John Johnson II: john.johnson@ttu.edu
Deontei Harris: dk.harris@ttu.edu
Chance Baucum: chance0203@aol.com
Matt Loyd: matt.loyd@ttu.edu

Table of Contents
Executive Summary……………..2
Overview of Firm…………6
Preliminary Data for Hilton
Sales Volume and Growth Tables…….7
Industry Comparison Table………8
Stock Price Activity Table….9
Industry Overview and Analysis…….10
Value Chain Analysis………….…….16
Firm Competitive Advantage Analysis………18
Accounting Analysis…………21
Ratio Analysis………………38
Forecast Financials………..61
Cost of Capital Estimation……….72
Method of Comparables……76
Intrinsic Valuation Analysis and Z-Score………….80
Analyst Recommendation…………85
References………………………86
Appendices
Appendix 1 (Financials, Ratios, and Valuation Models)…..A-J
Appendix 2 (Regression Data)……………………….K-Y
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Investment Recommendation: Overvalued, Sell 4/21/07
HLT-NYSE $36.13
52 week range $23.19-$38.00
Revenue (2006) $8.162Billion
Market Capitalization $13.74Billion
Shares Outstanding 387,000,000
Dividend Yield .16 (.50%)
3-m Avg dividend trading volume 3,412,020
Book Value Per Share $9.63
ROE 3.5%
ROA 15.3%
Est. 5-yr EPS growth rate 35%
EPS Forecast
(Yr end)2006 2007(E) 2008(E) 2009(E)
EPS 1.48 1.56 1.68 1.82
Ratio Comparison HLT HOT MAR
Trailing P/E 25.37 14.76 26.93
Forward P/E 22.64 23.08 20.18
M/B 3.65 4.92 8.03
Actual Price (as of 4/21/07) $36.13
Ratio Based Valuations
Cost of Cap Est. R2 Beta Ke P/E Trailing $21.31
Ke est. 10.93% P/E Forward $21.63
5-yr 22.33% 1.101 9.43% Enterprise Value $14.58
1-yr 22.41% 1.104 8.63%
10-yr 22.36% 1.102 11.65%
3month 22.45% .105 10.93%
Published 1.53 Intrinsic Valuations
Kd HLT: 6.89%
WACC HLT: 7.93%
Discounted Dividends $3.04
Free Cash Flows $7.33
Altman's Z-score
HLT: 1.45
Residual Income $23.70
Abnormal Earnings Growth $49.33
2

Recommendation – Overvalued Firm
Company, Industry Overview and Analysis
Hilton is one of the Top 3 in the Lodging industry with revenues totaling approximately $2.2 billion in 2006 and a market capitalization of $13.74 billion. It was founded in Cisco, TX in 1919 by Conrad Hilton and in April 2007 expanded its operations to over 500 hotels around the World. In addition to hotels, Hilton also owns numerous resorts, timeshares, and partnerships with various businesses around the World. These businesses range from airlines to Car
Rental corporations.
The Lodging industry is made up of numerous firms; however, it is dominated by three main competitors, Marriott, Hilton, and Starwood. Together, these three firms constitute “The Big 3” of the Lodging industry and compete primarily with one another. Due to the fact that little other firms pose major competition, those at the top of this industry tend to focus on a differentiation competitive advantage strategy. This strategy involves competing on quality rather than price through means such as loyalty programs, valet service, 5-star on site restaurants, shows, concierge service, etc.
Hilton uses a differentiation strategy due to the clientele they cater to
(Middle/Upper class) and the main competition they face (Marriott and
Starwood).
Accounting Analysis
Through research into Hilton’s financial statements, Balance Sheet,
Income Statement, and Statement of Cash Flows, we were able to begin to dissect where Hilton is trying to position themselves as far as there appearance to investors is concerned. We evaluated what are their Key Accounting policies,
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where they could be flexible, and the type of strategies they employed when disclosing things such as Depreciation.
Through this we did not find anything too unusual in how they disclose their financial information. In general, anything that may have been a concern was disclosed and/or talked about in their footnotes. For example, there was a slight discrepancy of $26 Million between the Retained Earnings presented in their Statement of Cash Flows and the R.E. that we calculated; however, Hilton discloses in their footnotes that this is due to the exercise of Stock options which indeed was equal to $26 million.
Hilton utilizes straight line depreciation and FIFO to account for their inventory which minimizes their tax burden. This causes no reason for us to be alarmed because this seems to be more of a preference among the managers rather than an attempt to hide or bury value.
Financial Ratio Analysis
Financial ratios are used to evaluate a firm in several different aspects; its
Liquidity status, its Profitability status and, its Capital Structure status (i.e. the way in which a firm may finance its assets). Each one of these areas contains several ratios ranging from its Current ratio (Current Assets/Current Liabilities), dollar amount of current assets per dollar of current liabilities to its Debt to
Equity ratio (Liabilities/Shareholder’s Equity), this amount of liabilities is financed by every dollar of Shareholder’s Equity. These ratios prove extremely useful when it comes to the ten-year forecasting of the company (See Ratio Analysis section) allowing the investor to see, at a glimpse, the predicted financial situation of the company over the next ten years. However, due to the assumptions that are made in forecasting out financial information, the Ratios can be skewed in one direction or the other. For the purpose of our forecasting though, we tried to remain more conservative in our assumptions of growth so as to not grossly overstate future earnings.
4

Intrinsic Valuations
An intrinsic valuation involves first coming up with a reliable Ke (Cost of
Equity), Kd (Cost of Debt), growth rates, and a WACC (Weighted Average Cost of
Capital). These numbers find their role in being used as a discount measure for many of the valuation models. The valuation models are the Discounted Cash
Flows Model, Discounted Dividends Model, Residual Income Model, AEG Model, and the Method of Comparables. These models allows for us to be able to come up with our own value for a firm and in comparing our value (Intrinsic Value) to that of the market, we can then see whether a firm is over, under, or moderately valued within the market.
Also included in this is an Altman Z-score which helps to constitute the credit worthiness of a firm. A firm with low credit worthiness will have a score that is below 1.8 and a company with good credit will have a score around 2.67.
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Hilton is the proud figurehead brand of Hilton Hotels Corporation and the most recognized name in the global lodging industry. Although Conrad Hilton purchased his first hotel in Cisco, Texas back in 1919, they have since grown to over 500 hotels in cities all over the world. Hilton was officially organized in the
State of Delaware on May 29, 1946. With the chief executive offices located at
9336 Civic Center Drive, Beverly Hills, California.
“Hilton Hotels Corporation is engaged with but not limited to ownership, management and development of hotels, resorts and timeshare-properties, and the franchising of lodging properties as well.” (Hilton 2006 10-K) They range into various business segments of the lodging industry with capacities
“ containing 2,388 properties with approximately 375,000 rooms, of such properties, leased six hotels, managed 210 hotels owned by others and franchised 2,054 hotels owned and operated by third parties.” (Hilton 2006 10-K)
From corporate-preferred accounts, internet based guests, leisure tourists, group- S.M.E.R.F accounts, they aim to gratify the needs of all consumer types, holding such extensive “hotel brands included within Hilton Hotel Corp. are
Hilton, Hilton Garden Inn, Doubletree, Embassy Suites, Homewood Suites by
Hilton, Hampton and Conrad. They develop and operate timeshare resorts through Hilton Grand Vacations Company. While also being engaged in various other activities related or incidental to the operation of hotels.” (Hilton 2006 10-
K) On February 23, 2006 Hilton acquired the lodging assets of Hilton Group plc.
As a result of the HI (Hilton International) Acquisition, they are the largest, by revenue, and most geographically diverse lodging company in the world, with nearly 2,800 hotels and approximately 475,000 rooms in 80 countries. The HI properties that have been acquired consist of 387 hotels with over 100,000 rooms, of which 41 hotels are owned, 194 are leased, eight are partially owned through joint ventures, 115 are managed and 29 are franchised. Such success has brought Hilton to the number two spot in the lodging industry.
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Preliminary Data to familiarize self with Hilton
(Preliminary Data 1)
Hilton HLT
Total Assets
Sales $Mil
Sales Growth
Stock Price
Market Cap 14,278B
Marriott
Total Assets
Sales $Mil
Sales Growth
MAR
Stock Price
Market Cap 19,291B
12/31/2002 12/31/2003 12/31/2004 12/31/2005 12/31/2006
8,348B
3,816
5.10%
$12.71
8,178B
3,819
-1.60%
$17.13
8,242B
4,146
6.00%
$22.74
8,743B
4,437
46.90%
$24.11
16,993B
7,013
179.00%
$36.93
12/29/2002 12/29/2003 12/29/2004 12/29/2005
9,107
8,415
8,296B 8,668B 8,530B n/a
9,014 10,099 11,550 11,720
-16.90%
$16.44
6.80%
$23.10
12.00%
$31.49
14.40%
$33.49
-0.40%
$48.79
Starwood
Total Assets
Sales $Mil
Sales Growth
Stock Price
HOT
Market Cap 14,030B
12/31/2002 12/31/2003 12/31/2004
12,259B
4,588
-2.20%
$19.36
11,894B 12,298B 12,454B n/a
4,360
-2.60%
$29.04
5,368
42.10%
$47.64
12/31/2005
5,977
11.40%
$52.09
5,923
5.10%
$66.18
Wyndam
Total Assets
Sales $Mil
Sales Growth
WYN 12/31/2002 12/31/2003 12/31/2004 12/31/2005
4,473M
2,241
-9.00%
3,783M 2,790M 9,167M 9,118M
2,652
-5.00%
3,014
17.00%
3,471
152%
3,733
11.90%
Stock Price
Market Cap 6,449M
Four
Seasons FS
Total Assets
Sales $Mil n/a
12/31/2002 12/31/2003 12/31/2004 12/31/2005
614.3M
181 n/a $33.45 n/a $32.55
733.8M 904.9M 880.2M n/a
221 261 248 n/a
Sales Growth
Stock Price
-7.80%
$28.25
4.70%
$51.15
38.20%
$81.79
-5.10%
$49.75 n/a
$83.11
Market Cap 3,045M
Gaylord
Total Assets
Sales $Mil
Sales Growth
GET
Stock Price
Market Cap 2,316M
12/31/2002 12/31/2003 12/31/2004 12/31/2005
2,192.2M
414
27.40%
2,577.3M 2521.1M 2532.6M 2658.8M
448.8
8.30%
750
67.00%
869
15.90%
930
11.20%
$20.06 $29.85 $41.53 $43.59 $56.84
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(Preliminary Data 2)
HILTON DIRECT COMPETITOR COMPARISON
Market Cap:
HLT HOT FS MAR Industry
14.28B 14.03B 3,045M 19.29B 2.01B
Employees:
Qtrly Rev Growth (yoy):
61,000 110,000 20,887 143,000 6.00K
100.30% 100.0% -4.9% -0.40% 7.00%
Revenue (ttm):
Gross Margin (ttm):
EBITDA (ttm):
Oper Margins (ttm):
Net Income (ttm):
EPS (ttm):
32.55% 100.0% 73.8% 13.12% 49.22%
1.46B 177.90M -39.8M
1.17B 76.71M
15.24% 31.17% 17.1% 7.79% 15.67%
470.00M 422.00M -28.2M 734.00M 31.54M
1.152 1.884 -0.77 1.445 0.91
P/E (ttm):
PEG (5 yr expected): 1.93 3.89 2.8 1.99 1.99
P/S (ttm): 2.04 2.40 5.07 1.62
HOT = Starwood Hotels & Resorts Worldwide
1.95
FS = Four Seasons Hotels
MAR = Marriott International Inc.
Industry = Lodging
-Courtesy of: http://finance.yahoo.com
8

(Preliminary Data 3)
Five Year Analysis
HLT HOT FS MAR GET WYN
-Courtesy of: http:// www.morningstar.com
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An industries’ and more specifically, a companies’, key to survival is influenced by five factors, 1) Competition, 2) Threat of Potential Entrants and Competitors, 3)
Threat of Substitute Products, 4) Bargaining Power of Buyers, and 5) Bargaining
Power of Suppliers. These five factors are grouped into what is commonly called the Five Forces Model and is used to specifically target where an industries risk as well as profit strategies lie. Within these five factors are sub-factors that further delve into their headings. For example, 1) Competition is evaluated on sub-areas of Industry Growth, Fixed Costs to Variable Costs, Entry and Exit barriers, etc. This in turn can be translated, on a micro scale, to a specific corporation within that industry. What follows is the Five Forces Model laid out for the Lodging Industry as defined by the NYSE.
1) Competition
Industry Growth
Growth within the industry is steady for the most part; this seems to have a heavy reliance on the Baby Boomer generation. As more and more of this generation begin to retire and receive Social Security and retirement benefits, it places more consumers in society that are willing and able to take more trips and thus need some form of lodging. If you look at the graph on the next page, the
Lodging industry has indeed recognized a steady increase in growth over the past 9 years.
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(Top 3 Competitors in Lodging Industry)
-Graph provided courtesy of Yahoo Finance
In addition, with business travel growing world wide, corporations in this industry gain the opportunity to grow both domestically and internationally. It is notable here that the attacks of 9-11 greatly affected the Airline industry leading to an indirect shock to the Lodging industry, however, the market has once again returned to a state of constant growth, as evidenced in the above graph.
Concentration and Balance of Competitors
Competition in this industry is fairly concentrated at the top, with the Top
3 competitors, Marriott, Hilton, and Starwood, respectively bringing in the most revenue and thus controlling a fair amount of the industry. They maintain their rankings by differentiating themselves on quality rather than on price; an issue that is vital in an industry with numerous competitors. However, a firm in this industry cannot make any revenue on unused rooms, so often they do compromise on price to a degree, and this is accomplished through the use of outside agents such as priceline.com and expedia.com. This differentiation on quality will be discussed in detail on the next page.
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Degree of Differentiation and Switching costs
As stated above differentiation is vital to a corporation’s success, in not just the Lodging industry but any industry that is saturated with numerous competitors. This differentiation can happen in two ways, either on price or on quality. However, in this industry, as stated above, the corporations that find the most success differentiate themselves on quality, with the top 2, Marriott and
Hilton, differentiating, to a high degree, on quality. Due to this, the switching cost for a corporation is extremely high while the switching cost for a consumer is low. Switching cost is high whether a company is trying to switch to providing a more quality product or provide on cost efficiency; in the latter way, the high cost would be based on potential client loss.
Ratio of Fixed costs to Variable Costs
The Lodging industry has a high fixed cost to variable cost ratio. Most of the corporation’s investments are in their buildings, furnishings, and land. These are all things that a corporation in this industry must own to run a Hotel. If you look at the balance sheet of the Top 3 firms in the Lodging industry, you’ll see that most of the firm’s assets are in their buildings and land. The Lodging industries variable costs are relatively low but are still high enough to be of concern. Variable costs in this industry include soap, sheets, even staffing to an extent. There is also the crossover of certain costs such as electricity, which would be higher with guests but would still be high regardless of occupancy of rooms. This brings up the question of whether electricity is, to a degree, a sunk cost.
Exit Barriers and Excess Capability
The exit barriers in this industry are quite large because of the high startup cost associated with starting up a hotel chain. Due to this, it allows firms such as the Top 3 to maintain quite a hold on the top of the Lodging industry.
The sheer value of the land alone, which is dependent on location, can make
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exiting the industry very costly. However, it could be more costly for a firm in this highly competitive industry to continue operating despite losing money. In this scenario, it would cause an exit from the industry to be high but not high enough to bar exit.
2) Threat of Potential Entrants and Competitors
Economies of scale
This implies that as a firm, in an industry, expands its operations, it actually begins to decrease it’s per unit cost. In the lodging industry, Economies of scale is realized especially among the Top 3. This is based on rising rates for hotel rooms (can be seen as an expansion of operations, i.e. profit growth), despite relative level costs of maintaining a particular room. However, with events like September 11 th , per unit costs began to significantly increase due to fixed to variable cost ratio rising; this has begun to level out in the past three years however with revenues increasing steadily in the past three years, on average, for the industry.
First Mover Advantage
Location is a very important aspect of the Lodging industry; therefore, there is a high first mover advantage. To the firm that gets the best locations goes the highest revenues. For example, the Top 3 in the Lodging industry have some of the most key locations for the clientele that they serve; for example, Las
Vegas, Los Angeles, New York, all serve home to the Top 3 in the industry. In addition to location, first mover advantage can include coming up with a revolutionary idea such as Hilton’s HHonors loyalty program. The ability to come up with fresh ideas enables a firm in this industry to tap into “un-chartered” industry niche arenas.
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Customer Relationships
All firms in the Lodging industry, especially those who differentiate on quality, must establish a customer or clientele base. Those in an industry who quality differentiates are all going after the same clientele base. Therefore, there is a first mover advantage in establishing repertoire with potential customers.
Firms do this through several different means, one of which is a loyalty reward program.
Legal Barriers
Legal barriers in this industry are very few, except in markets such as Las
Vegas where gaming laws and commissions can significantly lag entry into the industry. However, outside of this, legal barriers find themselves situated in
Building and Zoning codes but nothing that would provide significant entry into this industry.
3) Threat of Substitute products
Due to the high level of competition in this industry, the threat of substitute products is high within the same differentiated niches (i.e. differentiation of quality and cost). Within the quality niche, the Top 3 all serve as a substitute product, while in the cost niche, there are numerous and various different types of substitute products to choose from. In addition, there is also the possibility of camping and RV’s serving as substitute products, though this is not a major threat to the quality niche of the Lodging industry. However, relating back to the Customer Relationship section on the previous page, the threat of substitute products is inversely related to Customer relationship; the higher the repertoire with clientele, the less likely for them to find a substitute for a firm’s product.
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4) Bargaining power of Buyers
The bargaining power of buyers in the Lodging industry is low in the overall scheme of the industry, but high among the Top 3 in the industry. Due to the most successful firms in the industry falling into the quality niche of the industry (Top 3), it allows buyers to have a lot of bargaining power to switch between the Top 3. The inability for a firm to compromise (on factors other than price) can translate into loss of potential profits among those in the Top 3.
However, in the industry as a whole, the buyer possesses less power as the switching cost is high for a consumer to switch to a different firm, because they then sacrifice quality.
5) Bargaining power of Suppliers
Firms in the Lodging industry are customers that any supplier would want to have, with tremendous amounts of properties, firms are able to maintain a certain amount of power over their suppliers. When a company makes a contract with a firm in this industry, they will be able to sell a tremendous amount of product, due in no small part, to the amount of products that hotels need to be able to run their day to day operations. This causes firms to have more power as a buyer and the inverse among the supplier. The Top 3 firms in the Lodging industry maintain high standards, which must be met, in order for a supplier to be able to do business with them. According to the Hilton supply management website, the Number Two firm in the industry, “Suppliers are evaluated based on criteria including financial stability, delivery performance, product performance, industry wide reputation, responsiveness in solving problems, and other salient points. New suppliers are typically given consideration only when there is a need for a new bid or contract on a particular product or service.” This means that suppliers are not easily granted a contract, allowing the Top 3 to have a leverage of power over their suppliers.
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The Lodging industry is an industry that has enjoyed relative success over the past few years. Despite the tragedies of September 11 th , the Lodging industry has counted on the virtual certainty that people are going to need some place to “lay their heads”.
However, most firms in this industry have chosen to differentiate themselves. This can be seen in the vision statement of the industry’s Number
Two brand Hilton; Hilton creates value by “building on the rich heritage and strength of our brands…” In the very competitive industry of Lodging, there are several ways for a firm to differentiate itself. A firm must know its base, an upper class base will require a firm to differentiate itself on quality and service, and a firm with a middle lower class base will differentiate itself on cost, effectively pursuing a cost leadership competitive advantage.
First, a firm has to identify what product or service that a customer values over other services or its key success factors.
Key Success Factors
In this industry, a successful firm will focus on comfort and superior customer service. Secondly, the firm must position itself in such a way as to achieve this product or service in a superior and unique way; in this industry, it will focus on things such as concierge service, complimentary transportation to/from airport, 5-star on site restaurants, etc. Most importantly, location is key to catering to the right clientele (i.e. Las Vegas, New York Times Square). Lastly, a firm that wishes to differentiate itself must do so at a cost that is less than what the clientele would be willing to pay for it. Differentiation, especially in this industry, requires a large investment in Research and Development (hereafter referred to as R&D), this is due to the fact that a firm must find answers to how they can effectively do the items that have been listed above.
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On the other side, there is competitive advantage created through cost leadership. This allows for a firm, especially one in a very competitive environment, to compete on price. As stated above, this kind of strategy works well for firms catering to lower/middle class clientele. However, it is important to note that firms who compete on price, have to sacrifice some quality in order to maintain lower prices.
Through careful analysis of vision and mission statements of the most successful firms in this industry, especially the Top 3 and through the analysis of success through financial statements, it is our opinion that the Hotel industry is an industry that pursues an overall differentiation competitive advantage.
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In researching Hilton, we will evaluate the ways and effectiveness that
Hilton has had in implementing the key success factors listed above; in addition, we will compare Hilton’s competitive advantage to the differentiation strategies utilized by its competitors to further evaluate how effective Hilton has been to adapting to a changing climate, post September 11 th .
Hilton Corp has maintained their competitive advantages by implementing key success factors, fine tuned for their industry and more importantly for their competitive advantage strategy, having been identified previously as differentiation. By having one of the most powerful brand names in the industry,
Hilton brings a strong competitive presence to the hotel market. They believe
“there is a desire among global hotel owners for strong brands in the full-service, focused-service, and all-suite segments; and their brand portfolio is wonderfully positioned to fill that need.” (Hilton.com)
Hilton has made a name for itself with their superior customer service.
Falling in line with the key success factors listed above, Hilton has spent the last few years positioning itself to become the most dominant brand in the Lodging industry. Location has allowed Hilton to expand its operations into new avenues such as casinos and gaming in Las Vegas; in addition, with the addition of several overseas operations and restructurings, Hilton is truly trying to become a dominant force in this industry through its branching into new markets.
Technology has also increased customer satisfaction by implementing new types of entertainment for guests; for example, most high end hotels of
Hilton are putting in flat panel LCD big screen TVs with high-definition. This quality feature stands out from most competitors and focuses on bringing an “athome” feeling of comfort and luxury for the guests.
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Hilton Corp has developed ways of providing its superior product and service, all-suite segments, and full and focused-service, at a competitive cost.
The guest loyalty program known as, “Hilton Honors” or HHilton focuses on benefits for the frequent traveler. This program works well with major businesses that spend a lot of time traveling because they can now get discounts that allows decreases in their travel expenses. Another cost efficient strategy Hilton possesses is its ability to offer price matching with the other competitors’ hotels.
This program called, “Their Best Rates Guaranteed” ensures travelers that they are getting the best deal at the fair market price.
“It is also worth noting that the supply environment continues to work in
Hilton’s favor. There is little new competitive full-service hotel supply being introduced in the hotel industry’s major markets. This advantage in the market is definitely a benefit, with the only worries of losing customers to current competitors known in the market.”
-Hilton.com-2005 Annual Report
Indeed, Hilton pursues a differentiation strategy; however, it is unique in that Hilton attempts a mix of strategies, providing quality service at the lowest cost possible. Despite its offering of premium locations and amenities, Hilton is willing to couple this with programs such as HHilton and “Their Best Rates
Guaranteed”. This unique strategy allows Hilton to create value for its shareholders and brand name.
Risk Analysis
Since Hilton hotels business relies heavily on properties that are subject to a lot of environmental risks; any coastal hotel may be subject to hurricanes and possibly tsunamis. This would cause massive damages or completely destroy the property causing huge financial set backs. Another risk they must assume now is that of terrorist attacks. After reviewing some financial information after
September 11 th , Hilton noticed a drop off in stock prices (see below chart, Sept.
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20, 2001). This can be attributed to the amount of people that ceased travel due to the attacks.
(Hilton stock price chart to illustrate 9/11 effect)
-Graph provided courtesy of Yahoo Finance
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A goal of accounting analysis, as it relates to the valuation of a company, is to first determine the competitive strategy success factors and risks of the firm. Once these factors and risks have been identified, then this information is looked at to see how well the firm has managed and utilized them. These key success factors contribute to the financial future success or failure of the firm as compared to the industry.
Above, we described Hilton as employing a differentiation strategy, in which they do not compete on price but rather on quality and service. Due to this high emphasis on quality, Hilton places much importance on the acquisition and management of “quality” properties. As of the company’s latest 10-Q report,
Hilton operates over 2,500 properties around the World under several subheadings, Hilton, Embassy Hotels, Hampton, Inn, etc. Due to their World-wide endeavors, Hilton has an interest in the volatility of foreign currencies as it relates to their properties.
Hilton utilizes operating leases for its properties, see table below:
-Courtesy of Hilton 10-Q Report: 8-Nov-2006 (in millions)
Operating leases allows a firm (as the lessee) to keep the lease off of their balance sheet and expense the entire lease payment for tax purposes. This translates to a higher expense on the balance sheet and thus a lower net income. According to the above table, Hilton has over $12.1 billion in debt with
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approximately 40% of it due after five years. It should be noted however that a large portion of this debt stems from the acquisition of Hilton International in
2005.
Hilton uses straight line depreciation to depreciate its assets over their useful life, for buildings, 40 years, and between three to eight years for furniture and equipment. This depreciation expense “2003, 2004, and 2005 was $270 million, $271 million, and $247 million, respectively.” (Hilton 10-K footnotes 31-
Dec-2005) Hilton’s use of straight line depreciation allows for an even distribution expenses across the assets useful life.
As mentioned before, Hilton is self-insured for general liability, workers’ compensation, and employee medical and dental insurance coverage. Hilton has self retention reserves that are for single claims costing between, $250,000 to
$500,000. “The undiscounted amount of Hilton’s self-insurance reserves totaled
$148 million and $146 million at December 31, 2004 and 2005, as accrued based on the estimates of the present value of claims expected.” (Hilton 10-K) Hilton’s use of self retention could save money on insurance dollars as long as the number of claims in the self-retention range does not consistently increase.
Hilton accounts for brands and goodwill in accordance with FAS 142,
“Goodwill and Other Intangible Assets,” which requires that intangible assets with indefinite lives are not amortized, but are reviewed annually for impairment
(Hilton 2006 10-K). The annual impairment review requires estimates of future cash flow with respect to the brands and estimates of the fair value of our company and its components with respect to goodwill. During 2005 goodwill decreased by 24 million dollars due to 13 million dollars in adjustments to reserves and 11 million dollars due to asset sales. (Hilton 2005 10-K)
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Degree of Potential Accounting Flexibility
Flexibility for Hilton Hotels Corp. accounting policies can vary in many different degrees. While Hilton complies with SEC and GAAP when they prepare their financial statements, there are still other choices management can use to utilize accounting flexibility to optimize gains.
Inventories, which consist mostly of summary goods, account for more than 42 percent of all inventories, for the kitchen and the bar, are valued at the lower of cost or estimated net realizable value. From an income approach, FIFO, first inventory in first inventory out, is a more preferred policy that could be used to increase net income. This is very significant information to note but the flexibility is limited due to the fixed cost of these inventories and the only flexibility is the reporting (FIFO). Also, Hilton has another part of inventory which is work-in-progress inventory. This relates to the construction of new timeshare resorts and developments which they record as revenue under the percentage of completion method. As relates to the key accounting policy of straight line depreciation even with this being work-in-progress inventory. This can be flexible to the degree of the amount of revenues they can recognize during development.
Hilton uses operating leases vs. capital leases on some of their assets.
One reason for this is that using operating leases decreases the amount of tax expense since the firm has fewer assets on record. Capital leases would offer some flexibility for Hilton if they decided to buy out the current operating leased assets. If they purchase those assets instead of renting them, they could show an increase in net income because of the increase in assets and decreases in expenses that were from the previous operating leases.
Straight line depreciation is another accounting policy that Hilton chooses to use that allows for some accounting flexibility. Another route that could be chosen by Hilton is to use the accelerated method of depreciation; this would allow for faster write-offs than using the straight line method. In addition, this
23

method would provide a greater tax benefit by showing more expenses in the depreciation write-off account, but the trade-off would be the reduction in net income.
Since Hilton has chosen to be self-insured the only thing that is flexible about using retention is the discount rates associated with the claims and settlements. The discount rates used to calculate the present value of some of the past settlements has ranged from 3.0% to 4.25%. These are all numbers that can easily be manipulated by the manager’s preferences.
Since all of these policy choices can have significant impact on the reported performance of a firm, they offer an opportunity for the firm to manage its reported numbers. (Palepu p3-7)
Actual Accounting strategy
Hilton has a very detailed accounting strategy; when reviewing their 10k, it is very evident that the main priority is for all their policies to comply within
GAAP. Since they tend to always look back on historical experience and relate to the past with no new significant changes in accounting strategy we can say that
Hilton has conservative accounting practices.
All Items that are reported are in accordance to FAS regulations. To account for the sale of real estate they follow FAS 66, which means they defer the gains and realize them over the term of the contract. However, for intangible assets
Hilton chooses to follow FAS 144; this requires them to review items such as management and franchise contracts to find if carrying value may not be recoverable. They amortize their leases and contracts using straight line depreciation over the life of the agreements. When it comes to property that
Hilton has bought, they choose to account for it at the estimated fair value and take out the accumulated depreciation. This is required to make the proper flexibility of the asset account available. The concern for Hilton in stretching out their expenses equally over the periods of useful life (depreciation expense,
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amortization expense, etc.) further attributes to our perception that Hilton uses conservative accounting strategies, thus limiting the worry that Hilton is an overvalued company.
The fact that Hilton is a self insured firm affects what accounting strategies may be used. This is because of the large amounts of money not spent on insurance and instead it is retained in accounts of liquid assets that are set aside for future claims. They spend about $148 million dollars a year on insurance for their employees. This accumulation leads to heavy reserves, making it important for them to get outside assistance to make sure that the estimate is correct.
This proves to be an excellent policy to have and limits the “risk” of presenting a false perception of the welfare of their company.
Quality of Disclosure
The quality of disclosure is a vital dimension determining the accounting quality of a firm. While the management holds the majority stake in disclosing the firms truest transactions (being guided slightly by the GAAP rules), it becomes that much more pertinent to evaluate a firms disclosure relative to the other powerhouses within the industry. When a firm chooses the aggressive accounting approach of disclosure, it will ultimately depict the prettiest picture of its yearly fiscal transactions on the annual 10-K. Whether it may be based on management compensations, or favorable capital market considerations, this increases the level of complexity in comprehending the actual value of the firm.
In addition to the fact that the majority of shareholders hold a novice level involving financial statement analysis, being able to correctly interpret such data not only is value added, but becomes essentially imperative prior to making decisions regarding a firm’s standing. As for the lodging industry, none are strangers to such aggressive accounting tactics.
The Management’s Discussion, disclosed in the footnotes of the 10-K, still chose an aggressive accounting approach. The industry leader Marriott
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International Inc. (MAR) advanced to surprising levels above the industry norm of having a standard yet had a vague approach in identifying any irregularities that a firm may incur. Meanwhile, the other two of the industry’s leaders, Hilton
Hotels Corp. (HLT), and Starwood Hotels and Resorts (HOT), are almost identical in their reluctance in revealing any abnormalities.
Due to the fact that all three firms elect such an aggressive accounting approach, that essentially means that the industry norm is to deter from adequately disclosing operationally potential bad news. An astounding revelation that we encountered, was that of Top 3 in the Lodging industry, none chose to even disclose a Management Discussion and Analysis of the Financial Conditions section prior to 2003. We have yet to determine if this recent addition is a result of a new industry regulation or just a restoration of the investor’s faith after the deterioration of the travel and lodging industry after the bombing of the World
Trade Centers in 2001. Surprisingly, all firms held congruency with relative ease, despite its involvement amidst multiple business, geographical, and product segments. “We are engaged in the ownership, management, and development of hotels, resorts, and timeshare properties and the franchising of lodging properties domestically and internationally.”(Marriott International, Hilton Hotels
Corp., and Starwood Hotels and Resorts, 10-K 2006) This was the consistent verbatim exposition phrase within the footnotes on the 10K’s of Hilton, Marriott, and Starwood alike.
The most pronounced quandary we chanced on was the vigorous channelstuffing exhibited by Hilton Hotel Corp. “Notes receivable are reflected net of an estimated allowance for uncollected amounts.” (Hilton Hotel Corp. 10-K 2006)
Inflating such a receivable or deflating the amount of the estimated allowance for uncollected amounts, consequently boost reported revenues and net income for the period. The notes receivable asset accounts depicted on Hilton’s 10-K’s were; $558M in 2003, $635M in 2004, and $707M in 2005 respectively. While the estimated bad-debt expense liability accounts were reported as; $68M in 2003,
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$77M in 2004, and $72M in 2005. Distortions in these figures ultimately results to large negative adjustments to the next year’s pre-tax income. Total notes receivable for Hilton actually logged as; $236M in 2003, $350M in 2004, and
$401M in 2005. This very visible deviation reveals Hilton’s “aggressively accounted” revenues were distorted approximately; $332M in 2003, $285M in
2004, and $306M in 2005.
Their aggressive approach to disclosure proved to be a quite difficult task in regards to the overall valuation analysis. Overall accounting disclosure is subject to the discretions of management. Whether it be obtaining favorable capital market considerations to flatter Hilton’s investors, or intrinsically rooted within the management’s compensation. They resonated of an ever prevalent tendency for goal of the management amplify Hilton’s accurate financial performance and conceal any competitive obstacles that it may be facing. We concluded that Hilton Hotel Corp.’s quality of disclosure is ranging amongst the ranks of poor to mediocrity. Due to the sizeable capacity embellished with their inflated long-term assets resulting in an exaggerated net income for the period, and the augmented intricacy in obtaining critical information in determining their factual financial stature.
The following is an investigation of some of the Lodging Industry’s key financial ratios, which can also be used as central quantitative measures and indicators that there may be a pronounced presence of “accounting noise” from management. We will explicitly analyze ratios from the firms in which we previously referred to as “The Three-Headed Giant of the Lodging Industry”.
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HILTON (HLT)
Sales Manipulation Diagnostics net sales/ cash from sales net sales/ accts rec
2002 2003 2004 2005 2006
1.08 1.07 1.07 1.08 1.09
12.98 15.52 15.41 14.22 12.39
27.45 19.79 28.79 20.26 18.98
net sales/ inventory
Expense Manipulation Diagnostics sales/ assets
CFFO/ OI
CFFO/ NOA total accruals/ change in sales other employment exps/ sga
0.46 0.47 0.50 0.51 0.50
1.03 0.74 0.83 0.60 0.51
0.16 0.10 0.16 0.16 0.13
2.56 111.33 1.01 1.03 0.12
6.02 5.78 4.87 5.98 7.52
STARWOOD HOTELS (HOT)
Sales Manipulation Diagnostics net sales/ cash from sales net sales/ accts rec net sales/ inventory
Expense Manipulation Diagnostics sales/ assets
CFFO/ OI
CFFO/ NOA total accruals/ change in sales
2002 2003 2004 2005 2006
1.13 1.00 1.10 1.12 1.11
17.00 17.58 14.47 21.35 10.56
0.28 .32 0.44 0.48 0.64
1.20 1.00 0.50 1.09 .93
0.74 0.37 0.58 0.67 n/a other employment exps/ sga
MARRIOT HOTELS (MAR)
Sales Manipulation Diagnostics net sales/ cash from sales net sales/ accts rec net sales/ inventory
Expense Manipulation Diagnostics sales/ assets
CFFO/ OI
CFFO/ NOA total accruals/ change in sales other employment exps/ sga
2002 2003 2004 2005 2006
1.11 1.14 1.13 1.11 1.10
1.02 1.10 1.17 1.35 1.42
0.90 1.12 1.87 1.51 0.96
0.20 0.17 0.37 0.36 0.78
0.11 0.28 0.15 0.13 0.31
32.77 15.51 14.85 13.60 15.47
SALES & EXPENSE MANIPULATION DIAGNOSTICS
These ratios are screening tools that are used to identify potential manipulation of accounting numbers by managers. Managers are constantly concerned with the bottom line and often have quite an incentive to manipulate these numbers to boost profits. Simply, these ratios are in place to catch numbers that don’t add up. The sales manipulation diagnostics deal with a firms
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reported revenue and the contributing line items. We “run” these numbers to find any possible discrepancies between sales and the accounts that play a role in their reported revenue.
The expense manipulation diagnostics are in place for the same reason; to catch the possible manipulation of numbers in order to boost revenues. These ratios however deal mainly with expenses that can be hidden or manipulated to boost profits. Manipulating expenses for a firm may be as simple renaming certain business transactions. Basically, they don’t need a complex scheme for manipulating numbers in order to boost profits. The GAAP in the U.S. are quite flexible so a firm can portray an accurate picture of its economic standing.
However, some firms may choose to take advantage of these flexible accounting guidelines.
Sales Manipulation Diagnostics
Net sales/ cash from sales
This ratio is a measure of a firm’s ability to collect cash from sales transactions. An increasing number may indicate that a firm is relaxing its credit policy to create more sales. Technically it doesn’t mean a firm is making up sales it just means they are less likely to collect cash on a high percentage of their sales. Hiltons’ ratio along with their two top competitors’ ratio over the last five years is steady and indicates they are able to collect cash from sales at an acceptable rate.
Net Sales/ Cash from Sales
1.15
1.10
1.05
1.00
0.95
0.90
HLT
HOT
MAR
2002 2003 2004 ye ars
2005 2006
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Net sales/ Accounts Receivable
This ratio goes hand in hand with the previous one and is a further measure to indicate a firm’s ability to collect cash from sales. Again it also keeps an eye on the firm’s accounts receivables and credit policies. An increase in this number can also mean a firm is puffing up sales or unable to collect cash from those sales. Hilton’s ratio fluctuates slightly over the last five years, but overall evens out. Hilton is a brand name hotel that historically has a healthy rate of sales. Indicating to us that these numbers are rather accurate and with out any material distortions.
Net Sales/ Accts Rec
18.00
16.00
14.00
12.00
10.00
8.00
6.00
4.00
2.00
0.00
HLT
HOT
MAR
2002 2003 2004
Years
2005 2006
Net sales/ Inventory
Another ratio to catch false increases in sales is the net sales to inventory.
A steady and material decline in this ratio may indicate sales are being manipulated. Essentially if sales are increasing, a firm’s inventory should show a similar increase to uphold the sales increase. Hilton’s ratio is visibly declining and they have quite and increase to sales in 2006. This could indicate they are manipulating sales or simply their product is declining in demand. Looking at
Hilton’s balance sheet, we see their inventory increase at a rate that probably negates the possibility of sales manipulation- their inventory does increase, just
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35.00
30.00
25.00
20.00
15.00
10.00
5.00
0.00
not at the same rate sales increased. Given Hilton’s industry and type of inventory this doesn’t emphatically imply Hilton is manipulating its sales numbers.
Net Sales/ Inventory
2002 2003 2004
Years
2005 2006
HLT
HOT
MAR
Expense Manipulation Diagnostics
Sales/ Assets
Also known as Declining Asset Turnover; which are sales divided by assets. This ratio, hence the name can become a concern if it is found to be declining over a period of four to five years. Specifically, a firm can hide expenses in this manner by capitalizing expenses and recording them as assets.
Certain expenses incurred during a construction project for example are not to be capitalized until after completion. It would not be very difficult for a firm to shuffle expenses around during such a period and seemingly create more profits during periods of less activity. Generally, hiding expenses in this manner makes the ratio decline and pushes it below one. Hilton’s ratio is below one, however it
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is not declining and it stays at pretty steady rate. Since the majority of Hilton’s assets are real property their assets are generally going to be pretty high.
Declining Asset Turnover
1.60
1.40
1.20
1.00
0.80
0.60
0.40
0.20
0.00
HLT
HOT
MAR
2002 2003 2004
Years
2005 2006
Total Accruals/ Change in Sales
This ratio can be a sign of expenses getting buried if total accruals are declining at the same time the year over year change in sales is increasing. The bulk of total accruals are generally depreciation and amortization charges. There are a number of ways to account for these expenses, and accountants can be pretty creative in doing so all the while staying with in GAAP. Hilton’s total accruals are declining, all be it at a slow and steady rate. This ratio may very well indicate they are hiding expenses, especially when you look at their Net
Operating Assets. Which, as mentioned above with a lot of real property they have a good deal of NOA’s to depreciate. An increase in their PP&E should bring an increase in depreciation charges. The large spike in the ratio can be contributed to a dismal increase to sales in 2003.
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Total Accruals/ Change in Sales
10.00
9.00
8.00
7.00
6.00
5.00
4.00
3.00
2.00
1.00
0.00
HLT
HOT
MAR
2002 2003 2004
Years
2005 2006
Other Employment Exp/ S. G. & A. Exp
The two components of this ratio: Other Employment Expenses & Selling,
General, and Administrative Expenses (SGA) should generally move in the same direction. By the same notion an increase in sales should also bring a similar increase in these two items. When these two numbers move in different directions it is a pretty good indicator that managers could be playing around with the numbers to hide expenses. Hilton’s ratio doesn’t indicate anything out of sync and is pretty much “middle of the road” when compared to their competitors. Furthermore, the two expenses move along together over the past five years.
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Other Employment Exp/ SG & A
35.00
30.00
25.00
20.00
15.00
10.00
5.00
0.00
HLT
HOT
MAR
2002 2003 2004
Years
2005 2006
Identifying Potential Red Flags
One of the last steps in analyzing accounting quality is to look for potential red flags that may point to questionable accounting. This takes into consideration the previous steps of the key accounting policies used by the firm and which items managers have a material amount of flexibility or influence on, and to evaluate how aggressive or conservative the managers are in implementing these strategies. As discussed above, one of the tools used in this analysis are the revenue and expense diagnostic ratios that can possibly point out areas where manipulation of numbers or questionable accounting practices are used. These indicators however do not automatically assume that funny things are going on within the company. When these indicators pop up that means further analysis is needed to determine why these “red flags” are present.
Changes in accounting policy are sometimes necessary to accurately portray the economic picture of the company. When these changes occur however there should be adequate disclosure about what the changes are and why they were implemented. In analyzing Hilton’s 2005 10-k, we did not find any unexplained changes in their accounting that may imply Hiltons managers were
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dressing up financial statements. Another potential occurrence that may signify questionable accounting are unexplained transactions on the balance sheet that boost profits such as asset sales. Hilton actively seeks to benefit from sales of certain properties when conditions are right, however these transactions are well disclosed, and do not seem to be “balance sheet transactions” to simply puff up revenue. The revenue from the sale of these assets are generally deferred over the life of a managing contract they agree to with the buyer, as they still have an interest in these properties (p 34, 2005 10-k.)
Unusual increases in accounts receivable to sales is one of the revenue manipulation diagnostic ratios that when declining year over year can be a potential red flag. Hilton’s ratio of sales to accounts receivable while fluctuating over the last five years was found to have a significant decline from 2004 to
2005. While this may appear to be a red flag sales also increased significantly in the same time period and we found no changes in their credit policy that would indicate they were relaxing terms in order to load up this account and boost assets. Another revenue diagnostic ratio that was found to be declining was the inventory to sales ratio. Sometimes this can signal that demand for a firm’s product is slowing down (p. 3-9, Palepu, Healy, Bernard.) However, given
Hiltons’ industry classification and their type of inventory the opposite seems to be the case; this is likely due to a build up in “work in progress” inventories which generally indicates an increase in expected sales (p. 3-9, P, H, B.) “Work in progress” was not reported. However, we did find Hiltons’ management expects to see and increase in sales particularly in the timeshare segment where development of resorts and properties is ongoing (p. 25, 2005 10-k.)
An increasing gap between reported income and cash flows from operating activities was a potential red flag that also caught our attention. This can mean a firm is recognizing revenues unjustly (ahead of schedule), burying expenses, or both. This can be easily done and hidden when a firm is undertaking large construction contracts and employing the percentage of completion method to recognize revenues (p. 3-10, P, H, B.) Hilton uses this
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method and is constantly engaged in developing properties. We found that
Hilton’s net income increased by approximately 50 percent in 2004 and 100 percent in 2005. During the same time period their CFFO decreased 12 percent.
Hilton is currently allowed to defer selling and marketing expenses under the percentage of completion method during the construction of projects which would also aid in the increasing gap between their reported income and their
CFFO. In 2006 under FAS 152 (p. 53-54, 2005 10-k) Hilton will be not be allowed to defer these selling and marketing expenses, and is something to keep and eye on in future periods.
CFFO/ OI
2.00
1.80
1.60
1.40
1.20
1.00
0.80
0.60
0.40
0.20
0.00
HLT
HOT
MAR
2002 2003 2004
Years
2005 2006
Total Accruals to the change in sales is another one of the expense manipulation ratios that raised a red flag. This can be a problem if total accruals are declining while the change in sales keeps showing an increase. As mentioned earlier, this is the case with Hilton over the last five years, and can be a sign that expenses with regard to depreciation and amortization are being buried.
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Undo accounting distortions
The next step in the accounting analysis is to recognize the “red flags” that were identified in the last section that may be intentionally misleading. It should also be noted again that unusual accounting practices that are found may not simply be that the company is trying intentionally to hide or misrepresent information. After analysis of Hilton’s 10-k and many of their competitors 10-k’s
Hilton seems to stealthily report or generalize some information and numbers that could be used to undo potential red flags that were identified in the above section. As mentioned earlier, we found Hiltons accounting to be rather aggressive. Specific areas of aggressiveness where they employed this strategy were recognizing revenues under the percentage of completion method and the deferral of certain selling and marketing expenses while developing projects.
Although Hiltons reporting may be vague in some areas and overall aggressive we do not believe they are guilty of grossly distorting or reporting information that is materially misleading.
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The financial statements of a company can be very telling and provide a more accurate view of their financial condition. However, to realize the impact of these statements they need to be analyzed and interpreted. That is the purpose of this section; we will evaluate the financial condition of Hilton and the results of its operations. We’ll examine trends in their past performance and benchmark it against individual competitors and industry standards. This is the Trend and
Cross section analyses- a set of ratios that measure the condition of a company’s liquidity, profitability, and capital structure. We’ll express the implications of these ratios and attempt to relate them to underlying business strategies. Next, using this information on their past performance we will forecast each of Hilton’s basic financial statements for further insight into their financial health and effectiveness of their strategies.
Trend and Cross Sectional Analysis
2002 2003 2004 2005 2006
Gross Profit Margin 46.0% 32.8% 34.3% 37.6% 31.4%
Operating Exp. Ratio
Operating Profit Margin
9.9% 10.6% 11.7% 13.7% 11.1%
24.9% 22.2% 22.6% 23.9% 20.3%
Net Profit Margin
Asset turnover
Return on Assets
Return on Equity
5.2% 4.3% 5.7% 10.4% 7.0%
0.56 0.57 0.50 0.51 0.50
2.9% 2.5% 2.9% 5.3% 3.5%
9.6% 7.3% 9.3% 16.4% 15.3%
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Profitability Ratios
Amidst the balancing-act between enhancing overall consumer value, refortifying brand identity, and increasing firm profitability lies Hilton Hotel Corp’s intrinsic differentiation strategy, to separate the Hilton name from the Industry and fuse it with consumer quality. Such a commitment requires them to constantly entertain projects to achieve such a value-added status. Yet to come upon such glory does have its price. When successfully implementing a competitive strategy such as Hilton’s, the selling, general, and administrative expenses, (SG&A), and research and development (R&D) costs will increase in line with the firms various other operating activities thus affecting overall operating efficiency and most importantly, profitability. Hilton’s recent acquisition of HI (Hilton International), the Hilton Group plc, provides insight into the influx of liabilities and the overall fiscal performance of the firm and the results of its operations. When determining a firm’s operating efficiency all items pertaining to the income statement are set as a proportion to sales to easier depict the trend of certain expense investitures and profit margins.
GROSS PROFIT MARGIN
2002 2003 2004 2005 2006
46.0% 32.8% 34.3% 37.6% 31.4% H L T
H O T
M A R
((Gross Profit/ Sales))
Above is Hilton’s Gross Profit Margin which is a measure of pure revenue,
(sales net of all the cost of goods sold). An increased amount is favorable that shows peak operations at decreasing normally fixed expenses. Although obtaining a large increase (45%) in the dollar amount of sales from 2005-2006, the cost of goods sold (COGS) did not decrease substantially enough for a positive percentage change. With and increase as big as 45% in sales an increase in expenses is an industry norm.
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H L T
H O T
M A R
OPERATING EXPENSE RATIO
2002 2003 2004 2005 2006
9.9% 10.6% 11.7% 13.7% 11.1%
11.0% 14.3% 6.2% 6.2% 7.9%
2.8% 5.8% 6.0% 6.5% 5.65%
((SG&A Expenses/ Sales))
Exacting a competitive strategy for quality is prevalent with the top ranks of the industry’s leading firms. Although the Marriott holding the top spot of the industry has done fine job of minimizing their operating expenses, which is a measurement of how much is expensed for a single dollar of sales. The laggards of the three headed giant, Hilton and Starwood, seem to be gradually increasing.
Obtaining the number one spot from the principle firm requires larger commitments than the actual leader.
Operating Exp Ratio
16.00%
14.00%
12.00%
10.00%
8.00%
6.00%
4.00%
2.00%
0.00%
2002 2003 2004
Years
2005 2006
H L T
H O T
M A R
Ind. Avg.
Whether it may be Starwood’s investments into streamlining its new elite brand W hotels, or Hilton’s massive acquisition of its International brand lines, the gradual increase of operating expense justifiable by increased R&D costs as a
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part of SGA explains why Hilton holds highest operating Profit margin on the industry.
H L T
OPERATING PROFIT MARGIN
2002 2003 2004 2005 2006
24.9% 22.2% 22.7% 23.89% 20.3%
H O T 15.1% 11.3% 12.2% 13.8% 14.0%
M A R 6.8% 4.2% 4.7% 4.8% 8.3%
((Operating Income / Sales))
The recent year activity 2005 -2006 the increase in sales was proportionally higher than the total percentage increase in operating expense, and the operating income, which in turn affect the operating profit margin.
Operating Profit Margin
30.00%
25.00%
20.00%
15.00%
10.00%
5.00%
0.00%
H L T
H O T
M A R
Ind. Avg.
2002 2003 2004
Years
2005 2006
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The Net Profit Margin is a key indicator for evaluating Operating
Efficiency. This ratio is a measurement of the percentage of every marginal dollar of sales that is retained as actual profit.
H L T
H O T
M A R
NET PROFIT MARGIN
2002 2003 2004 2005 2006
5.2% 4.3% 5.7% 10.4% 7.1%
9.2% 8.2% 7.4% 7.1% 17.4%
3.3% 5.6% 5.9% 5.8% 5.0%
((Net Income / Sales))
With increases in the overall dollar amount of sales and net income, due to inflated operating expenses, Hilton was unable to maximize on such a productive year. While Starwood whose operating expenses are much more diminutive than Hilton’s was able to enjoy the industry’s highest actual profit yield. And the industry leader has held a mixture of consistent competitive strategies, and operating activities, that result in steady yields.
20.00%
15.00%
10.00%
5.00%
0.00%
-5.00%
-10.00%
2002 2003
Net Profit Margin
2004 2005
Years
2006
42
H L T
H O T
M A R
Ind. Avg.

Determining the revenue productivity of all of a firm’s assets becomes vital in the profit valuation of a company. How many times can a firm turn a single asset into profit? Well, this Asset Turnover Ratio derives how much every dollar of assets can be utilized into a single dollar amount of sales.
H L T
ASSET TURNOVER
2002 2003 2004 2005 2006
.56 .57 .50 .51 .50
H O T .31 .31 .44 .48 .64
M A R 1.0 1.1 1.2 1.3 1.4
(( Sales/ Totals Assets ))
While asset management and operating efficiency both summate to overall profitability, both can be gauged by considering the profits themselves and the resources used to produce those profits (productivity.) The return on the asset ratio is tied to the net profit margin and the asset turnover. Each firm sets its own benchmark with the idea to increase this variable demonstrating a positive trend in overall operational management, leading to positive profitability trends.
Asset Turnover
1.6
1.4
1.2
1
0.8
0.6
0.4
0.2
0
2002 2003 2004
Years
2005 2006
H L T
H O T
M A R
Ind. Avg.
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Since the majority of firms utilize investiture spending on their assets, analyzing the efficiency of their investment management process is critical to valuing overall profitability. The asset turnover which is depicted above is the dollar amount of assets set proportional to its ability to generate a dollar of sales.
This being coupled with a firm’s overall return on sales ratio, or its net profit margin from above, can effectively demonstrate how much profit a firm can produce from each dollar of assets invested. (Return on Assets)
H L T
RETURN ON ASSETS
2002 2003 2004 2005 2006
2.9% 2.5% 2.9% 5.3% 3.5%
H O T 2.9% 2.6% 3.3% 3.4% 11.2%
M A R 3.2% 6.1% 7.1% 7.8% 7.1%
((Net Income/ Total Assets))
Although Hilton saw substantial gains in their sales and net income volume, their actual return on sales was ultimately negatively impacted due to their lack-luster year effectively managing their operating expenses. This being coupled with the recent investment into the HI project proved to have declining results for the firms return on the assets. Hilton’s differentiation competitive strategy, indicates that they will be bound to higher than average operating (R & D) costs to secure brand image with the consumer. The key is to ensure that with the increased investments in the assets, comes a greater or equal return to justify the efficiency, and correlation firm’s competitive strategy and its management activities.
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Return on Assets
12.00%
10.00%
8.00%
6.00%
4.00%
2.00%
0.00%
-2.00%
-4.00%
2002
H L T
H O T
M A R
Ind. Avg.
2003 2004
Years
2005 2006
H L T
H O T
RETURN ON EQUITY
2002 2003 2004 2005 2006
9.6% 7.3% 9.3% 16.4% 15.4%
9.2% 7.4% 8.7% 8.5% 34.7%
M A R 7.9% 13.6% 15.1% 18.5% 21.0%
((Net Income/ Owners Equity))
As a whole the Profitability Evaluation depicts a harrowing year for Hilton.
Seeing substantial gains in profitability, Starwood can attribute its gains with the success of its newest “W” Hotel premium brand line, to the highest net profit margins to offset their increasing operating costs. While the same increase in operating costs hedged Marriott’s success. Yet Hilton with increases in full operating expenses with the new HI acquisitions coupled with its use of debt to primarily finance such investitures, increased liabilities to a point the shadowed their extensive gains in net income. These gains were the key factor that contained what otherwise should have been a considerable decrease in the overall profitability of the owner’s interest in the total assets, the return on equity.
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40.00%
30.00%
20.00%
10.00%
0.00%
-10.00%
2002 2003
Return on Equity
2004
Years
2005 2006
H L T
H O T
M A R
Ind. Avg.
In conclusion the concept is simple; the goal is to obtain consumer loyalty through a definitive competitive strategy. But a good idea can only be set in place to gain sufficient yields, when operating efficiency is optimal. If the two deviate, then initial returns to sale will increase at a decreasing rate, being cannibalized by the operating expenditures to implement the project. Firms should not undertake projects that require higher investments and produce lower returns. When the balancing act between the company’s values, profitability, and consumer value are on the same page and forefront with the management, then all facets of the firm will see gains, including the owner’s equity.
Liquidity
When firms follow the trend of utilizing debt to finance capital ventures, they consequently expose themselves to much more market risk. This is where the universal theory is applied, the higher the risk, the higher the required rate of return from the investors. Thus, evaluating a firm’s risk-exposure and its ability to convert its material goods into cash (liquidity) to pay its short-term liabilities is vital to key in on the actual performance for the period and can give foresight into the future performance as well. “Liquidity refers to the cash
46

equivalence of assets and the firm’s ability to maintain sufficient near-cash resources to meet its obligations in a timely manner.” (FSA ratio packet pg. 49)
2002 2003 2004 2005 2006
Current ratio 1.11 1.14 1.76 2.42 0.77
Quick asset ratio
Accounts Rec. turnover
0.61 0.37 1.41 2.05 0.5
13.0 15.5 15.4 14.2 12.4
Days Sales Outstanding
Inventory turnover
27.9 23.5 23.7 25.7 29.5
11.2 13.3 18.7 12.7 13.0
Days Supply of Inventory 32.5 27.5 19.3 28.9 28.0
Working Capital turnover 69.4 30.6 8.7 3.6 -14.6
H L T
H O T
CURRENT RATIO
2002 2003 2004 2005 2006
1.11 1.14 1.76 2.42 0.77
0.53 n/a 0.79 0.79 0.74
M A R 0.79 0.70 0.83 1.01 1.31
(( Current Assets/ Current Liabilities ))
Above is a look into the lodging industry leader’s performance with their assets set directly proportional to their liabilities. This current ratio is an indication of a firm’s ability to cover its current liabilities with the cash realized from its current assets. Generally, a current ratio above one indicates a firm is able to do this. Hilton’s current ratio was above one and inclining by a relatively steady rate until 2006, when it took a steep decline. This was due to a huge increase (186%) in current liabilities in 2006, current assets also declined slightly
47

in 2006 adding to this decline. This essentially says that for every $1 of current liabilities Hilton has $0.77 of current assets.
Current Ratio
3
2.5
2
1.5
1
0.5
0
2002
H L T
H O T
M A R
Ind. Avg.
2003 2004
Years
2005 2006
When compared to the industry Hilton’s current ratio seems to be in better shape than some of its top competitors, however the competitors seem to have a smoother transition from year to year. Within a firm’s quick asset ratio are their cash, marketable securities, and account receivable.
HLT
QUICK ASSET RATIO
2002 2003 2004 2005 2006
0.61 0.37 1.41 2.05 0.50
H O T 0.42 n/a 0.62 0.70 0.51
M A R 0.46 0.74 0.82 0.66 0.52
((Cash+Mark. Sec.+Accts. Rec. / Current Liabilities))
Hiltons Q.A.R. seems to take another steep decline in 2006. The large increase in CL in 2006 noted above is the main factor for this sharp decline.
Another factor in the drop is the unusually large increase in cash in 2005, which
48

shot up the ratio, setting it up for a fall in 2006. Although Hilton’s Q.A.R. of 0.5 in 2006 is potentially troubling, it’s line with the rest of the industry.
Quick Asset Ratio
2.5
2
1.5
1
0.5
0
HLT
H O T
M A R
Ind. Avg.
2002 2003 2004
Years
2005 2006
A firm’s credit policies are captured within their accounts receivable ratio.
This is a measurement of the number of days that the firm takes to collect on their receivable accounts. This can be calculated by dividing the amount of the accounts receivable from the balance sheet into the amount of sales listed form the income statement.
H L T
H O T
M A R
ACCTS REC TURNOVER
2002 2003 2004 2005 2006
13.0 15.5 15.4 14.2 12.4
10.08
10.9
9.31 11.14
10.3 8.6
((Sales/ Accts Rec)) n/a
8.3
8.44
10.2
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This is a slight indication that Hilton has probably relaxed its credit policies allowing extended dates to collect on an outstanding amount. Having a history of immense channel-stuffing for aggressive accounting procedures, along with the consistent increase in sales volume year after year, could hint at inflated future increases in their allowances for bad debt. . An investor should be looking for a larger number that shows gradual positive progression. This is a crucial liquidity ratio that demonstrates a firm’s cash equivalence of its assets, and its ability to pay it’s liabilities in a timely manner. Whenever a firm is truly operating efficiently, the increased result of this ratio interprets into a shorter Cash
Collection Cycle. Here we see the similarities between Hilton and Starwood, who are ranked 2 nd and 3 rd in the industry, hold both similar fluctuating traits with slight increases in their receivable turnover ratios but have shown a trend to gradually decline since 2004. While the #1 ranked Marriott, justifies why it is so and illustrates a consistent incline since 2004.
20.0
Accts Rec Turnover
15.0
10.0
5.0
0.0
2002 2003 2004
Years
2005 2006
MAR
Ind. Avg.
Accounts Rec.
turnover
HOT
50

H L T
DAYS SALES OUTSTANDING
2002 2003 2004 2005 2006
27.9 23.5 23.7 25.7 29.5
H O T 36.2 39.2 32.8 n/a 43.3
M A R 33.5 35.4 42.3 44.1 35.8
Having seen their A/R turnover decrease over the last few years would implicitly increase their Holding Period. This longer collection period could indicate something of a short term liquidity problem. If they do not create enough cash flow from operations they may be forced to use some portion of debt to keep up with their operations.
50.0
40.0
30.0
20.0
10.0
0.0
2002 2003
Days Sales Outstanding
2004
Years
2005 2006
Days Sales
Outstanding
HOT
MAR
Ind. Avg.
Inventory management is usually mandated by the nature of the business and its need to obtain an optimal level of operating inventory. The correlation of inventory to the cost of goods sold is vital in examining the efficiency of not only liquidity, but inventory management. Inventory turnover is computed by dividing
Inventory into Cost of Goods Sold. It is essentially the dollar amount of held inventory leveraged against the dollar amount spent to acquire sold inventory.
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H L T
INVENTORY TURNOVER
2002 2003 2004 2005 2006
11.2 13.3 18.7 12.7 13.0
H O T 13.8 14.6 8.2 11.7 14.4
M A R 15.3 13.1 14.9 18.5 6.4
((Cost of Goods Sold/ Inventory))
From 2005 to 2006 Hilton doesn’t have much of a change in their inventory turnover. Their type of inventory is mainly real property that over a short period of time stays fairly constant. So essentially, since our rate of sales has increased year over year, this implies to a higher cost of goods sold.
H L T
H O T
DAYS SUPPLY OF INVENTORY
2002 2003 2004 2005 2006
32.5 27.5 19.3 28.8 28.0
26.6 24.9 44.2 31.0 25.4
M A R 23.8 28.1 24.4 19.8 56.4
Days Supply of Inventory, also known as the Holding Period is a measure of the number of days every dollar of inventory is converted into a dollar of sales. It is computed by dividing 365 by the Inventory turnover ratio that was mentioned above. After seeing how the ratio is computed you can understand how Hiltons decreasing Inventory turnover above equates into a longer holding period.
H L T
H O T
WORKING CAPITAL TURNOVER
2002 2003 2004 2005 2006
69.4 30.6 8.7 3.6 -14.6
M A R 10.3 8.3 8.7 10.4 11.0
(( Sales/ Current Assets – Current Liabilities ))
Working capital is CA – CL. A negative WC turnover like Hilton’s has to be due to a decrease in WC, which is done by decreasing CA or increasing CL. Both
52

are the case with Hilton, and underscore their low current ratio. Another factor for the low WC as mentioned above Hilton’s liabilities increased significantly in
2006. This is the primary the cause of the negative WC turnover.
80
60
40
20
0
-20
2002
Working Capital Turnover
2003 2004
Years
2005 2006
H L T
H O T
M A R
Ind. Avg.
A decreasing Working Capital would normally be a positive sign. However
Hiltons’ decreased by almost 100%; turning negative in less than four years.
Once again Hilton’s underlying problem relates back to their primary policy on debt financing. Consequently, any increase in CA, sales, and income will be offset by their heavily leveraged position. This is exactly the case; they had a substantial increase in sales and an encouraging increase in CA over the last couple of years. Despite the initially successful years in regards to CA, sales volume and net income, Hilton could not capitalize because their obligations far exceeded their returns.
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2002
Debt to Equity Ratio
2003 2004 2005 2006
3.1% 2.7% 2.2% 2.1% 3.4%
Times Interest Earned 1.9 1.7 2.3 3.4 2.7
Debt Service Margin 56.7 1.1 39.1 10.3 1.6
The Capital Structure of a company refers to the sources of financing used to acquire resources for operation and is shown by the Liabilities and Owner’s
Equity section of the balance sheet (FSA and ratios, p55.) This section reveals how much equity financing to debt financing the firm is using and how they are able to manage these sources of financing.
H L T
H O T
M A R
DEBT TO EQUITY RATIO
2002 2003 2004 2005 2006
3.1 2.7 2.2 2.1 3.4
1.3 1.1 .94 .80 .90
.50 .38 .32 .53 .70
((Total Liabilities / Owners Equity))
The debt to equity ratio helps evaluate the mix of debt and equity that make up the firm’s capital structure (P,H,B, p.5-17.) It is also an indicator of the credit risk of a company, which is the possibility that interest and debt repayment can not be satisfied with available cash flows (FSA and ratios, p55.)
When this ratio gets above 2.5 or 3 it may be a sign of high credit risk and that the firm is relying too much on debt financing . Not only is Hiltons’ ratio above this mark, but also well above its industry peers. This is a troubling sign for
Hilton and can be potentially costly to its shareholders (P,H,B, p.5-16.)
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Debt to Equity
2
1
0
4
3 HLT
HOT
MAR
Ind. Avg.
2002 2003 2004
Years
2005 2006
H L T
H O T
M A R
TIMES INTEREST EARNED
2002 2003 2004 2005 2006
1.8 1.7 2.3 3.4 2.7
1.7 1.5 2.6 3.4 3.9
6.6 3.4 4.8 5.2 8.2
((NIBIT / Interest Expense))
Net Income before interest and taxes = (NIBIT). This ratio is a measure of how easily a firm can meet its interest payments, and indicates the degree of risk associated with its debt policy (P,H,B, p.5-17.) This essentially means that a firm’s Operating Income must be sufficient enough to cover the required interest expenses of operation before there can be profits to the shareholders (FSA and ratios, p. 56.) Hilton’s decrease from 3.4 to 2.7 is not a good thing, however 2.7 is not a number that seems outrageously troubling to us. It also doesn’t come as much of a surprise; Hilton relies heavily on debt financing, so their Interest expense will generally be high - driving down the ratio. As you can see Hilton’s
T.I.E. ratio is noticeably smaller than its competitors. Even though Hilton is fairly highly leveraged, they seem to be able to keep up with their interest charges.
55

10
8
Times Interest Earned
6
4
2
0
2002 2003 2004
Years
2005 2006
HLT
HOT
MAR
Ind. Avg.
DEBT SERVICE MARGIN
2002 2003 2004 2005 2006
56.7 1.1 39.1 10.3 1.6 H L T
H O T 1.2 n/a .92 .63 .62
M A R 7.8 6.6 1.8 55.8 17.3
((Operating Cash Flow / Notes Payable ~ current portion))
The Debt Service Margin of a company measures the adequacy of cash provided by operations (CFFO) to cover the required annual installment payments on the principal amount of long term liabilities. Within the capital structure of a company CFFO should be viewed as a major source of cash that can be used to retire long term debt. Hilton’s DSM of 1.6 indicates that $1.60 of
CFFO was generated to service each dollar of long term debt that will mature in
2007 (FSA and ratios, p.56.) This substantial decrease in Hilton’s DSM is another negative impact on their capital structure. Even though CFFO should be used as a source to pay off long term debt, this large decrease in the DSM equates into even more pressure on their CFFO to service long term debt (FSA and ratios,
56

p.56.) To further understand the negative impact of this ratio, consider that their
CFFO increased 34% from 2005. However, it wasn’t near enough to keep up with the 700% increase in the current portion of their long term Notes Payable.
When considering the steady increase in CFFO over the past years the apparent volatility of this ratio indicates that Hilton may rely too heavily on debt financing to sustain operations.
60
50
40
30
20
10
Debt Service Margin
HLT
HOT
MAR
Ind. Avg.
0
2002 2003 2004
Years
2005 2006
Overall status of Hilton’s Capital Structure
Hilton’s debt to equity ratio of 3.4 for 2006 is potentially troubling in itself.
While the past ratios for 2002-2005 may not set off red flags, it underscores their heavy reliance on debt financing. It also brings the possibility of increasing their credit risk to outside lenders. Thus, the negative impact of this ratio is two-fold since Hilton relies so much on outside sources for financing. This ratio gives us a broad look at Hilton’s capital structure; tying in TIE and DSM will help break it down. The TIE ratio indicates Hilton is able to generate enough income to cover their interest charges. However, this ratio by itself can be misleading because keeping up with interest payments is only half the equation. When coupling this ratio with their DSM, Hilton seems to be generating only enough income to keep the creditors off their back. Cutting it this close in both of these ratios brings the
57

real possibility of not being able to cover their debt payments in full. Hilton seems to be “living paycheck-to-paycheck.”
In a large corporation such as Hilton we understand the need for, and potential upside of, debt financing. However, largely due to their highly leveraged position their overall capital structure is not in good shape. If Hilton’s reliance on debt financing continues to increase it could mean the start of a crippling trend. Without getting into the endless quandary of the manager – owner relationship; we are hard pressed to believe Hiltons’ owners and executives would let such a trend continue.
SUSTAINABLE GROWTH RATE – (SGR)
2002 2003 2004 2005 2006
H L T 8.18% 5.98% 8.06% 14.73% 13.68%
H O T 7.78% 3.35% 4.90% 4.93% 25.50%
M A R 6.01% 11.72% 13.20% 16.23% 17.80%
{ROE * (1- DPR)}
A company’s Sustainable Growth Rate is computed by multiplying its ROE by one minus the dividend payout ratio (DPR= cash dividends paid/ NI.) Keep in mind: (ROE= NI/ OE.) A firms ROE and its dividend payout policy determine the pool of funds available for growth. The SGR of a company is impacted by every one of the liquidity, profitability, and capital structure ratios that was discussed earlier. By linking these previous ratios to Hilton’s SGR we can determine and further examine the drivers of their growth (P,H,B, p.5-19, 20.) With ROE and dividend payout policy in mind, seeing Hilton’s NI increase in 2005 (92%) and
2006 (24%) brings the potential for considerable growth. However their DPR for the last few years remained pretty constant hovering around 10%. So regardless of the increases to NI they continue to retain a fairly constant rate of earnings.
(This is supported by the small steady growth in owner’s equity.) With that, the potential for growth that came with the large increases in NI is diminished by
58

that portion of earnings that went to the shareholders. Simply stated, NI can either be kept within the company and used to foster growth or paid out to shareholders in the form of dividends. That’s not to say that paying more dividends won’t help grow the company, it is however a less certain measure.
The drop in Hilton’s SGR in 2006 was set up by the 92% increase in Net Income in 2005. We believe this spike in NI might have been better allocated and kept within the company to possibly curb the downturn in 2006. Overall, a SGR of
13.68% is not an unhealthy or troubling number; it does however appear to us that Hilton has the potential for a higher SGR.
30.00%
25.00%
20.00%
15.00%
10.00%
5.00%
0.00%
2002 2003
S. G. R.
2004 2005 2006
HLT
HOT
MAR
Years
H L T
INTERNAL GROWTH RATE – (IGR)
2002 2003 2004 2005 2006
2.45% 2.01% 2.51% 4.74% 3.09%
H O T 2.44% 1.15% 1.85% 1.99% 9.27%
M A R 2.40% 5.31% 6.20% 6.80% 6.03%
{ROA * (1- DPR)}
The internal growth rate (IGR) is computed the same way as the SGR, except ROE is replaced by ROA; (ROA= NI/ TA.) It measures the potential growth of the company’s own assets. Hilton’s declining IGR in 2006 can be contributed to a couple main factors: the 89% increase in total assets in 2006,
59

which decreases ROA; and the fore mentioned 92% increase in NI in 2005.
Again, the increase to NI in 2005 seems to be out of the norm for Hilton and sets their IGR up for a fall in 2006. Although NI increased by 24% in 2006 it wasn’t enough to keep up with the increase in assets. This occurrence would drive down
ROA and implicitly their IGR.
I. G. R.
10.00%
8.00%
6.00%
4.00%
2.00%
0.00%
HLT
HOT
MAR
2002 2003 2004
Years
2005 2006
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Forecasting financials is an important and integral part to understanding the value of a firm. With an inability to accurately look in to the future, we must use historical data as a means to try to estimate various aspects of a firm. This process involves making assumptions as to how much a company will grow, or decline, ten years into the future. What follows are our assumptions that we made on each of Hilton’s financial statements as well as our analysis of their key ratios, which are separated into three groups (Liquidity, Profitability, and Capital
Structure). Our overall method on forecasting is called “Growing to Average” which allows us to have a more conservative approach to forecasting so as to not grossly overstate any item.
Balance Sheet
The balance sheet forecasting helps us to project the future financial health of Hilton Inc. We began by forecasting the integral items of the Balance
Sheet, Assets, Liabilities, and Shareholder’s Equity; to do this we took the average growth rate over the past five years and then divided that number by ten. By doing this, we were able to grow items at a very conservative rate.
(See below)
For items like Cash, Accounts payable, and L-T Liability Charge we used the average of the percentages from the common-size income statement. For example, Cash had a common size of (See Below):
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We averaged out the common sizes (leaving out 2005 because it is an outlier and would skew the growth rate higher) and got a number of 2.57%. This number means that, on average, Cash was approximately 2.57% of Total Assets.
We used 2.57% as a means for forecasting out Cash, as well as other items such as Accounts payable. This method once again allows for a conservative approach to forecasting out Hilton’s financials.
We used an Average Growth Rate method to forecast out items such as
PP&E, Accounts and Notes Receivables, and Capital Surplus as these are numbers that are subject to grow as the company grows. The method involves a way similar to the way that Liabilities were forecasted except that we took a year by year growth rate and averaged those. We then grew the line-item by this amount. This method was not as conservative as the other two but we can sacrifice some level of conservativeness in order to not grossly understate these forecasted line items.
We used a basic average of the five years worth of actuals to forecast for other items like Pre-paid expenses and other current assets, intangible assets, long term debt, capital leases, and other long term liabilities as well as common stock. These accounts were forecasted on an average basis because they consist mostly of steady growth and remain pretty consistent. The inventory turnover was also used in efforts to forecast inventory projections. Using simple algebra, we solved for inventory by plugging in the newly forecasted cost of goods sold over x, the variable for unknown inventory, and set it equal to the inventory turnover that we established for the past 5 years of actuals. We used mostly averages in forecasting the balance sheet because we feel like an average
62

growth of the past years will produce the small growth expected in the future ten years.
Special Consideration for forecast of Retained Earnings
Retained Earnings was a special case in that we did not forecast out R.E. per say, rather, we used the formula of:
R.E. = Beg. R.E. + Net Income – Dividends paid
This allowed our R.E. to fall inline with our forecasted Net Income with relative ten year growth steady between the two. For the five year actuals, R.E. grew by 416%, for the ten-year forecasted, R.E. grew by 320% with N.I. growing by
188% over five year actuals and 98% over ten-year forecasted. However, it is important to note that Hilton has disclosed that they take the exercise of
Common Stock into account in their R.E. (See Below).
-Courtesy of Hilton 2006 10-K
It is important to note that R.E. will likely not be as high as our forecasted due to our assumption that none will be reinvested. However, in reality, Hilton would likely reinvest in new capital such as PP&E or reduction of L-T debt, as the opportunity cost of just holding cash is high.
“Un-Forecastable” Items
There were line-items that were either unable to be forecast due to being too volatile or unable to be predicted in a stable manner. Due to this, there is a discrepancy between Assets and Liabilities + Shareholder’s Equity; this discrepancy is captured in the red row (See below).
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This column grows as it nears the end of the ten forecasted years, this growth represents the “un-forecastable” growth of all the “un-forecastable” line items spread out over ten years.
64

65

66

Income Statement
For the income sheet, the assumptions were made very similar to the balance sheet. First we took the averages of the growth rates of the Net Sales as expressed below:
We took the 7.92% and used that to grow our Net Sales for the next ten years.
Next, we took the seven other essential forecast-able components (C.O.G.S.,
S.G.A. Expenses, Interest Expense, Depreciation, Non-Operating Income,
Provision for Income Taxes, Minority Interest) and averaged their 5-year common-size data. For example:
We added 53.99% through 68.57% and divided that number by 5 to get
63.57%. We then made the conservative assumption that COGS would be approximately 63.57% of N.I. We used this method for all seven essentials as listed above. We found this method to be conservative in nature due to it being a steady number across the ten years so as to not overstate N.I. in any period.
Having forecasted out those line items Operating Income and Net Income are not forecasted per say but rather computed through traditional means having already forecasted their components. For example, Operating Income is equal to
Gross profit – S.G.A., both of which were forecasted out using the above methods. This same concept applies to Net Income, allowing for an accurate
67

portrayal of O.I. and N.I. Using this method we found a 98% growth rate over the entire ten years for N.I.; this is conservative indeed as Hilton had a 188% over the entire five years of actual N.I. We justify our smaller growth rate through the fact that firms go through the complete business cycles complete with periods of significant growth and growth at a declining rate towards the end of this significant growth (See Below).
-Courtesy of http://hsc.csu.edu.au/economics
68

69

Statement of Cash Flows
The Statement of Cash Flows (hereafter referred to as SCF) is by far the most difficult of the financials to forecast and it is because of this fact that we did not forecast CFFI nor CFFF (except for Dividends paid). We instead only forecasted out CFFO; for a couple of the items on the SCF, we were able to pull the forecasted information from the other financials. For example, the forecasted Net Income can be pulled from the Income Statement, which was
$844 (in millions) in 2007 (Year 6). We used this same method for Depreciation.
As far as the other items on the Cash Flow Statement, we used the same method as used on the Income Statement above, “Growing to Average”. Some numbers we forecasted to be growing at a negative rate, in line with the concept that the Cash Flow is a measure of Cash Flows in and out of the company.
Dividends Paid
We forecasted Dividends paid as an average of its % of Net Income, this method is similar to Cash on the Balance Sheet. We found that, on average, dividends are 13.46% of N.I. therefore we used this as the basis for forecasting dividends paid out for all ten years. This conservative approach is important in that it translates into our valuation models at the end of our analysis.
70

71

Cost of Equity – (Ke)
The Cost of Equity Capital is related to the market value of the firm’s equity and can be computed using the Capital Asset Pricing Model (CAPM); however, there are a number of different ways to compute a firms’ cost of equity. The CAPM expresses the cost of equity (K e
) as the sum of a required return on risk less assets plus a premium for systematic risk (beta) (Palepu,
Healy, Bernard, p8-3.) Actual components of the CAPM are: a risk free rate, the market risk premium (MRP= expected mrkt return – Rfr), and beta.
K e
r f
B[ E ( r m
) – r f
]
Mrkt Cap. = MV e
MV a
= MV f
= MV l
+ MV e
^( K d
) ^( K e
)
In order to compute the firms cost of equity (K e
) we had to first run a regression with various risk free rates from 2000 through 2007(3 month, 1 year, 5 year, 7 year, and 10 year Treasury Bill rates) in order to find the best estimation of beta.
The best estimation of beta is the regression analysis that yields the highest adjusted R squared percentage that relates to the type of risk free rate chosen in the regression. This is why we had to run a number of regressions using different risk free rates. For the market return we used the S & P 500’s monthly return data. However we ended up estimating the market risk premium at 6%.
We used 6% because the historical risk premium of 7% is thought to be less valid today. Recent academic research has found the MRP has declined substantially and may actually be around 3 to 4 percent (P,H,B, p.8-4.) Since this is an unresolved matter we simply used a slightly smaller rate.
(Rf) -- Risk free rate
3mnth 1yr 5yr 7yr 10yr
0.04300 0.04208 0.03925 0.03925 0.03933
72

We ended up using the 3 month Treasury bill rate from 2007 since it was the most current and because its beta had the highest adjusted R squared percentage. When we ran the regression using the 3 month Treasury bill rate for
72 months it yielded a beta of 1.105 and an adjusted R squared of 24.45%.
Once we derived these numbers we plugged them into the CAPM model and estimated Hilton’s K e
at 10.93%. A firm’s estimation of its K e is important for a number of reasons. It is used as the discount rate when analyzing potential future projects, and also measures the required return of an investor. It can also be used as benchmark for the firm’s ROE. The chart above on the right side shows the association of the K e
, and how it effects the computation of a firm’s weighted average cost of capital (WACC).
3 month Regression Analysis
72 1.1052 0.2245 0.1093
Cost of Debt – (Kd)
The cost of a firm’s debt is a weighted average and it is estimated using the respective interest rate associated with each type of debt. Both short and long term debt are used in the estimation of the cost of capital. Actually computing the estimate of the cost of debt is relatively simple. We first computed a weighted average of each necessary liability- with Total Liabilities as the common denominator. Then multiplied them by their respective interest rates, which were either found from the St. Louis Fed or in their 10-k. For the interest rates regarding their short term debt and accounts payable we used the three month Treasury bill rate of 4.97% (St. Louis Fed.) Other rates regarding income taxes and long term debt were found in their 10-k. To discount their long term debt which has a floating interest rate, we used an average of these rates
73

found in their 10-k of 7.95%. For their income taxes an interest rate of 5.02% was used which again was in their 10-k in the tax table. Using this formula we estimated Hilton’s Kd to be 6.89%. A large portion of Hilton’s debt is long term and coupled with their ongoing operating lease obligations. Note that the cost of borrowing money long term brings a higher interest rate. Since Hilton has a lot of leases on their books and a strong position in long term debt in general, this likely equates to Hilton’s cost of debt (Kd) being slightly higher than some of its industry peers.
Int. Rate
Int. Rate 2006 source
Current Liabilities
Short/Current Long Term Debt
Income taxes payable
Accounts Payable
*1
10-k
*1
4.97%
5.02%
4.97% weight
Kd per item
522 0.04093 0.0020
44 0.00345 0.0002
1,736 0.13611 0.0068
L T liabilities and debt
Long Term Debt and Capital Leases
Insurance reserves &other LTL
Deferred Long Term Liability Charges
Total Liabilities
10-k
10-k
10-k
7.95%
4.25%
7.65%
6946 0.54461 0.0433
1276 0.10005 0.0043
2065 0.16191 0.0124
12754 1.00000
K d = 6.89%
*1 -- 3-Month Treasury Constant Maturity Rate (GS3M)
0.06891
Weighted Average Cost of Capital – (WACC)
The WACC can be computed before or after tax. This is simply done by inserting or removing the tax rate from the equation. The tax in the WACC
AT
is accounted for by (1- tax rate.) The WACC is a product of the K e
and the K d
that was computed above.
WACC =
[
(V d
/ V f
)(
K d
)
]
(V e
/V f
)(
K e
)
V f irm
V d ebt
V e quity
74

The different values of the firm (Vd, Ve, Vf) that are needed to compute the
WACC are in terms of the market value. The chart below was introduced at the beginning of this section for the K e
estimation, and may help give a clearer picture of how these market values of the firm are derived.
Mrkt Cap. = MV e
MV a
= MV f
= MV l
+ MV e
^( K d
) ^( K e
)
For our valuation we used the after tax WACC and estimated Hilton’s WACC to be
7.91%. In 2006 Hilton had a substantial increase in liabilities; as was discussed earlier in relation to some of the Liquidity ratios. The increase in liabilities was mainly attributable to deferred taxes. In 2006 Hilton had to pay a substantial amount of taxes that had been deferred over the recent years. This is primarily the reasons why we feel the after tax method gives us a more realistic idea of
Hilton’s cost of capital.
Hilton’s estimated WACC - (after tax)
7.91 % =
[
(
12,754
/
27,264
)(
.0599
)
1-.35
]
(
14,510
/
27264
)(
.1093
)
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To value a company using the Method of Comparables you look for firms within the same industry that have similar operating and financial characteristics.
You can use a number of different measures of performance for calculations. In this case we use the: trailing and forecasted Price to Earnings (P/E), Price to
Book (P/B), Dividend to Price (D/P), Price to Earnings Growth (P.E.G.), Price to
Earnings Before Taxes, Depreciation and Amortization (P/ EBITDA), Price to Free
Cash Flow (P/ FCF), and Enterprise Value to EBITDA. Each measure of performance is an average of the selected comparable firms multiple applied to the multiple of the firm being analyzed. This method of valuation is widely used for its simplicity. Unlike the other methods used, it does not rely on multiple year forecasts about growth, profitability, any cost of capital measure (P,H,B, p. 7-5.)
However, because this method relies on other firms to estimate a value it can be somewhat erratic. That is the reason we use a number of different performance measures, to see which one may value the firm in question- Hilton, the closest. per share multiples
PPS
forecasted
EPS trailing
EPS
BPS
DPS ebitda PS fcf PS
Trailing Price to Earnings – (P/E)
HLT
34.9
1.56
1.48
9.63
0.16
1.68
1.89
To estimate a share price using the trailing P/E measure, we took the average P/E ratio of the two competitors; Starwood Hotels (HOT) and Marriot
(MAR), then multiplied it by Hilton’s trailing EPS. That yielded an estimated share
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price of $31.5. The estimated share price is less than Hilton’s actual market share price of $34.9. By this measure Hilton’s actual market share price is considered to be overvalued.
HOT MAR Ind. HLT' s (T) EPS Est. share price trailing P/E 14.82 27.79 21.31 1.478 31.49
Forecasted Price to Earnings – (P/E)
The forecasted P/E measure is computed the same way as the Trailing P/E method. The obvious difference being we used forecasted P/E multiples for the competitors and multiplied it by Hilton’s forecasted EPS. This measure yielded an estimated share price of $33.74. Technically this says Hilton’s actual market share price of $34.9 is overvalued. However, this measure yielded the closest estimated share price to Hilton’s actual market price.
HOT MAR Ind. HLT' s (F) EPS Est. share price forecasted P/E 23.17 20.08 21.63 1.56 33.74
Price to Book – (P/B)
The Price to Book measure is computed by multiplying the competitor’s average
P/B ratio times Hilton’s BPS. This measure yielded an estimated share price of
$57.2. This measure states Hilton’s actual market price of $34.9 is undervalued.
Keep in mind that we mentioned earlier this method of valuation can be a little erratic, and give less than accurate estimates.
Avg. HLT' BPS Est. share price
P/B 4.9 6.98 5.94 9.63 57.20
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Dividend to Price – (D/P)
The D/P measure is computed slightly different than the previous ones. To formulate an estimated share price here we divided Hilton’s DPS by the competitor’s average D/P ratio. This measure yielded an estimated share price of
$29.1. By this measure Hilton’s actual market price of $34.9 is overvalued.
Avg. HLT' DPS Est. share price
D/P 0.006 0.005 0.01 0.16 29.09
Price to Earnings Growth – (P.E.G.)
The P.E.G. ratio is simply a company’s P/E ratio divided by the one year projected growth rate of their P/E ratio. To get an estimated share price for this measure we took the average P/E ratio of the two competitors and multiplied it by one minus Hilton’s EPS growth rate, and then we multiplied that value by
Hilton’s EPS. This measure yielded an estimated share price of $29.8. Again, this states that Hilton’s actual market price of $34.9 is overvalued.
HLT' s EPS & EPS growth rate
Est. share price
P.E.G. 14.82 27.79 21.31 1.478 ~ (g = .0534) 29.81
Price to EBITDA – (P/EBITDA)
The Price to Earnings Before Interest, Taxes, Depreciation, and Amortization measure is calculated similar to the P/E measure. The average of the two competitors P/EBITDA ratio is multiplied by Hilton’s EBITDA per share, and yields an estimated share price of $21.2. Once again this measure of the comparables method states that Hilton’s actual market price is overvalued.
P/ EBITDA
HOT MAR Ind. HLT' s EBITDA ps Est. share price
10.1 15.05 12.57 1.69 21.19
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Price to Free Cash Flow – (P/FCF)
The P/FCF measure is also computed similar to the P/E measure. It takes the average P/FCF multiple of the two competitors and multiplies it by Hilton’s Free
Cash Flow per share. It gives us an estimated share price of $78.4. Meaning
Hilton’s actual market value of $34.9 would be undervalued. This measure is a good example of how erratic the Method of Comparables method can be.
HOT MAR Ind. HLT' s FCF ps Est. share price
P/ FCF 64.2 18.8 41.50
Enterprise Value to EBITDA – (EV/ EBITDA)
1.89 78.40
This measure takes into consideration a firm’s Enterprise Value. Which is their
(market value of equity + long term debt + preferred stock) – cash and equivalents. It is also computed similar to the P/E measure. We took the average
EV/ EBITDA multiple of the two competitors and multiplied it by Hilton’s EBITDA per share. This measure once again states that Hilton’s actual market price per share is overvalued.
HOT MAR Ind. HLT' s EBITDA ps Est. share price
EV/ EBITDA 13 16.2 15.58 1.69 24.56
Summary of Method of Comparables
You probably noticed something of a recurring theme with each measure of this method. Six of the eight measures we used to value Hilton under this method yielded an estimated share price that views Hilton’s actual market price of $34.9 to be overvalued. Throughout our analysis of Hilton we have picked up on some indicators that their actual market price per share may be somewhat overvalued.
This valuation underscores our belief that Hilton’s current market price per share is overvalued.
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Discounted Dividends Valuation
The Discounted Dividends Valuation is a method that involves forecasting out future dividends and then discounting them back using a Ke (Cost of Equity) of 10.93% as a discount rate. This is done for ten years with the tenth year value becoming the perpetuity; this perpetuity is also discounted back to the present using the same method above. However, with a perpetuity it is important to note that a growth rate is taken into account in order to discount the perpetuity initially back to the tenth year and then back to the present. In running this model we got a value of $3.04 per share (with 387 million shares outstanding) causing the firm to be over-valued in our estimation. In addition, we found this model not to have a great deal of explanatory power as Hilton just recently began paying dividends.
The above represents the overall valuations sensitivity to a change in the growth rates and the Costs of Equity. In doing this, none of our results caused the firm to be under-valued as compared to the Current Market Price of $36.13 as of
4/21/07.
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Discounted Cash Flows Valuation
The Discounted Cash Flows Model is a method that involves forecasting out future Cash Flows (specifically CFFO and CFFI) and then discounting back those flows to the present. Much like in the previous section, there is a discount rate used; however, the difference lies in that the Cash Flows are discounted back to the present using a WACC (Weighted Average Cost of Capital) of 7.91%, which was discussed previously. In addition, similar to the Dividends Model, the tenth year is used as a perpetuity which is discounted back using WACC and the growth rate to Year Ten and back to the present, using WACC only, after that.
In doing this we got a value of $15.79 per share, causing the firm to be overvalued by our estimation.
The above represents the sensitivity analysis as it relates to this model and once again shows no values to cause the firm to be under-valued as compared to the
Current Market Price of $36.13. The Cash Flow Model does possess more explanatory power than the Dividends Model; however, it is still weak in this power due to the high volatility of forecasting CFFI.
LR ROE/Residual Income Valuation
The Residual Income Model has the most explanatory power of all the valuations and is thus the one that analysts rely on the most. This is due to the
“anchor” of EPS (N.I./Shares Outstanding) which diminishes the disparity between the forecasting of dividends and the forecasting of N.I. The R.I. Model is unique in that it utilizes both N.I. and dividends in order to find a per share
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intrinsic value of the firm. In addition it uses the BVe (Book Value of Equity) to help in this valuation. In running this model, R.I. (EPS - Normal Income) is discounted back to the present using Ke as a discount rate and then the perpetuity is discounted back using a growth rate and Ke to bring it into Year 10 and then just Ke, after that, to discount it back to the present. In running this model we got a value of $20.85 which causes the firm to be over-valued according to our estimation.
The above represents our sensitivity analysis as it relates to this model. Unlike the previous models, this model give us a value of Ke (11%) and growth rates
(5% and 10%) that will cause the firm to be Under-valued as compared to the
Current Market Price of $36.13.
Abnormal Earnings Growth
The Abnormal Earnings Growth model is computed by using a variety of factors. After establishing all of your actual and forecasted earnings per share(EPS), and dividends per share(DPS), you can plug them into the equation.
The previous years DPS is used to multiply with your Ke, or cost of equity percentage, to give you DRIP then Cumulative earnings are obtained by adding this DRIP to your current year’s EPS. The normal income is then subtracted from your found cumulative earnings giving you AEG. The present value factor is needed to find the proper discount rate to discount your future forecasted AEG’s back to the present. Once all PV of AEG’s are summed then you can take your PV of the perpetuity and add them together along with your core EPS, and this
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number gives you your intrinsic value estimation for Abnormal Earnings. In doing this we got a value of $49.33 which causes the firm to be Under-valued in our estimation.
The above represents our sensitivity analysis as it relates to this model. Unlike the previous models, this model give us values of Ke (2.5%, 5%, and 11%) and various growth rates that will cause the firm to be Under-valued as compared to the Current Market Price of $36.13.
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Altman’s Z-scores 2002 2003 2004 2005 2006
1.66 1.84 2.08 2.42 1.45
The Altman’s Z-score for Hilton Hotels Corporation shows their credit risk.
By having a Z-score below 1.8 throws a red flag and tells analyst that a company may be heading towards bankruptcy. Since Hilton is an asset based corporation you can assume the low Z-score can be explained by its large amounts of debt.
The most recent drop from 2005 and 2006 was due to a large asset purchase of
Hilton International where Hilton Hotels Corp. issued a large amount of debt. I would expect that this Altman Z-score will not have much change in the positive direction in the near future because of Hilton’s future plans to purchase up to 50 luxury hotels by 2010.
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As analyst we have performed in-depth evaluations and calculations of Hilton
Hotels Corporation as a firm. With this analysis we were able to use different valuation models to calculate estimated intrinsic value. Our actual price of Hilton
Hotels Corp (HLT:NYSE) as of April 21, 2007, was $36.13 at day closing and had a 52 week range of $23.19-$38.00. The valuation models showed estimated values of $3.04 in the Discounting Dividend model, $15.79 for the Free Cash
Flows, $20.85 for the Residual Income and, $49.33 for the Abnormal Earnings
Growth model. The average estimated intrinsic value of Hilton using all of the valuation models is $22.25, and the estimated intrinsic value of the residual income valuation model, the most reliable model, is $20.85. If the low estimate of the Discounted Dividend model and the high estimate of the Abnormal
Earnings Growth model are implied to be outliers and taken out, the average value is $18.32. With both the averages, with and without the outliers, and the most reliable intrinsic values being below the actual price, as well as the 52 week price range, this tells us to believe Hilton is slightly overvalued. Since all of our valuation models were relatively close estimates within each other as well as compared to the actual price per share, we can conclude that they are accurate.
With the calculations showing us a distinct overvaluation of Hilton in almost all valuation models, we recommend no purchase of Hilton stock and to utilize the opportunity to sell.
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1.) http://hiltonworldwide.hilton.com/en/ww/company_info/company_info.jhtml;jses sionid=0EKBNUX2I4SKYCSGBIW2VCQKIYFCVUUC
2.) http://www.morningstar.com
3.) http://www.finance.yahoo.com
4.) http://www.hilton.com
(2002, 2003, 2004, 2005, 2006 10-K)
5.) http://hsc.csu.edu.au/economics
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Appendix 1 (Financials, Ratios, and Valuation Models)
Ratios
A

Common Size Income Statement
B

Common Size Cash Flows
C

Common Size Balance Sheet
D

Common Size Balance Sheet cont.
E

Avg. Actual Common Size
F

Discounted Cash Flows Model
G

Discounted Dividends Model
H

Residual Income Model
I

Abnormal Earnings Model
J

3 month Regression Analysis
72 1.1052 0.2245 0.1093
5 year Regression Analysis
10 year Regression Analysis
1 year Regression Analysis
7 year Regression Analysis
K

Return Series
L

Return Series cont.
M

3 month
N

O

P

1 year
Q

R

S

5 year
T

U

V

7 Year
W

X

Y

10 Year
Z

AA

BB