of Comparables……………………………………………………………………85
Other Method of Comparables…………………………………………………………..90
Intrinsic Valuation Models…………………………………………………………………92
2
Credit Risk Analysis…………………………………………………………………..99
Analyst Recommendation…………………………………………………………100
Appendix………………………………………………………………………………..102
Works Cited……………………………………………………………………………119
3
Executive Summary
Investment Recommendation as of 6/1/07: Overvalued, Sell
DRI trading Price 6/1/07: $45.80
52 Week Range: $32.91- $47.60
Revenue (5/28/06): $5,720,640,000
Market Capitalization: $6.09 B
Shares Outstanding: 146,998
3-Month Avg. Daily Trading Volume:1,399,270
Percent Institutional Ownership: 81.84%
Book Value Per Share: $1.29
ROE: .266
ROA: .115
Cost Of Capital Est.
Estimated
3-Month
11.64
6-Month
2 Year
13.63
5 Year
13.58
10 Year
13.58
Kd: 6.4%
WACC: 10.57%
R2
.068
Beta
.98
.9821
Ke
11.29
.059
.06
.1.266
1.259
13.60
.059
1.254
.0588
1.258
Altman Z-Score
2002 2003 2004
9.44
17.64
7.82
Moneycentral.msn.com
2005
23.04
EPS Forecast
2007 2008 2009 2010 2011 2012
3.08
3.59
4.18
4.86
5.66
6.59
Ratio Comparison DRI
EAT APPB
Trailing P/E
18.79 17.38 30.13
Forward P/E
16.11 16.02 19.09
PEG
1.52
1.19 1.77
P/B
5.43
3.47
3.81
Valuation Estimates
Actual Price (6/1/07): 45.80
Ratio Based Evaluations
Trailing P/E:
$57.89
Forward P/E:
$52.74
PEG:
$24.92
P/B:
$29.51
P/EBITDA:
$69.02
P/FCF:
$98.3
EV/EBITDA:
$43.07
Intrinsic Valuations
Discounted Dividends:
Residual Income:
LR ROE:
Free Cash Flows:
AEG:
$6.29
$39.23
$35.63
$9.79
$61.14
2006
23.58
Moneycentral.msn.com
4
Industry Analysis
“Darden Restaurants, Inc. is the largest publicly held casual dining
restaurant company in the world.” (Darden 2006 10-K) Darden operates in the
specialty foods dining industry. They target consumers that are looking for high
quality prepared foods with high quality service and atmosphere. In May of
1995, Darden became a publicly traded company. Based out of Florida, the firm
currently has approximately 1400 restaurants and are opening an average of
about 54 stores per year. Darden is constantly growing, having a record setting
year in 2006 for sales, earnings and share price.
Direct competitors of Darden include Applebee’s, Brinker, The Cheesecake
Factory, OSI Restaurant Partners, and Texas Roadhouse. During the authoring
of this report, OSI Restaurant Partners became a privately owned company
which cannot be monitored on the stock exchange. Therefore there is not
sufficient information to completely compare them to Darden.
The specialty foods dining industry is a market that thrives on
differentiation of product and specialization. There is a low threat of new
entrants into the industry, but the threat of substitute products is a moderate
factor in sales. The customer has a moderate amount of bargaining power with
regards to price since there is a large amount of possible substitute products.
Not only could the consumer easily switch to another restaurant in the specialty
dining industry, but they also have other choices, such as cooking food
themselves or paying less to eat at a restaurant with low differentiation among
products (i.e. fast food restaurants). Threats to business and competition have
many forms in multiple industries for Darden Restaurants Inc.
Accounting Analysis
A key factor in valuing any firm is its accounting methods. To effectively
evaluate Darden, we had to take into account their accounting practices and
relate them back to their key success factors. The SEC allows a great deal of
5
flexibility in accounting, so reporting across firms in Darden’s industry may be
difficult to compare.
A main accounting policy that is taken into account is their pension
plans. Darden uses a defined benefit plan to attract and keep high quality
employees. Since defined benefit plans are considered high risk to the company,
this should be a concern of the company. They are liable for future costs of
these pension plans. Darden has planned for these costs, however, with a very
reasonable estimated growth rate of 9%.
Inventory is one area of accounting that has much flexibility. Darden
must keep customers happy by absorbing the cost of bad meals and spoilage.
Their financial statements do not make it clear in any way how much is written
off from these comped meals and spoilage of food. Although the costs may be
lumped with other liabilities, this shows a low level of disclosure for the
company’s financial statements.
Land leases are another concern in Darden’s accounting practices.
Darden records their leases as operating leases instead of capital leases. This
allows them to have no effect on assets or liabilities, which can understate both
of these sections of the balance sheet and can cover up future obligations.
Darden is clear in stating their future lease obligations in their financial reports
even though they use operating leases.
The amount of transparency that Darden’s financial statements have help
to show a true value of the company. Even though they do not break everything
down completely to show as much information as possible, they further discuss
all sections to adequately convey important information.
Processing of Darden’s accounting policies can identify “red flags” for the
company. Although no major red flags were found for Darden, some small
issues are considered later in the report.
6
Financial Analysis, Forecast Financials and Cost of Capital Estimation
To value a firm, all future performance must be taken into account. After
all, a company’s stock price in the future depends on it’s performance in the
future. To take this into account, several ratios were first calculated to show the
past performance of Darden and several of its competitors. After assessing past
performance based on these ratios, we used them to forecast financial
statements for Darden for the next ten years. We then estimated a beta for the
company, calculated the cost of equity and debt, and finally computed Darden’s
cost of capital using the Weighted Average Cost of Capital method.
Our ratio analysis revealed that Applebee’s is at the top of the industry for
liquidity. Darden has the best accounts receivable turnover, showing that the
company collects on its receivables quicker than its competitors. In general, the
liquidity ratios computed are slightly favorable for Darden. The profitability ratios
that were computed showed that the net profit margin for Darden is about
average for the industry. Gross profit margin was extremely low, which could
indicate value in the company that is not recognized. Capital structure ratios
showed bad trends for Darden in general. Their debt to equity, times interest
earned and debt service margin are all on the low side of the industry. In short,
their current capital structure is inferior compared to the rest of the industry.
We used the ratios we computed to forecast Darden’s financial statements
for the next ten years. We forecasted the income statement based off of the
past sales of the company. This growth rate was 8.4%. We used the asset
turnover ratio as a base for forecasting the balance sheet. We then used other
ratios and growth rates to forecast the rest of the balance sheet and statement
of cash flows.
Valuations
Once we evaluated the three major aspects of the firm that give it value,
we used several models to calculate the value of the company’s share price. We
7
used the method of comparables and five intrinsic valuation models to valuate
the company’s share price.
The method of comparables used information from several firms in the
industry to value the company. We took statistics from each company to get
industry averages for several different ratios. We then used the industry average
to estimate Darden’s share price. These ratios included Forward and trailing
price to earnings, Price to Book Value and the PEG ratio among others. These
valuations showed that Darden is slightly overvalued. These valuations are not
as reliable as the intrinsic valuations, though.
The formulas for the intrinsic valuations are based on financial and
accounting theory, and tend to be more accurate. The intrinsic valuations we
used were the Free Cash Flows, Residual Income, Long Run ROE Residual
Income, Abnormal Earnings Growth, and the Discounted Dividends Models.
Using these models, we found that the firm is slightly overvalued.
8
Industry Analysis
Company Overview
Darden Restaurants, Inc. operates in the casual dining industry. Their
mission statement is “To nourish and delight everyone we serve.” (Darden’s’
2006 10k) Darden is composed of two main restaurants, Red Lobster and Olive
Garden, and two smaller units, Bahama Breeze and Seasons 52. Red Lobster
was founded in 1968 by William Darden, and was later acquired by General Mills.
In May of 1995, Darden became an independent publicly traded company.
Today, Darden Restaurants is based out of Florida. As of May 28th, 2006,
Darden operated 1,427 restaurants in 49 states (excluding Alaska) and Canada.
This was up from the previous year’s total of 1,381 stores. Over the previous 5
years, Darden has opened up an average of 54 restaurants per year. (Darden
2006 10k) We believe this represents a strong trend towards commitment to
constant growth. Forecasts are for the firm to open up additional 39-45 units
during the fiscal year of 2007. This is below the firms stated goal of 5%-7%
annual expansion, but Darden anticipates accelerated growth in the near future.
(S&P Stock Report) The year of 2006 was a record setting year for the firm,
which reported the highest sales, net earnings, net earnings per share, and
share price in its history.
Fiscal Year
Sales
Costs &
Expenses
Earnings
EPS
2002
4,366,911
4,011,476
2003
4,654,971
4,317,368
2004
5,003,355
4,670,579
2005
5,278,110
4,854,193
2006
5,720,640
5,238,122
232,711
1.33
225,979
1.33
227,173
1.39
290,606
1.85
338,194
2.26
$18.70
$22.37
$32.48
$36.13
Stock Price $25.54
(Darden 2006 10-K)
9
Darden faces competition from many different firms in the casual dining
industry. Direct competitors include Applebee’s International (APPB), Brinker
International (EAT), Cheesecake Factory (CAKE), OSI Restaurant Partners (OSI),
and Texas Roadhouse (TXRH). Brinker International possesses the most assets
of this group with just over $2.2 billion. Darden is larger than all of its direct
competitors, with over $3 billion in assets. We believe the firm’s aggressive
expansions are intended to maintain and increase this gap. Darden also has the
largest market capitalization of this group with $6.4 billion, with Brinker
International the next largest, at $3.6 billion. This shows that the firm is the
highest valued firm among its direct competitors. From 2002-2005, Darden’s
stock lagged behind its competitors and the market index. From 2005-present,
the stock has rebounded and has outperformed the market and many of its
competitors. As of June 1 2007, the companies stock was at an all time high of
$46.59/share.
http://moneycentral.msn.com
10
Five Forces Model
The Five Forces Model allows for an “outside-in business strategy that is
used to make an analysis of the attractiveness or value of an industry structure”
(www.valuebasedmanagement.net). This method does this by the identification
of five fundamental competitive forces: rivalry among existing firms, threat of
new entrants, threat of substitute products, bargaining power of buyers, and
bargaining power of suppliers. High competition among firms can cause for a
loss in profit for a firm. With there being several different firms for a customer to
choose from, a firm must differentiate itself from the competition, thereby
getting more power and allow them to gain a higher profit share. These “five
forces” are important because it shows that the average profitability is influenced
by these forces on a daily basis. In other words, firms can not compete or grow
sufficiently if they do not have a basic understanding of each of these five
headings that we will explain below.
CASUAL DINING RESTAURANT INDUSTRY
RIVALRY AMONG EXISTING FIRMS:
MODERATE
THREAT OF NEW ENTRANTS:
THREAT OF SUBSTITUTE PRODUCTS:
BARGAINING POWER OF CUSTOMERS:
BARGAINING POWER OF SUPPLIERS:
LOW
MODERATE
MODERATE
LOW
Rivalry among Existing Firms
When discussing this topic, it is only appropriate to say that the
profitability of a firm is influenced the most by the rivalry among existing firms
section of the “five forces” model. This force looks at how strong the competition
between the existing firms are, looks at a firms ability to dominate over the
competition, or shows if all firms are among equal size and strength. Industry
growth tells us how well the industry is doing among its competitors financially
11
and economically. Having a well rounded industry can not only influence
customer inflow but also make room for potential profits to expand.
Industry Growth:
By keeping up with the current restaurant industry growth levels, we can
tell if these areas are expanding, contracting, or remaining stagnant. As
researched, the Restaurant Performance Index (RPI), which is a “monthly
statistical barometer that tracks the health of the restaurant industry”
(www.restaurant.org), stood at 101 points in April 2007, down .9 percent from
its March 2007 levels. The industry as a whole has remained above 100 points
for 48 consecutive months concluding a growth within the restaurant casual
dining industry.
Sales have also shot up for Darden Industries, recording “$5.72 billion in
fiscal 2006, $5.28 billion in fiscal 2005 and $5.00 billion in fiscal 2004” (Darden 10K). Compared to its competitors, Brinker Incorporated showed revenues for
“fiscal 2006 of $4.15 million, $3.74 million in fiscal 2005 and finally $3.54 million
for fiscal 2004” (Brinker 10-K). This slight growth in sales each year proves that the
casual dining restaurant industry is increasing slowly each fiscal year. With this
said, industries will not have to take market share from each other in order to
grow steadily.
Concentration:
If you have one company who dominates the industry and sets extensive
rules to its competitors, this industry is said to have high concentration. The
casual dining industry deals with a monopolistic competition atmosphere because
of its many producers and consumers in its market. Sellers in this case will
attempt to differentiate their products from those of their competitors instead of
specifically competing on product price. This allows this industry to have a low
concentration field of study. Darden Incorporated currently is the largest dining
12
restaurant company in the world based on market share, sales and number of
company owned restaurants. The graph below proves this theory by comparing
Darden’s (DRI) three main competitors, Brink (EAT), Applebee’s (APPB) and OSI
(OSI) with the percentage change over the past two years. Clearly Darden’s
growth exceeds its competitors by a long shot. As you can see Darden’s percent
increase in the number of new restaurants overshadows the competition by at
least seventy percent.
http://finance.yahoo.com
Switching Costs and Differentiation:
The restaurant industry differentiates their products from their
competitors to gain the advantage. Since these competitors are continually
changing and re-innovating their products and services, customer switching costs
are reasonably high. This allows customers’ propensity to move from one
product to another to increase. Price competition is not a main focus within these
companies because they are trying to set themselves apart from one another.
Since this industry consists of mostly differentiation, firms must compete mainly
on customer service, restaurant layout, and product separation.
13
Fixed/Variable Costs and Scale Economies:
Firms in every industry are continually fighting for market share and if
fixed costs (Ex. utilities, rent) are higher than variable costs (Ex. cheese, bread)
companies are able to reduce their prices to level out the difference. Darden
reportedly increased its food and beverage variable costs in 2006 to more than
6.2% from 2005. In this case, since the competitors in this industry strive for
quality and not price, fixed costs will ultimately be lower than its variable costs.
Gradually, firms are opening up new chain locations nation wide. For instance,
Applebee’s opened up an additional 41 restaurants from 2005 to 2006. As new
locations transpire, so will the overall scale of the businesses explode. This
allows a restaurant to accommodate a greater number of people and increase
their profit margin.
Excess Capacity and Exit Barriers:
Excess capacity exists when marginal cost is less than the average cost, or
in other words, when the amount of inventory held exceeds the demand from
customers. Knowing that the casual dining industry operates at a monopolistic
level and the market demand has been steadily growing, excess capacity will
most likely rise as well. The casual dining industry has been known for its little
exit barriers over the past few decades. Firms are finding that the cost to leave
the competition exceeds the benefits of staying. This low exit barrier dilemma
reduces rivalry and makes the industry more attractive to customers.
The restaurant casual dining industry is a highly competitive yet growing
market. There is a low level of concentration, low fixed to variable cost ratio,
high switching costs, and very few exit barriers within this industry. Each of the
firms in this sector competes on a unique product, high level of quality, but at
the same time focuses on low costs.
14
Threat of New Entrants
The threat of new entrants is how easy or difficult it is for new firms to
start competing with existing firms. Like all profitable industries, new entrants
are drawn toward that particular market to hopefully grab at a piece of market
share. There are several barriers of entry that new firms must overcome before
officially claiming a name stake in an industry. These include how loyal
customers are to existing products, how quickly they can achieve economies of
scale, would they have access to suppliers, would government legislation prevent
them or encourage them to enter the industry, switching costs, and capital
requirements. It is extremely important in the restaurant industry for new
entrants to be able to establish a strong customer backing and to have a good
relationship with its suppliers.
Economies of Scale:
When new firms want to enter a competitive market, they will be forced
to match the scale of size of the previous existing firms. The two largest firms in
the casual dining industry are currently Darden Incorporated with 1,427
restaurants and $3,010,170 in total assets and Applebee’s standing at 1,804 total
locations and $935,465 in total assets. Since Darden is a top competitor and has
a key influence over the market share in this industry, they are able to utilize
fully the economies of scale within the market. This means that these two
companies are able to set the costs for the casual dining restaurant industry as a
whole.
Distribution Access and Supplier Relationships:
New firms trying to enter into a highly competitive market may have
major barriers that they must overcome. Experienced companies have most likely
established networks and relationships with distributors and suppliers that are
contract based. This competitive advantage can sometimes monopolize larger
15
firms like Brinker or Darden Incorporated from smaller companies trying to enter
into the restaurant chain business. For example, as a regulation for restaurant
chains, each company must have at least $1 million in annual sales with two or
more operating stores. This first mover advantage can limit entry into this
industry by a significant amount.
Darden currently has contracts with Jtech communications, General Mills,
and 1,998 other suppliers around the world. Applebee’s has partnered up with
Weight Watchers, Tyler Florence (world renowned chef) and Cue Search. Brinker
Incorporated has thousands of exclusive contracts currently. The relationships
these firms hold puts them one step ahead in the casual dining industry allowing
them to promote and sell their products at a discounted price. New entrants will
have a hard time keeping up and competing with billion dollar firms with well
established networks.
Legal Barriers to Entry:
The legal barriers to enter into the restaurant business are few and far
between. Like all businesses, there are legal complications that have to be faced
at some point in time. If an industry has locations in countries other then the
United States, their rules of business and currency conversions are undoubtedly
going to be different than that of the United States. Also, new entrants may be
faced with civil lawsuits like customer injuries, or racial discrimination. Regardless
of the industry, all businesses face public and private issues daily which make
smaller firms that more hesitant to enter into the competition.
As obvious as it sounds, new firms will have a difficult time entering a
market with significantly low barriers of entry. Relationships between firms and
distributors/suppliers already exist between larger firms who have been in the
business longer. The majority of revenue generated and market share companies
will also have higher benefits when establishing economies of scale. With this
said, new entrants will find it difficult to enter into the casual restaurant dining
16
industry. This being so, they will have a hard time establishing themselves and
will be more likely to not last long in the market.
Threat of Substitute Products
In any industry, companies must be aware of possible substitute products.
In the casual dining industry, there is a great threat of competition from other
restaurants and the supermarket industry. Because the casual dining restaurants
cater to a specific type of food, a main factor effecting customer’s willingness to
switch products is their preference in food type. People are willing to pay a
premium to eat the specific type of food they want prepared in specialty ways.
Customer’s that choose restaurants in this industry are also willing to pay a
premium for good service, such as well trained wait staff and cooks.
The supermarket industry also poses a threat by offering ingredients to
make the food yourself, and also by providing quality made entrees and side
dishes that are pre-made in the deli section (Darden 10-K). Price plays a role in
customer’s decision of eating cheaper from the supermarket or eating at a
restaurant. Darden’s main customer bases are those who are willing to pay
extra to dine in a nice atmosphere while eating well cooked food.
Bargaining Power of Buyers
Customers have some control over prices in casual dining restaurants.
Switching costs are low to none, so extremely high prices could easily force
customers to choose alternative products. Most casual dining restaurants do
have a degree of specialization and differentiation in the products sold at each
restaurant. Therefore customers are less price sensitive and the business is able
to charge an amount greater than other restaurants that have more generalized
items on their menus.
The casual dining customer base does not have much relative bargaining
power because each customer represents only a small fraction of a restaurant’s
business. The volume of customers is high and the volume of product bought
17
per customer is low. If a single customer is lost, the impact on the company is
minimal, so bargaining has little effect on prices.
Bargaining Power of Suppliers
Each casual dinning restaurant purchases food and supplies from
approximately 2000 different suppliers in several countries around the world.
There is little price sensitivity with respect to many of the seafood products that
they buy. Seafood is shipped from around the world, and availability can be
dependant on many factors of nature. Because of the specialty of some of its
product, the company has little control over prices it pays. All other supplies are
bought from competitive suppliers that can be replaced on short notice and with
little hassle. This gives the business a lot of bargaining power with all other
supplies.
Value Chain Analysis
Industry Classification
The restaurant business is an extremely aggressive industry that
competes heavily on price, cost, and the opening of new restaurants, therefore
using a differentiation strategy making them a low competition firm. An industry
that can execute the key success factors of this strategy can gain a competitive
advantage over other industries. The restaurant with the best food selection for
the price and most accessible locations will gain the majority market share.
Superior Product Quality and Variety
In the casual restaurant industry a company must have a superior product
to offer that is of the utmost quality to gain the highest customer base. With
there being a large amount of casual restaurants one must offer a variety of
products of the best quality to stand above their competitors. If a company does
18
not provide a unique dining experience it will fall below the competition and lose
all demand for its product.
Superior Customer Service
The restaurant business relies heavily on its customer service. The
restaurant has to ensure that its customers have an enjoyable experience
therefore ensuring their continued business. Customer service is the key
component in surviving the restaurant industry. A customer will remember the
service that they receive while dining at the establishment and that will
determine if they return or not.
Investment in Brand Imaging
Brand imaging is a key element of a successful company. A memorable
atmosphere must be created to ensure that customers have an enjoyable time
and would guarantee their return. Customers associate company names with the
atmosphere they have experienced. A company must have a unique distinction
about them that diversifies them from their competitors. This will ensure that
customers will recognize these characteristics and associate them with a certain
brand.
Firm Competitive Advantage Analysis
Competitive Strategies
Darden Restaurants Incorporated has strived to be “the best casual
dining, now and for generations” and “to nourish and delight everyone we serve”
since 1995 (Darden’s 2006 10-K). They focus to give an enjoying, casual dining
experience that is affordable. Through superior product quality and variety,
19
superior customer service, and investment in brand imaging, Darden Restaurants
Incorporated has risen to the casual dining leader.
Superior Product Quality and Variety
According to Darden’s 2006 10-K, the restaurant industry is “intensely
competitive with respect to the type and quality of food, price, service,
restaurant location, personnel, concept, attractiveness of facilities, and
effectiveness of advertising and marketing.” Darden offers a variety of dishes to
complement the atmosphere and design of the restaurant. Red Lobster, the
largest casual seafood restaurant, provides fresh fish, shrimp crab, lobster,
scallops, and other seafood. Olive Garden, the market share leader among casual
dining Italian restaurant, imports numerous wines and coffee straight from Italy.
Their menu includes appetizers; soups, salads, and breadsticks; a variety of
baked pastas; sautéed dishes with chicken; seafood; grilled meats; and an
assortment of desserts. Bahama Breeze mirrors their Caribbean atmosphere by
offering Caribbean style food, such as seafood, chicken, and steaks, along with
exotic, tropical drinks. Finally, Smokey Bones provides barbequed pork, beef, and
chicken.
Not only do the four restaurants of Darden supply a variety of food
choices, but their food is have excellent quality because it is all fresh. Darden’s
ability to provide fresh and tasty food depends on their relations with their
suppliers. Their purchasing staff analyzes, negotiate, and purchase from more
than 2,000 suppliers in 45 different countries. One of Darden’s requirements is
that the suppliers must meet “strict quality control standards in the development,
harvest, catch and production of food products” (Darden’s 2006 10-K). For
example, the seafood is tested to make sure they are microbiologically safe.
Darden’s variety and quality of food gives them a great advantage over their
competitors.
20
Superior Customer Service
Since Darden began in 1995, they have focused their attention of their
guests having excellent food, service, and experience. They desire “to nourish
and delight everyone we serve,” the core purpose of Darden (Darden’s 2006 10K). This would not be accomplished without the great customer service Darden
provides. Darden believes that the customer is the top priority. For example,
Olive Garden’s purpose is “Hospitaliano!, our passion for 100% guest delight”
(www.olivegarden.com). When you dine at Olive Garden, you are catered to your
every need. Also, Darden provides a Guest Service Satisfaction Survey in which
the guests rate their customer service on a scale of one to ten. Without Darden’s
excellent customer service, they would not have risen to the top casual dining
restaurants in the United States.
Investment in Brand Imaging
Brand Imaging is one of the main commitments to strengthen this multibrand casual dining company. They want to leave a lasting impression in their
guests’ minds of the enjoyable atmosphere, the terrific food they ate, and the
excellent service they received while dining with the Darden restaurants. For
example, Olive Garden focuses on providing their guests with a family fun
environment that is a genuine Italian dining experience, “when you’re here your
family” (www.olivegarden.com). Also, Bahama Breeze focuses on the Caribbean
theme by providing “Caribbean-inspired food, handcrafted tropical drinks, [and
a] vibrant atmosphere” (www.bahamabreeze.com). From these examples, we
have concluded that Darden Restaurants does an excellent job at providing
brand imaging.
21
Accounting Analysis
In order for an analyst to properly “evaluate the degree to which a firm’s
accounting captures its underlying business reality,” he/she must conduct a
thorough accounting analysis (Palepu 3-1). There are six steps to this process
that must be completed. First, the analyst must identify key accounting policies.
The policies are used to measure the firm’s critical factors and risks. The next
step is to assess the accounting flexibility of the firm that is allowed under the
Generally Accepted Accounting Practices (GAAP). Third, the analyst must
evaluate the accounting strategy that the firm chooses to implement. The fourth
step is to evaluate the quality of disclosure. Fifth, the analyst must identify
potential red flags that point to questionable accounting practices. Finally, if the
accounting analysis suggests that the firm has misleading numbers, then the
analyst must undo the accounting distortions by using the statement of cash
flows and the financial statement footnotes.
Key Accounting Policies
To be able to value a firm properly, the key success factors of Darden
Restaurants must be analyzed to see if they correspond with the accounting
practices that they choose. Under the five forces model, we stated that Darden
Restaurants’ key success factors include the following: superior product quality
and variety, inventory management, and investment in brand imaging. These
key success factors and the accounting policies chosen by Darden should be
closely related. If they do not somewhat mirror each other, then red flags are
identified and further analysis is needed.
22
Pensions
One key accounting policy for Darden centers on its need for superior
product quality and variety. In order to achieve this, the firm must continuously
attract superior employees. One of the ways in which Darden attracts and
retains these high talent individuals is by offering both a non-contributory
defined benefit pension plan for their salaried employees as well as a
contributory postretirement benefit plan for retirees. These funds are “primarily
invested in U.S., international and private equities, long duration fixed-income
securities and real assets” (Darden 10-K).
Capital Lease vs Operating Lease
Next, we will take a look at the effect of capitalizing some of the longterm leases the firm currently identifies as operating leases. It is often
advantageous for firms to recognize leases as operating leases, which are
treated as rent expense, because it does not recognize the liability of future
obligations. However, it is also misleading, as most leases are non-cancelable.
We will examine how Darden accounts for leases, as well as what effect these
choices have on our perception of the company.
Inventory Waste
Another key accounting policy, not only for Darden but for the restaurant
industry as a whole, is how firms deal with inventory losses. Two of Darden’s
key success factors were offering superior quality and variety and enhancing
brand image. In order to do this, they must continuously offer only fresh foods
and take steps to sooth any dissatisfied customers. Darden attempts to
accomplish this in three ways. First, the company has a meal replacement
policy. That is, if a customer doesn’t like the meal they ordered, they can send it
back to the kitchen and order something else, with the restaurant absorbing the
cost of one of the meals. Second, the firm has a policy of compensating
23
customer meals to prevent an incident in a wide variety of cases. (This can
include long wait times, a hair in the food, undercooked meats, etc.) Finally, the
company minimizes its inventory loss due to spoilage by maintaining strict levels
of inventory and observing proper storage techniques.
Areas of Accounting Flexibility
While there is a minimum accounting standard (GAAP in the U.S.) which
all companies must conform to, there remains a large degree of flexibility in
accounting methods. In an ideal world, this flexibility would be used by
managers to provide a clearer picture of “the economic consequences of its
business activities” (Palepu). However, this flexibility can also be used to
manipulate the financial statements, either for the manager’s personal gain or to
mislead investors. Areas of flexibility in the casual dining industry include
inventory valuation, pension plans, and capital and operating leases. In the
following sections, we will examine how Darden utilizes this flexibility in regards
to its key accounting policies.
Pension Plans
Defined benefit plans, by definition, represent a high level of risk for the
beneficiary (in this case, Darden.) The firm is responsible for providing the
necessary funds to cover future costs of providing these benefits. It is difficult to
assign a particular dollar amount to this total due to the uncertainty of future
economic conditions. Darden estimates their long term rate of return on these
assets to be 9%. “The expected long-term rate of return on plan assets and
health care cost trend rates are based upon several factors, including our
historical assumptions with actual results, an analysis of current market
conditions, asset allocations and the views of leading financial advisers and
economists” (Darden’s 10-K). The 9% rate represents the liability Darden books
to cover its expected future pension costs. We find that a 9% rate of return is
very reasonable given the company’s investment strategy and previous results.
24
In comparison to the industry, Darden is unique among its direct
competitors as the only corporation that offers a defined benefit plan. As such, it
is difficult to analyze the believability discount rates, expected rate of return and
estimated liabilities provided. However, it is still possible to assess these
variables to some degree. The firm uses a discount rate of 5.75% (used to find
the present value of future benefit obligations), a number that we believe
represents a conservative estimate. However, we are dissatisfied with Darden’s
estimation of future health care costs. In their 10-K report, Darden assumes an
8.5% annual increase in health care expenses for 2007, and forecasts that this
will gradually decrease to 5% in 2011. This does not reflect what we believe to
be the current trend in rising health care costs. This concern is illustrated in the
following chart depicting historic health care costs in the U.S.
Year
1999
2000
2001
2002
2003
% Increase in
7.3%
8.1%
11.2%
14.7%
10.1%
total health care
benefit cost
(http://www.commondreams.org/headlines03/1208-03.htm)
Factoring in estimates for 2005 (8%) and 2006 (12%, as estimated by
the Segal Group), we find that Darden’s stance on the deceleration of health care
costs is misleading.
Inventory Management
it is how Darden accounts for these policies that we will ultimately focus
on. We were not able to find any information on how the firm accounts for
these losses. Given that it is possible the charges are simply lumped into some
other liability, this is not necessarily an indication of aggressive accounting. It
does however raise questions as to whether or not these costs are being
accurately represented in the company’s financial statements. We will examine
25
this problem further when we discuss what we see to be “red flags” within
Darden’s accounting policies.
Leases
Generally speaking, there are two acceptable methods for recording
leases under GAAP. First, there are “capital” leases. A capital lease is used
when the company will have the rights to use the asset for all (or close to all) of
the assets useful life. When a company enters a capital lease, the entire amount
of the asset is debited to assets and credited to liabilities. For this reason, it is
common for companies to attempt to classify leases as operating leases. Under
an operating lease, there is no effect on either assets or liabilities. Instead, the
company recognizes the lease by recording rent expense charges. The problem
with this is that, in general, leases are long-term, non-escapable contracts.
Failing to recognize the future obligations of the company leads investors to
underestimate liabilities and over-value the firm.
Darden recognizes their leases as operating leases. However, the
company is very open in its disclosure of future obligations in regards to these
leases. The following table illustrates the amount of future obligations the
company is carrying in operating leases.
OPERATING LEASES (figures in thousands)
Payments due in
< 1 year
1-3 years
3-5 years
5+ years
Amount
$72876
$124505
$93046
$134987
By breaking down the costs of their future obligations, Darden
acknowledges that they have a total future obligation of $425 million. We
believe that this is a fairly accurate representation of the unrecognized liability
facing the company.
26
Quality of Disclosure
The quality of disclosure is an important measure of the firm’s accounting
quality. It helps the outsiders of a company see inside the company. The better
the quality of disclosure, the more transparent the company will be. Having
transparent financial reporting practices means the company allows users to get
a true and fair picture of the firm. This allows analysts the ability to make a more
precise evaluation of the company.
Qualitative Analysis
The majority of the information needed for the qualitative analysis is
found in the company’s SEC filing of the 10-K. This report is “an annual report
required by the U.S. Securities and Exchange Commission (SEC), that gives a
comprehensive summary of a public company's performance….[It] includes
information such as company history, organizational structure, executive
compensation, equity, subsidiaries, and audited financial statements, among
other information” (www.wikipedia.org). Overall, Darden Restaurants does a
superb job at reporting its financial condition.
Darden does not necessarily provide a transparent view of their assets,
liabilities, and equity in their financial statements, but they do break down each
segment in their 10-K to further explain. For example, they explain in depth their
long-term debt and pension plans.
The company did an excellent job at providing a transparent view of their
long-term debt. Because they list each of the note and debentures along with
their interest rates and dates to maturity, an investor has a very enlightened
view of the company’s long-term debt. They can clearly see how much money
they owe in each category and year.
27
May 28, 2006
May 29, 2005
----------------------------------------------------------------------------8.375% senior notes due September 2005
$
-$ 150,000
6.375% notes due February 2006
-150,000
5.750% medium-term notes due March 2007
150,000
150,000
4.875% senior notes due August 2010
150,000
-7.450% medium-term notes due April 2011
75,000
75,000
7.125% debentures due February 2016
100,000
100,000
6.000% senior notes due August 2035
150,000
-ESOP loan with variable rate of interest (5.41% at May 28,
2006) due December 2018
22,430
26,010
-------------------------------------------------------------------------------------------------Total long-term debt
647,430
651,010
Less issuance discount
(2,829)
(763)
-------------------------------------------------------------------------------------------------Total long-term debt less issuance discount
644,601
650,247
Less current portion
(149,948)
(299,929)
-------------------------------------------------------------------------------------------------Long-term debt, excluding current portion
$ 494,653
$ 350,318
#’s from Darden’s 10-K
Darden Restaurants explain their retirement plans in detail. They break
down these plans into defined benefit plans and postretirement plans. They
describe what they are currently paying and also give a future forecast of what
they expect to pay in each of these plans. For example, they expect to contribute
about $400 to their postretirement plan during the fiscal year 2007. The
company reveals the relevant information, such as the discount rates, the future
discount rates, and the expected return on plan assets. This important
information has a “significant effect on amounts reported for defined benefit
pension plans” (Darden’s 10-K).
Despite Darden’s excellent disclosure of their long-term debt and
retirement plans, they give very little information about their inventory. Besides
giving the amount of inventories that they hold on the balance sheet, the only
information that was given about their inventory is that they “consist of food and
beverages and are valued at the lower of weighted-average cost or market”
(Darden’s 10-K). We believe that they do not disclose this information because
28
they don’t want to advertise to their competitors how much they expect of their
inventory to sell in the next year.
In summary, Darden Restaurants has clearly done an outstanding job in
disclosing its financial performance throughout its 10-K. Despite the poor job of
disclosing its inventories, we believe that the report is sufficient and helpful.
Anyone can read and understand their financial status to make an informed
decision about possibly investing.
Quantitative Analysis
Quantitative information is found using ratios in either raw form or change
form. Raw form is finding the ratio using the numbers from the same year.
Change form is finding the ratio by using the difference of two years. This
quantitative information expresses the company’s performance in number terms.
In order for red flags to be identified, the ratios must be computed. Therefore,
conducting a quantitative analysis is very important in valuing a firm.
Sales Manipulation Diagnostics
Since managers have the incentives to alter the sales numbers in order to
benefit them personally, sales manipulation should be a general concern for most
companies. We compared the ratios of Darden Restaurants with those of its
competitors to see where DRI stands. Neither Darden nor any of its competitors
disclose warranty liabilities. We believe this is due to the fact that they do not
offer a guarantee that their customers will be satisfied with their purchase after
five years. Therefore, a graph of Net Sales/Warranty Liabilities ratios is not
available.
29
Sales Manipulation Diagnostics
DRI
Net
Net
Net
Net
Net
Sales/Cash from Sales
Sales/Net Accounts Receivable
Sales/Unearned Revenues
Sales/Warranty Liabilities
Sales/Inventory
2006 2005 2004 2003 2002
1.01
1.01
1.01
1.01
1.01
154.15 144.57 165.36 160.39 150.12
56.77
59.66
66.26
64.04
N/A
N/A
N/A
N/A
N/A
N/A
28.79
22.42
25.17
26.81
25.33
EAT
Net
Net
Net
Net
Net
Sales/Cash from Sales
Sales/Net Accounts Receivable
Sales/Unearned Revenues
Sales/Warranty Liabilities
Sales/Inventory
2006
1.01
79.01
62.33
N/A
102.93
2005
1.01
86.01
73.01
N/A
77.08
2004
1.01
93.35
85.13
N/A
92.91
2003 2002
1.01
1.01
91.21 127.67
121.05 106.37
N/A
N/A
134.63 114.61
2006
1.01
77.93
20.96
N/A
45.02
2005 2004 2003 2002
1.01
1.00
1.00
1.00
115.30 146.69 170.97 197.38
20.96
34.52
32.03
33.03
N/A
N/A
N/A
N/A
52.28
50.17
44.42
65.73
2006
1.04
25.04
24.79
N/A
103.81
2005
1.04
28.60
27.65
N/A
53.14
OSI
Net
Net
Net
Net
Net
Sales/Cash from Sales
Sales/Net Accounts Receivable
Sales/Unearned Revenues
Sales/Warranty Liabilities
Sales/Inventory
APPB
Net
Net
Net
Net
Net
Sales/Cash from Sales
Sales/Net Accounts Receivable
Sales/Unearned Revenues
Sales/Warranty Liabilities
Sales/Inventory
2004
1.04
24.95
32.24
N/A
27.18
2003
1.03
27.14
35.95
N/A
40.69
2002
1.04
27.77
N/A
N/A
63.00
#’s from 10-K’s
30
Net Sales/Cash from Sales
1.05
1.04
1.03
1.02
1.01
1.00
0.99
2002
2003
DRI
2004
EAT
2005
OSI
2006
APPB
The ratio of net sales/cash from sales is computed by taking the net sales
of the company and dividing it by the net sales minus net accounts receivable.
This ratio helps to indicate the amount of cash collected each year from
customers. If the ratio equals one, then the company collects cash from sales
equal to the net sales. Each of the companies’ ratios are very close to one. This
ratio is a measure of how well sales are supported by cash received from sales.
If the ratio begins to increase dramatically, we would worry that the firm might
be artificially inflating their numbers to increase net income. However, since the
firm has a consistent ratio at (or close to) $1 in cash from sales for every $1 net
sales, we find their sales figures to be highly reliable.
31
Net Sales/Net Accounts Receivable
200
190
180
170
160
150
140
130
120
110
100
90
80
70
60
50
40
30
20
2002
2003
DRI
2004
EAT
2005
OSI
2006
APPB
When analyzing net sales/net accounts receivable, a higher ratio is
preferred to a lower ratio. A higher ratio suggests that accounts receivable make
up a smaller portion of sales. If the receivables make up a smaller portion of
sales, then there are higher cash sales than there are sales on account. In our
case, we are attempting to deduce how reliable the firms sales figures are.
Darden consistently has over $150 in sales for every $1 in accounts receivable, a
number which could possibly raise a red flag in our evaluation of the reliability of
the firms sales. However, since it is relatively in line with its competitors, and its
sales/cash from sales ratio is near 1, we do not find this to be a significant
concern.
32
Net Sales/Unearned Revenue
125
120
115
110
105
100
95
90
85
80
75
70
65
60
55
50
45
40
35
30
25
20
2002
2003
DRI
2004
OSI
2005
EAT
2006
APPB
When analyzing the ratio of net sales to unearned revenue, an analyst
would look for a sudden decrease in unearned revenue, for this could possibly be
a red flag. If there is a sudden decrease in unearned revenue, then there would
be an increase in net sales making the ratios of the company increase rapidly.
When this occurs, it could be caused by booking revenue prematurely, meaning
they mark it in their books before they have completed the task or delivered the
goods and the revenue is earned. Looking at Darden’s net sales/unearned
revenue, between the years 2003 and 2004, net sales increase and unearned
revenue decreases. This causes the ratio to rise. However, from 2004 and on,
net sales decrease and unearned revenues increase, causing the ratio to decline.
33
We are not able to determine what happens during 2002 since unearned revenue
was not disclosed during that year. Since there are not any sudden increases in
the ratio, there is no reason to be concerned about accounting fraud. When
comparing the firms in the industry, there is a wide gap between them.
Applebee’s and OSI have very close ratios that are for the most part declining
due to their declining net sales and increasing unearned revenues. Brinker has
fluctuated over the past five years from having a sudden increase in the ratio to
having a sudden decrease.
Net Sales/Inventory
140
130
120
110
100
90
80
70
60
50
40
30
20
2002
2003
DRI
2004
EAT
2005
OSI
2006
APPB
When comparing net sales/inventory, a higher ratio would indicate a
quicker turnover of inventory and a more efficient operation cycle. When a ratio
increases, it is due to either a rise in sales or a drop in inventory, both of which
are very desirable and positive situations. A dramatic rise in this ratio could be
34
an indicator of sales manipulation, as inventory levels must support an increase
in sales. In Darden’s case, it appears that their sales figures are supported by
inventory, thus increasing their reliability.
Core Expense Manipulation Diagnostics
Every company in each industry will most likely deal with a professional
auditor. These analyses will compute core diagnostic ratios to check for potential
expense manipulations by company managers. We have calculated six ratios
based on each of four leading competitors in the field of restaurant casual dining.
Before 2005, Darden Restaurants did not disclose a pension or benefit plan for
its employees. OSI International and Applebee’s also did not disclose any
information about its employee pension plans as shown in the chart below.
35
Core Expense Manipulation Diagnostics
DRI (Darden Restaurants)
Asset Turnover
CFFO/OI
CFFO/NOA
Total Accruals/Change Sales
Pension Expense/ SG&A
Other Employment Expenses/SG&A
2006
1.91
1.49
.17
.75
.28
.17
2005
1.80
1.38
.15
.64
.27
.15
2004
1.80
1.58
.14
.64
N/A
N/A
2003
1.75
1.50
.14
.55
N/A
N/A
2002
1.73
1.46
.16
.45
N/A
N/A
2006
1.87
1.44
.26
.76
.06
.05
2005
1.81
2.00
.17
.85
.06
.04
2004
1.68
1.92
.20
.67
.10
.08
2003
1.69
1.68
.21
.49
.13
.09
2002
1.62
1.58
.19
.46
.14
.08
2006
1.74
2.42
.24
.97
N/A
N/A
2005
1.83
1.59
.27
.85
N/A
N/A
2004
1.87
1.28
.26
.56
N/A
N/A
2003
1.87
1.02
.26
.50
N/A
N/A
2002
1.70
1.17
.37
.49
N/A
N/A
2006
1.28
1.33
.27
.66
N/A
.02
2005
1.23
1.40
.37
.50
N/A
.03
2004
1.29
1.15
.39
.43
N/A
.05
2003
1.35
1.14
.42
.48
N/A
N/A
2002
1.28
1.04
.35
.51
N/A
N/A
EAT (Brinker International)
Asset Turnover
CFFO/OI
CFFO/NOA
Total Accruals/Change Sales
Pension Expense/ SG&A
Other Employment Expenses/SG&A
OSI (Restaurant Partners)
Asset Turnover
CFFO/OI
CFFO/NOA
Total Accruals/Sales
Pension Expense/ SG&A
Other Employment Expenses/SG&A
APPB (Applebee’s)
Asset Turnover
CFFO/OI
CFFO/NOA
Total Accruals/Sales
Pension Expense/ SG&A
Other Employment Expenses/SG&A
Information computed from http://www.mergentonline.com
36
Asset Turnover
2.50
2.00
1.50
1.00
0.50
0.00
2002
2003
DRI
2004
EAT
2005
OSI
2006
APPB
The average asset ratio is calculated by adding the assets for the five most recent quarters and
dividing them by five. “This sector tells you how quickly the company is converting its physical asset base
into sales.” (Darden 10-K)
If the company ratio is low then the degree of capital
intensity will be higher. The overall asset turnover for Darden Restaurants (1.91)
was relatively higher then the industry average of 1.31. Deflated results in this
ratio could be an indication that the firm is not writing off assets, and therein
understating expenses. This is a common tactic to inflate net income. In our
case, we found the firms asset turnover ratio to be fairly indicative of a healthy
firm in the casual dining industry.
37
CFFO/OI
3.00
2.50
2.00
1.50
1.00
0.50
0.00
2002
2003
DRI
2004
EAT
2005
OSI
2006
APPB
This area of ratios gives us the reader a comparison of the source of
income for a firm by comparing the operating end of cash flows by operating
income. A smaller percentage could be caused by a decrease in cash flow
operations or an increase in operating income on the income statement. Darden
Restaurants has shown a pretty even level of outcome for the past five years. As
a whole, this industry has done an excellent job of matching cash flows from
operations to total income
38
CFFO/NOA
0.45
0.40
0.35
0.30
0.25
0.20
0.15
0.10
0.05
0.00
2002
2003
DRI
2004
EAT
2005
OSI
2006
APPB
This ratio of cash flow from operations relates itself with property, plant,
and equipment found in the balance sheet. The higher the percentage ratio, the
more cash is being generated from these total assets. This ratio is a good check
point to feel out whether the firms cash flow from operating activities is
supported by their plant, property, and equipment. If this ratio blows up over
time, it may indicate that the firm is artificially inflating their results. We did not
find any such problems in Darden’s numbers. While there has been an increase,
we feel that the market as a whole seems be increasing progressively since 2002
and will more than likely continuing this trend because of the expanding
industry, and thus we are not concerned.
39
Total Accruals/Sales
1.20
1.00
0.80
0.60
0.40
0.20
0.00
2002
2003
DRI
2004
EAT
2005
OSI
2006
APPB
The ratio above shows how the total accrual liabilities of companies match
up with a company’s total net income (earnings). This is important because
accruals allow expenses to be reported when incurred, not paid. This area of
consolidation has shown a rising trend in the accrual/sales ratio as shown in the
chart above. This is a result of firms reporting their long-term debt directly on
their balance sheets each year. This ratio measures how timely the firm is in
recognizing accrued expenses. The higher the ratio, the more efficient the firm
is. In Darden’s case, we found the firm to be right around the average for their
industry. Combined with their reasonable ratio of 0.6, we believe that this
increases the believability of Darden’s information.
40
Pension Expense/SG&A
0.30
0.25
0.20
0.15
0.10
0.05
0.00
2002
2003
DRI
2004
EAT
2005
OSI
2006
APPB
This ratio (pension expense/SG&A) compares the companies employee
benefit plan to that of the other operating expenses in “sales, general, and
administrative”. This option will allow employers to forecast or estimate the
direction that their pension programs may take. These expenses can accurately
be described as “people expenses” and one must worry about possible
manipulation. If this ratio decreases dramatically, one must worry about all of
the estimations that go into pension expenses. (It is possible that a company
may be underestimating these expenses.) However, in Darden’s case, it seems
41
as though this ratio is very reasonable, i.e. that the firms pension expenses are
supported by its SG&A expenses. Furthermore, when compared with the
industry, the ratio seems even more reliable.
Other Employment Expense/SG&A
0.18
0.16
0.14
0.12
0.10
0.08
0.06
0.04
0.02
0.00
2002
2003
DRI
2004
EAT
2005
OSI
2006
APPB
This ratio (other employment expense/SG&A) computes the difference
between a firms employer expense (ex. health care, medical expenses) to that of
other operating expenses as in “sales, general, and administrative.” Other non
pension expenses could also include post-retirement benefits which Darden
Restaurant began in early 2005. Since there is a very limited history regarding
this ratio for Darden, we are unable to come up with a definitive interpretation of
42
the results. We can say that, in general, the results produced are not by
themselves cause for concern. Since Darden’s ratio is much higher than the
industry, we conclude that their “other expenses” number is believable and is
supported by their SG&A total.
Potential Red Flags
By evaluating several categories of the financial statements one can
identify potential red flags. Several ratios, changes in accounting policies, and
drastic changes in figures across multiple years on the financial statements can
indicate red flags. These red flags must be identified in order to properly
evaluate the company.
Our ratio analysis showed no major variations from their normal trends
However, small changes were noticed in the year 2005 in the sales to account
receivables, sales to inventory, and income to cash flow from operations ratios.
These changes could possibly be explained by the closing of several restaurants
in the year 2004. We also noticed a spike in restructuring and impairment
charges in 2004, which could also be explained by the closing of restaurants.
There have been no changes in accounting policies since 1996. This
indicates no apparent red flags in their accounting policies. As well, they have
not changed auditors since 1996. This could signify a partnership between
Darden and its external auditor. The auditor could have some incentive to ignore
inaccuracies of the financial statements.
Darden clearly states their financial obligations with respect to their
operating leases. These future obligations are worth approximately $425 million.
This is a large financial obligation which has an adverse affect on the cash flows
of the company.
43
Darden does not clearly state write-offs from inventory spoilage as well as
comped meals. This may or may not be an issue for the company; however it is
not addressed in any financial statements. This could be a potential red flag.
The company has a defined benefit pension plan. These pension plans are
a large future obligation for Darden. Also Darden’s forecast of decreasing health
care expenses does not coincide with current health care trends. Their
undervaluation could pose future expenses which the company may not be
prepared for.
After the evaluation of potential red flags we have come to the conclusion
that there are no major red flags. However, there are some red flags that still
deserve proper consideration.
Fixing Accounting Distortions
While for the most part we found Darden’s financial statements to be
fairly transparent, there were several areas which require further analysis. The
area which we are most concerned with is the recognition of leases as “operating
leases.” To examine the effect that recognizing these expenses as capital leases
has, we used Darden’s previously established discount rate of 3.25%. We
believe this is a reasonable figure, as it slightly outpaces inflation over the past 5
years. Once calculated, we found that recognizing the $425 million in obligations
as current liabilities would result in an increase to liabilities of $411 million.
Given Darden’s current balance of $1.7 billion in liabilities, this represents an
increase of 23%. We find this to be a significant understatement in liabilities.
While this is consistent with industry trends, as most of Darden’s competitors
recognize leases in a similar way, we feel this represents important information
to consider in ratio analysis, among other things.
44
Financial Analysis, Forecast Financials, and Cost of
Capital Estimation
Profitability and growth are the two key factors that are used to value a
firm’s current performance and future outlook. This section uses financial ratios
and a cash flow analysis to forecast the growth of the firm over the next ten
years. Before we can forecast the future growth, a series of ratios must be
computed to obtain a true picture of the current value of the firm. The ratios are
divided up into three sections: liquidity, profitability, and capital structure. With
these ratios, we can determine how the firm is changing its business structure
and then be able to more accurately forecast future performance. The forecasts
are estimates and should not be valued as facts or error free.
Financial Analysis
The ratio analysis takes the past and present financial reports and
determines liquidity, profitability, and capital structure ratios that will be used to
help better forecast the future growth and value of the firm. By conducting a
ratio analysis, we not only can see the firm’s current growth, but we can
compare it to its competitors. This analysis allows us to determine whether the
firm is competitive among their competitors in the industry or whether they are
outliers. If we discover that a firm in an outlier in many aspects, then it could
indicate that the firm is not performing efficiently and therefore can lead to a
false perception of the firm’s value.
Liquidity Analysis
Liquidity ratios are a class of financial measurements used in determining
whether a company can pay off its short-term debt obligations. The ability for
firm’s to cover short-term debt with cash is a critical factor when creditors are
45
looking for payment from the company borrowing money. The current ratio and
quick asset ratio are of significant importance because they show if the firm has
enough resources (liquidity) to pay back its debts over the next 12 months. The
inventory and accounts receivable calculations show the number of times that
the company’s accounts receivable and inventory is collected or turned over
throughout the year. Generally creditors would prefer to see higher numbers
with these ratios because this reduces the risk of the loan. The chart below
breaks down the four most competitive companies within the casual dining
industry: Darden Restaurants, Brinker International, OSI Restaurants, and
Applebee’s.
46
Liquidity Analysis
DRI (Darden Restaurants)
Current ratio
Quick Asset Ratio
Inventory Turnover
Receivables Turnover
Working Capital Turnover
Inventory Days
A/R Days
2002
2003
2004
2005
2006
Change on
Liquidity
0.74
0.30
19.63
150.18
4.16
18.59
2.43
0.51
0.12
20.93
160.39
4.82
17.44
2.28
0.51
0.10
19.60
165.37
4.86
18.62
2.21
0.39
0.08
17.40
144.56
3.64
20.98
2.53
0.37
0.07
22.28
154.15
4.08
16.38
2.37
Unfavorable
Unfavorable
Favorable
Favorable
No Change
Favorable
No Change
2002
2003
2004
2005
2006
Change on
Liquidity
0.47
0.11
31.63
127.68
-18.01
11.54
2.86
0.54
0.22
36.90
94.90
-22.86
9.89
3.85
1.05
0.70
26.89
97.74
170.40
13.58
3.74
0.57
0.21
22.24
86.65
-21.77
16.41
4.21
0.49
0.22
28.79
79.01
-16.28
12.68
4.62
No Change
Favorable
Unfavorable
Unfavorable
Favorable
Unfavorable
Unfavorable
2002
2003
2004
2005
2006
Change on
Liquidity
0.73
0.91
24.79
271.98
66.83
14.72
1.34
0.79
0.46
16.50
211.95
-42.83
22.13
1.72
0.596
0.30
18.81
163.47
-21.47
19.41
2.23
0.52
0.27
19.10
123.46
-16.93
19.11
2.96
0.56
0.21
16.26
181.99
-15.74
22.45
2.01
Unfavorable
Unfavorable
Unfavorable
Unfavorable
Unfavorable
Unfavorable
No Change
2002
2003
2004
2005
2006
Change on
Liquidity
0.60
0.36
53.41
27.77
-15.89
6.83
13.14
0.58
0.33
34.99
27.14
-13.83
10.43
13.45
0.66
0.33
22.94
24.67
-19.14
15.91
14.79
0.46
0.26
46.02
28.34
-10.08
7.93
12.88
0.56
0.38
91.25
24.67
-14.66
4.00
14.80
Unfavorable
No Change
Favorable
Unfavorable
Favorable
Favorable
Unfavorable
EAT (Brinker International)
Current ratio
Quick Asset Ratio
Inventory Turnover
Receivables Turnover
Working Capital Turnover
Inventory Days
A/R Days
OSI (Restaurant Partners)
Current ratio
Quick Asset Ratio
Inventory Turnover
Receivables Turnover
Working Capital Turnover
Inventory Days
A/R Days
APPB (Applebee’s)
Current ratio
Quick Asset Ratio
Inventory Turnover
Receivables Turnover
Working Capital Turnover
Inventory Days
A/R Days
(All decimals rounded 2 places)
47
Current Ratio
Current Ratio
1.20
1.00
0.80
0.60
0.40
0.20
0.00
2002
2003
DRI
2004
EAT
2005
OSI
2006
APPB
The current asset ratio is computed by dividing total current assets by
total current liabilities. This ratio shows how many resources are available and
whether the firm can pay off its current debt. In this case, bigger is better and a
ratio around 1.00 for most businesses is preferred. A current asset ratio of 1
literally means that the firm has exactly enough current assets (assets converted
to cash within one year) to cover its current liabilities (liabilities due inside of one
year). When comparing Darden and its competitors over a five year period, it is
safe to say that each of them carry a current ratio of less than one. While this
could represent an inability for these firms to pay off their short-term debt
obligations within terms, it is worth noting that “A current ratio of less than 1.0
does not necessarily signal problems unless this weak current ratio shows
persistent inability of a company to meet short term obligations.”
(investorglossary.com)
48
Comparing it to the industry, Darden Restaurants shows a slightly lower
current ratio than its competitors with a slowly declining trend. If Darden
continues to show an inability to increase in this area, they may have future
problems concerning liquidity. Brinker (EAT) is the only company that has
surpassed 1.00 in 2004 but has since declined dramatically. We believe that due
to the nature of the casual dining industry, it is actually the norm to carry a
current asset ratio of less than one. Clearly, however, the fact that Darden’s
ratio has declined for each of the past 5 years is cause for some concern.
Quick Asset Ratio
Quick Asset Ratio
1.00
0.90
0.80
0.70
0.60
0.50
0.40
0.30
0.20
0.10
0.00
2002
2003
DRI
2004
EAT
2005
OSI
2006
APPB
The quick asset ratio (acid test ratio) is computed by adding the cash
(equivalents), securities, and accounts receivables and dividing it by the total
current liabilities. This ratio measures a company’s ability to meet its obligations
of debt with liquidity. Usually a number greater than 1 is preferred by creditors.
The only company which showed significant improvement over the 5 year period
we examined was Applebee’s (APPB). Brinker (EAT) showed a neutral trend
49
while Darden (DRI) and OSI (OSI) had a declining trend. Applebee’s has
rebounded since 2002 with the highest number among its competitors
symbolizing their strength in covering their current liabilities. Darden Restaurants
has the lowest quick asset ratio below the .10 mark, a ratio which suggests the
company would have trouble meeting is obligations. However, after further
research, we believe this threat can be partially discounted, as the company
holds a BBB+ debt rating with the Standard and Poor’s (S&P Stock Report) and
has shown no problem meeting its obligations in the past. Still, it is our opinion
the fact that Darden is lagging behind its direct competitors in the industry
reflects unfavorably on the firm.
Inventory Turnover
Inventory Turnover
100.00
80.00
60.00
40.00
20.00
0.00
2002
2003
DRI
2004
EAT
2005
OSI
2006
APPB
Inventory turnover tells analysts how many times per year that a
company’s inventory is sold and replaced. This is calculated by dividing the cost
of goods sold by the amount of inventory on hand. In this case, a higher number
is better for firms because it demonstrates how efficient they are at selling and
replenishing inventory supplies. Generally, a faster turnover rate means higher
sales for a period. The restaurant industry typically has a much higher inventory
turnover than other industries, due to its use of perishable goods.
50
Of the companies we looked at, only Applebee’s has shown significant
improvement. The firm increased its inventory turnover nearly 2 fold since 2002
and it shows no signs of slowing down. Since the restaurant industry is
continually perishing its inventory due to food spoilage and shorter shelf-life,
these competitors want to improve each year with higher returns on their
inventory turnover ratios. Darden’s turnover ratio, while competitive, is not
outstanding. We found this ratio to be neutral in terms of our view of the
company.
Days Supply of Inventory
Days Supply of Inventory
25.00
20.00
15.00
10.00
5.00
0.00
2002
2003
DRI
2004
EAT
2005
OSI
2006
APPB
Day’s supply of inventory is inversely related to the inventory turnover
ratio. For this ratio to work, a smaller number is more efficient because it tells
you in how many days time are you recycling out your inventory and firms want
to do this as quickly as possible to increase sales. You take 365 days in a year
and divide it by the inventory turnover rate. General restaurant concepts allow 813 days to sell and replace inventory.
51
As you can see, Applebee’s and Brinker (EAT) have done the best job in
turning over their inventory on a yearly basis. Darden Restaurant has a relatively
high day’s supply of inventory possibly caused by a broader span of menu
options. Brinker International (12.82 average) stays close to the industry
average of about 14.95. Since Applebee’s has the lowest day’s supply of
inventory (9.02 averages) they are able to reduce food spoilage by getting the
freshest food to their customers the fastest. We found this trend to be slightly
unfavorable to the company, as Darden has been holding inventory for close to a
week longer than the industry average. As our results show, receivables turnover
is an insignificant ratio in relation to the casual-dining industry because of the
high vulnerability of inventory spoilage.
Receivables Turnover
Receivables Turnover
300.00
250.00
200.00
150.00
100.00
50.00
0.00
2002
2003
DRI
2004
EAT
2005
OSI
2006
APPB
Receivables turnover measures how many times a firm collects its
accounts receivable during a given year by dividing sales by accounts receivable.
Basically, this shows how efficient the firm is at collecting money owed to it by
customers. “A low ratio implies the company should re-assess its credit policies
in order to ensure the timely collection of imparted credit that is not earning
interest for the firm.” (investopedia.com) In other words, the bigger the number
52
the better – the more times you “turn over” your accounts receivable, the faster
you are collecting the money which is owed to you. Since the restaurant
industry for the most part runs a cash-based operation of sales, accounts
receivables are usually made up of strictly credit card sales.
Every competitor in this industry besides Darden Restaurants showed a
steady unfavorable decline. Darden (DRI) had a slight increase over the five
year period making it (along with OSI) the most efficient company in terms of
collecting its accounts receivable. For example, Darden “turned over” its
accounts receivables balance 154 times during 2006, compared to 75 times for
Brinker (EAT) and a mere 24 times for Applebee’s (APPB). This demonstrates
that Darden is very efficient in collecting outstand debts, a favorable trend in
terms of our view of the company.
Days Supply of Receivables
Days Supply of Receivables
16.00
14.00
12.00
10.00
8.00
6.00
4.00
2.00
0.00
2002
2003
DRI
2004
EAT
2005
OSI
2006
APPB
Day’s supply of receivables is a ratio that tells analysts the amount of time
(in days) for the firm to collect its money from its debtors. This liquidity ratio is
computed by dividing 365 days in a year by total receivables turnover. In this
field of ratios, a smaller number is best. Since Applebee’s had the lowest
receivable turnover ratio, it must be that their day’s supply of receivables is the
53
highest. The other three competitors have done a pretty stable job of keeping
up with their accounts receivable, with Darden Restaurants coming out on top
with an average of 2.34 days. As with the accounts receivable turnover ratio, we
found this ratio to favorably reflect on the firm. It is consistent with previous
indications that Darden is very efficient in collecting money from its debtors in a
timely manner.
Working Capital Turnover
Working Capital Turnover
200.00
150.00
100.00
50.00
0.00
-50.00
2002
2003
2004
2005
2006
-100.00
DRI
EAT
OSI
APPB
Working capital is taken when total sales are divided by the working
capital (Current assets-current liabilities) of a firm. “Positive working capital
means that the company is able to pay off its short-term liabilities.
Negative working capital means that a company currently is unable to meet its
short-term liabilities with its current assets (cash, accounts receivable,
inventory).”(investopedia.com) A negative working capital is a common metric to
the restaurant industry (as shown in the chart above). Three companies have
dipped into negative territory, while Darden Restaurant has hugged the line. Net
working capital reflects how much cash a company can quickly raise from
operations. Brinker International’s higher working capital in 2004 could have
54
indicated an excess of inventory resulting in a lower inventory turnover rate.
Darden has shown virtually no changeover the past 5 years. We found this trend
to be slightly favorable to our view of the firm, as Darden has been able to
maintain an advantage in this area over the past five years. We also were able to
compute Darden’s cash to cash cycle by taking the days sales of inventory and
adding it with the days supply of receivables. This cycle expresses the length of
time (days) a company takes in order to convert resource inputs into actual cash
flows. Darden’s numbers seemed to drop slowly starting in 2002 at 21.02 days
then falling to 18.75 days in 2006. A yearly decrease in Darden’s cycle shows
that less capital time is tied up in business processes which are a positive sign
for this company.
After analyzing the seven liquidity ratios for the past five years we have
found that Applebee’s restaurants is the most liquid firm in the casual-dining
restaurant industry. Applebee’s current ratio and inventory turnover is the best
the industry has to offer. Darden Restaurant leads the industry in accounts
receivable turnover just above OSI Restaurant Partners. OSI (OSI) also has the
highest averaged quick asset ratio (.483) showing its ability to pay off short-term
debt annually. Generally speaking, we found the results of these ratios to have a
slightly favorable impact on our view of the company. Specifically, Darden has
maintained an advantage in working capital as well as accounts receivable
collections over its competitors.
Profitability Analysis
Profitability Analysis involves comparing the firm to its competitors in
respect to the firm’s ability to turn a profit. The profitability analysis uses six
different ratios to determine the turn of profit: Gross Profit Margin, Operating
Expense Ratio, Net Profit Margin, Asset Turnover, Return on Assets and Return
on Equity. The first three ratios access the firm’s ability to operating efficiently,
55
while the last three ratios measure the actual profitability of the firm. Below is a
table summarizing the results of these ratios for Darden and its competitors.
56
Profitability Analysis
DRI (Darden Restaurants)
Gross Profit Margin
Net Profit Margin
Operating Profit Margin
Asset Turnover
Return on assets
Return on equity
2002
2003
2004
2005
2006
Change on
Liquidity
0.23
0.05
0.09
1.84
0.11
0.23
0.22
0.05
0.08
1.79
0.09
0.21
0.22
0.05
0.09
1.84
0.09
0.19
0.22
0.06
0.09
1.85
0.11
0.23
0.23
0.06
0.09
1.92
0.12
0.27
No Change
Favorable
No Change
Favorable
Favorable
No Change
2002
2003
2004
2004
2006
Change on
Liquidity
0.72
0.05
0.09
1.72
0.09
0.18
0.73
0.05
0.08
1.76
0.09
0.17
0.72
0.04
0.07
1.79
0.08
0.14
0.719
0.04
0.06
1.79
0.07
0.16
0.72
0.05
0.08
1.87
0.01
0.19
2002
2003
2004
2005
2006
Change on
Liquidity
0.64
0.07
0.12
1.80
0.12
0.60
0.65
0.06
0.01
1.96
0.12
0.16
0.63
0.05
0.01
2.16
0.11
0.15
0.64
0.04
0.07
2.09
0.09
0.14
0.64
0.03
0.04
1.99
0.05
0.08
No Change
Unfavorable
Unfavorable
Favorable
Unfavorable
Unfavorable
2002
2003
2004
2005
2006
Change on
Liquidity
0.26
0.10
0.16
1.55
1.65
2.54
0.16
0.11
0.18
1.43
1.53
2.21
0.26
0.10
0.15
1.59
1.73
2.42
0.23
0.08
0.13
1.49
1.61
1.61
0.21
0.06
0.10
1.52
1.52
3.24
No Change
No Change
No Change
No Change
Unfavorable
Favorable
EAT (Brinker International)
Gross Profit Margin
Net Profit Margin
Operating Profit Margin
Asset Turnover
Return on assets
Return on equity
No Change
No Change
Unfavorable
Favorable
No Change
Favorable
OSI (Restaurant Partners)
Gross Profit Margin
Net Profit Margin
Operating Profit Margin
Asset Turnover
Return on assets
Return on equity
APPB (Applebee’s)
Gross Profit Margin
Net Profit Margin
Operating Profit Margin
Asset Turnover
Return on assets
Return on equity
(All decimals rounded 2 places)
57
Gross Profit Margin
Gross Profit Margin
0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1
2002
2003
DRI
2004
EAT
2005
OSI
2006
APPB
Gross profit margin is determined by measuring the percentage difference
between a firm’s gross profit and the costs of goods sold. An increasing gross
profit margin indicates that the firm is increasing their efficiency. In order to
increase the gross profit margin, a firm needs to devise a way to cut product
costs so that the cost of goods sold decreases therefore causing the gross profit
to increase. As it is apparent from the graph, Darden has one of the lowest gross
profit margin ratios in the industry. This indicates that the company has not been
able to cut its costs or increase profit in order to increase its gross profit. The
average of the industry over the past five years is 45.3%. Darden has been
significantly less than the average with an average of 22.3%. The gross profit
margin of Darden is a negative indicator of its operating efficiency. We found
these results to be significantly unfavorable to the firm.
58
Operating Profit Margin
Operating Profit Margin
0.2
0.15
0.1
0.05
0
2002
2003
DRI
2004
EAT
2005
OSI
2006
APPB
The Operating Profit Margin compares a firm’s operating income to its
total sales. This ratio is an indication of the firm’s ability to reduce operating
expenses. The higher the ratio, the more efficient the firm is at reducing these
costs. Over the past five years, Darden has shown effectively no change. There
are two possible explanations for this: either they have already cut the
operating expenses as much as they can, or they are not actively seeking to do
so. We found that as an industry, restaurants tend to have a low operating
profit margin (all of the firms we examined have operating profit margins that
are below 10% in 2006.) The average for the industry over the past five years is
9.7%. Darden’s average is 8.9%, indicating it is slightly below the industry
average, but not enough to make a dramatic difference. Since this is a trend
among the industry, we have concluded these figures are neither favorable nor
unfavorable for the firm.
59
Net Profit Margin
Net Profit Margin
0.12
0.1
0.08
0.06
0.04
0.02
0
2002
2003
DRI
2004
EAT
2005
OSI
2006
APPB
Net Profit Margin is calculated by dividing net income by the firm’s sales. A
decreasing net profit margin indicates that the company is not operating
efficiently. If this is the case, then the company needs to implement a profit
maximizing output of sales plan. This can be accomplished by maximizing profit
and reducing costs. If the company increases profits, then it can increase its net
profit margin. Since 2004, Darden has increased its net profit margin from 4.6%
in 2004 to 5.9% in 2006. This is a dramatic increase, indicating that the firm is
operating efficiently and maximizing its profits. Because of Applebee’s drastic
decline, Applebee’s and Darden are the industry leaders in net profit margin. The
industry average over the past five years is 6%, while Darden’s average is 5.3%.
Again, this is pretty constant with the industry. The recent increase in net profit
margin is a slightly positive indicator of Darden’s operating efficiency. We feel
that Darden’s fairly strong net profit margin may reflect potentially unrecognized
value within the firm.
60
Asset Turnover
Asset Turnover
2.5
2
1.5
1
0.5
0
2002
2003
DRI
2004
EAT
2005
2006
OSI
APPB
Asset turnover measures the firm’s ability to use resources to generate or
support sales volume. It is calculated by dividing sales by the total assets (the
average of the previous year and the current year). Asset turnover, in simple
terms, simply means “how many times did the company ‘turn over’, or sell, its
assets in a given year.” All of the firms in the industry have relatively equal
asset turnover rates. Even though Darden is below OSI in its asset turnover rate,
it is able to turn its assets into profitability just as quickly as its competitors. The
industry average over the past five years is 1.79. Darden’s asset turnover
average is 1.848, indicating it is above the industry average. This means that
Darden is able to turn over its assets 1.84 times per year, slightly above the
industry average. Overall, this gives a positive perception of Darden’s
profitability, and favorably affects our view of the firm.
61
Return on Assets
Return on Assets
2
1.5
1
0.5
0
2002
2003
DRI
2004
EAT
2005
OSI
2006
APPB
The rate of return on assets is influenced by net profit margin and asset
turnover. It is computed by dividing net income by the total assets of the
previous year. This ratio takes into consideration the firm’s net profit margin and
its asset turnover rate. Darden, Brinker, and OSI all have low return on assets.
Darden’s return on assets has been quite constant over the past five years. From
2004 to 2006, there has been a slight increase. This is due to the greater
percentage increase of net income than in total assets. From 2005 to 2006,
Darden’s net income has increased by 14% and its total assets have increased
by 5%. However, this increase is still not enough to make a dramatic difference
in the company’s return on assets. The industry’s average rate of return on
assets over the past five years is 47.4%. Darden’s average is drastically lower
with an average of 10.1%. Overall, this is a negative indicator of Darden’s
profitability.
62
Return on Equity
Return on Equity
3.5
3
2.5
2
1.5
1
0.5
0
2002
2003
DRI
2004
EAT
2005
OSI
2006
APPB
Return on equity is a measure of profitability that compares the firm’s net
income to its owner’s equity. This ratio is calculated by dividing net income by
the owner’s equity from the previous year. A high return on equity indicates that
the owner’s equity of the firm is used to make a company more profitable. An
increasing ratio indicates that the firm is operating efficiently. Darden has an
increasing return on equity, however it is not high. They are operating efficiently,
but do not use the company’s owner’s equity to make it more profitable. The
average for the industry over the past five years is 73.4%, while Darden’s
average is greatly below with 22.6%. This indicates a negative trend concerning
the firms ROE and weighs unfavorably on our view of the company.
The conclusions we drew from this analysis show the favorability that
Darden Restaurant has as opposed to its competitors. This may prove that
Darden’s future financials are heading in a positive direction because of their
continuous increase in profitability.
63
Capital Structure Analysis
Capital structure ratios analyze the financing sources of the company.
The three main ratios used for capital structure analysis compare liabilities to
owner’s equity, income to interest, and cash flow from operations to debt.
These ratios show a company’s ability to cover the principal and interest on their
debt and their debt with respect to owner’s equity. The debt to equity ratio
shows favorable trends when it is a lower number. This means that there are a
low number of liabilities to owner’s equity. The times interest earned shows how
income goes to interest. Higher numbers are preferable with this ratio. The
debt service margin relates cash provided by operations and current payments
due on long-term assets. This ratio shows whether long-term assets are paying
for themselves or not. A larger number is favorable with this ratio as well.
Capital Structure Analysis
DRI
Debt to Equity Ratio
Times interest earned
Debt to service margin
2002
1.241
10.860
N/A
2003
1.228
9.155
5.92
2004
1.232
9.747
36.24
2005
1.308
10.937
1.94
2006
1.448
12.420
3.70
Ratio Change
Favorable
Favorable
Unfavorable
EAT
Debt to Equity Ratio
Times interest earned
Debt to service margin
2002
1.504
18.572
22.556
2003
1.173
21.416
25.462
2004
2.168
21.656
26.588
2005
1.479
8.724
245.695
2006
1.671
14.289
214.158
Ratio Change
Favorable
Unfavorable
Favorable
OSI
Debt to Equity Ratio
Times interest earned
Debt to service margin
2002
0.280
0.000
19.358
2003
0.379
146.305
5.503
2004
0.524
69.449
5.899
2005
0.615
34.192
5.867
2006
0.819
10.287
6.098
Ratio Change
Unfavorable
Unfavorable
favorable
APPB
Debt to Equity Ratio
Times interest earned
Debt to service margin
2002
0.442
59.828
358.989
2003
0.401
88.660
916.089
2004
0.519
101.648
858.581
2005
1.129
36.114
854.066
2006
0.922
11.451
658.845
Ratio Change
Unfavorable
Unfavorable
Unfavorable
64
Debt to Equity Ratio
Debt To Equity Ratio
2.500
2.000
DRI
1.500
EAT
OSI
1.000
APPB
0.500
0.000
2002
2003
2004
2005
2006
The debt to equity ratio shows debt as a portion of owner’s equity.
Companies want to have the least amount of debt compared to its equity.
Darden’s debt to equity ratio seems to fluctuate a large amount. It is also on
average higher than any other company in the industry. This could signal a
problem for Darden if they do not get their debt under control. Because equity is
a way to finance debt, we believe Darden should work on lowering its debt to
equity ratio.
65
Times Interest Earned
Times Interest Earned
160.000
140.000
120.000
DRI
100.000
EAT
80.000
OSI
60.000
APPB
40.000
20.000
0.000
2002
2003
2004
2005
2006
The times interest earned ratio shows income from operations as a
portion of interest expense. In short, it tells you how much of your income is
used on interest. Higher numbers are favorable here because companies want
the least amount of their income going to interest expense. Darden is on the
low side of the industry, meaning more of its income goes towards paying
interest expense on liabilities. As another measurement of ability to cover debt,
this ratio shows that Darden has a harder time covering their expenses than
other firms in the industry. This negatively impacts our view of the company, as
its high interest expenses will continue to eat into profits.
66
Debt Service Margin
Debt Service Margin
1,000.00
900.00
800.00
700.00
DRI
600.00
500.00
EAT
OSI
400.00
APPB
300.00
200.00
100.00
0.00
2002
2003
2004
2005
2006
The debt service margin is measured by dividing cash flow from
operations by the current installment due on long-term debt. This measures
how well current cash flows from operations pay for the current payments on
long-term debt. Higher numbers are better with this ratio, since it shows how
many times cash from operations can pay for current installments on long-term
debt. Once again, Darden is on the wrong end of the industry spectrum. It has
the lowest numbers of any firm. This ratio along with the other two capital
structure ratios shows problems with Darden’s capital structure. They are able
to cover their debt currently, but in all ratios they are at the bottom of the
industry. This is a significantly negative trend in our mind, and one that weighs
heavily on our view of the company.
67
Extended Ratio Analysis
Extended ratio analysis simply refers to the use of ratios not included in
the fourteen we normally focus on. For Darden Inc., we decided to run 5 “other”
ratios and compare the results to the firm’s competitors. We ran an Operating
Cash Flows analysis, checked their PP&E turnover ratio and ran an EBITDA
margin analysis. We believe that these additional ratios will allow us to gain an
even better understanding in how efficiently the firm is operating, particularly in
regards to how they stack up to their competitors.
Operating Cash Flow Ratios
1.80
1.70
1.60
1.50
1.40
1.30
1.20
1.10
1.00
0.90
0.80
0.70
0.60
0.50
0.40
0.30
0.20
0.10
0.00
2002
2003
2004
DRI
EAT
2005
OSI
2006
APPB
This ratio is simply a measure of the films ability to cover its existing
liabilities using only the cash it creates for operations. It is derived by dividing
cash flow from operations by current liabilities. Over the past 5 years, Darden
has lagged behind its competitors in regards to this ratio. After further
examination of the firm, we believe that this is a result of Darden’s aggressive
expansion policies. These expansions, in general, tend to increase current
68
liabilities immediately. The cash flows form these expansions, however, may
take longer to realize.
PP&E Turnover
3.00
2.50
2.00
1.50
1.00
0.50
0.00
2002
2003
2004
DRI
EAT
2005
OSI
2006
APPB
This ratio is calculating by taking sales and dividing it by PP&E (that is,
plant, property, and equipment). In Darden’s case, this asset is recognized as
“land, buildings, and equipment, net”, but for our purposes we will be referring
to it as PP&E. This is useful in that it reveals how well the company has been
able to earn revenue on its long term assets. Generally, PP&E represents a very
large portion of the assets on the balance sheet, making it very important to
understand how well these assets are performing. As illustrated in the graph
above, Darden typically generates $2.4 in sales for every $1 in PP&E they carry.
When compared to the industry, we find this trend to be slightly favorable to our
view of the company.
69
EBITDA Margin
0.50
0.40
0.30
0.20
0.10
0.00
2002
2003
2004
DRI
EAT
2005
OSI
2006
APPB
To calculate a firms EBITDA margin, you simply take earnings before
income taxes, depreciation and amortization and divide them by sales.
(EBITDA/Sales) This is of particular interest for our purposes, because it negates
the effect of many accounting and finance decisions firms may have made.
While Darden does not have a margin of error as large as Applebee’s, they do
fall into an acceptable range when compared to the rest of the industry. We
conclude this margin to be neither favorable nor unfavorable.
IGR and SGR Analysis
2002
2003
2004
2005
2006
Internal Growth Rate
10.28%
8.67%
8.21%
10.05%
11.5%
Sustainable Growth Rate
23.04%
19.32%
18.32% 23.20% 28.15%
The internal growth rate measures the maximum amount of growth a
business may obtain without resorting to outside financing (http://financialdictionary.thefreedictionary.com). It is calculated by taking the firm’s return on assets
and multiplying it by one minus the dividend payout ratio {ROA*[1-(total
dividends/net income)]}. The sustainable growth rate is the “maximum growth
rate that a firm can sustain without having to increase financial leverage”
70
(http://www.investopedia.com). It is calculated by multiplying the return on equity by
one minus the dividend payout ratio {IGR*[1+ (Debt/Equity)]}. Darden
Restaurants’ internal and sustainable growth rates are as follows in the table.
IGR & SGR Analysis
0.30
0.25
0.20
0.15
0.10
0.05
0.00
2002
2003
2004
IGR
2005
2006
SGR
The internal growth rate for Darden decreased from 2002 to 2004 and
then increased from 2004 to 2006. The major factor for the decrease in IGR is
due to the large reduction in the return on assets, while the reason for the
increase in IGR is due to the large expansion in the return on assets. As seen
from the table, the sustainable growth rate also decreased from 2002 to 2004,
but increased from 2004 to 2006. Because IGR is used to find the sustainable
growth rate net income also determines how the SGR grows. However, the SGR
is growing at a considerably rapid rate compared to IGR. Even though there is a
slight decrease in IGR and SGR, they have rebounded and are increasing
gradually each year.
71
Forecasting Analysis
Forecasting a firm’s financial documents is an important step in valuing a
firm. It allows the analyst the ability to predict how the company will do over the
future years. By using Darden’s past five years of financial statements and
applying the firm’s basic methods of profitability, we have forecasted Darden’s
balance sheet, income statement, and statement of cash flows ten years into the
future. This forecast will show how well we believe Darden Restaurants is going
to sustain its annual growth.
Income Statement
We began our forecasting by starting with the Income Statement. To
begin the income statement forecast, you have to determine the future rate of
growth for net sales. We determined how much sales went up from 2005 to
2006. That rate was 8.4%. We believed that this was a reasonable rate for sales
to grow, so we used this rate to forecast the next ten years. After forecasting the
net sales, we looked to see how much the growth of cost of goods sold, gross
profit, total costs and expenses and net earnings increased from year 2005 to
year 2006. The rates for these categories are 8.1%, 9.4%, 7.9%, and 16.4%,
respectively. After examining these rates, we determined that all of these rates
seemed reasonable. From there, we went on to forecast each of these categories
over the next ten years. Below is our forecast of the Income Statement.
72
CONSOLIDATED STATEMENTS OF EARNINGS ( Darden forecast)
(In Thousands)
Net Sales
Cost of sales and
expenses:
2001
2002
2003
2004
2005
2006
Assume
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
$3,992,419
$4,366,911
$4,654,971
$5,003,355
$5,278,110
$5,720,640
8.4%
$6,201,174
$6,722,072
$7,286,726
$7,898,811
$8,562,312
$9,281,546
$10,061,196
$10,906,336
$11,822,468
$12,815,556
Food and beverage
1,302,926
1,384,481
1,449,162
1,526,875
1,593,709
1,691,906
Restaurant labor
1,261,837
1,373,416
1,485,046
1,601,258
1,695,805
1,850,199
559,670
628,701
713,699
774,806
806,314
885,403
COGS
$3,124,433
$3,386,598
$3,647,907
$3,902,939
$4,095,828
$4,427,508
8.1%
$4,786,136
$5,173,813
$5,592,892
$6,045,916
$6,535,636
$7,065,022
$7,637,289
$8,255,909
$8,924,638
$9,647,533
Gross Profit
Selling, general and
administrative
Depreciation and
amortization
$ 867,986
$ 980,313
$1,007,064
$1,100,416
$1,182,282
$1,293,132
9.4%
$1,415,038
$1,548,259
$1,693,834
$1,852,895
$2,026,676
$2,216,524
$2,423,907
$2,650,427
$2,897,830
$3,168,022
389,240
417,158
431,722
472,109
497,478
536,379
7.9%
$5,651,934
$6,098,436
$6,580,213
$7,100,050
$7,660,954
$8,266,169
$8,919,196
$9,623,813
$10,384,094
$11,204,437
16.4%
$393,658
$458,218
$533,365
$620,837
$722,655
$841,170
$979,122
$1,139,698
$1,326,608
$1,544,172
Restaurant expenses
146,864
165,829
191,218
210,004
213,219
221,456
Operating income
331,947
399,945
390,400
376,435
467,036
525,623
Interest expense
35,196
41,493
47,566
47,710
47,656
48,922
Interest income
861
1,255
1,499
551
1,355
3,121
30,664
36,585
42,597
43,659
43,119
43,105
0
-2,568
3,924
41,868
4,549
9,674
Interest, net
Asset impairment and
restructuring charges
Total costs and
expenses
$3,691,201
$4,003,602
$4,317,368
$4,670,579
$4,854,193
$5,238,122
EBITA
301,218
363,309
337,603
332,776
423,917
482,518
Income taxes
104,218
125,521
111,624
105,603
133,311
144,324
Net earnings
Net earnings per share:
$ 197,000
$ 237,788
$ 225,979
$ 227,173
$ 290,606
$ 338,194
Basic
$1.10
$1.36
$ 1.33
$ 1.39
$ 1.85
$ 2.26
Diluted
$ 1.06
$ 1.30
$ 1.27
$1.34
$ 1.78
$ 2.16
AVG number of shares OS:
Basic
Diluted
Dividend Payout %
179,600
174,700
170,300
163,500
156,700
149,700
185,600
183,500
177,400
169,700
163,400
156,900
-
-24.899%
-5.534
-5.715
-4.646
-2.728
-8.704
Common Size Income Statement
(percentages)
Sales Growth
Net Sales
2001
2002
2003
2004
2005
2006
Average
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
-
9.380%
6.596%
7.484%
5.491%
8.384%
7.467%
9.01%
9.683%
10.556%
11.578%
12.800%
14.282%
16.110%
18.411%
21.377%
25.312%
5.51%
5.48%
5.81%
5.80%
6.15%
6.16%
6.52%
6.56%
6.95%
7.02%
100%
100%
100%
100%
100%
100%
100%
COGS
78.259%
84.826%
83.535%
78.006%
77.600%
77.395%
79.937%
Gross Profit
21.741%
22.449%
21.634%
21.994%
22.400%
22.605%
22.137%
SGA
Total costs & exp:
Interest Expense
9.749%
92.455%
9.553%
91.680%
9.274%
92.747%
9.436%
93.349%
9.425%
91.968%
9.376%
91.565%
9.469%
92.294%
0.882%
0.950%
1.022%
0.954%
0.903%
0.855%
0.928%
Income Expense
0.022%
0.029%
0.032%
0.011%
0.026%
0.055%
0.029%
EBIT (Loss)
7.545%
2.610%
8.314%
4.934%
-
8.320%
2.874%
9.159%
5.445%
29.949%
13.364%
1.241
.107
7.253%
2.398%
8.387%
4.855%
21.632%
9.709%
1.228
.092
6.651%
2.111%
7.524%
4.540%
20.528%
9.197%
1.232
.087
8.032%
2.526%
8.849%
5.506%
25.360%
10.988%
1.308
.105
8.435%
2.523%
9.188%
5.912%
28.920%
11.814%
1.448
.115
7.706%
2.507%
8.570%
5.199%
25.278%
11.014%
1.291
.101
Income Taxes (Loss)
Operating income
Net Earnings/Loss
SGR
IGR
Debt to Equity Ratio
Rate return - Assets
-
73
Balance Sheet
When forecasting Darden’s balance sheet ten years into the future, we
began by determining which ratios provide the best estimate of the firm’s future
profitability. Since total assets were the largest item on our balance sheet, we
were able to successfully compute the average asset turnover by dividing the
total revenues by the total amount of assets. This average came out to be 1.848.
We were able to take this assumed number and estimate a ten year forecast
from 2007-2016. The only other valid trend from the assets section of the
balance sheet was the current assets section where we saw an increase in
$49,465 from 2002 to 2006. The current assets portion was forecasted by taking
the average of the total current assets percentage (common-size section) of
13.93% and multiplying it by the total assets.
When viewing the trends in the liabilities section of the balance sheet, we
chose to focus on the current and total liabilities row of mobility. The current
ratio which is current assets over current liabilities helped us generate a fairly
accurate forecast for the ten year period. Here is where we took Darden’s
average of .504 and multiplied it by the total assets from the forecasted 2007
results. Computing stockholders equity forecasts were the last line item on the
balance sheet. Retained earnings showed a steady increase of $ 1,152,621 from
2002 to 2007. To forecast retained earnings we multiplied the percentage
average of Darden’s retained earnings (.907%) by the total calculated forecast of
total stockholder’s equity (2007). Darden’s calculated percent average was found
by taking the total retained earnings from the balance sheet and dividing it by
total stockholder’s equity for that specific year.
We also made sure that the forecasted balance sheet was able to balance
over the ten year span. For instance, by taking the total liabilities of $1,610,137
and adding it with that of total stockholder’s equity ($1,741,849) we found our
total assets to correctly equal out ($3,351,986) for Darden Restaurant’s.
74
CONSOLIDATED BALANCE SHEETS (Darden Forecast)
Assume
2007
2008
2009
2010
2011
2012
2013
2014
2015
$37,111
154.93%
$40,025.65
$43,387.80
$470,032.38
$50,983.10
$55,265.68
$59,908.00
$64,940.27
$70,395.25
$76,308.45
$82,718.36
$235,444
$198,723
19.967%
$239,702
$259,118
$280,107
$302,795
$327,322
$353,835
$382,496
$413,478
$446,969
$483,174
N/A
N/A
N/A
$25,316
$55,258
$28,927
$63,584
$29,889
$69,550
13.93%
$466,932
$506,154
$548,671
$594,759
$644,719
$698,875
$757,581
$ 821,218
$ 890,200
$ 964,977
1.85%
$3,351,986
$3,633,553
$3,938,771
$4,269,628
$4,628,277
$5,017,052
$5,438,484
$5,895,317
$6,390,523
$6,927,327
0.504%
926,452
1,004,274
1,088,633
1,180,078
1,279,204
1,386,657
1,503,137
1,629,400
1,766,270
1,914,636
1,610,137
1,606,041
1,578,747
1,522,560
1,430,690
1,295,061
1,106,086
852,406
520,575
94,707
$1,579,857
$1,838,953
$2,491,591
$2,900,211
$3,375,846
$3,929,485
$4,573,920
$5,324,043
$6,197,186
2001
2002
2003
2004
2005
2006
$61,814
$152,875
$48,630
$36,694
$42,801
$42,334
0
9,904
N/A
N/A
N/A
N/A
Receivables, net
$32,870
$29,089
$29,023
$30,258
$36,510
Inventories, net
Net assets held for
disposal
Prepaid expenses and
other current assets
Deferred income taxes
Total current assets
Land, buildings and
equipment, net
$148,429
$172,413
$173,644
$198,781
10,087
10,047
N/A
$26,942
$48,000
$23,076
$52,127
$25,126
$49,206
(In Thousands)
Current assets:
Cash and cash
equivalents
Short-term Investments
Other assets
$328,142
$449,531
$325,629
$346,307
$407,266
$377,607
1,779,515
1,920,768
2,157,132
2,250,616
2,351,454
2,446,035
108,877
159,437
181,872
183,425
179,051
186,528
Total assets
=
Liabilities and SH
equity
Current liabilities:
$2,216,534
$2,529,736
$2,664,633
$2,780,348
$2,937,771
$3,010,170
Accounts payable
Short-term debt
$156,859
12,000
$160,064
0
$175,991
0
$174,624
14,500
$191,197
0
$213,239
44,000
Accrued payroll
82,588
87,936
85,975
103,327
114,602
123,176
Accrued income taxes
47,698
68,504
67,975
48,753
52,404
64,792
Other accrued taxes
27,429
30,474
35,069
38,440
43,825
46,853
Unearned revenues
Current portion of longterm debt
Other current liabilities
Total current
liabilities
Long-term debt, less
current portion
Deferred income taxes
Deferred rent
Other liabilities
Total liabilities
Stockholders' equity:
Common stock:
500,000 shares; issued
274,683 and 271,102
shares, respectively
Preferred stock, no par
value. Authorized
25,000 shares; none
issued and outstanding
Retained earnings
Treasury stock,
127,685 and 116,711
shares, at cost,
respectively
Accumulated other
comp. income (loss)
Unearned
N/A
N/A
72,698
75,513
88,472
100,761
2,647
225,037
0
254,036
N/A
202,201
N/A
228,324
299,929
254,178
149,948
283,309
$554,258
$601,014
$639,909
$683,481
$1,044,607
$1,026,078
517,927
90,782
662,506
117,709
658,086
150,537
653,349
176,216
350,318
114,846
494,653
90,573
N/A
20,249
N/A
19,630
N/A
19,910
N/A
21,532
130,872
24,109
138,530
30,573
$1,183,216
$1,400,859
$1,468,442
$1,534,578
$1,664,752
$1,780,407
$1,405,799
$1,474,054
$1,525,957
$1,584,115
$1,703,336
$1,806,367
0
0
0
0
0
0
$532,121
$760,684
$979,443
$1,197,921
$1,405,754
$1,684,742
(840,254)
(1,044,915)
(1,254,293)
(1,483,768)
(1,784,835)
(2,211,222)
(13,102)
(49,322)
(12,841)
(46,108)
(10,489)
(42,848)
(9,959)
(41,401)
(8,876)
(41,685)
(5,570)
(44,186)
0.907%
$ 2,140,542
2016
75
compensation
Officer notes
receivable
Total stockholders'
equity
Total liabilities and
stockholders' equity
Beg retained earnings
Plus: net income
Minus: dividends
Equals: Ending
retained earnings
(1,924)
(1,997)
(1,579)
(1,138)
(675)
(368)
$1,033,318
$1,128,877
$1,196,191
$1,245,770
$1,273,019
$1,229,763
$1,741,849
$2,027,512
$ 2,360,024
$2,747,068
$3,197,587
$3,721,991
$4,332,398
$5,042,911
$5,869,948
$6,832,620
$2,216,534
$2,529,736
$2,664,633
$2,780,348
$2,937,771
$3,010,170
$3,351,986
$3,633,553
$ 3,938,771
$4,269,628
$4,628,277
$5,017,052
$5,438,484
$5,895,317
$6,390,523
$6,927,327
344579
197,000
532,121
237,788
760,684
225,979
979,443
227,173
1,197,921
290,606
1,405,754
338,194
1,684,742
1,579,857
1,838,953
2,140,542
2,491,591
2,900,211
3,375,846
3,929,485
4,573,920
5,324,043
393,658
458,218
533,365
620,837
722,655
841,170
979,122
1,139,698
1,326,608
1,544,172
9,458
9,225
7,220
8,695
82,773
59,206
498,543
199,121
231,777
269,788
314,034
365,535
425,483
495,262
576,485
671,029
532,121
760,684
979,443
1,197,921
1,405,754
1,684,742
1,579,857
1,838,953
2,140,542
2,491,591
2,900,211
3,375,846
3,929,485
4,573,920
5,324,043
6,197,186
2007
2008
2009
2010
2011
2012
2013
2015
2016
0.226%
Common Size Balance Sheet
(percentages)
2001
2002
2003
2004
2005
2006
Average
Current Assets:
Cash and cash
equivalents
Short-term investment
Accounts receivable,
net
2.789%
0.000%
6.043%
0.392%
1.825%
N/A
1.320%
N/A
1.457%
N/A
1.406%
N/A
2.473%
1.483%
1.150%
1.089%
1.088%
1.243%
1.233%
1.214%
6.696%
6.815%
6.517%
7.150%
8.014%
6.602%
6.966%
1.216%
14.804%
0.912%
17.770%
0.943%
12.220%
0.911%
12.456%
0.985%
13.863%
0.993%
12.544%
0.993%
13.943%
80.284%
4.912%
75.928%
6.303%
80.954%
6.825%
80.947%
6.597%
80.042%
6.095%
81.259%
6.197%
79.902%
6.155%
100%
100%
100%
100%
100%
100%
100%
Inventories
Prepaid expenses and
other current assets
Total Current Assets
Land, buildings and
equipment, net
Other Assets
Total Assets
Liabilities and
Shareholders Equity
Current Liabilities:
Short-term debt
1.014%
0.000%
0.000%
0.945%
0.000%
2.471%
0.738%
Accounts payable
Other current liabilities
Total Current
Liabilities
Long-term debt, less
current portion
Deferred Income Taxes
Other Liabilities
13.257%
19.019%
11.426%
18.134%
11.985%
13.770%
11.379%
14.879%
11.485%
15.268%
11.977%
15.913%
11.918%
16.164%
Total Liabilities
Stockholders Equity:
Common Stock
Retained earnings
Accumulated other
comprehensive income
(loss)
Total Shareholders
Equity
46.843%
42.903%
43.577%
44.539%
62.749%
57.632%
49.707%
43.773%
7.672%
1.711%
47.293%
8.403%
1.401%
44.815%
10.251%
1.356%
42.575%
11.483%
1.403%
21.043%
6.899%
1.448%
27.783%
5.087%
1.717%
37.880%
8.299%
1.506%
100%
100%
100%
100%
100%
100%
100%
136.047%
51.496%
130.577%
67.384%
127.568%
81.880%
127.160%
96.159%
133.803%
110.427%
146.887%
136.997%
133.674%
90.724%
-1.268%
-1.138%
-0.877%
-0.799%
-0.697%
-.453%
-0.872%
100%
100%
100%
100%
100%
100%
100%
ATO
1.841
1.792
1.838
1.846
1.924
1.848
ITO
19.631
20.930
19.598
17.396
22.280
19.967
A/R TO
150.184
160.389
165.356
144.566
154.150
154.929
0.748
0.509
0.507
0.390
0.368
0.504
Current Ratio
2014
76
Statement of Cash Flows
The net earnings from Darden Restaurant’s cash flow statement have
shown a steady stagnated average over the past five fiscal years (46.588%). We
feel that this slow growth may not increase in the future concluding that Darden
has reached maximum growth compared to its net operating activities. To find
the operating cash flow, we took the average of CFFO divided by the total sales
for the five year period. This gave us an 11.2% output which we believed was
the best method for forecasting the operations of cash flow. We have computed
below the forecast and common-size numbers from Darden Restaurant’s financial
statement.
77
CONSOLIDATED STATEMENTS OF CASH FLOWS (Darden Forecast)
(In thousands)
CFFO:
Net earnings
Depreciation/amort.
Asset impairment charges, net
Restructuring charge
Amortization of unearned
compensation & loan costs
Amortization of loan
Change in current assets and
liabilities
Contribution to postretirement
plan
Loss on disposal of land,
buildings and equipment
Insurance
Deferred income taxes
Change in deferred rent
Change in other liabilities
Income tax benefits credited
to equity
Amortization of unearned
compensation
Non-cash compensation
expense
Other, net
Net cash provided by
operating activities
CFFI:
Purchases of land, buildings
and equipment
Purchases of intangibles
Increase in other assets
Purchase of trust-owned life
insurance
Proceeds from disposal of
land, buildings & equip.
investments
Net cash used in investing
activities
CFFF:
Proceeds from issuance of
common stock
Dividends paid
Purchases of TS
ESOP note receivable
repayments
Increase (decrease) in shortterm debt
Proceeds from issuance of
long-term debt
Repayment of long-term debt
Payment of loan costs
Cash for finance act.
(Decrease) increase in cash
and cash equivalents
Cash & cash equivalents beginning of year
Cash and cash equivalents end of year
Receivables
Inventories
Prepaid expenses and other
current assets
Accounts payable
Accrued payroll
Accrued income taxes
Other accrued taxes
Unearned revenues
Other current liabilities
Chg in CA and CL
2001
2002
2003
2004
2005
2006
$ 197,000
$ 237,788
$232,260
$ 227,173
$ 290,606
$ 338,194
146,864
N/A
N/A
165,829
0
(2,568)
191,218
4,282
(358)
210,004
40,756
1,112
213,219
4,549
0
221,456
9,674
0
7,031
N/A
7,578
N/A
6,901
N/A
N/A
3,401
N/A
3,577
N/A
3,020
41,740
49,604
36,046
2,207
28,967
121,401
N/A
(164)
(20,203)
(172)
(472)
(410)
N/A
N/A
11,750
N/A
(642)
1,803
743
22,743
N/A
(496)
2,456
2,441
35,890
N/A
420
104
(6,106)
16,688
7,583
1,490
1,164
(3,451)
(24,722)
7,993
11,920
2,719
(6,032)
(29,796)
7,658
6,874
15,287
24,989
16,385
15,650
42,996
34,316
N/A
N/A
N/A
5,059
8,470
8,611
N/A
(19)
0
252
758
139
N/A
462
N/A
(1,574)
N/A
(595)
$ 420,570
$ 508,101
$ 508,635
$ 525,411
$ 583,242
$ 717,090
(355,139)
(11,215)
485
(318,392)
N/A
(24,700)
(423,273)
N/A
(8,100)
(354,326)
N/A
(5,128)
(329,238)
N/A
(1,931)
(338,155)
N/A
(7,021)
N/A
(31,500)
(6,000)
N/A
N/A
N/A
13,492
N/A
10,741
(9,904)
7,641
10,000
16,197
N/A
18,028
N/A
20,560
N/A
$(352,377)
$(373,755)
$(419,732)
$(343,257)
$(313,141)
$(324,616)
36,701
(9,458)
(176,511)
40,520
(9,225)
(208,578)
33,664
(13,501)
(213,311)
39,856
(12,984)
(235,462)
74,697
(12,505)
(311,686)
61,783
(59,206)
(434,187)
8,145
5,315
4,710
5,027
3,393
3,580
(103,000)
(12,000)
0
14,500
(14,500)
44,000
224,454
(10,658)
(2,154)
149,655
(7,962)
(1,010)
0
(4,710)
0
0
(5,027)
N/A
0
(3,393)
N/A
294,669
(303,580)
N/A
$ (32,481)
$ (43,285)
$(193,148)
$(194,090)
$(263,994)
$(392,941)
35,712
91,061
(104,245)
(11,936)
6,107
(467)
26,102
61,814
152,875
48,630
36,694
42,801
$ 61,814
(4,908)
(6,242)
$152,875
3,781
(23,984)
$ 48,630
66
(1,231)
$ 36,694
(279)
(25,137)
$ 42,801
(5,533)
(36,663)
$ 42,334
(601)
36,721
(289)
16,372
4,783
14,442
1,905
N/A
15,677
$ 41,740
1,987
3,205
5,348
20,806
3,045
18,487
16,929
$ 49,604
(8,523)
15,927
(1,961)
(529)
4,595
16,066
11,636
$36,046
(190)
(1,027)
17,352
(19,222)
3,371
2,815
24,524
$2,207
(4,463)
16,573
11,275
3,651
5,385
12,959
25,783
$28,967
(2,325)
22,042
8,574
12,388
3,028
12,289
29,285
$121,401
Assume
2007
2008
2009
2010
2011
2012
2013
0.1165
$ 800,272
893,104
996,704
1,112,322
1,241,351
1,385,348
1,546,048
(0.674)%
(0.438)%
(539,383)
(350,519)
2014
2015
2016
1,725,390
1,925,535
2,148,897
(601,952.13)
(671,778.57)
(749,704.89)
(836,670.)
(933,724.)
(1,042,036.48)
(1,162,912.72)
(1,297,810.59)
(1,448,35)
(391,179.57)
(436,556.40)
(487,196.94)
(543,711.)
(606,782.)
(677,169.11)
(755,720.73)
(843,384.33)
(941,216.)
78
Common Size CF Statement
(percentages)
Net earnings
Depreciation and amortization
Change in current assets and
liabilities
Contribution to postretirement
plan
(Gain) loss on disposal of land,
buildings and equipment
2001
2002
2003
2004
2005
2006
Average
46.84%
34.92%
46.799%
32.637%
45.663%
37.594%
43.237%
39.969%
49.826%
36.558%
47.162%
30.883%
46.588%
35.427%
9.925%
9.763%
7.087%
0.420%
4.967%
16.930%
8.182%
N/A
-0.032%
-3.972%
-0.033%
-0.081%
-0.057%
-0.835%
Deferred income taxes
Income tax benefits credited to
equity
Other, net
Cash Provided by Operating
Activities
0.371%
2.794%
N/A
4.476%
N/A
7.056%
N/A
3.176%
N/A
-4.239%
N/A
-4.155%
1.518%
3.635%
-0.005%
4.918%
0.050%
3.221%
0.027%
2.979%
0.088%
7.372%
-0.270%
4.785%
-0.083%
4.485%
-0.032%
100%
100%
100%
100%
100%
100%
100%
CFFO/NI
CFFO/Sales
CFFO/OI
Change in Total assets
2.135
0.105
1.267
313202
2.137
0.116
1.270
134897
2.190
0.109
1.303
115715
2.313
0.105
1.396
157423
2.007
0.111
1.249
72399
2.120
0.125
1.364
34534
2.150
0.112
1.308
138028
2007
2008
2009
2010
2011
2012
2013
2014
2015
79
2016
Cost of Capital Estimation
In order to properly estimate Darden’s ability to sustain its historical rate
of growth, it is first necessary to calculate the firms cost of capital. Using
information obtained from a debt schedule on Darden’s most recent 10-k, we
were able to calculate a long term cost of debt of 6%. We then calculated the
additional cost that current liabilities represent by using the interest rate of a 1
year T-bill, which came out to 5.24%. This additional cost of debt brought the
firms total cost of debt to 6.4%. Upon obtaining this information we proceeded
to run a regression analysis, which provided us with beta estimations (measures
of a firm’s systematic risk) and other information. We utilized information
regarding Treasury bills (St. Louis Federal Reserve website) to estimate the risk
free rate and market risk premium. We then ran regressions for various time
periods. The following tables illustrate the results these regressions provided.
Regression Analysis
T-Bill
Months Observed
Beta
R^2
Ke
3 month
48
0.9821
0.06789598
11.64%
6 month
24
1.266
0.059917
13.60%
2 year
24
1.259
0.059062
13.63%
5 year
24
1.254
0.058894
13.58%
10 year
24
1.2584
0.0588
13.58%
80
Number of Months
72
60
48
36
24
Number of Months
72
60
48
36
24
Beta
0.4394
0.4752
0.9821
1.0415
1.2616
3 Month T-Bill
R^2
0.018691324
0.018071781
0.067895976
-0.01294048
0.059335
Ke
7.85%
8.09%
11.64%
12.06%
13.60%
Beta
0.44
0.4765
0.9826
0.4645
1.266
6 Month T-Bill
R^2
0.018831
0.018256
0.047585
0.016086
0.059917
Ke
7.85%
8.10%
11.64%
8.02%
13.63%
2 Year T-Bill
Number of Months
72
60
48
36
24
Beta
0.4379
0.4759
0.9806
0.4607
1.259
Number of Months
72
60
48
36
24
Beta
0.4375
0.4779
0.0982
0.0458
1.2584
5 Year T-Bill
R^2
0.018617
0.018642
0.047276
0.015822
0.058894
Ke
7.83%
8.11%
5.45%
5.09%
13.58%
Beta
0.4375
0.4779
0.9824
0.4588
1.2584
10 Year T-Bill
R^2
0.0186
0.0186
0.0472
-0.013
0.0588
Ke
7.83%
8.12%
11.65%
7.98%
13.58%
Number of Months
72
60
48
36
24
R^2
0.018609
0.034924
0.047362
-0.01303
0.059062
Ke
7.84%
8.10%
11.63%
7.99%
13.58%
81
As previously stated, we used the rates of various T-bills (3 month, 6
month, 2 year, 5 year, and 10 years) to come up with the risk free rates needed
to compute the cost of capital for Darden. Each different time period that we
used represents a different point on the yield curve. Our task was to discern
which point along said yield curve provided the most information about the firm.
After running these regressions, we discovered that the R^2 (which measures
the explanatory power of the model) of the 3 month treasury bills was the
highest. This model provided us with an estimated beta of 0.98 nearly twice that
of Darden’s published beta of .5. We interpreted these results to illustrate that
Darden is viewed as a short term investment by the market as a whole.
Furthermore, the fact that our estimated beta is nearly twice that of the
published beta is cause for concern. This could be an indication that the market
has only priced half of the actual risk into the stock, a strong sign that the price
per share may be artificially high. However, the R^2 of this model was only
.067, which is to say that the results have an explanatory power of a meager
6.7%. After finding the beta, we found a reasonable market return.
Finally, we used the Capital Asset Pricing Model (CAPM) to determine our
Ke. To do this we used a risk free rate of 4.77% using the most recent two year
Treasury Bill and a market risk premium of 7%.
CapM = Ke = Risk Free Rate + Beta*(Market Risk Premium)
Ke = 4.77% + .9821*(7%) = 11.6%
However, since our R^2 was 6.7% the explanatory power is very low. Therefore,
we had to find a more accurate Ke by using the long-run residual income
formula.
In order to get a better estimate of the cost of capital, we used the
formula for the long-run residual income perpetuity and backed into it. This
model describes the value of equity as a piece of the book value and the future
performance of the company. We took the market price on June 1, 2007 and
82
solved for Ke. We believe the average return of equity to be around 26.6% and
growth to be 8.04%.
Price Per Share = Book Value Per Share * (1+ ((ROE-Ke)/ (Ke-g))
$45.8 = $7.812 * (1 + (26.6%-Ke)/ (Ke-8.04%))
Ke = 11.5%
Using the long run residual income model allowed us to achieve a more accurate
Ke that we need for our valuations in the following sections.
Weighted Average Cost of Capital
WAAC, or weighted average cost of capital, is simply a calculation of a
firm's cost of capital that weights each category of capital proportionately. The
formula used to derive this number is as follows (www.financialdictionary.com):
Where:
Re = cost of equity
Rd = cost of debt
E = the market value of the firm's equity
D = the market value of the firm's debt
V=E+D
E/V = percentage of financing that is equity
D/V = percentage of financing that is debt
Tc = the corporate tax rate
We were able to come up with Darden’s cost of debt by taking a weighted
average of their outstanding debt, which the company disclosed on their most
83
recent 10-K. The following is a table of Darden’s current debt and each
components interest rate.
Senior Notes due August 2010
Amount of
Interest
Weighted
Debt
Rates
Average
150
4.88%
1.06%
75
7.45%
0.81%
100
7.13%
1.03%
150
6.00%
1.30%
22
8.00%
0.25%
150
5.75%
1.25%
44
5.24%
0.33%
Medium-term Notes due April
2011
Debentures due February 2016
Senior Notes due August 2035
Commercial Bank Loan due
December 2018
Medium-term Notes due March
2007
Short-term Debt
Total Debt and Cost of Debt
691
6.04%
After multiplying each factor of the amount of debt by its interest rate, we added
all of these weighted averages to give us Darden’s cost of debt. We found this
number to be 6.04%.
The book value of Darden is roughly 3.12 billion. We used the book value
of liabilities as a reasonable estimate of the firm’s market value of liabilities,
which gave us a total of $697 million for the current value of liabilities. As
previously stated, the cost of equity with the highest explanatory power from our
regression analysis was 11.5%. We then used Darden’s share price as of June 1,
2007 (our valuation date) and multiplied it by the number of shares outstanding
to calculate Darden’s market value of equity. We then used all of these numbers,
including a 35% effective tax rate (standard in the restaurant industry), to
84
calculate Darden’s after tax WACC to be 10.15%. The before tax WACC equals
10.57%, which we will use in our valuation models.
Analysis of Valuations
The previous sections of this report have allowed us to understand how
Darden operates in the casual dining industry. By taking into consideration of all
of the aspects that have been analyzed, we can now value the firm. The
valuation process entails “converting a forecast into an estimate of the value of
the firm or some component of the firm” (Palepu). There are several different
methods that are used to determine if the firm is overvalued, undervalued, or
fairly valued. The first of the valuation methods is the Method of Comparables
that is comprised of recent financial information, along with the competitor’s
data, taking the average of the industry, and then determining what we believe
the price per share should be. However, these comparables are not reliable since
the estimated price is based upon the industry’s average. Despite this downfall,
the good aspect of these comparables is that they are quick and easy to
compute.
In order to get a more accurate valuation, we use the intrinsic valuation
methods. These methods involve detailed forecasts and analysis and require
substantial professional judgment and estimates. It is important to remember
that the intrinsic valuations are the analyst’s opinion of the firm value. They are
not facts. These models use what we previous calculated as the weighted
average of cost of capital (WACC) and cost of equity (Ke). The models that are
included in the intrinsic valuation method are as followed: Discounted Dividends,
Discounted Free-Cash Flows, the Residual Income Method, the Residual Income
Perpetuity, and Abnormal Earnings Approach.
85
Method of Comparables
The Method of Comparables takes into account each competitor
individually to obtain an industry average of the particular method. All of the
numbers used in this section are the current financial data of Darden and its
competitors. The only method that does not use the current data is the Trailing
P/E model. It uses the previous year’s numbers. By obtaining the industry
average, we then use this average to estimate the share price of Darden. Below
are all of the models under the method of comparables. OSI’s information is not
available because as of June 14, 2007, OSI has gone private by being bought by
the Bain Capital Partners LLC and Catterton Management Co. LLC, along with
OSI’s founders (www.finance.yahoo.com). Therefore, the OSI stock has stopped
trading on the New York Stock Exchange and is no longer listed. Even though
we do not discuss Texas Roadhouse (TXRH) and the Cheesecake Factory (CAKE)
in the previous sections, we had to bring them into the method of comparables
in order to obtain a better industry average.
Forward P/E (2007)
Trailing P/E (2006)
P/B
D/P
PEG
Price/EBITDA
Price/FCF
EV/EBITDA
DRI Share Price
Valuation
52.74
57.89
29.51
44.23
24.92
69.02
98.30
43.07
Undervalued
Undervalued
Overvalued
Fairly Valued
Overvalued
Undervalued
Undervalued
Fairly Valued
In reference to the table above, we have concluded that Darden
Restaurant’s is an undervalued firm. We took Darden’s four major competitors
and found the casual-dining industry average method of comparables. With this
we found Darden’s estimated share price and compared it to its actual price per
86
share, dividend per share, and enterprise value therefore determining Darden as
an overall undervalued firm.
Forward Price to Earnings (2007)
DRI
EAT
APPB
TXRH
CAKE
PPS
45.8
33.29
25.98
14.03
28.39
EPS
2.84
2.08
1.36
0.71
1.48
P/E
16.11
16.02
19.09
19.85
19.24
Industry AVG
18.55
DRI Share Price
52.74
Valuation
Undervalued
To calculate Darden’s share price with this model, we first found the P/E
ratio using an investments website. The corresponding price per share and
earnings per share are showed for each company. P/E is found by dividing price
per share by earnings per share. We then got an industry average of P/E by
adding all P/E ratios together, excluding Darden’s, and divided it by the number
of firms in the average. To get Darden’s price per share, we multiplied the
industry average by Darden’s EPS. This gave us a share price of $52.74.
Compared to the current stock price of $45.80, the company is slightly
undervalued.
Trailing Price to Earnings (2006)
DRI
EAT
APPB
TXRH
CAKE
PPS
35.56
35.43
19.49
13.09
27.10
EPS
2.31
2.04
0.65
0.50
1.03
P/E
18.79
17.38
30.13
26.31
26.40
Industry AVG.
25.06
DRI Share Price Valuation
57.89
Undervalued
87
The difference between the forward and the trailing P/E is that while
forward uses the current financial data, the trailing P/E uses the previous year’s
financial data. However, both of these models use the same method of
computing. First, you find the competitors in the industries trailing P/E, and then
take the average of all of the competitors to obtain the industry average. Then
we multiplied the average of $57.89 by Darden’s EPS to get an intrinsic stock
price of $57.89. This shows that Darden is undervalued since the intrinsic share
price is lower than the actual price per share.
Price to Book
PPS
BPS
P/B
Industry AVG.
DRI Share Price
Valuation
DRI
45.8
8.43
5.43
3.50
29.51
Overvalued
EAT
33.29
9.59
3.47
APPB
25.98
6.82
3.81
TXRH
14.03
4.69
2.99
CAKE
29.39
7.63
3.72
When using the price to book (P/B) equation we used the current price
per share (PPS) and divided by the P/B to find the book value per share (BPS).
We then took the average of the P/B for Darden’s competitors to find the
industry average. Then we took the industry average of 3.5 and multiplied it by
the book value per share to find Darden’s estimated share price of $29.51. From
this we found that Darden is overvalued. Darden’s P/B ratio is 1.55 higher then
the industry average showing that from the estimated share price Daren is
overvalued.
88
Dividend to Price
DRI
EAT
APPB
TXRH
CAKE
DPS
0.46
0.36
0.22
N/A
N/A
PPS
45.8
33.29
25.98
14.03
28.39
D/P
0.0100
0.0108
0.0085
N/A
N/A
Industry AVG.
0.0098
DRI Share Price
44.23
Valuation
Fairly Valued
In this comparables method, we divided dividends per share by price per
share for all of the firms. We then found the average for the industry. TXRH and
CAKE are not included in the industry average since they do not pay dividends.
To obtain Darden’s share price, we divided the dividend price per share by the
industry average to obtain a share price of $44.23. This method suggests that
Darden is fairly priced. The intrinsic share price is a little more than a dollar of
the actual price.
Price Earning Growth
DRI
EAT
APPB
TXRH
CAKE
PPS
EPS
PEG
45.8
33.29
25.98
14.03
28.39
2.31
2.04
N/A
0.65
0.50
1.52
1.30
1.53
1.15
1.21
Industry
AVG.
1.30
DRI Share
Price
24.92
Valuation
Overvalued
The P.E.G. ratio stands for price/earnings growth and is calculated by
dividing the P/E by the projected earnings growth rate. A P.E.G. ratio of above
one usually means that a company is trading at a discount to its growth rate
where as most investors would be interested in a lower than one price earnings
ratio. We first took the industry average P.E.G. of the top four leading
competitors then multiplied this number by Darden’s P/E divided by its growth of
89
8.4%. We came up with a share price of $24.92 which is significantly lower than
Darden’s actual price per share of $45.80. This would in term make this ratio
overvalued.
Other Methods of Comparables
Price/ EBITDA
DRI
EAT
APPB
TXR
H
CAKE
PPS
EBITD
A
P/EBITD
A
Industry
AVG.
DRI Share
Price
45.8
33.29
25.98
0.802
0.564
0.225
57.08
58.99
115.27
86.06
69.02
14.03
28.39
0.893
0.184
15.71
154.26
Valuation
Undervalu
ed
The Price/EBITDA is “a measure of the operating cash flows of the
business, compared with its share price.” (http://demoseafoodol.platypus.net)
The lower the number, in this case for Darden (1%) the more attractive the
company is to an investor. Since the industry average favors around 1% as
compared to Darden Restaurant’s company average of 1%, this is a fairly
undervalued margin.
90
Price/Free Cash Flows
DRI
EAT
APPB
TXRH
CAKE
PPS
FCF
P/FCF
45.8
33.29
25.98
14.03
28.39
221.87
-90.5
58.64
-33.16
-34.3
0.206427
-0.36785
0.443042
-0.4231
-0.8277
Industry
AVG.
0.443042
DRI Share
Price
98.30
Valuation
Undervalued
The Price/Free Cash Flows equation is important because it allows a
company to pursue opportunities that enhance shareholder value. The industry
average was only used by Applebee’s because it produced a positive P/FCF
value. Since Darden’s other three competitors had a negative turn around, we
excluded them from the total industry average of .443. We then multiplied this
industry average by Darden’s free cash flows of 221.87 to get an undervalued
result.
Enterprise Value/EBITDA
DRI
EAT
APPB
TXRH
CAKE
EV
EBITDA
EV/EBITDA
Industry Avg.
DRI Share Price
Valuation
7.33
3.96
2.05
1.02
2.07
802.45
564.31
225.38
89.33
184.04
9.14
7.01
9.09
11.38
11.25
9.68
43.07
Fairly Valued
The EV/EBITDA is used to analyze and compare the profitability between
a company and the total industry. EBITDA is also a good metric to evaluate
profitability instead of actual company cash flows. The industry average for this
91
ratio was calculated to be 9.68 which was then multiplied by Darden Restaurant’s
current EBITDA of 802.45. We then added the cash and financial investments of
42,334. Next, we subtracted the book value of liabilities that equaled 178,047.
Finally, we divided the number of shares outstanding. After these calculations,
Darden’s intrinsic share price equaled $43.07. Since, the actual share price is
$45.80 and the intrinsic price is only a little over two dollars less than the actual,
then this ratio shows that the firm is fairly valued.
Intrinsic Evaluation Models
We used 4 intrinsic valuation models to value our company. These
models tend to be more accurate than our previous methods of valuation
because they are based off of theory. The four models we used are the Free
Cash Flow, Residual Income, Long Run Residual Income Perpetuity, and the
Discounted Dividends Model. As with the previous valuations, we are comparing
the valuations to the current stock price at June 1, 2007, which was $45.80. In
our sensitivity analysis, we compared the cost of equity rates to the growth rates
based upon an upper boundary of 15% above the actual price per share, $52.67,
and a lower boundary of 15% below the actual price per share, $38.93. If the
share price is between these two boundaries, then the share price is fairly
valued.
92
Discounted Dividends Model
Sensitivity Analysis
Ke
0.14
0.13
0.115
0.1
0.09
0.00
4.96
5.42
6.29
7.42
8.40
Undervalued < $52.67
Fairly Valued +/- 15%
Overvalued > $38.93
Not Applicable
0.02
5.30
5.86
6.93
8.42
9.78
Growth
0.04
5.79
6.49
7.92
10.08
12.25
0.06
6.51
7.49
9.63
13.40
18.02
0.08
7.71
9.28
13.30
23.37
46.87
Actual PPS $45.80
The discounted dividends model values the firm by taking the present
value of all future dividends. Several factors make this model the least accurate
of all intrinsic valuations we will be doing. It has the least explanatory value
because dividends stick while stock prices have a lot of variance. There is no
relationship between the two.
To use this model, we first forecasted the dividends per share that will be
paid in the future. We then used a present value factor to bring these prices
back the current date. We then estimated the dividends after 10 years in the
future with a formula for perpetuities. After taking the present value of the
perpetuity, we added the present value of the dividends for the next ten years
and the present value of the perpetuity. This number gave us the estimated
value of the firm.
We did a sensitivity analysis, which showed that the firm is extremely
overvalued with all growth rates and Ke’s that we tested. The only situation in
93
which the share price is fairly valued is at a Ke equal to 9% and a growth rate of
8%. The observed share price is $45.80 and all of our outcomes were much
lower than this.
Discounted Free Cash Flows
Sensitivity Analysis
WACC
0.06
0.08
0.1057
0.12
0.14
Undervalued < $52.67
Fairly Valued +/- 15%
Overvalued > $38.93
Not Applicable
0.00
34.84
20.45
11.11
7.95
4.80
0.02
47.73
24.96
12.64
8.85
5.26
Growth
0.04
86.40
34.00
15.10
10.21
5.91
0.07
-145.61
115.32
23.97
14.29
7.57
0.09
-42.49
-101.54
48.72
21.53
9.79
Actual PPS $45.80
To create the model of free cash flow we used the FCF of Darden
Restaurant’s, the growth rate of the perpetuity, and the weighted average cost
of capital. We found Darden’s free cash flow from using the forecasted amounts
from ten years of cash flow from operations, and subtracting from the cash flow
from investing. Then we took Darden’s weighted average cost of capital of .1084
and used it as the discount factor and found Darden’s present value factor and
multiplied it by the ten years of the free cash flow. Doing this we brought each
one back to June 1, 2007. The sum of these is our present value of annual cash
flow, $2,427,711. We found the perpetuity by forecasting the year of 2017 free
cash flow and dividing it by the WACC minus the growth rate. We then took this
value and discounted it back to its present value by multiplying it by the present
value factor from year ten. Then we added the present value of annual cash
94
flows to the present value of perpetuity and subtracted the book value of
liabilities to give us Darden’s equity value. Then we divided the value of equity
by the number of shares to gives us Darden’s intrinsic share price.
By looking at Darden’s sensitivity analysis we see that Darden is falling
into a majority of the sections that are below the lower boundary, this tells us
that Darden is overvalued.
Residual Income
The residual income method tends to be the most accurate of the models
we will be using. It uses both market based values and accounting based values
to estimate the value of the company. The principle of the Residual Income
Model comes from finding the present value of a company’s estimated residual
income.
Sensitivity Analysis
Ke
0.09
0.115
0.13
0.15
0.17
Undervalued < $52.67
Fairly Valued +/- 15%
Overvalued > $38.93
Not Applicable
0
53.77
39.23
33.08
26.76
27.96
-0.05
45.54
34.87
29.98
24.74
20.59
Growth
-0.1
41.64
32.54
28.24
23.53
19.73
-0.15
39.36
31.09
27.11
22.72
19.14
-0.2
37.87
30.09
26.33
22.14
18.71
Actual PPS $45.80
The first step in calculating the residual income is to find the book value of
equity (BVE) for the next ten years, and then multiply that last year’s BE by the
cost of equity (Ke) that we had calculated earlier. This gave us the “normal”
earnings. We then calculated residual income by subtracting normal earnings
95
from the net income. By using the Ke as our discount factor, we found the
present factor in order to bring each year’s residual income back to June 1,
2007. To account for years after ten years in the future we used a perpetuity
formula. The year 2016 residual income was used for the perpetuity and
discounted back by dividing by the Ke minus the growth rate of zero. Then we
found the present value of the perpetuity. These two PV’s were added to the
ending BVE for 2006 and divided by the number of shares outstanding to give us
an intrinsic price per share at June 1, 2007. We then added the total value of
residual income for the next ten years (adjusted to present values) to the
present value of the perpetuity and the initial book value of the equity.
After performing a sensitivity analysis, we observed that the residual
income model shows that the firm is overvalued. For most Ke’s, the estimated
share price is above the upper boundary. Only at significantly larger Ke’s is the
expected share price within the boundaries or lower than the lower boundary.
96
Long Run ROE Residual Income
g=
8.4%
Ke
0.08
0.09
0.115
0.13
0.15
0.17
-53.84
125.64
24.32
16.39
12.58
0.19
-66.37
154.85
29.97
20.20
14.08
ROE = 21%
Ke
0.07
0.09
0.115
0.13
0.15
g
Undervalued < $52.67
Fairly Valued +/- 15%
Overvalued > $38.93
Not Applicable
0.23
-91.41
213.29
41.28
27.82
19.39
0.25
-103.93
242.50
46.94
31.63
22.05
g
0.04
49.67
29.80
19.87
16.56
13.55
0.06
131.48
43.83
23.91
18.78
14.61
0.084
-78.89
184.07
35.63
24.01
16.73
0.10
-32.14
-96.42
64.28
31.14
19.28
0.12
-15.78
-26.30
-157.77
78.89
26.30
0.19
17.53
20.72
29.97
52.59
-122.71
ROE
0.21
19.87
23.91
35.63
64.28
-157.77
0.23
22.21
27.09
41.28
75.97
-192.84
0.25
24.54
30.28
46.94
87.65
-227.90
Ke = 11.5%
0.04
0.06
0.084
0.1
0.12
ROE
0.21
-78.89
184.07
35.63
24.01
16.73
0.17
15.19
17.53
24.32
40.90
-87.65
Actual PPS $45.80
The Long-run Residual Income Perpetuity model is derived from the
original residual income model. In order to find the intrinsic share price we need
the Ke, Return on Equity, and the growth rate. This model values the firm by
97
taking into account the book value of equity per share, the return on equity, Ke
and a growth rate. To find this model you take the book value per share and
multiply it times one plus your ROE minus your cost of equity divided by your
cost of equity minus your growth rate.
P = BV (1+ (ROE – Ke)/ (Ke – g))
This is the same equation to figure out our cost of equity in the previous section.
Since we backed into this model to find our Ke, then this swayed our results.
Because we did this, we had to assume that our growth rate was 8.4%, the
percent of growth sales, in order to have a growth rate less than the Ke. By
using a long run average of ROE of 17%, a cost of equity as 11.5%, and a long
run growth rate of equity as 8.04%, then we found an intrinsic share value to
equal $22.15.
The sensitivity analysis shows that the firm is overvalued. For almost all
combinations of the variables, the company is below the lower boundary.
Abnormal Earnings Growth
Sensitivity Analysis
Ke
0.07
0.09
0.115
0.13
0.15
0
162.32
99.86
61.14
47.45
35.01
Undervalued < $52.67
Fairly Valued +/- 15%
Overvalued > $38.93
Not Applicable
-0.05
134.45
87.40
55.74
43.96
32.97
Growth
-0.1
122.97
81.50
52.85
42.00
31.74
-0.15
116.71
78.06
51.05
40.73
30.92
-0.2
112.77
75.80
49.82
39.85
30.34
Actual PPS $45.80
The Abnormal Earnings Growth Model is calculated by using a company’s
earnings and dividends. To begin, the D.R.I.P. income has to be calculated which
98
is the previous year’s dividends times Ke. The Cumulative Dividends Earnings are
found by adding the earnings and D.R.I.P. Then we had to subtract the normal
earnings which are comprised of last year’s earnings grown by the Ke. That will
give us AEG. The Ke is then used to find the present value factor, which is
multiplied by the AEG to get the Present Value. The year ten, 2016, is also used
for the perpetuity of AEG, and is discounted back to year nine by dividing it by
the Ke minus the growth rate. The growth rate should be negative in order to
slowly bring the perpetuity AEG back to zero over time. Then the core perpetuity
earnings are found by discounting the perpetuity back to 2007. We then added
the total PV of AEG, the core earnings, and the core perpetuity earnings to equal
the total earnings perpetuity. We then took this number and divided it by Ke to
come up with an estimated intrinsic value of $61.14.
By analyzing the sensitivity analysis, we discovered that this model shows
Darden to be undervalued. Everything in the analysis is undervalued unless there
is a Ke equal to 11.5% and a declining growth rate of 15%. The only time the
firm is overvalued is when there is a Ke equal to 15% no matter what the growth
rate is. Even though AEG is the best estimation, we have determined that
Darden is slightly overvalued.
Credit Risk Analysis
Z-Score
2002
9.44
2003
17.637
2004
7.82
2005
23.039
2006
23.579
Altman’s Z-Score is a credit risk analysis that is implemented by banks and
lenders to help them determine the risk that is associated with loaning a firm
capital. The Z-Score use five weighted financial ratios to determine the
probability of a firm declaring bankruptcy. The Z-Score is calculated by using the
following formula:
99
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)
If a company has a Z-Score that is greater than 2.7, then they have a low
risk of default and bankruptcy resulting in a lower interest rate being paid by the
firm. If they have a Z-Score that is less than 1.8, then they have a high default
risk and therefore are paying a high interest rate. If the Z-Score is between
these two numbers, then it is undetermined whether the firm is high or low risk.
Using the Z-Score has proven to be relatively accurate since the “real world
application of the Z-Score successfully predicted 72% of corporate
bankruptcies two years prior to these companies filing” for bankruptcy
(www.investopedia.com).
As the table states, Darden’s Z-score has drastically increased from 9.44 in
2002 to 23.579 in 2006. This shows that Darden has a low risk of default and
bankruptcy. Therefore, they are paying a lower interest rate. The heavy
weightings of the retained earnings to total assets ratio, combined with the fact
that retained earnings grew faster than the assets, explains the large increases
in its credit worthiness.
Analyst Recommendation
After a complete and thorough industry, financial and accounting analysis,
along with forecasting for future results, we feel that we have obtained a much
better understanding of Darden Restaurants, as well as the casual dining
industry as a whole. Darden operates in a highly competitive, mildly price
sensitive industry with low barriers to entry. Differentiation and specialty
100
products are of high importance. The firm competes against well known
companies such as OSI restaurants, Applebees, and Brinker, Intl. Darden
appears to posses several key success factors, including the ability to develop
and maintain positive brand image, superior customer service, and superior
product variety.
In regards to ratio analysis, Darden was (in aggregate) slightly more
favorable than its competitors. However, our most realistic and reliable intrinsic
valuation models produced results in the ballpark $10-$15 dollars lower than
Darden’s current price of $45.80. (This is disregarding less reliable valuation
models, such as the discounted dividends model and “naïve” ratio models.) Our
best rationale for the premium at which the firm’s shares (and the extreme
differences in our models) is that investors are currently overestimating the
firm’s potential for maintaining the current growth rate without exponentially
increasing expenses. Armed with this information, we conclude that Darden
(DRI) is currently overvalued and reinforce our sell recommendation.
101
Appendix
Current Ratio
DRI
EAT
OSI
APPB
2002
0.748
0.470
0.728
0.604
2003
0.509
0.537
0.785
0.58
2004
0.507
1.057
0.596
0.664
2005
0.390
0.572
0.515
0.457
2006
0.368
0.487
0.559
0.563
Change on Liquidity
Unfavorable
No Change
Unfavorable
Unfavorable
2006
0.077
0.217
0.208
0.38
Change on Liquidity
Unfavorable
Favorable
Unfavorable
No Change
2006
154.150
79.012
181.985
24.67
Change on Liquidity
Favorable
Unfavorable
Unfavorable
Unfavorable
Quick Asset Ratio
DRI
EAT
OSI
APPB
2002
0.303
0.108
0.907
0.358
2003
0.121
0.220
0.461
0.334
2004
0.098
0.698
0.297
0.331
2005
0.076
0.208
0.265
0.259
Accounts Receivable Turnover
DRI
EAT
OSI
APPB
2002
150.184
127.675
271.979
27.772
2003
160.389
94.901
211.949
27.141
2004
165.356
97.735
163.472
24.686
2005
144.566
86.654
123.459
28.344
102
Days Sales Outstanding
DRI
EAT
OSI
APPB
2002
2.430
2.859
1.342
13.143
2003
2.276
3.846
1.722
13.448
2004
2.207
3.735
2.233
14.786
2005
2.525
4.212
2.956
12.878
2006
2.368
4.620
2.006
14.795
Change on Liquidity
No Change
Unfavorable
No Change
Unfavorable
2006
22.280
28.786
16.257
91.246
Change on Liquidity
Favorable
Unfavorable
Unfavorable
Favorable
2006
16.382
12.680
22.452
4
Change on Liquidity
Favorable
Unfavorable
Unfavorable
Favorable
Inventory Turnover
DRI
EAT
OSI
APPB
2002
19.631
31.628
24.792
53.41
2003
20.930
36.896
16.497
34.988
2004
19.598
26.886
18.807
22.944
2005
17.396
22.238
19.102
46.017
Days Supply of Inventory
DRI
EAT
OSI
APPB
2002
18.593
11.540
14.722
6.834
2003
17.439
9.893
22.125
10.432
2004
18.624
13.576
19.408
15.908
2005
20.982
16.413
19.108
7.932
103
Working Capital Turnover
DRI
EAT
OSI
APPB
2002
4.159
-18.014
66.831
-15.888
2003
4.821
-22.856
-42.827
-13.828
2004
4.859
170.396
-21.465
-19.138
2005
3.635
-21.770
-16.927
-10.08
2006
4.075
-16.275
-15.743
-14.655
Change on Liquidity
No Change
Favorable
Unfavorable
Favorable
2006
0.226
0.720
0.644
0.21
Change on Liquidity
No Change
No Change
No Change
No Change
2006
0.094
0.079
0.039
0.1
Change on Liquidity
No Change
Unfavorable
Unfavorable
No Change
Gross Profit Margin
DRI
EAT
OSI
APPB
2002
0.225
0.724
0.642
0.26
2003
0.219
0.726
0.646
0.16
2004
0.221
0.724
0.631
0.26
2005
0.224
0.719
0.641
0.23
Operating Profit Margin
DRI
EAT
OSI
APPB
2002
0.091
0.086
0.124
0.16
2003
0.084
0.081
0.097
0.18
2004
0.085
0.068
0.097
0.15
2005
0.089
0.057
0.065
0.13
104
Net Profit Margin
DRI
EAT
OSI
APPB
2002
0.054
0.053
0.067
0.1
2003
0.050
0.051
0.063
0.11
2004
0.046
0.042
0.049
0.1
2005
0.055
0.041
0.042
0.08
2006
0.059
0.051
0.026
0.06
Change on Liquidity
Favorable
No Change
Unfavorable
No Change
2006
1.924
1.896
1.995
1.52
Change on Liquidity
Favorable
Favorable
Favorable
No Change
2006
0.115
0.099
0.051
1.523
Change on Liquidity
Favorable
No Change
Unfavorable
Unfavorable
Asset Turnover
DRI
EAT
OSI
APPB
2002
1.841
1.723
1.800
1.55
2003
1.792
1.763
1.961
1.43
2004
1.838
1.785
2.158
1.59
2005
1.846
1.792
2.096
1.49
Return on Assets
DRI
EAT
OSI
APPB
2002
0.107
0.097
0.119
1.652
2003
0.092
0.095
0.122
1.532
2004
0.087
0.079
0.106
1.726
2005
0.105
0.072
0.088
1.613
105
Return on Equity
DRI
EAT
OSI
APPB
2002
0.230
0.179
0.157
2.543
2003
0.206
0.173
0.162
2.209
2004
0.193
0.135
0.152
2.418
2005
0.233
0.156
0.137
1.613
2006
0.266
0.193
0.084
3.243
Change on Liquidity
No Change
Favorable
Unfavorable
Favorable
2006
1.448
1.671
0.819
0.922
Change on Liquidity
Favorable
Favorable
Favorable
Unfavorable
2006
12.420
14.289
10.287
11.451
Change on Liquidity
Favorable
Unfavorable
Unfavorable
Unfavorable
2006
3.70
214.158
6.098
658.845
Change on Liquidity
Unfavorable
Favorable
Favorable
Unfavorable
Debt to Equity Ratio
DRI
EAT
OSI
APPB
2002
1.241
1.504
0.280
0.442
2003
1.228
1.173
0.379
0.401
2004
1.232
2.168
0.524
0.519
2005
1.308
1.479
0.615
1.129
Times Interest Earned
DRI
EAT
OSI
APPB
2002
10.860
18.572
0.000
59.828
2003
9.155
21.416
146.305
88.660
2004
9.747
21.656
69.449
101.648
2005
10.937
8.724
34.192
36.114
Debt Service Margin
DRI
EAT
OSI
APPB
2002
N/A
22.556
19.358
358.989
2003
5.92
25.462
5.503
916.089
2004
36.24
26.588
5.899
858.581
2005
1.94
245.695
5.867
854.066
106
EBITDA Margin
DRI
EAT
OSI
APPB
2002
0.080
0.079
0.039
0.146
2003
0.080
0.057
0.065
0.204
2004
0.070
0.068
0.079
0.195
2005
0.070
0.081
0.097
0.203
2006
0.080
0.086
0.124
0.187
Change on Liquidity
No Change
No Change
Favorable
Favorable
2006
2.274
2.130
2.560
1.313
Change on Liquidity
Unfavorable
Unfavorable
No Change
Favorable
2006
0.70
1.292
1.413
1.174
Change on Liquidity
Unfavorable
Favorable
Favorable
Favorable
PP & E Turnover
DRI
EAT
OSI
APPB
2002
2.339
2.316
2.531
1.253
2003
2.245
2.291
2.576
1.246
2004
2.223
2.366
2.577
1.350
2005
2.158
2.191
2.596
1.405
Operating Cash Flow Ratio
DRI
EAT
OSI
APPB
2002
0.85
0.945
0.652
0.933
2003
0.79
0.989
0.853
1.119
2004
0.77
1.234
0.877
1.256
2005
0.56
1.44
0.908
1.177
IGR/SGR Analysis
IGR (DRI)
IGR Average
SGR (DRI)
SGR Average
2002
10.28%
9.74%
23.04%
22.41%
2003
8.67%
2004
8.21%
2005
10.05%
2006
11.5%
19.32%
18.32%
23.20%
28.15%
107
3 Month Regression
SUMMARY OUTPUT
Regression Statistics
Multiple R
R Square
Adjusted R Square
Standard Error
Observations
0.180312431
0.032512573
0.018691324
0.088581209
72
Coefficients
Intercept
X Variable 1
Standard Error
0.015553382
0.439416136
0.010442
0.2865
t Stat
1.489564
1.533741
P-value
0.140831
0.129601
Lower 95%
-0.00527
-0.13199
Upper 95%
0.036378
1.010822
Lower 95.0%
-0.00527
-0.13199
Upper 95.0%
0.036378
1.010822
SUMMARY OUTPUT
Regression Statistics
Multiple R
R Square
Adjusted R Square
Standard Error
Observations
0.18631863
0.034714632
0.018071781
0.087540146
60
Coefficients
Intercept
X Variable 1
Standard Error
0.010129123
0.475216754
0.011362
0.32904
t Stat
0.891475
1.44425
P-value
0.376358
0.154049
Lower 95%
-0.01261
-0.18343
Upper 95%
0.032873
1.133863
Lower 95.0%
-0.01261
-0.18343
Upper 95.0%
0.032873
1.133863
SUMMARY OUTPUT
Regression Statistics
Multiple R
R Square
Adjusted R Square
Standard Error
Observations
0.260568563
0.067895976
0.047632845
0.080523723
48
Coefficients
Intercept
X Variable 1
Standard Error
0.01450114
0.982176401
0.01232
0.536563
t Stat
1.177
1.830496
P-value
0.24525
0.073659
Lower 95%
-0.0103
-0.09787
Upper 95%
0.039301
2.062222
Lower 95.0%
-0.0103
-0.09787
Upper 95.0%
0.039301
2.062222
SUMMARY OUTPUT
Regression Statistics
Multiple R
R Square
Adjusted R Square
Standard Error
Observations
0.126487758
0.015999153
-0.012942048
0.075271482
36
Coefficients
Intercept
X Variable 1
Standard Error
0.017978846
0.463284384
0.012937
0.6231
t Stat
1.389732
0.743516
P-value
0.173644
0.462277
Lower 95%
-0.00831
-0.80301
Upper 95%
0.04427
1.729575
Lower 95.0%
-0.00831
-0.80301
Upper 95.0%
0.04427
1.729575
SUMMARY OUTPUT
Regression Statistics
Multiple R
R Square
Adjusted R Square
Standard Error
Observations
ANOVA
0.316596017
0.100233038
0.05933454
0.073485379
24
df
Regression
Residual
Total
SS
1
22
23
Coefficients
Intercept
X Variable 1
0.008853363
1.261612943
0.013234
0.118802
0.132037
Standard Error
0.015929
0.805887
MS
0.013234
0.0054
t Stat
0.555792
1.565495
F
2.450776
P-value
0.583962
0.131739
Significance F
0.131739
Lower 95%
-0.02418
-0.4097
Upper 95%
0.041889
2.932921
Lower 95.0%
-0.02418
-0.4097
108
Upper 95.0%
0.041889
2.932921
6 Month Regression
SUMMARY OUTPUT
Regression Statistics
Multiple R
R Square
Adjusted R Square
Standard Error
Observations
0.180693945
0.032650302
0.01883102
0.088574904
72
Coefficients
Intercept
X Variable 1
SUMMARY OUTPUT
0.015546597
0.440048512
Standard
Error
0.010440903
0.286285721
t Stat
1.489008843
1.537095564
P-value
0.140976803
0.12877806
Lower 95%
-0.005277127
-0.130930347
Upper 95%
0.03637032
1.01102737
Lower 95.0%
-0.005277127
-0.130930347
Upper 95.0%
0.03637032
1.01102737
Regression Statistics
Multiple R
R Square
Adjusted R Square
Standard Error
Observations
0.186803823
0.034895668
0.018255939
0.087531936
60
Coefficients
Intercept
X Variable 1
SUMMARY OUTPUT
0.010104212
0.476504046
Standard
Error
0.011362613
0.329043993
t Stat
0.889250676
1.44814692
P-value
0.377541834
0.152960477
Lower 95%
-0.01264053
-0.182149064
Upper 95%
0.032848953
1.135157155
Lower 95.0%
-0.01264053
-0.182149064
Upper 95.0%
0.032848953
1.135157155
Regression Statistics
Multiple R
R Square
Adjusted R Square
Standard Error
Observations
0.260479169
0.067849397
0.047585254
0.080525735
48
Coefficients
Intercept
X Variable 1
0.014431645
0.982632508
Standard
Error
0.012333856
0.537009856
t Stat
1.170083733
1.82982211
P-value
0.247993961
0.073761344
Lower 95%
-0.01039512
-0.098312251
Upper 95%
0.039258409
2.063577268
Lower 95.0%
-0.01039512
-0.098312251
Upper 95.0%
0.039258409
2.063577268
SUMMARY OUTPUT
Regression Statistics
Multiple R
R Square
Adjusted R Square
Standard Error
Observations
0.126832481
0.016086478
-0.012852155
0.075268142
36
Coefficients
Intercept
X Variable 1
0.017933433
0.46450087
Standard
Error
0.012949223
0.623010048
t Stat
1.3849041
0.745575246
P-value
0.175102635
0.461047691
Lower 95%
-0.008382555
-0.801607872
Upper 95%
0.044249421
1.730609611
Lower 95.0%
-0.008382555
-0.801607872
Upper 95.0%
0.044249421
1.730609611
SUMMARY OUTPUT
Regression Statistics
Multiple R
R Square
Adjusted R Square
Standard Error
Observations
0.317475385
0.10079062
0.059917466
0.073462606
24
Coefficients
Intercept
X Variable 1
0.008743791
1.266122719
Standard
Error
0.015942906
0.806278014
t Stat
0.548444014
1.570330205
P-value
0.588909939
0.130610526
Lower 95%
-0.024319772
-0.405995532
Upper 95%
0.041807355
2.93824097
Lower 95.0%
-0.024319772
-0.405995532
109
Upper 95.0%
0.041807355
2.93824097
2 Year Regression
SUMMARY OUTPUT
Regression Statistics
Multiple R
R Square
Adjusted R Square
Standard Error
Observations
0.180086651
0.032431202
0.01860879
0.088584934
72
Coefficients
Intercept
X Variable 1
0.015714404
0.437922417
Standard Error
0.01044
0.285896
t Stat
1.505154
1.531756
P-value
0.136784
0.13009
Lower 95%
-0.00511
-0.13228
Upper 95%
0.036537
1.008123
Lower 95.0%
-0.00511
-0.13228
Upper 95.0%
0.036537
1.008123
SUMMARY OUTPUT
Regression Statistics
Multiple R
R Square
Adjusted R Square
Standard Error
Observations
0.186880628
0.034924369
0.018285134
0.087530635
60
Coefficients
Intercept
X Variable 1
0.010254518
0.47591949
Standard Error
0.011352
0.3285
t Stat
0.903321
1.448764
P-value
0.370092
0.152789
Lower 95%
-0.01247
-0.18165
Upper 95%
0.032978
1.133484
Lower 95.0%
-0.01247
-0.18165
Upper 95.0%
0.032978
1.133484
SUMMARY OUTPUT
Regression Statistics
Multiple R
R Square
Adjusted R Square
Standard Error
Observations
0.260060238
0.067631328
0.047362443
0.080535153
48
Coefficients
Intercept
X Variable 1
0.014700911
0.980647993
Standard Error
0.012289
0.536851
t Stat
1.196274
1.826666
P-value
0.237719
0.074243
Lower 95%
-0.01004
-0.09998
Upper 95%
0.039437
2.061274
Lower 95.0%
-0.01004
-0.09998
Upper 95.0%
0.039437
2.061274
SUMMARY OUTPUT
Regression Statistics
Multiple R
R Square
Adjusted R Square
Standard Error
Observations
0.126149492
0.015913694
-0.01303002
0.075274751
36
Coefficients
Intercept
X Variable 1
0.018024843
0.460797162
Standard Error
0.012925
0.621443
t Stat
1.394625
0.741495
P-value
0.172175
0.463485
Lower 95%
-0.00824
-0.80213
Upper 95%
0.044291
1.723722
Lower 95.0%
-0.00824
-0.80213
Upper 95.0%
0.044291
1.723722
SUMMARY OUTPUT
Regression Statistics
Multiple R
R Square
Adjusted R Square
Standard Error
Observations
Intercept
X Variable 1
0.316183674
0.099972115
0.059061757
0.073496034
24
Coefficients
0.008716048
1.259572769
Standard Error
0.015964
0.80575
t Stat
0.54599
1.56323
P-value
0.590567
0.13227
Lower 95%
-0.02439
-0.41145
Upper 95%
0.041823
2.930597
Lower 95.0%
-0.02439
-0.41145
110
Upper 95.0%
0.041823
2.930597
5 Year Regression
SUMMARY OUTPUT
Regression Statistics
Multiple R
R Square
Adjusted R Square
Standard Error
Observations
0.180110321
0.032439728
0.018617438
0.088584544
72
Coefficients
Intercept
X Variable 1
0.015973588
0.437585654
Standard Error
0.01044
0.285637
t Stat
1.530042
1.531964
P-value
0.130513
0.130038
Lower 95%
-0.00485
-0.1321
Upper 95%
0.036795
1.007271
Lower 95.0%
-0.00485
-0.1321
Upper 95.0%
0.036795
1.007271
SUMMARY OUTPUT
Regression Statistics
Multiple R
R Square
Adjusted R Square
Standard Error
Observations
0.187817307
0.035275341
0.018642157
0.087514717
60
Coefficients
Intercept
X Variable 1
0.010503822
0.477961594
Standard Error
0.011334
0.328205
t Stat
0.926716
1.45629
P-value
0.357914
0.150705
Lower 95%
-0.01218
-0.17901
Upper 95%
0.033192
1.134935
Lower 95.0%
-0.01218
-0.17901
Upper 95.0%
0.033192
1.134935
SUMMARY OUTPUT
Regression Statistics
Multiple R
R Square
Adjusted R Square
Standard Error
Observations
0.25989797
0.067546955
0.047276236
0.080538797
48
Coefficients
Intercept
X Variable 1
0.01510273
0.982418837
Standard Error
0.012221
0.538181
t Stat
1.235842
1.825443
P-value
0.222791
0.074431
Lower 95%
-0.0095
-0.10088
Upper 95%
0.039702
2.065721
Lower 95.0%
-0.0095
-0.10088
Upper 95.0%
0.039702
2.065721
SUMMARY OUTPUT
Regression Statistics
Multiple R
R Square
Adjusted R Square
Standard Error
Observations
0.125785005
0.015821868
-0.013124548
0.075278263
36
Coefficients
Intercept
X Variable 1
0.018124194
0.458833501
Standard Error
0.012896
0.620617
t Stat
1.405461
0.739318
P-value
0.168957
0.464788
Lower 95%
-0.00808
-0.80241
Upper 95%
0.044331
1.720079
Lower 95.0%
-0.00808
-0.80241
Upper 95.0%
0.044331
1.720079
SUMMARY OUTPUT
Regression Statistics
Multiple R
R Square
Adjusted R Square
Standard Error
Observations
0.315929277
0.099811308
0.05889364
0.073502599
24
Coefficients
Intercept
X Variable 1
0.008697165
1.258425138
Standard Error
0.015971
0.805736
t Stat
0.544566
1.561832
P-value
0.59153
0.132599
Lower 95%
-0.02442
-0.41257
Upper 95%
0.041819
2.92942
Lower 95.0%
-0.02442
-0.41257
111
Upper 95.0%
0.041819
2.92942
10 Year Regression
SUMMARY OUTPUT
Regression Statistics
Multiple R
R Square
Adjusted R Square
Standard Error
Observations
0.180110321
0.032439728
0.018617438
0.088584544
72
Coefficients
Intercept
X Variable 1
Standard Error
0.015973588
0.437585654
0.01044
0.285637
t Stat
1.530042
1.531964
P-value
0.130513
0.130038
Lower 95%
-0.00485
-0.1321
Upper 95%
0.036795
1.007271
Lower 95.0%
-0.00485
-0.1321
Upper 95.0%
0.036795
1.007271
SUMMARY OUTPUT
Regression Statistics
Multiple R
R Square
Adjusted R Square
Standard Error
Observations
0.187817307
0.035275341
0.018642157
0.087514717
60
Coefficients
Intercept
X Variable 1
Standard Error
0.010503822
0.477961594
0.011334
0.328205
t Stat
0.926716
1.45629
P-value
0.357914
0.150705
Lower 95%
-0.01218
-0.17901
Upper 95%
0.033192
1.134935
Lower 95.0%
-0.01218
-0.17901
Upper 95.0%
0.033192
1.134935
SUMMARY OUTPUT
Regression Statistics
Multiple R
R Square
Adjusted R Square
Standard Error
Observations
0.25989797
0.067546955
0.047276236
0.080538797
48
Coefficients
Intercept
X Variable 1
Standard Error
0.01510273
0.982418837
0.012221
0.538181
t Stat
1.235842
1.825443
P-value
0.222791
0.074431
Lower 95%
-0.0095
-0.10088
Upper 95%
0.039702
2.065721
Lower 95.0%
-0.0095
-0.10088
Upper 95.0%
0.039702
2.065721
SUMMARY OUTPUT
Regression Statistics
Multiple R
R Square
Adjusted R Square
Standard Error
Observations
0.125785005
0.015821868
-0.013124548
0.075278263
36
Coefficients
Intercept
X Variable 1
Standard Error
0.018124194
0.458833501
0.012896
0.620617
t Stat
1.405461
0.739318
P-value
0.168957
0.464788
Lower 95%
-0.00808
-0.80241
Upper 95%
0.044331
1.720079
Lower 95.0%
-0.00808
-0.80241
Upper 95.0%
0.044331
1.720079
SUMMARY OUTPUT
Regression Statistics
Multiple R
R Square
0.315929277
0.099811308
Adjusted R Square
Standard Error
0.05889364
0.073502599
Observations
24
Coefficients
Intercept
X Variable 1
0.008697165
1.258425138
Standard Error
0.015971
0.805736
t Stat
0.544566
1.561832
P-value
0.59153
0.132599
Lower 95%
-0.02442
-0.41257
Upper 95%
0.041819
2.92942
Lower 95.0%
-0.02442
-0.41257
112
Upper 95.0%
0.041819
2.92942
Discounted Dividend Approach
WACC
10.57%
Kd
6.04%
Ke
11.50%
0
1
2
3
4
5
6
7
8
9
10
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
0.46
0.49
0.53
0.51
0.58
0.68
0.74
0.8
0.87
0.94
DPS (Dividends Per Share)
PV Factor
0.8969
0.8044
0.7214
0.6470
0.5803
0.5204
0.4667
0.4186
0.3754
PV Dividends Year by Year
0.4126
0.3941
0.3823
0.3300
0.3366
0.3539
0.3454
0.3349
0.3266
Total PV of Annual Dividends
3.22
51%
PV of Terminal Value Perpetuity
3.07
49%
Estimated Price per Share
6.29
100%
Continuing (Terminal) Value Perpetuity
Observed Share Price
Initial Cost of Equity
8.17
Growth
0.00
0.02
0.04
0.06
0.08
$45.80
0.14
4.96
5.30
5.79
6.51
7.71
0.115
0.13
5.42
5.86
6.49
7.49
9.28
0.115
6.29
6.93
7.92
9.63
13.30
0.1
7.42
8.42
10.08
13.40
23.37
0.09
8.40
9.78
12.25
18.02
46.87
Perpetuity Growth Rate (g)
0
52.67
UB
Ke
38.93
LB
113
Free Cash Flows
WACC
10.57%
Kd
6.04%
Ke
11.50%
Perp
0
1
2
3
4
5
6
7
8
9
10
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
Cash From Operations
Cash Investments
Book Value of Debt and Preferred Stock
893,104
996,704
1,112,322
1,241,351
1,385,348
1,546,048
1,725,390
1,925,535
2,148,897
(601,952.13)
(671,778.57)
(749,704.89)
(836,670.65)
(933,724.45)
(1,042,036.48)
(1,162,912.72)
(1,297,810.59)
(1,448,356.62)
260,888.38
291,151.87
324,925.43
362,617.11
404,680.35
451,623.55
504,011.52
562,477.28
627,724.41
700,540.38
0.8772
0.7695
0.6750
0.5921
0.5194
0.4556
0.3996
0.3506
0.3075
0.2697
228,849.46
224,031.91
219,315.41
214,698.44
210,178.29
205,753.61
201,421.81
197,181.50
193,030.24
188,966.43
1,780,407
Annual Free Cash Flow
PV Factor
PV of Free Cash Flows
Total PV of Annual Free Cash Flows
800,272
(539,383.62)
2,083,427
64%
1,162,173.57
36%
Value of Firm
3,245,601
100%
Book Value of Liabilities
1,780,407
Estimated Market Value of Equity
1,465,194
Continuing (Terminal) Value Perpetuity
PV of Terminal Value Perpetuity
Number of Shares
Estimated Price per Share (end of 2006)
Observed Share Price
3,779,328.62
149,700
WACC
9.79
Growth
0.00
0.02
0.04
0.07
0.09
0.06
34.84
47.73
86.40
-145.61
-42.49
0.08
20.45
24.96
34.00
115.32
-101.54
0.1057
11.11
12.64
15.10
23.97
48.72
0.12
7.95
8.85
10.21
14.29
21.53
0.14
4.80
5.26
5.91
7.57
9.79
$45.80
Initial WACC
0.14
Perpetuity Growth Rate (g)
0.09
52.67
38.93
114
Residual Income
WACC
10.57%
Kd
6.04%
Ke
11.50%
Perp
0
1
2
3
4
5
6
7
8
9
10
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
393,658
458,218
533,365
620,837
722,655
841,170
979,122
1,139,698
1,326,608
1,544,172
63,872
69,237
75,053
81,358
88,192
95,600
103,630
112,335
121,771
132,000
1,559,549
1,948,530
2,406,842
2,946,321
3,580,784
4,326,354
5,201,846
6,229,209
7,434,046
8,846,218
393,658
458,218
533,365
620,837
722,655
841,170
979,122
1,139,698
1,326,608
1,544,172
Net Income
Total Dividends
Book Value of Equity
1,229,763
Net Income
"Normal" (Benchmark)
Earnings
141,422.75
179,348.14
224,080.95
276,786.83
338,826.92
411,790.16
497,530.71
598,212.29
716,359.04
854,915.29
Residual Income (Annual)
252,235.26
278,869.87
309,284.05
344,050.17
383,828.09
429,379.84
481,591.29
541,485.71
610,248.97
689,256.71
0.8969
0.8044
0.7214
0.6470
0.5803
0.5204
0.4667
0.4186
0.3754
0.3367
226,219.96
224,311.66
223,117.13
222,598.54
222,721.64
223,456.22
224,778.39
226,666.88
229,104.30
232,077.12
PV Factor
PV of Annual Residual
Income
BV Equity Per Share
Total PV of RI
Continuing (Terminal)
Value Perpetuity
PV of Terminal Value
Perpetuity
Estimated Price per Share
(end of 2006)
Observed Share Price
Initial Cost of Equity (You
Derive)
Perpetuity Growth Rate (g)
8.77
22%
16.07
41%
5993536.61
14.38
37%
39.23
100%
$45.80
0.115
0
Ke
Growth
0
-0.05
-0.1
-0.15
-0.2
0.09
53.77
45.54
41.64
39.36
37.87
0.115
39.23
34.87
32.54
31.09
30.09
0.13
33.08
29.98
28.24
27.11
26.33
0.15
26.76
24.74
23.53
22.72
22.14
0.17
27.96
20.59
19.73
19.14
18.71
115
689,256.71
Long Run Return on Equity
0.21
Long Run Growth Rate in Equity
Cost of Equity
0.084
0.115
Estimated Price per Share (end of 2006)
35.63
Observed Share Price
$40.85
0
2006
Net Earnings
Total Dividends
Book Value of Equity
1,229,763
ROE
% change Eq
g = 8.4%
Ke
1
2007
393,658
2
2008
458,218
3
2009
533,365
4
2010
620,837
5
2011
722,655
6
2012
841,170
7
2013
979,122
8
2014
1,139,698
9
2015
1,326,608
10
2016
1,544,172
63,872
69,237
75,053
81,358
88,192
95,600
103,630
112,335
121,771
132,000
1,559,549
1,948,530
2,406,842
2,946,321
3,580,784
4,326,354
5,201,846
6,229,209
7,434,046
8,846,218
32%
27%
29%
25%
26%
22%
25%
22%
23%
21%
23%
20%
22%
20%
21%
19%
21%
19%
0.17
0.19
27%
24%
ROE
0.21
0.23
0.25
0.08
-53.84
-66.37
-78.89
-91.41
-103.93
0.09
125.64
154.85
184.07
213.29
242.50
0.115
24.32
29.97
35.63
41.28
46.94
0.13
16.39
20.20
24.01
27.82
31.63
0.15
12.58
14.08
16.73
g
19.39
22.05
0.04
0.06
0.10
0.12
0.07
49.67
131.48
-78.89
-32.14
-15.78
0.09
29.80
43.83
184.07
-96.42
-26.30
0.115
19.87
23.91
35.63
64.28
-157.77
0.13
16.56
18.78
24.01
31.14
78.89
0.15
13.55
14.61
19.28
26.30
0.17
0.19
16.73
ROE
0.21
0.23
0.25
0.04
15.19
17.53
19.87
22.21
24.54
0.06
17.53
20.72
23.91
27.09
30.28
0.084
0.1
0.12
24.32
40.90
-87.65
29.97
52.59
-122.71
35.63
64.28
-157.77
41.28
75.97
-192.84
46.94
87.65
-227.90
ROE = 21%
Ke
Ke = 11.5%
g
0.084
52.67
UB
38.93
LB
N/A
116
AEG Valuation
WACC
2007
Net Income
10.57%
Kd
6.04%
Ke
11.50%
0
1
2
3
4
5
6
7
8
2008
2009
2010
2011
2012
2013
2014
2015
2016
458,218
533,365
620,837
722,655
841,170
979,122
1,139,698
1,326,608
1,544,172
Total Dividends
69,237
75,053
81,358
88,192
95,600
103,630
112,335
121,771
132,000
Annual Income
458,218
1,544,172
533,365
620,837
722,655
841,170
979,122
1,139,698
1,326,608
7,962.26
8,631.10
9,356.17
10,142.08
10,994.00
11,917.45
12,918.53
14,003.67
Cumulative Dividend Income
541,327.26
629,468.10
732,011.17
851,312.08
990,116.00
1,151,615.45
1,339,526.53
1,558,175.67
"Normal" Annual Income (Benchmark)
Drip Income
510,913.07
594,701.98
692,233.26
805,760.33
937,904.55
1,091,721.03
1,270,763.27
1,479,167.92
Annual AEG
30,414.19
34,766.12
39,777.92
45,551.76
52,211.45
59,894.42
68,763.25
79,007.75
Change in RI
30,414.19
34,766.12
3,977.92
45,551.76
52,211.45
59,894.41
68,763.25
79,007.75
PV Factor
PV AEG (Annual)
Total PV of AEG
1.71
3.27
47%
Core Perpetuity Earnings
2.05
29%
Total Earnings Perpetuity
7.03
100%
Estimated Price per Share (end of
2006)
Observed Share Price
Perpetuity Growth Rate (g)
0.8044
0.7214
0.6470
0.5803
0.5204
0.4667
0.4186
27,964.46
28,695.74
29,471.73
30,296.43
31,170.03
32,094.63
33,072.78
0
-0.05
-0.1
-0.15
-0.2
0.07
162.32
134.45
122.97
116.71
112.77
0.09
99.86
87.40
81.50
78.06
75.80
0.115
61.14
55.74
52.85
51.05
49.82
0.13
47.45
43.96
42.00
40.73
39.85
0.15
35.01
32.97
31.74
30.92
30.34
Growth
0.1150
61.14
79,007.75
24%
Core EPS
Capitalization Rate (Ke)
0.8969
27,277.30
9
100%
Ke
687,023.91
$40.85
0
52.67
UB
38.93
LB
117
10
References
1. Darden’s Website: www.darden.com
1998-2007 Annual Reports
2002 10-K – 2007 10-K
2. Brinker’s Website: www.brinker.com
2006 Annual Report
2006 10-K
3. Applebee’s Website: www.applebees.com
2006 Annual Report
2006 10-K
4. Yahoo Finance: www.finance.yahoo.com
5. Olive Garden Website: www.olivegarden.com
6. Bahama Breeze Website: www.bahamabreeze.com
7. Standard Employers: www.ameritrade.com
8. MSN: www.moneycentral.msn.com
9. Investopedia: www.investopedia.com
10. Demoseafoodol: www.demoseafoodol.net
11. Financial Dictionary: www.financialdictionary.com
12. Free Dictionary: www.freedictionary.com
13. Business Analysis and Valuation by Krishna G. Palepu, Paul M. Healy, and
Victor L. Bernard
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119