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1.

Define equity valuation models and


explain the information required to
value equity securities. (p. 14-4)

2.

Describe and apply the residual


operating income model to value
equity securities. (p. 14-5)

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3.

Explain how equity valuation models can


aid managerial decisions. (p . 14-1 0)

D U L E

perating-lncomeased Valuation

the three years prior to 2008, corporate earnings were steady and climbing , stock prices grew continuously, and growth
peared limitless. Then , the recession of 2008-2009 hit. Almost all companies saw revenues and profits decline. Healthcare
companies, however, weathered the storm reasonably well. Compared to
other sectors, healthcare tends to be less sensitive to econom ic changes
for three reasons. First, demand for healthcare products persists as the
U.S. population ages regardless of current events. Second, healthcare
products are fairly immune to depressions in the economic cycle as consumers and patients need products and devices regardless of economic
alth. Third, government spending in healthcare is a large portion of overall healthcare spending, approaching $13 trillion
2011. Government healthcare spending does not closely mirror economic changes as highlighted in the following graph.
c:

..

$1 ,500

i:i5

VI

$1 ,000

Cl>

....

..

$500

::c

$0

co
.::::.

(,)

cuCl>

14,000

13,000

12,000

11 ,000

10,000

<(

::;

9,000
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

8,000

..... oow-Jones

Healthcare cost

Johnson & Johnson (J&J) is a dominant company in the healthcare industry. The company engages in the research
d development, manufacture, and sale of various healthcare products. Among healthcare firms, Johnson & Johnson often is
favorite for those who seek so-called ruler stocks. A ruler stock is one that has an earnings plot with an upward sloping line,
if drawn with a ruler. By this definition, Johnson & Johnson is a classic ruler stock, as the gr~ph below shows.

Cl>

(,)

;:

a.

Johnson & Johnson's Price and EPS

80
70
60

-,---------------------------~6 . 00

50

-+--.!:::========-------------..a.11-_I"~J___---::;-.;'-'.:.._l~--r

Price 1 - - - - - - - - - --

EPS

- - - -- .---=--.,...,.t--- "TI

5.00
~

40 -+-----------------F--'-------,,,,,.~-----+-- 3.00
30 -+----- - - - - - - - - --.11r-- - ---2'""'-- -- - - - - - t

fli

20100 ~
~~~~=====t 0.00
1981 to Present

(continued on next page)

14-2

(continued from previous page)

Sales by
Segment

U.S. and
International Sales
for 10 Years

70
60

(in billions of dollars)

Module 14 I Operating-Income-Based Valuation

50

(in billions of dollars)

Consumer

u.s.

30

Medical Devices
and Diagnostics

50
40

40

Pharmaceutical

70
60

30
20

10

10

2008

2009

L. L.
L. L.
'02 '03 '04 '05 '06 '07 '08 '09 '10

'00 '01

2010

Ruler stocks are arguably attractive because their steady earnings growth hints at more of the same .for th~ future.
Investors often have more confidence in continued earnings growth for a ruler stock than for a company with a history of
erratic earnings.
How has Johnson & Johnson managed to create and sustain such steady earnings growth? Much of the answer rests
in its diversified portfolio of products, which includes consumer, pharmaceutical and medical devices.' The company is a~so
diversified geographically. The two charts above show Johnson & Johnson's balanced product portfolio and strong, growing
international sales.
.
Johnson & Johnson's steady earnings are matched with solid dividend payments. In times of market turr~o il, as during
2011, blue chip stocks with dependable dividends are perceived as providing go_od value _to investors. Some might argue that
Johnson & Johnson might not be the most "exciting" stock, but it is a solid bet in a volatile market.
Supported by its more diversified operations and fueled by a
steady increase in operating profits, Johnson & Johnson's stock
price has nearly completely rebounded from the decline of late
2007 and early 2008, as shown in the graph to the right.
This raises several questions. What factors drive the Johnson
& Johnson stock price? Why do analysts expect its price to continue to rise? How do accounting measures of performance and
financial condition impact stock price? This module provides
insights and answers to these questions. It explains how we can
use forecasts of operating profits and cash flows to price equity
securities such as Johnson & Johnson's stock.
Sources: Johnson & Johnson 10-K and Annual Reports; Yahoo Finance,
www.usgovernmentspending.com.

2007

2008

2009

2010

2011

0 3:

:a 0
e>c
,. c:

,.

Module 7 explains thl\t the value of a debt security is the present value of the interest and principal payments that the investor expects to receive in the future . The valuation of equity securities
is similar in that it is also based on expectations. The difference lies in the increased uncertainty
surrounding the timing and amount of payments from equity securities.
There are many equity valuation models in use today. Each of them defines the value of an
equity security in terms of the present value of forecasted amounts. They differ primarily in terms
of what is forecasted.
The basis of equity valuation is the premise that the value of an equity security is determined
by the payments that the investor can expect to receive. Equity investments involve two types
of payoffs: ( I) dividends received during the holding period and (2) proceeds received when the
security is so ld. The value of an equity security is, then, based on the present value of expected
dividends plus the present value of the security at the end of the forecasted holding period . This
dividend discount model is appealing in its simplicity and its intuitive focus on dividend distribution. As a practical matter, however, the model is not always useful because many companies
that have a positive stock price have never paid a dividend, and are not expected to pay a dividend
in the foreseeable future.
A more practical approach to valuing equity securities focuses on the company's operatino
and investing activities; that is , on the generation of cash by the company rather than the distribu~
tion of cash to the shareholders. This approach is called the discounted cash flow (DCF) model.
The focus of the forecasting process for the DCF model is the company's expected.free cash flows
to the firm, which are defined as operating cash flows net of the expected new investments in net
operating assets that are required to support the business .
Another approach to equity valuation also focuses on operating and investing activities. It
is ~own as the residual operating income (ROPI) model. This model uses both net operating
profits after tax (NOPAT) and the net operating assets (NOA) to determine equity value; see
Mo~ul e 3 for complete descriptions of the NO PAT and NOA measures. This approach highlights
the importance of return on net operating assets (RNOA), and the disaggregation of RNOA into
net operating profit margin and NOA turnover.
When the DOM was introduced in Module 12, it was based on the following relation:
!Vo

Nm
-f

EQUITY VALUATION MODELS

Operating-Income-Based Valuation

r-

stand the determinants of equity value to make informed decisions . Employees at all levels of
understand the factors that create shareholder
value so that they can work effectively toward that objective. For many senior managers, stock
value serves as a scorecard. Successful managers are those who better understand the factors
affecting that scorecard.

an organization, whether public or private, should

International

20

I +re
Both the DCF and ROPI models derive from this basic starting point and are, therefore, mathematically equivalent. Any differences between the estimated valuations of equity using these models arise due to implementaStep 1-Understandlng the BusiMSS Environment
tion issues rather than the frameworks themselves. Assumpand Accounting lnfonnatlon
Modules 1 and 2
tions such as forecast horizon length or terminal growth rate
(discussed later in the module) can be easier to determine
Step 2-Adfustlng and Aa-.lng Flnanclal lnfonnatlon
with less uncertainty for a particular company using a particuand Accounting Information
Profitabilily
Analysis-Module 3
Investing- Modules 6, 9. and 10
lar valuation model , which can lead to a more reliable value
Credit Analysis-Module 4
Financing-Modules 7 and 8
Operations - Module 5
estimate. Following our 4-step process from Module 1, the
quality of our value estimate (Step 4) is based on the quality of our forecasts of future payoffs (Step 3). Further, those
Step 3-FOfeCasting Financial Information
Module 11
forecasts are only as good as the adjustments/assessment of
]"
financi al information made (Step 2) and our understanding of
Step 4-Uslng Information for Valuation
the company's business environment (Step I). If the forecasts
Cost of Capital and Valuation Basics-Module 12
Cash-Flow-Based Valuation-Module 13
made are identical across the different payoffs , the resulting
Operating-Income-Based Va1uat1on-Module 14
Market-Based
Valuation-Module 15
value estimates from the models will also be identical.

Dividend Discount Model

Discounted Cash Flow Model

Steps for Application

Residual Operating Income


Model

Illustrating the Model

Extending the Model

This module focuses on valuino equity securities (we explain the valuation of debt securities in
Module 7). Specifically, we de;cribe and illustrate the residual o~erat!ng _income mod~l (ROP;~
in this module. We then concl ude by discussing the management imphcat1ons from an increas
understanding of the factors that impact values of equity securities. It is important that we under-

L01 Define equity


valuation models and
explain the information
required to value
equity securities.

+ IV

1
1
= ---'----=-

14-3

14-4

14-5

Module 14 I Operating-Income-Based Val uation

Module 14 I Operating-Income-Based Valuation

hurdle oper~ting pr~fit (N OABeg ~ r) is greater than NOPAT. IN either case, we must understand
the economic meaning of a negative ROPI and the valuation implications .
Speci~i cally, ~ecall that .the NOPAT we use in the ROPl model represents future ex pected
net operatrng profits to the firm. Thus, the first step in the ROPI model is to develop reasonable
forecasts of NOPAT. As explained in Module 11 , good fo recasts begi n with sound assumptions.
forecasted NO PAT can sometimes be negative for a certain period such as with new firms or with
firms experiencing an economic downturn. But over the long run , firms cannot sustain continuous
n~g~tive N?PAT as such .fi rms would run short of cash and be closed or forced into bankruptcy.
S1rrular logic leads us to mfer that firms cannot generate such low NOPAT that they do not earn
at least the average investor 's hurdle rate. (Recall that the hurdle rate is the weio-hted averaoe
cost of capital.) Firms that earn profits below the hurdle rate are destroying shareh~lder value.If
a firm consistantly earns less than the hurdl e rate, its shareholders would be better off if the firm
liquidated because they could invest their funds elsewhere and at least expect to earn the hurdle
rate. Thus, it is not economically reasonable to model ROPI that is consistentl y negative for a
viable firm . A ?1.odel that includes negative ROPI in each forecasted period , would suggest that
we need .to ~ev1s1t our forecast assumptions. If ROPI is still negati ve after more careful scrutiny,
the firm is likely not viable and the ROPI model valuation is inappropriate. The value of such a
firm is likely equal to the fair value of its individual assets less the value to settle its liabilities.
Understanding the ROPl model helps us reap the benefits from the di saggregation of return
on net operating assets (RNOA) in Module 3. In addition, the ROPI model is the foundation for
many internal an.d external performance evaluation and compensation systems marketed by management consulting and accounting services firms. 2

RESIDUAL OPERATING INCOME (ROPI) MODEL


LO 2 Describe and
apply the residual
operating income
model to value
equity securities.

The residual operating income (ROPl) model focuses on net operating profit a~er tax (NOPAT)
and net operating assets (NOA). This means it uses key measures from both the income statement
and balance sheet in determining firm value.
The rationale for usi ng the ROPI model is that book value provides an anchor to our valuation
that is then augmented based on earnings. Accounting earnings are a mea~ure of wealth creation,
which measure economic resources generated (revenues) less econorruc resource~ consumed
(ex penses) regardless of whether a cash flow has concurrently occurred. T?e accountin.g earnings
attempt to match accrual recognition to the timing of chang~s in economic value. This measure
of wealth creation provides an alternative approach to valuation w?en compared to the measures
of wealth distribution (dividends) and di stributable wealth generation (free. ~ash flo ws). We hold
an equity security, or any asset, in the expecta.tion that it will create ~dd1t10n~l wealth for our
future consumption. Thi s focus on wealth creation for future consumption has increased the use
of earnings-based valuation in recent years.

ROPI Model Structure


The ROPI model defines firm value as the sum of two components:
Firm Value= NOA+ Present Value of Expected ROPI
where
NOA= Net operating assets

Steps in Applying the ROPI Model

ROPI = Residual operating income


Net operating assets (NOA) are the foundation of fir?1 value under the ROPI ?1o~el. T~is is
potentiall y problematic because we measure NOA u~ing. th~ balance sheet, wh1c.h 1~ unlikely
to fully and contemporaneously capture the true (or mtnns1c) value of all of a firm s ope~at
ing assets.1 However, the ROPI model adds an adjustment that corrects for the ~ndervaluat~on
or overvaluation of NOA . Thi s adjustment is the present value of expected residual operatrng
income, and is defined as follows:

Application of the ROPI model to equity valuation in volves five steps:

1. Forecast and discount ROPI for the horizon period. 3


2. Forecast and di scount ROPI for the terminal period. 4
3. Sum the present values from both the horizon and terminal periods; then add thi s sum to current NOA to get firm (enterprise) value.

ROPI = NOPAT - (NOA 8 eg x r w)

4. Subtract net nonoperating obligations (NNO), along with any noncontrolling interest, from
firm value to yield firm equity value.

Expected NOPAT

5. Divide firm equity va lue by the number of shares outstanding to yield stock value per share .

where
NOA Beg = Net operating assets at beginning (B eg) of period

BUSINESS INSIGHT

r w =Weighted average cost of capital (WACC)


Residual operating income (ROPI) is the net operating profit a firm earns over and above the return
that the operating assets are expected to earn given the firm 's WACC. Shareholde.rs expect the
company to use NOA to generate, at least, a " hurdle" profit to cover the cost of capital C~A_CC) .
Companies that earn profits over and above that hurdle , create value for. s~areholders. This is the
concept of residual income: that is , income earned over and above the mm1?1um amount of return
required by investors. Typically, ROPI is positiv~ but there are ~wo algebr~1c way~ that ROP! c:
be negative: (I) if a company reports a net operating loss- that 1s, NO PAT 1s negative , or (2) if t

If the assets earn more than ex pected , it could be because NOA does not capture all of the firms ' assets. For examt~
R&D and advertisin o are not fully and contemporaneously reflected on the balance sheet as assets though they II e Y
Produce future earni~os. Likewise internall y generated goodwill is not fully refl ected on the balance sheet as an asset.
"'

S imi 1arl y, assets are generall


y not 'written up to reflect unrealized
gains._
Conversely,_somelimes
the ba Iance s hee t overtate
states the true value of NOA. For example, companies can delay the wnte-down of impaired assets and, thus , overs ue
their book values. These examples, and a host of others, can yield reported values of NOA that differ from the fa ir val
of operating assets.
1

ings: Nominal (Risk-Adjusted) vs Real

Module 12 explained that the value of the payoffs (earnings) is unaffected by whether nominal (riskadjusted) or real inputs are used in valuation provided that nominal earnings are discounted using
nominal discount rates (and real earnings are discounted using real discount rates). This means
that in practice, nominal earnings and nominal discount rates are used; analysts do not forecast
real payoffs (earnings).

Ex~mples are economic value added (EVA T") from Stern Stewart & Company, the economic profit model from
McKinsey & Co ., the cash flow return on investment (CFROJ ni) from Holt Value Associates, the economic value management from KPMG , and the value builder from PricewalerhouseCoopers (PwC).
2

When discounting RO_PI , the appropri ate di scount rate (r J is the weighted average cost of capital (WACC), where
the wei ghts are the relative percentages of debt (d) and equity (e) in the capital st ructure applied to the expected returns
on debt (r) and equity (r. ), respecti vely: WACC = r w = (rd X % of debt) + (r, X % of equity); see Module 12 .
4
For an assumed growth , g, the present value of the perpewity of ROPl beyond the horizon period is given by ~0~';.
where ROPlT is the res idual operallng income for the term inal penod , r., is WACC for the firm, and g is the assumed
growth rate of ROPlT fo llow in g the hori zon period . The res ultin g amount is then di scounted back to the prese nt using
the WACC , computed over lhe length of the horizon period .

14-6

14-7

Module 14 I Operating-Income-Based Valuation

Module 14 I Operating-Income-Based Valuation

Illustrating the ROPI Model

is $9,069 milli on , computed as $9,795 m illi on X 0 .92593 (the present value o ne year hence
8
discoun ted at 8%). S imil arl y, the present va lue of201 2 ROPI (two years he nce) is $8,6 14
mi ll ion , computed as $ 10,047 m illi o n X 0 .85734 , a nd so o n th ro ug h 20 15. T he su m of
these present va lues (cumu lative present value) is $33,966 milli o n .
Compute present value of terminal period ROPI. The present va lue of the terminal period

. o f the ROPI model , we use Johnson & Johnson . .Forecasted


To .illustrate app11cat1on
. . financials
for J&J (forecast hori zon of 20 lJ -20 14 and terminal period of 20 I 5) are 111 ~x h 1b1t ~4. l .5 The
fo recasts (in bo ld) are fo r sales, NOPAT, and NOA (the same fo recasts fro m 1ll ustrat1on of the
DCF model in Module 13) . These fo recasts assume an annual ~% sa l ~s growth for the horizon
1 d a term inal period sales O'rowth of 1%, net o perating profit margin (NOPM) of 21 %, and a
net operating asset
(NOAT) of 1.30 (which is
20 10 turnover rate based on
yyear-end NOA, year-end amounts are used because we are forecast mg year-end account balances,
not average ba lances).6 ' 7

p:: ~e~d

I
I

EXHIBIT 14.1

tu~nover

C I0,847 mill ion)

t~e

ROPI is $ 11 3,898 milli on , computed as

Sales (unrounded) . ... . .........

$ 61,587

$64,050.48
(61,587

61 ,587
13,065
45,694

Sales (rounded) ............. .


NOPAT* ..... . ...
NOA** . . . . .......... .:
ROP I (NO PAT - [NOA 809 X rw])
Discount facto r (1 /(1 + rwl~ * ....... .... .
Present value of horizo n ROPI ........ .
Cum present value of horizo n ROPI .... .
Present value of te rminal ROPI . . . ... . .
NOA ............. . .
Total fi rm value ....... . ........
Less NNOt . .....

1.04)

$66,612.49
(64,050.48

1.04)

$69,277.00
(66,612.49

1.04)

$72,048.08
x 1.04)

(69,277.00

$72,768.56
(72,048.08

x 1.01)

64,050
13,451
49,269

66,612
13,989
51 ,240

69,277
14,548
53,290

72,048
15,130
55,422

72,769
15,281
55,976

9,795
0.92593
9,069

10,047
0.85734
8 ,614

10,449
0.79383
8,295

10,867
0.73503
7,988

10,847

..

$ 33,966
113,898
45 ,694
193,558
(10,885)

Firm equ ity value ........... . . . ..

$204,443

S hares outstanding ... . ............


Stock value per share ............

~~O J

or ($ 10,847/0 .07) X 0 .73503 .

2014

2013

2012

2011

1.08

($33,966 milli on) and termina l peri od ($ 11 3,898 m illion), plus NO A ($45,694 milli o n), to
get firm (enterprise) va lue of $ 193,558 m illi o n . We then subtract the value of net no no perating obli gati o ns of $ 10,885 milli o n to get fir m equity va lue of $204,443. Di viding fir m
equity va lue by the 2,738 .1 milli o n shares outstand ing y ie lds the es tim ated per share valuati o n of $74 .67 .

Horizon Period
Reported
2010

~8

Compute fi r m eq uity value. We mu st sum the present va lues from the hori zon period

Application of Residual Operating Income Model

(In millions, except per share


values and discount factors)

2,738.1
74.67

We perfo rm th is valuation as of February 25, 20 11 , which is the SEC fi ling date for J&J's 10-K.
J&J's stock closed at $59 . 13 o n February 25, 20 11. Our valuation estimate of $74 .67 indicates
that the company 's stock is underva lued as of that date . J&J's stock price c limbed steadi ly thro ugh
the spring of 20 11 and was trading fo r $65 by July. Our estimated price is hi gher than analysts'
target pri ce but J&J was still recommended as a strong BUY stock.
The ROPI model estimate fo r J&J is equal to that computed using the DCF model illustrated
earlier in Module 13. Thi s is the case so long as the fi rm is in a steady state, that is, NOPAT and NOA
are growing at the same rate (for example, when RNOA is constant). When the steady-state condition
is not met, fo r example, when a company has variable growth rates over time or when profit margins are changing from year to year, the two models yield diffe rent valuations. (The terminal period
estimate of ROPLr+i is normally computed as ROPLr + 1 = [NOPATT X (l + g)] - (NOAy X r,).
A common mi stake is to compute it as ROPLr+i = [ROPIT X (l + g)]. The diffe rence is that the
latter computatio n requires that NOA grow at rate g from period T to T + I , which may or may not
be an intended assumption.) Analysts typically compute va lues fro m several models and use qualitative analys is to determine a fin al price estimate.

o
re rted in the tax footnote to its 201O 10-K, NOPAT for 2010 is computed as follows ($ .
_ $
_ $
]}) = $ ,
. A note on rounding: To forecast sales, we multiply pnor
'Given J&J 's combined federal and state statutory t~ rate of ~.O l'o ~ x ~
13 065
768
107
13
35
millions): ($61 ,587 - $18,792 - $19,424 - $6,844)
($3,6
{o.
[
.
Th n we round each year's forecasted sales to whole units and use

1
00
year's unrounded sales by (1 + Grow1h rate); this is done for the horizon an~ ~en111~a :n ~- sucec~ssive step we round the number to whole units before proceeding
rounded sales to compute NOPAT and NOA, where both are rounded to w o e urn s.
eac

55

Discounted cash fl ow (DC F) and resi dual operating income (ROPI) models yield identical esti mates
when the expected payoffs are forecasted for an infinite horizon. For practical reasons, we must use
horizon period forecasts and a terminal period forecast. This truncation of the forecast horizon is
a main cause of any difference in value estimates for these models. Importantly, if we can forecast
(GAAP-based} NOPAT and NOA more accurately than forecasts of cash inflows and outflows, we
will obtain more accurate estimates of firm value given a finite horizon .

to the next step.

$ 694
. .
. $ 2 908 - $19 355 - $8 303) - ($46 329 - $7 ,617 - $9 ,156) = 45,
.
.. NOA computations for 2010 follow($ m1Jhons). ( 10 ,
'
.
.'
'
. .
_
_
= ${10 ,885). J&J 's NNO is negative
56 579
tN NO is the difference between NOA and total shareholders' equity; 1n this case NNO ($ m1l11ons) - 45, 69 4
because it carries substantial cash and securities that exceed its debt.
.
:j:For simplification , present value computations use discount factors rounded to 5 decimal places.

T he bottom line of Ex hibit 14 .1 is the estimated J&J equi ty value of $204,443 m i ll i~n , orn~
per share stock value of $74.67. T he present v.alue computat.ions use an 8% WACC as the d1scou
rate. Specifically, we obtain thi s stock valuat10n as fo ll ows.

m ute resent value of horizon period ROPI. The fo recasted 2011 ROPI of $9 ,7_95

1.

The weighted average cost of capital (WACC) for J&J is computed using the fo ll ow in g three-step process:
I.

The cost of eq ui ty capital is given by the capital asset prici ng model (CA PM): re = r + ~ (r,,, - r ), where ~ is the
1
1
beta of the stock (an esti mate of stock pri ce vari abili ty that is reported by several services such as Yahoo!
and Standard
and Poors), r1 is the ri sk-free rate (commonly assumed as the I0-year treasury bond rate), and r,,, is the expected return
to the entire market. The expression (r,,, - r1) is the "spread" of eq uities over the risk-free rale , often assumed to be
about 5% to 7%. For J&J, given a beta of 1.00 and a 10-year treasury bond rate of 3.58% (r ) as of February 28 , 20 11 ,
1
r, is estimated as 9.58%, computed as 3.58% + ( 1.00 x 6%).

2.

Two alternative computations for pretax cost of debt capital are: ( I) Interest expense/Average inte rest-bearing debt,
and (2) Weighted-average effective interest rate on debt . For the latter, J&J reports its 5.25% rate in footnote 7 to its
10- K, whi ch we use. To obtain J&J's after-tax cost of debt capital, we multi ply 5.25% by I - 0.360, where 36.0%
is the federal and state statutory tax rate from its tax foo tnote, yiel ding 3.36% (J&J's after-tax cost of debt).

3.

WACC is the weighted average of the cost of eq ui ty capital and the cost of debt capital. J&J capital structure is 77%
equity and 23 % debt. Thus, J&J's weighted average cost of capital is (77% X 9 .58%) + (23 % X 3.36%) = 8. 15%,
rounded to 8% . (The capital structure of J&J depends on its stock price. To achi eve an internall y consistent va lue
estimate, an iterative process can be used where the esti mated val ue !in thi s case $74 .67 1 is used to recompute its
capital struct ure and get an updated WACC esti mate. After several iterations, the valuation estimate and the weights
used to compute WACC converge.)

;~lli~n is ~omputed from the forecasted 2011 NO PAT ($ 13,45 1) less th~ product of begin~
ning peri od NOA ($45,694) and WACC (0 .08). The present value of thi s ROPI as of 201

s We use a four-period horizon in the tex t and

assignmen~s simp:if~ the :~~o~~1i~~ t~:de~ou~~~~~utr~ ~y~~~:~;~::~

to
burden. In practice, analysts use spreadshe_ets to forecas t uture cas i

ows

have a forecast horizon of seven to ten pen ods.

1
d d . . trative

h
cost of ooods sold selhn 0 enera , an a m1111 s
NOPAT eq uals revenues less operati ng expenses sue as .
"'
, d
"'~"' s or losses from financial
d
NO PAT excludes any interest reven ue and mterest expense an any ,,am
.
d
reflects the operati ng si de of the firm as opposed to nonoperating activities such as borrowmg an
securi ty in vestment act ivi ti es. NOA eq uals operati ng assets less operall ~g habil 1t1es. (See Modul e 3 .~ d I 11 I this
7 NOPAT and NOA are typicall y forecasted using the detail ed .forecastmg procedures ~1 scussed 111
o ut~e v~l:ation
module we use the parsimonious method to multiyear forecas t111 g (see Modu le 11 ) to ocus attention on
process .

~::~~!~~; N~~~T

14-8

14-9

Module 14 I Operating- Income-Based Valuation

Module 14 I Operating-Income-Based Valuation

(1 + [r j2]). The Oppenheimer report in ~ppendix 138 applies a mid-year adjustment factor. For
of 8% would yield an adJustment factor of 1.04 , whi.ch increases

J&J, our
estimate
t" WACC
.
$
the
val ua ion estimate to 212,626 ($204,448 X 1.04), or $77.65 per share.

Extending the ROPI Model


The Johnson & Johnson illustration makes several assumptions that can be refined to derive more
precise stock values. We describe some of these refinements here.

Reverse Eng~~eerin~. One alte~ative to s~nsitivity analysis is to use reverse engineering in


an ~ttempt to unlock the m.arket s a~sumpt1ons in determining price. The process of reverse
engm~enng uses observed pn.c e combined with valuation assumptions to solve for one of the
valuat10n parameters such as discount rate or terminal growth rate. If the observed market price of
Johnson & Johnson of $59 .13 a~ February 25, 2011, is used with the other assumptions in Exhibit
14.1 , we can s?lve fvr the .tcrmmal. gro":~'th rate (often implemented using reiterative estimation).
In our case, this process yields an implied terminal growth rate for ROPI of -3 2 m A
l t
Id h d .
. -10 . n investor
or ~a ys cou . t. en ec1de whether he or she believes this rate to be too high or too low as a
basis for determmmg a buy or sell decision.

Horizon Period. The illustration uses a relatively short horizon period. It might be more reasonable to anticipate growth for longer than four years before the company achieves a long-term
growth of I%, as in our example. The downside to much longer horizon periods is that it is more
difficult to accurately project growth as the time horizon extends. Thus, the shorter horizon period
might provide a more conservative stock value.
Growth Rate. The illustration assumes a constant growth rate , NOPM and NOAT during the
horizon period. As an alternative, we can alter these, even having different rates for each year. For
example, we might assume that the recent economic downturn will depress J&J's sales for 20 11
and 2012 and, thus, we might forecast a growth rate less than 4% for those two years followed by
4% growth in 2013 and 2014. Similarly, we could change NOPM and/or NOAT for each year to
better match our expectations of future profitability and/or asset efficiency.

MANAGERIAL INSIGHTS FROM THE ROPI MODEL

Financial Statement Forecasts. The illustration uses a parsimonious method to multiyear forecasting to focus attention on the valuation process. As an alternative, we can prepare detailed yearby-year forecasts of the income statement and balance sheet to derive NOPAT and NOA , respectively. Year-by-year forecasts allow us to more precisely model relations on the income statement, and
between the income statement and the balance sheet. For example, the parsimonious model assumes
a constant NOPM of 21 % for the J&J illustration. This implies that all expenses vary in exactly the
same way with revenue growth. We can refine that assumption by including different growth rates
for different expenses. As another example, the parsimonious model assumes one turnover rate for
all net operating assets. In the J&J example, we apply a NOAT of 1.3 , which is the average historic
turnover rate across accounts receivable , inventory, PPE, accounts payable, and so forth. A year-byyear forecast would allow the turnover rates to vary across different operating assets and liabilities
and yield potentially more precise estimates for future expected NOA.
Terminal Growth Rate. A crucial assumption in valuation is the choice of a terminal growth
rate. This rate reflects all future ROPI beyond the forecast horizon, which is captured in terminal
value. Many valuations are sensitive to variations in terminal growth rate. The choice of a forecast
horizon is influenced by whether the company has achieved a long-run steady state where a pattern of future ROPI is expected to persist for the long-run of the company. Ideally, the forecast
horizon is sufficiently long to allow steady state to be achieved within the horizon. The terminal
growth rate can be a positive percentage (but not exceeding the discount rate), or zero, or negative (but not less than -100%). An increase in the terminal growth rate in ROPI for Johnson &
Johnson from 1% to 2% would increase the present value of the terminal ROPI from $11 3 ,898
to $132,881 [$10,847/(0.08 - 0.02)/1.08 4], yielding an increase in estimated value per share of
$6.93 [($132,881 - $113,898)/2,738 .1]. This shows the sensitivity of a valuation to a terminal
growth rate. The quality of our forecasts within the horizon period directly impacts the quality of
our terminal growth rate estimate.
Sensitivity Analysis of Stock Price. The illustration uses only one set of assumptions and derives
only one stock price. To refine our valuation we can perform sensitivity analyses. For example, the
J&J illustration uses 8% for WACC, which is our best estimate of the company's weighted average
cost of capital. We might derive stock value using a larger and smaller WACC to gauge how sensitive the stock price is to changes in the discount rate. Extending this idea, we commonly derive a
"worst case" stock value by simultaneously applying the lowest reasonable assumptions for growth,
NOPM , and NOAT, and the highest reasonable assumption for WACC. We also commonly derive
the "best case" scenario by applying the highest reasonable assumptions for growth, NOPM , and
NOAT, and the lowest reasonable assumption for WACC. This provides a range of reasonable stock
values and gives us more information and confidence about potential outcomes.
Mid-Year Adjustment. Payoffs in our valuation model are assumed to occur at year-end and are
discounted for the entire year. An alternative is to assume that payoffs occur evenly during the
year. A common adjustment in this case is to multiply the estimated value by a mid-year adjustment factor defined as (1 + r ) 05 . Another common approximation of the adjustment factor is

14-10

The R?PI.model defines firm value as the sum of NOA and the present value of expected residual
operating income as follows:

Firm Value = NOA + Present Value of Future [NOPAT - (NOA

Beg

x r )]
w

ROPI
Increasing ROPI , therefore, increases firm value . Managers can increase ROPI in two ways:

1. Decrease the NOA required to generate a given level of NOPAT (improve efficiency)
2. Increase NO PAT with the same level of NOA investment (improve profitability)

Thes~ are two very important observations. It means that achieving better performance requires
effecti ve management o.f bot~ th~ balance sheet and the income statement. Most operating managers
are accustomed to wor.kin.g with ~ncome statements. Further, they are often evaluated on profitability
~easures , such as ach1evmg desired levels of sales and gross profit or efficiently managino operating expenses. The ROPI model focuses management attention on the balance sheet as well.
Manage~ent Focus on Improved Efficiency
The ~wo points above highlight two paths to increase ROPI and, accordingly, firm value. First, let's
consider how mana~eme~t can reduce the level of NOA while maintaining a given ]eve] of NOPAT.
Many managers begm by implementing procedures that reduce net operating working capital, such as:

Reducing receivables through:

0 Better assessment of customers ' credit quality


0 Better controls to identify delinquencies and automated payment notices
0 More accurate and timely invoicing

Reducing inventories through:

0
0
0
0

Use of less costly components (of equal quality) and production with lower wage rates
Elimination of product features not valued by customers
Outsourcing to reduce product cost
Just-in-time deliveries of raw materials

0 Elimination of manufacturing bottlenecks to reduce work-in-process inventories


0 Producing to order rather than to estimated demand

Increasing payables through:

0 Extending the payment of low or no-cost payables (so long as the supplier relationships are
unharmed)

L03 Explain how


equity valuation
models can aid
managerial decisions.

14-11

Module 14 I Operating-Income-Based Valuation

Module 14 I Operating-Income-Based Valuation

Management must also look at its long-term operating assets for opportunjties to reduce unnecessary operating assets, such as the:

Sale of unnecessary property, plant or equipment

Acquisition of production and administrative assets m partnership with other entities for
greater throughput

Acquisition of finished or semifinished goods from suppliers to reduce manufacturing assets

Advantages and Disadvantages of DCF and ROPI Valuation Models


~~~~~~--~~~~~~~~

Advantages

Disadvantages

Performs Best

Popular and widely


accepted model

Cash investments in plant assets are treated as cash


outflows, even though they create shareholder value

When the firm reports positive


FCFF

Value not recognized unless evidenced by cash flows

When FCFF grows at a


relatively constant rate

Cash flows are unaffected


by accrual accounting

DCF

FCFF is intuitive

Management Focus on Improved Profitability

When a long-run steady-state


pattern of FCFF emerges in a
short horizon

- Securitization, which GAAP treats as an operating cash


flow when many view it as a financing activity

Increasing gross profit dollars through:


0 Better pricing and mix of products sold
0 Reduction of raw material and labor cost without sacrificing product quality , perhaps by
outsourcing, better design , or more efficient manufacturing
0 Increase of throughput to minimize overhead costs per unit (provided inventory does not
build up)

Computing FCFF can be difficult as operating cash flows


are affected by
- Cutbacks on investments (receivables, inventories, plant
assets); can yield short-run benefits at long-run cost

The second path to increase ROPI and, accordingly, firm value is to increase NOPAT with the same
level of NOA investment. Management would look to strategies that maximize NO PAT, such as:

ROPI

Focuses on value drivers


such as profit margins and
asset turnovers

Financial statements do not reflect all company assets,


especially for knowledge-based industries (for example,
R&D assets and goodwill)

Uses both balance sheet


and income statement,
including accrual
accounting information

Requires some knowledge of accrual accounting

Reduces weight placed on


terminal period value

When financial statements


reflect more of the assets
and liabilities; including
those items often reported
off-balance-sheet
When a long-run steady-state
pattern of ROPI emerges in a
short horizon

Reducing selling , general, and administrative expenses through:


0
0
0
0

Better management of personnel


Reduction of overhead
Use of derivatives to hedge commodity and interest costs
Minimization of tax expense

Before undertaking any of these actions , managers must consider both short- and long-run implications for the company. The ROPI model helps managers assess company performance (i ncome
statement) relative to the net operating assets committed (balance sheet).
ANALYSIS DECISION

You Are the Chief Financial Officer

The residual operating income (ROPI) model highlights the importance of increasing NOPAT and
reducing net operating assets, which are the two major components of the return on net operating
assets (RNOA). What specific steps can you take to improve RNOA through improvement of its
components: net operating profit margin and net operating asset turnover? [Answer, p. 14-15]

ASSESSMENT OF VALUATION MODELS


Exhibit 14.2 provides a brief summary of the advantages and disadvantages of the DCF and ROPI
models. Neither model dominates the other in all cases, and both are theoretically equivalent.
Instead, professionals must choose the model that performs best under practical circumstances.
There are numerous other equity valuation models in practice. Many require forecasting, but
several others do not. A quick review of selected models follows:
The method of comparables (often called multiples) model predicts equity valuation or
stock value using price multiples. Price multiples are defined as stock price divided by some key
financial statement number. That financial number varies across investors but is usually one of
the following: net income, net sales, book value of equity, total assets, or cash flow. The method
then compares companies' multiples to those of their competitors to assign value.
The net asset valuation model draws on the financial reporting system to assign value. That
is, equity is valued as reported assets less reported liabilities. Some investors adjust reported
assets and liabilities for several perceived shortcomings in GAAP prior to computing net asset
value. This method is commonly applied when valuing privately held companies.

14-12

The dividend discount model predicts that equity valuation or stock values equal the present value of expected cash dividends . This model is founded on the dividend discount formula
and depends on the reliability of forecasted cash dividends .
There are additional models applied in practice that involve dividends, cash flows, research
and development outlays, accounting rates of return, cash recovery rates, and real option models. Further, some practitioners, called chartists and technicians , chart price behavior over time
and use it to predict equity value .

RESEARCH INSIGHT Using Models to Identify Mispriced Stocks

Implementation of the ROPI model can include parameters to capture differences in growth opportunities, persistence of ROPI, and the conservatism in accounting measures. Research finds differences in how such factors, across firms and over time, affect ROPI and changes in NOA. This
research also hints that investors do not entirely understand the properties underlying these factors
and, consequently, individual stocks can be mispriced for short periods of time. Other research
contends that the apparent mispricing is due to an omitted valuation variable related to riskiness
of the firm.

ANALYZING GLOBAL REPORTS


~here _are no differences in the method or technique of valuing equity securities using IFRS
frnancial statements. We can use the ROPI method with IFRS data as inputs and determine intrinsic values. The extent to which NOA overstates or understates market value is corrected by the
present value of future expected ROPJ; this continues to hold when using different accounting
standards such as IFRS. The key is accurate forecasts, which is driven by an understanding of
accou~tin~, the comp~ny, and its environment. The four steps for financial statement analysis and
valuat10n introduced m Module 1, and reproduced at the beginning of this module, are the same
regardless of the accounting standards followed.

14-13

Module 14 I Operating-Income-Based Valuation

Module 14 I Operating-Income-Based Valuation

MODULE-END REVIEW

areholders' equity
ferred stock. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Common stock-par value $1 .00 per share
(authorized 4,320,000,000 shares; issued 3,119,843,000 shares) .... . .... .. ..... . . .. .
Accumulated other comprehensive income . . ... .. . . .... . .. ..... ... .... ...... . . . .. .
Retained earnings ... .. .... ... . ............ ..... ..... . ... ... .. ... ... .. . .... . .
Less: common stock held in treasury, at cost (381,746,000 shares and 365,522,000 shares) . . .

Following are forecasts of Procter & Gamble 's sales, net operating profit after tax (NOPAT), and n
operating assets (NOA). These are taken from our forecasting process in Module 11 and now include a
terminal period forecast that reflects a long-term growth rate of 1% .
Horizon Period
Reported
Sales growth ...... . ....
Net sales (unrounded) ...

$ 82 ,559

Net sales (rounded) ... . .


NOPAT ......... . .....
NOA ...... . ........ ..

$ 82 ,559
12, 193
97,247

2014

2013

2012

2011

(In mllllons)

4.6%
$86,356.71
($82,559 x 1.046)
$ 86,357
12,781
101,596

4.6%
$90,329.12
($86,356. 71 x 1.046)
$ 90,329
13,369
106,269

4.6%
$94,484.26
($90,329.12 x 1.046)
$ 94,484
13,984
111,158

2015
4.6%
$98,830.54
($94,484.26 x 1.046)
$ 98,831
14,627
116,272

1%
$99,818.84
($98,830.54 x 1.01)
$ 99,819
14,773
117,434

3,120
(3,531)
77,773
20,783

3,120
(3,058)
70,306
19,780

Total shareholders' equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

56,579

50,588

Total liabilities ar:id shar<tholdern' equity ... .. . ... . . ... . . ...... . : .... . .. . .. . ...... . .

$102,908

$94,682

2010

2009

2008

$61 ,587
18,792

$61,897
18,447

$63,747
18,511

Gross profit. ....................... .. ..................... .. . .. .


Selling, marketing and administrative expenses .. ... . .. . ........ ... ... .
Research and development expense ... ... .... ..... ................. .
Purchased in-process research and development. . . . ... . .... . ...... . .. .
Interest income . .... . . . .. ... . . . .......... .... . . .. . .......... ....
Interest expense, net of portion capitalized . . ........ . .. .. . . .. .. . . ....
Other (income) expense1 . . . . . . . . . . . . . . . . . . . . . . . . . .
Restructuring .. . ..... ...... ....... . ... .. .......... . ........... . .

42,795
19,424
6,844

43,450
19,801
6,986

(107)
455
(768)

(90)
451
(526)
1,073

. 45,236
21,490
7,577
181
(361)
435
(1,015)

Earnings before provision for taxes on income ... . . ...... . . . ...... .... .
Provision for taxes on income ............... . .................. ... .

16,947
3,613

Net earnings ................ . ..... . . ........ . . . . . .. ... . ........ .

$13 ,334

Income Statement

The solution is on page 14-28.

JOHNSON & JOHNSON FINANC IAL


STATEMENTS
-.,
JOHNSON & JOHNSON

JOHNSON & JOHNSON

Drawing on these forecasts, compute P&G's residual operating income (ROPI) and an estimate of
its stock value using the ROPI model. Assume the following: discount rate (WACC) o~ ~ %, shares
outstanding of 2,765 .7 million , and net nonoperating obligations (NNO) of $29,607 m1lhon (which
includes $36 1 million in noncontrolling interest).

APPENDIX 1 4 A:

15,755
3,489

16,929
3,980

$12,266

$12,949

---

Balance Sheet

-1

2010

2009

Assets
Cash and cash equivalents . ..... .. ..... . ... ....... . .. .. .... ... ....... . . .. .. .
Marketable securities . .. . .. . ...... . ...... . .. . . . ... .. .. . .. .... . .... ..
Accounts receivable trade, net of allowances for doubtful accounts $340 (2009, $333) . . ..
Inventories . .... . . . ... . .... .. .......... . .. ..
Deferred taxes on income .... ... . . .. .... .... . . . .. .... . .. . . .. .... ... . . . .. . . . . .
Prepaid expenses and other receivables ... ....... ............... .. . . . . . . . . . .. .

$ 19,355
8,303
9,774
5,378
2,224
2,273

$15,810
3,61 5
9,646
5,1 80
2,793
2,497

Total current assets .... .... .. ........ ... ... .... . ... .......... . . ... .. . . ... .

47,307

39,541

Property, plant and equipment, net . .......... ... .. . ........ . . . ........ .... . . . . .
Intangible assets, net . .. .. ... .... . .......... . . .. ... .. .................. . ... .. .
Goodwill ... . .............. ... .. . ..... ... ............... . ....... .... ....... .
Deferred taxes on income .. . ....... . . .. ...... . .... ................. .. .
Other assets . .... . ... .... . ... .... .... .. ..... . . . . .. . .. . ........... . .. ....

$ 14,553
16,716
15,294
5,096
3,942

$14,759
16,323
14,862
5,507
3,690

Total assets ...... . ....... . ..... .... ... ........ .... . ...

$102,908

At Fiscal Year End ($ millions, except shares and per share)

1 We classify Other (Income) Expense as nonoperating because it includes, among other items: royalty income; gains and losses related to
the sale and write-down of investments in equity securities; currency gains and losses; non-controlling interests; and hedge ineffectiveness.

"""-

Liabilities and Shareholders' Equity


Loans and notes payable . ........ . .. .... . ...... ... .. ..... .. . .... . .. . ...
Accounts payable ..... . ....... . ...... . . .... .. .. . .. .. . ..... .. .... . . . .. .. ..
Accrued liabilities .. .. .. . . . .... . ...... ........ .. . .... . .. . . .. . ... .. . . . .. . . ..
Accrued rebates, returns and promotions .. ..... . ... .. ..... ........ . ...... ....
Accrued compensation ... . ......... . .... . . .. ..... . ...... . ... .. ... . .... .. ..
Accrued taxes on income .. ...... . .... .. ... . . . . ............ .. .. ... ... .. . . . .

7,617
5,623
4,100
2,512
2,642
578

$94,682

--$ 6,31 8
5,541
4,625
2,028
2,777
442

$21 ,731

Total current liabilities .. ......... . . . .. .... ... . . . . . .. . .. .... . .. . .... .. . ..

$ 23,072

Long-term debt . ... . . . ..... . .... . ... . . . ... ... ..... .. ..


Deferred taxes on income ..... ... ............ .. . . . ...... . . . .. .... . . . .
Employee related obligations . . . . . ... ........ .... . . . . .... .. .... . .. . . . .. .... . ... .
Other liabilities . ..... . ... ...... .... . . . . .. . . ...... ... .

9,156
1,447
6,087
6,567

8,223
1,424
6,769
5,947

Total liabilities . ....... .. ...... .. .... . .... ... ........ . .... ... .. . ... . . ... .... .

$ 46,329

$44,094
continued

JOHNSON & JOHNSON


Statement of Cash Flows

~ Fiscal Year Ended ($ mlllons)


Cash flows from operating activities
Net earnings . ....... ..... ... .. . ... .. . .. ... ... .................. .
Adjustments to reconcile net earnings to cash flows:
Depreciation and amortization of property and intangibles .. .. . . . ...... .
Stock based compensation . .... . ... ....... ..... ... .............
Purchased in-process research and development .. ..... ...... ... ....
Deferred tax provision ... ........ .... ... ... . .... . ..... . . ..... . . .
Accounts receivable allowances ..... .. ....... . .. . . . . . ........... . .
Changes in assets and liabilities, net of effects from acquisitions:
(lncrease)/decrease in accounts receivable .... ..... . ..... .... . . .... .
(lncrease)/decrease in inventories . . ... . . ...... . ... . .... ...... .. . . .
lncrease/(decrease) in accounts payable and accrued liabilities .. ... .. .. .
(lncrease)/decrease in other current and noncurrent assets .. . .. .... . .. .
Increase in other current and noncurrent liabilities .. .. . . . . ............ .

2010

2009

2008

$13,334

$12,266

$12,949

2,939
614

2,774
628

356
12

(436)
58

2,832
627
181
22
86

(207)
(196)
20
(574)
87

453
95
(507)
1,209
31

(736)
(101)
(272)
(1 ,600)
984

Net cash flows from operating activities ... . . .. .... . ........ .... . . ... .

16,385

16,571

14,972

Cash flows from investing activities


Addition to property, plant and equipment. . . ...... ..... .. ...... ... ... .
Proceeds from the disposal of assets ...... .. .... . ....... ..... ...... .
Acquisitions, net of cash acquired . .... .... .. . . .. . . . .... . .... .. ..... .
Purchases of investments .. . ..... .. ....... . . . ... ...... . ... . .. .... .
Sales of investments .... ..................... .... ... . . ......... . .
Other (primarily intangibles) .... .. . .... . ...... . .. .. .... ........ .... .

(2,384)
524
(1,269)
(15,788)
11 ,101
(38)

(2 ,365)
154
(2,470)
(10,040)
7,232
(109)

(3,066)
785
(1,214)
(3,668)
3,059
(83)

Net cash used by investing activities ................... . . . ...... ... . .

(7,854)

(7,598)

(4,187)
continued

14-14

14-15

Module 14 I Operating-Income-Based Valuation

Module 14 I Operating-Income-Based Valuation

continued from prior page

Cash flows from financing activities


Dividends to shareholders . .. .. . . .... . . ...... . ... .. ... . . .. . . . . . . .. .
Repurchase of common stock . . .. . ..... . . . . . ... . ...... . ..... . .. . . . .
Proceeds from short-term debt ..... . . .. .. . . .. . ... . . . . . . . . .... . .. . . .
Retirement of short-term debt . .. ... .... . . .. ...... . . .... . . .. .. . .. .. .
Proceeds from long-term debt .. .. ... . . . ... . .. . . . . . ... .. . .. . . . . .. .. .
Retirement of long-term debt .. . . . . . ..... . . ..... . . .... . . .. . ... . . . .. .
Proceeds from the exercise of stock options/excess tax benefits .. ... ... . .
Net cash used by financing activities . . . . . . ... ... . . . ..... . . . . . . . .. ... .

1\114-9.
(5,804)
(2,797)
7,874
(6,565)
1,118
(32)
1,226

(5,327)
(2 ,130)
9,484
(6,791 )
9
(219)
882

(4,980)

(4,092)

---

Effect of exchange rate changes on cash and cash equivalents ... . . . . .. . . .

(6)

161

Increase in cash and cash equivalents .. ... . . . . . . . ... . . . . ..... . .. . .. . .


Cash and cash equivalents, beginning of year . . . . . .. . . . . . . . . .. . . . ... . .

3,545
15,810

5,042
10,768

Cash and cash equivalents, end of year . . . .. ... . . ... . . . . . . . ... . . . . . . .

- - -

- --

$19,355

$15,810

(5,024)
(6,651)
8,430
(7,319)
1,638
(24)
1,486

--

(7,464)

Co.m puting, Ana lyzing a nd Interpreting R esid ual O p erating Incom e (ROPI) (L02)
In its 20 IO fis cal year annual report , CVS reports net operating income after tax (NOPAT) of $3 ,777mil hon. As of the beginning of fisca l year 20 I 0 it reports net operatin g assets of $45 ,889 millio n.

a.
b.

1\114-10. Estima ting S ha r e Value Using the ROPI Mod el (L02)


Fo llowing are fo recasts of Target Corporation 's sales, net operatin g profit after tax (NOPAT) , and net
operating ilssr.ts (NOA) as of Jan uary 29 , 20 I I .

Sales .. . ....... . . .
NOPAT .. . .. . . ... .
NOA . .. . . . ... . ...

Q 14-2.

Define the weighted average cost of capital (WACC).

Q 14-3 .

Define net o perating profit after tax (NOPAT) .

Q14-4.

Define net o perating assets (NOA ).

Q14-S.

Define the concept of residual operating income . How is residual operatin g income used in pricing
equity securities?

Q14-6.

What insight does disaggregation of RNOA into net operatin g profit margin and net operati ng asset
turnover prov ide for manag ing a company?

Assignmen ts with the ~ logo in the m argin are available in an online homework system.
See the P r eface of the book for details.

M14-7 .

STARBUCKS
(SBUX)

M14-8.

HALLIBURTllN
COMPANY
(HAL)

Inter preting Earnings Annou ncement Effects on Stock Prices (L01, 2)


In a recent quarterl y earnings announcement , Starbucks announced th at its earnings had markedly
increased (up 7 cents per share over the prior year) and were I cent higher th an analysts ' ex pectations.
Starbucks' stock "edged higher," according to The Wall Street Journal, but did not markedl y increase.
Why do you believe that Starbucks ' stock price did not markedly increase given the good news?
Com p u ting R esidual Operating Income (ROPI) {L02)
Halliburton Company reports net operating profit after tax (NO PAT) of $2 ,0 32 million in 2010 . Its net
operatin g assets at the beginning of 2010 are $9 ,937 million . Assumin g a 10% weighted average cost of
capital (WACC), w hat is Halliburton's residual operating income for 2010 ? Show computations.

TARGET
CllllPUllA TIUN

Horizon Period

Reported
(In mllllons)

$10,768

In general, what role do expectati ons play in pricing equity securities? What is the relati on between
security prices and ex pected return s (the di scount rate , or WACC , in this case)?

(CVS)

(TGT)

2,998
7,770

margin and net operating asset turnover. Net operating profit margin can be increased by im proving gross profit
margins (better product pricing , lower-cost manufacturing , etc.) and closely monitoring and controlling operating
expenses. Net operating asset turnover can be increased by reducing net operating working capital (better monitoring of receivables, better management of inventories, carefully extending payables, etc.) and making more effective use of plant assets (disposing of unused assets, form ing corporate alliances to increase plant asset capacity,
selling productive assets to contract producers and purchasing the output, etc.). The ROPI model effectively
focuses managers on the balance sheet and income statement.

1:vs l:AllEMAllK

Did. CVS earn p~s iti ve residual operatin g income (ROPI) in 2010 if its weighted average cost of
capital (WACC) 1s 7%? Explain .
At what level of WACC would CVS not report positive residual operating income fo r 2010? Explain .

You Are the Chief Financial Officer RNOA can be disaggregated into its two key drivers: net operating profit

14- 16

2011

2012

2013

2014

2015

Terminal
Period

$67,390

$70,086

$72,889

$75,805

$78,837

$79,625

3,397
29,501

3,504
30,472

3,644
31 ,691

3,790
32,959

3,942
34,277

3,981
34,620

Answer the fo llowing requirements assumin g a terminal period growth rate of I%, discount rate (WACC)
of 7%, shares outstanding of 704 million, and net nonoperating obligations (NNO) of $ 14,014 million.

a.
b.

Estimate the value of a share of Target common stock using the residual operatin g income (ROPI)
model as of January 29 , 2011 .
Target Corporation (TGT) stock closed at $49.99 on March 18, 2011. How does your valuation estimate compare w ith this closing price? What do you believe are some reasons fo r the di fference?

El4-11. Estima ting Sha r e Value Using t he ROPI M odel (L02)


Following are forecasts of Abercrombie & Fitch 's sales, net operatin g profit after tax (NOPAT), and net
operating assets (NOA) as of January 29 , 2011 (Current-year NOPAT is lower due to transitory items;
we use a longer term estimate for NOPM of 8% .).

~
AREHCllUMBIE &
FITCH
(ANF)

Horizon Period

Reported

(In mHlions)
Sales .. .. . . .. .. ..
NOPAT .. . ... .. . .
NOA . . . . ... .. ...

2011

2012

2013

2014

2015

$3,469
152
1,032

$3,989
319
1,173

$4,587
367
1,349

$5,275
422
1,551

$6,066
485
1,784

'nlnnlnel
Period
$6,187
495
1,820

Answer the fo llowing requirements assuming a discount rate (WACC) of 10%, a terminal period growth
rate of 2%, common shares outstanding of 87 .2 million , and net nonoperating obligations (NNO) of $(858)
mi llion (negative NNO reflects net nonoperating assets such as investments rather than net obligations).

a.
b.

Estimate the value of a share of Abercrombie & Fitch common stock using the residual operating
income (ROPJ ) mode l as of January 29 , 2011 .
Abercrombie & Fitch stock closed at $56.71 on M arch 29 , 2011 . How does your valuation estimate
compare with this closing price? What do you believe are some reasons fo r the differen ce?

E14-12. Estima ting S ha r e Value Using the ROPI Mod el (L02)


Following are fo recasts of sales, net operating profit after tax (NOPAT) , and net operatin g assets (NOA)
as of February 26 , 2011 , for Best Buy, Inc.

~
BEST BUY
(BBY)

Horizon Period

Reported

(In mllUona)
Sales . . . ....... ..
NOPAT . . . .. . .. . .
NOA . . . . .. . .... .

2011

2012

2013

2014

2015

Terminal
Period

$50,272
1,389
7,876

$52,786
1,584
8,248

$55,425
1,663
8,660

$58,196
1,746
9,093

$61,106
1,833
9,548

$61,717
1,852
9,643

14-17

Module 14 I Operating-Income-Based Valuation

Module 14 I Operating-Income-Based Valuation


Answer the following requirements assuming a discount rate (WACC) of 11 % , a terminal period growth
rate of I %, common shares outstanding of 392.6 million , and net nonoperating obligati ons (NNO) of

Identifying and Computing Net Operating Profit after Tax (NOPAT) and Net Nonoperating
Expense (NNE) (LO 1, 2)
Following i s the income statement for Halliburton Company.

$1 ,274 mjllion.

a.

Estimate the value of a share of Best Buy common stock using the residual operating income

b.

(ROPI) model as of February 26 , 20 11 .


Best Buy (BBY ) stock closed at $30 .20 on April 25 , 2011. How does your valuation estimate compare with this closing price? What do you believe are some reasons for the difference?

(HAL}

:1
2010

2009

$ 1,398
3,924
653
257
714

$ 2,082
2,964
1,598
1,312
210
472

Total current assets .. . . . .. . . . . ... . . .. .. . .. . . .. . . . . . . . .... .


Property, plant and equipment-net . . . .. . . .. . .. . . . . ... .. . .. . .
Goodwill . . .. .. ... . . . .. ... . . . . ..... . . . . . . . ...... . . . .. .. . .
Other assets . . . . .... . ..... . .. . . .. . ... .. ..... . .. . .. .. ... . .

8,886
6,842
1,315
1,254

8,638
5,759
1,100
1,041

Total assets ......... ... .. . .. . . ... . . . .... . .... . . . ... . .. . . .

$18,297

$16,538

$ 1,139

At December 31 (Miiiions of dollars and shares)


Assets
Cash and equivalents. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Receivables, net .. . ... . ... . . ... .. . . . . .. . .... .. .. .. ... . . .. .
Inventories ...... . .. .. .. . . . . . . . .. . .. .. . . ..... . .. . . . ..
Investments in markeatable securities . . . . . . . .. . .. . .... .... . . . .
Current deferred income taxes ... . . . . ... . ... . ... . ... . . . ... . . .
Other current assets . . ... .. . . . . ... . ....... .. .. . . . . . . . . . . . . .

Liabilities and Stockholders' Equity


Accounts payable .. . . . .. . .. . . . . .. . . . . . . . . .... . .. . .. . . ..
Current maturities of long-term debt . . ....... . . . . ... .. ... ... . .
Accrued employee compensation and benefits . .. . . .. . .... . ... . .
Deferred revenue . . . .. . .. . .... . . . . . ... . .... . . . . .... . .. . . . .
Other current liabilities . . .. . . . . . . .. . . .. . .. .. .. . . . ... . . . . . .. .
Total current liabilities . . .......................... . . ... .... .
Long-term debt ... .. . ... . ... .. .. .. .. .. .. . ... . . ... .. ..... .
Employee compensation and benefits . . . . . . .. . . . . ......... . .. .
Other liabilities .... . . . . . . . .. .. . ... . . .. .. .. .. . .... . ...... . .

1,940

716
266
636
2,757
3,824
487
842

2,889
3,824
462
606

Total liabilities .... . . .. . ... . .. .. . . .... .. .... .. . ..... . .. . .. .

7,910

7,781

Shareholders' equity
Common shares, par value $2.50 per share-authorized 2,000 shares,
issued 1 ,069 shares and 1,067 shares .. .. . . .... . . .. .. .. . ... .

2,674

2,669

Paid-in capital in excess of par value . .. . . . . ........ . .. . ...... .


Accumulated other comprehensive loss ... ... . ... . . . . . . . . . ... .

b.

2008

$13,779
4,194

$ 10,832
3,843

$13,391
4,888

Total revenue . . . . ...... . . .. . .. . . .. . . . . . .. .. . . . . .. .


Operating costs and expenses

17,973

14,675

18,279

Cost of services ....... . .. . .. . .. .... .. .... .. ...... .


Cost of sales ...... . . . .... . . .. . . .............. . ... .
General and administrative... . ... ... . .... . .... . . .. .. .

11,237

9,224
3,255
207
(5)

10,079
3,970
282
(62)

of operating assets, net . . .......... ... . . . .

3,508
229
(10)

Total operating costs and expenses . .. . . . . . . . . .... .... .

14,964

12,681

14,269

Operating income . . .. . .... ..... .. . . . . . ... . .... . ... .


Interest expense, net of interest income
of $11 , $12, and $39 . . ...... . ... . ... . .. . .. . .. .. . . .
Other nonoperating expenses, net .. . . . . ... . . . . .... . .. .

3,009

1,994

4,010

(297)
(57)

(285)
(27)

(128)
(33)

Income from continuing operations before


income taxes .... . ... . . ... . . . .... .. ....... . .... .
Provision for income taxes .. . .. .. ..... .... . . .. . . . . . . .

2,655
(853)

1,682
(518)

3,849
(1,211)

Income from continuing operations .. . .. . ... . . . . . . . .. . .

1,802

1,164

2,638

Income (loss) from discontinued operations,


net of income tax . ... .. ... . .... . .. . .. . . . .... . .. . .

40

(9)

(423)

Net income ... . . . .. ... . ... . .. .. . . . ... .. . ....... . . .

1,842

1,1 55

2,215

Noncontrolling interest in net income of subsidiaries . ... . .

(7)

Net income attributable to company .... . . . ...... . .. . . .

$1,835

(10)

$ 1,145

$ 2,224

Compute net operating profit after tax (NO PAT) for 20 JO , assuming a federal and state statutory tax
rate of 35 %.

E14-15. Estimating Share Value Using the ROPI Model

(L02)

Following are forecasts of Halliburton Company's sal es, net operating profit after tax (NOPAT) , and
net operating assets (NOA) as of D ecember 31, 2010.

HALLIBUllTIJN
COMPANY
(HAL)

411

339
(240)

(213)

Retained earnings ..... . . .. . .... .. . .. ... ... .. . ... .. . . . . .. .

12,371

10,863

Treasury stock, at cost-159 and 165 shares . .. . . . . .. .. . . .. . .. .

(4,771)

(5,002)

Company shareholders' equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

10,373

8,728

Noncontrolling interest in consolidated subsidiaries. . . . . . . . . . . . . .

14

29

Total shareholders' equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

10,387

8,757

Total liabilities and shareholders' equity. . . . . . . . . . . . . . . . . . . . . . . .

$18,297

$16,538

Compute net operating assets (NOA) and net nonoperating obligations (NNO ) for 2010 .
For 2010 , show that: NOA= NNO +Stockholders' equity.

Horizon Period

Reported
(In mlllons)
Sales .. . . . . . . . . ..
NOPAT .. .. . . ... .
NOA . .. .. .... . . .

Tennlnal

2010

2011

2012

2013

2014

Period

$17,973
2,032
12, 160

$21,028
2,376
14,208

$24,603
2,780
16,624

$28,786
3,253
19,450

$33,680

$35,027
3,958
23,667

3,806
22,757

Answer the fo llowing requirements assuming a discount rate (WACC) of I 0 %, a terminal period growth
rate of 4 %, common shares outstanding of 910 million , and net nonoperating obligations (NNO) of
$1 ,787 million .

a.
a.

2009

Services . .. .... .. . .. . . . .. .. . . . ......... . . . .... . . . .


Product sales . .... . .. .. ..... . .. .. .. . .. .. . . . . . . . . . .

Gain on sale

---

787
750
514
215
623

(HAL)

Revenue

Following is the balance sheet for Halliburton Company .

HALLIBURTON COMPANY
Consolidated Balance Sheets

HALLIBUllTIJN
COMPANY

HALLIBURTON COMPANY
Conaolldated Statements of Operations
At December 31 (mlHlons of dollars}
2010

E14-13. Identifying and Computing Net Operating Assets (NOA) and Net Nonoperating Obligations
(NNO) (L01, 2)

HALLIBURTIJN
COMPANY

14-18

b.

Estimate the value of a share of Halliburton Company common stock using the residual operating
income (ROPI) model as of February 17 , 2011.
H alliburton Company stock closed at $48.43 on February 17 , 2011. How does your valuation estimate compare with this closing price? What do you believe are some reasons for the difference?

14-19

Module 14 I Operating- Income-Based Valuation

Module 14 I Operating-Income-Based Valuation

E14-16. Explaining the Equivalence of Valuation Models and the Relevance of Earnings (L02, 3)
M odules 13 and 14 focused on two different valuation models: the discounted cash flow (DCF) model

INTEL CORPORATION
Consolidated Balance Sheets

and the residual operati ng income (ROPI ) model . T he models focus on free cash fl ows to the firm and on
residual operating income, respectively. We stressed th at these two models are theoreti cally equivalent.

a.
b.

Wh at i s the intuition for w hy these models are equi valent?


Some analysts focus on cash flow s as they believe that companies manage earnin gs, w hich presumably mak es earnings less relevant. A re earnin gs relevant? Ex plain .

E14-17. Applying and Interpreting Value Driver Components of RNOA (L03)


The net operatin g profit m argin and the net operatin g asset turnover components of return on net operating assets are often termed value drivers, w hich refers to their pos iti ve infl uence on stock value by virtue
of their role as components of return on net operatin g assets (RNO A) .

a.
b.

December 25,

December 26,

2010

2009

Assets
Current assets
Cash and cash equivalents ....... . . . . . ...... . . . ..... .
Short-term investments . ........ . ...... . . . ......... .
Trading assets .. . ...... . .... . .. .. . ....... .. ....... .
Accou nts r.'\Ceivable, r.ot . . . ..... . .. .. ....... ... .. . . .
Inventories . . . ... .. ..... ..... ... .. ........ .. . .... .
Deferred tax assets ...... .. .. . . .. ... . . .. . . ...... . .. .
Other current assets ........ . ....... . .. . ..... . . ... . .

$ 5,498
11 ,294
5,093
2,867
3,757
1,488
1,614

$ 3,987
5,285
4,648
2,273
2,935
1,216
813

Total current assets . . . . .... . .......... . . . ...... . ... .


Property, plant and equipment, net ... ........ . . .. ...... .
Marketable equity securities . ... . ... . . . ... . ... . . ... .. . .
Other long-term investments1 . . ... . . . .... .. . .. .. . ..... .
Goodwill ........ . .. . .... . . ...... .. .. . . .... . .... . .. .
Other long-term assets ... . ... . .... .. ..... . . .. . .. . ... .

31 ,611
17,899
1,008
3,026
4,531
5,111

21,157
17,225
773
4,179
4,421
5,340

Total assets ....... . ... . .. . .. . . ... .. . ... . .... . . . . . . . .

$63, 186

$53,095

As of Year-Ended (In mlDlons, except par value)

H ow do profi t margins and asset turnover rati os influence stock values?


A ssuming that profit margins and asset turnover ratios are value drivers, w hat insight does this give
us about managing companies if the goal is to create shareholder value?

P14-18. Forecasting and Estimating Share Value Using the ROPI Model

(L02, 3)

Liabilities
Current liabilities
Short-term debt . . . ... . ... . ..... . ...... . ... . .. . . . . .
Accounts payable .. ... . . . ... . .. ....... . .. ... . ... . . .
Accrued compensation and benefits . . .............. . . .
Accrued advertising . . ... . .. . ... . . . . ......... . ..... .
Deferred income on shipments to distributors .. .. .. .. ... .
Other accrued liabilities . . . .. . .... . . ... ...... . .. . ... .

Following are the income statement and balance sheet for Intel Corporation .

INTEL

l:llllPlll\A TlllN

INTEL CORPORATION

(INTC)

Consolldatecl Statements of Income

Year Ended (In mlRlons)


Net revenue ... . . . . . . . .. . . . .... .. .. . ............ .
Cost of sales . . .. ............. . . . ..... . . . . . ..... . .
Gross margin . .. ... . .. . ........... . .. . ....... . ..
Research and development . . ..... .. ...............
Marketing, general and administrative . . ..... ... . .. . ..
Restructuring and asset impairment charges . . . . . . ....
Amortization of acquisition-related intangibles . .... .. ..

.
.
.
.
.

December '

December
25,2010

December
26,2009

1:7,2008

$43,623
15,132

$35,127
15,566

$37,586
16,742

28,491
6,576
6,309

19,561
5,653
7,931
231
35

20,844
5,722
5,452
710
6

18

13,850

11 ,890

Operating expenses . . .. . . . . . ... . ... . .... . . . . . .. .. .

12,903

Operating income .. . . . . . .. . . .. . ..... . . .. . ...... .. .


Gains (losses) on equity method investments, net. ..... . .
Gains (losses) on other equity investments, net. .. . . .. .. .
Interest and other, net . . ... .. .... . ... . .. . . . ..... . . .

15,588
117
231
109

5,711
(147)
(23)
163

8,954
(1,380)
(376)
488

Income before taxes .......... . ...... . ............ .


Provision for taxes . . .. . ... ... ... . . . . . .. . . . . . .... . .

16,045
4,581

5,704
1,335

7,686
2,394

Net income ... . . . .. . . .. ... .. .. . . . . ... . . ......... .

$11,464

$ 4,369

$ 5,292

---

172
1,883
2,448
773
593
1,722

Total current liabilities . . . .. . .. .. .. . . . . .. . ... . . . .... . .


Long-term income taxes payable. . . . . ... ... . . . ......... .
Long-term debt .. . .. .... . . .. .. .. . .. . . .. . .. .. .. . . .. . .
Long-term deferred tax liabilities ..... . ... . ....... . .. ... .
Other long-term liabilities . ..... . ....... . . .. .. ......... .

9,327
190
2,077
926
1,236

7,591
193
2,049
555
1,003

Total liabilities .. . . .. ... ... .. . . . . . . . .. ... . . . . . . . . .

13,756

11 ,391

Stockholders' equity
Preferred stock, $0.001 par value . . . .... . .... .. .... . .. .
Common stock, $0.001 par value, 10,000 shares authorized;
5,581 issued and 5,511 outstanding and capital
in excess of par value . . ... . .. . . . .... .. ... . ....... .

16,178

14,993

Accumulated other comprehensive income . ............ .


Retained earnings . . . .............. . ......... . .. . .. .

333
32,919

393
26,318

Total stockholders' equity . ... . .. .. .. ...... . ... . ... . .. .


Total liabilities and stockholders' equity . .... .. . . . . . . . . . .. .
1

38
2,290
2,888
1,007
622
2,482

49,430

41,704

- --

- --

$63,186

$53,095

These investments are operating assets as they relate to associated companies.

Required

a.
b.

Compute I ntel's net operatin g assets (NOA) for year-end 20 I 0 .


Compute net operating profi t after tax (NOPAT) for 20 10, assuming a federal and state statutory
tax rate of 37%.

c.

Forecast Intel 's sales , NOPAT, and N O A for years 20 1l through 20 14 using the following assumptions:

14-20

14-21

Module 14 I Operating-Income-Based Valuation

Module 14 I Operating-Income-Based Valuation

Sales growth ....... . ... .. .. . ..... . .. .. .......... .


Net operating profit margin (NOPM) . .. . ..... . .. . ... .. .
Net operating asset turnover (NOAT) at year-end . . . . . . . .

d.

e.

P14-19.

10%
26%
1.50

CVS CAREMARK INC.

Consolidated Statements of Income


For the year ended December 31 (In mHllons)

Forecast the termi nal peri od value assuming a I % terminal peri od growth and using the NOPM and
NOAT assumptions above.
Estimate the value of a share of Intel common stock using the residual operatin g income (ROPI)
model as of D ecember 25 , 20 10 ; assume a discount rate (WACC) of 11 %, common shares outstanding of 5,5 11 m i llion, and net nonoperating obli gations (NNO) of $(20 ,778) m ill ion (NNO is
negative which means th at Intel has net nonoperatin g in vestments) .
Intel (I NTC) stock closed at $22. 14 on February 18, 20 l l. How does your valuation estimate
compare w ith thi s closing price? W hat do you believe are some reasons for the difference? What
investm ent decision is suggested from your res ults?

Forecasting and Estimating Share Value Using the ROPI Model

(L02, 3)
Following are th e income statement and balance sheet fo r CVS Caremark .

CVS CAREMAl\K
(CVS)

CVS CAREMARK INC.


Balance Sheets

2010

2009

Assets
Cash and cash equivalents .. .. ............... . .. . . . ..... . .. . .. . . .
Short-term investments ............. . ........................ . . .
Accounts receivable, net .......... . . . ....... .. . . .. . ............ .
Inventories . . . .. .... . .. . . .. .. ... ....... . .. .. . .. . . . . .......... .
Deferred income taxes ... . .. . .. ... ........ . . ..... .... .. ... .. . . . .
Other current assets . .............. . . . .. .. . . . .............. .. .. .

$ 1,427
4
4,925
10,695
511
144

$ 1,086
5
5,457
10,343
506
140

Total current assets ... . . . ... ... ..... . .......... . ........ ..... .
Property and equipment, net ....... . .. ... .. . . .. . .. ......... . .... .
Goodwill ........... . ... . ... . . . . ... .......... .. . . . .. . . .... .. . .
Intangible assets, net . ............ .. ..... . .. . .. . . . ..... . . . ..... .
Other assets ... . .. . .. ... .. .. ..... . . . .. .. . .. . .... . ........ . ... .

17,706
8,322
25,669
9,784
688

17,537
7,923
25,680
10,127
374

Total assets ............ . ... .. ......... . .. . ... . .... . ....... . .... .

$62,169

$61,641

Liabilities
Accounts payable ............. . .... .. .... . ... . .............. .. .
Claims and discounts payable . .. ... ... . . . . . . .. . .. .. . .. . . ....... . .
Accrued expenses ... . . . ... .. .... . ..... .. . . .. .. .... . . . . . . .. . .. .
Short-term debt ... .. . .. ... .. . .... ................. .. ... . . .... .
Current portion of long-term debt . . . .. .. . . .. . . ... .. . ........ . ... . .

$ 4,026
2,569
3,070
300
1,105

$ 3,560
3,075
3,246
315
2,104

Total current liabilities ......... .. ........ .. . . . . . . .. .. .... . .... .


Long-term debt. . . ...................... ... . . .. .. . . . . ........ . .
Deferred income taxes .... . .. . . . ............ . ... . . . .. . . . . . ..... .
Other long-term liabilities . . .. .... . ... . ..... .. .. . . . .. . .. .. ....... .
Redeemable noncontrolling interest . . . ............... . ... . ....... . .

11,070
8,652
3,655
1,058
34

12,300
8,756
3,678
1,102
37

Total liabilities ... . . . .... . . . . .. . .. ... . .... . ............ .. ... . .

24,469

25,873

December 31 (In mllllons, except per share amounts)

Shareholders' equity
Common stock, par value $0.01 : 3,200 shares authorized; 1,624 shares
issued and 1,363 shares outstanding at December 31 , 2010 .... .. . .. .
Treasury stock at cost: . ....... . .. . .. .. . . . . .. . . . .... . . . ....... .. .
Shares held in trust. .. . .......... . . . .... .. .. . .. . .. . .... . . . .... . .
Capital surplus .. . .. .. ........... . ... . .... . . ... .. . .. . . .. .. ... . .
Retained earnings . ..... .. . . .. . . .. ......... .... .. . . ... . .. . . .... .
Accumulated other comprehensive loss .... . . .. .. . .. . .. .. ... .. .... .
Total shareholders' equity . . ..... . .. . . .... ..... . . . ............. .
Total liabilities and shareholders' equity .... . .. . .......... . .. . .. . . .

2010

2009

2008

Net revenues . . . ........ . ....... .... ...... ... ... . . .... .

$96,413

$98,729

$87,472

Cost of revenues . .. . .... .... ... . .. . .. . . . ... . .. . .... . ...

76,156

78,349

69,182

Gross profit .. . .. .. . ... .......... . . . . ... . .. . . ... ... .... .


Operating expenses ...... . . . ..... . ... . . . ..... . ...... ... .

20,257
14,092

20,380
13,942

18,290
12,244

Operating prn1fit . .. .. . . , . . . . ... . . . .. ... . . .. .... . . .. . ... .


Interest expense, net ........ . .. . ........ .. ......... . .. . .

6,165
536

6,438
525

6,046
509

Income before income tax provision ........... . ... . ... . ....


Income tax provision . ... . ... .. .. . ....... .. ... ; .. . ..... . .

5,629
2,190

5,913
2,205

5,537
2,193

Income from continuing operations . . . . . . ..... . .... . ...... . .


Loss from discontinued operations, net of income tax benefit ....

3,439
(15)

3 ,708
(12)

3,344
(132)

Net income . .... . . .. . . .... . . . .... . .. . ... . . . ... . .. . .. .. .


Net loss attributable to noncontrolling interest . .. .... . ..... . ..
Preference dividends, net of income tax benefit ....... . ... . . . .

3,434
3

3,696

3,212

Net income attributable to CVS Caremark . .... .. ... .. . . ... . ..

$ 3,427

$ 3,696

$ 3,198

b.

c.

16
(7,610)
(56)
27,198
16,355
(135)

37,700

35 ,768

$62 ,169

$61 ,641

- --

Compute net operatin g assets (NOA) as of December 3 1, 20!0 .


Compute net operating profi t after tax (NO PAT) for fi scal year ended December 3 1, 20 JO, assuming a federal and state statutory tax rate of 37% .
Forecast CYS's sales, NOPAT, and N OA for 20 11 through 201 4 using th e fo llowing assumptions:
Sales growth . .. . . .. . . . .. . . . .. . ... .... . . .. . ... ... .
Net operating profit margin (NOPM) .. . . . ... . .... .. . . . .
Net operating asset turnover (NOAT) at fiscal year-end . .. .

---

16
(9,030)
(56)
27,610
19,303
(143)

(14)

Required

a.

d.

---

14-22

e.

5%
4%
2.10

Forecast the terminal period value assum ing a l % term inal peri od growth and using the NOPM and
NOAT assumptions above .
Estimate the value of a share of CVS common stock using the residual operating income (ROPI)
model as of D ecember 31, 20 IO ; assume a di scount rate (WACC) of 7% , common shares outstanding of l ,363 million, and net nonoperating obligati ons (NNO) of $8,660 million.
CVS 's stock closed at $33.06 on February 18, 2011 . How does your valuation estim ate compare
w ith this clos ing pri ce? Wh at do you bel ieve are some reasons for the difference?

P14-20. Forecasting and Estimating Share Value Using the ROPI Model

(L02, 3)
Following are the i ncome statement and balance sheet for Abbott Laboratories (ABT) .

AR BOTT

LABllllA TlllllES
ABBOTT LABORATORIES
Balance Sheet
December 31 ($ mlHlons)

(ABT)
2010

2009

Assets
Cash and cash equivalents . ... . ...... . . .... . . . .... . . . . .. .... . . . .
Investments and restricted funds . .. . .. ..... .... . . .. ... . ... . ..... . .
Trade receivables, net ..... . . . ...... . . . . . .. .. .. . .. . . . ... .. ... .. .
Total inventories .... . . . .... . . . .. ..... ... .. . ... .... . ... .. .. .. .. .
Deferred income taxes . . .. . . . ... ... ..... .... .. . ........ . ...... . .
Other prepaid expenses and receivables .. . . ... ......... . ...... . ... .

$ 3,648.371
3,675.569
7,184.034
3,188.734
3,076.051
1,544.770

$ 8,809.339
1,122.709
6,541.941
3 ,264.877
2,364.142
1,210.883

Total current assets . ....... .. ... . ..... . .. . ..... . ....... . ... . .. .

22 ,317.529

23,313.891
continued

14-23

Module 14 I Operating-Income-Based Valuation

Module 14 I Operating-Income-Based Valuation

14-24

Required

continued from prior page


Investments .. . .. .. .... ... .. . . . ... .... ... . . ... . . . .
Property and equipment, net .. . . .. .. .. . .. ... . .. . .. .. . . . .
Intangible assets, net of amortization . . ..... . .. .. . . . .. . . . . . .....
Goodwill ... . . . .... . .... . .. . . . ..... .. .. .... . .
Deferred income taxes and other assets . ... .. . . . .. . . . ... .. .... . . .

302 .049
7,970.956
12, 151 .628
15,930.077
790.027

1,132.866
7,619.489
6,291.989
13,200.174
858.214

Total assets . .. . .... . ..... . . .. .. . . . . . ..

$59,462.266

$52,416.623

Liabilities and Shareholders' Investment


Short-term borrowings .. . . .. ...... . .. . . . .
Trade accounts payable . . .... . .. . ... .. ....
Salaries, wages and commissions . .. ... .. .. . ... ... . . . . ....
Other accrued liabilities .. ... . . . . . ... . . ... . . .. . . ... .. .
Dividends payable .... . . . ... . . . . . ... . . .

$ 4,349.796
1,535.759
1,328.665
6,014.772
680.749

$ 4,978.438
1,280.542
1,117.410
4,399.137
620.640

Income taxes payable .. ..... . .. . . . . .. . . . .. . . . ... . . .


Current portion of long-term debt . .. . . . . . ..... . . . . .... .

1,307 .723
2,044.970

442.140
211 .182

Total current liabilities . ... .. ... ... . . . ... . ........ . . . .

17,262.434

13,049.489

Long-term debt . . . ....... . . .. . . .. . . .. . ..... .


Post-employment and other long-term obligations . . . .. .. . . . . . . ...
Shareholders' investment
Common shares, without par value. Authorized : 2,400,000,000 shares.
Issued : 1,619,689,876 and 1,612 ,683,987 . . ... .. . .. . .. . . ... . .. . . .
Common shares held in treasury: 72,705,928 and 61 ,516,398 . . . . .. . .. . .
Earnings employed in t he business .. .. . . .. . . .... . . ... .. ..... . ...
Accumulated other comprehensive income (loss) .... ... ... . .. . . .. . . .

12,523.517
7,199.851

11,266.294
5,202 .11 1

8,744.703
(3,916.823)
18,927.1 01
(1,366.846)

8,257.873
(3,310.347)
17,054.027
854.074

Total Abbott shareholders' investment .... . ... . . .. .. . . . .... ..


Noncontrolling interests in subsidiaries . . .. . . . . . . . .. . . . . . . . . . .

22 ,388.135
88.329

22 ,855.627
43.102

Total shareholders' investment. . . . . .. . . ... . . .... . ... . .. . ... . .

22,476.464

22,898.729

Total liabilities and shareholders' investment . ..... .. .. . .. . . . . . . . ... . .

$59,462 .266

$52,416.623

ABBOTT LABORATORIES AND SUBSIDIARIES


Consolidated Statement of Earnings
Year Ended December 31
(dollars in millions)

2010

Net sales . .. . . . .. . . .. .. . .. ... . . . . ... . .. . . . .. . . ... .. .. $35,166.721


Cost of products sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14,665.192
3,724.424
Research and development . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Acquired in-process research and development . . . . . . . . . . . . . .
313.200
Selling, general and administrative . . . . . . . . . . . . . . . . . . . . . . . 10,376.324
Total operating cost and expenses . . . . . . . . . . . . . . . . . . . . . . . . 29,079.140
Operating earnings .. .... . ... ... . . .. . . . . .. .. . . .... ..
Interest expense . .. . . . . . . . ... . .. . . . .. . . . .. . . . . .
Interest (income) . . . .. . . . . ... .. . .. . . . . . .. .. . .. ...
{Income) from the TAP Pharmaceutical joint venture ....... ... .
Other (income) expense, net . . ... .. . . . ..... . . . . .. . . .

2009

2008

$30,764.707
13,209.329
2,743 .733
170.000
8,405.904

$29,527.552
12,61 2.022
2,688.811
97.256
8,435.624

24,528.966

6,087.581
553.135
(105.453)

6,235.741
519.656
(137 .779)

(72 .935)

(1 ,339.910)

23,833.713
5,693.839
528.474
(20 1.229)
(118.997)
(370. 695)

5,712 .834
1,086.662

7,193.774
1,447.936

5,856.286
1,122.070

Earnings from continuing operations . . . . . . . . . . . . . . . . . . . . . . .


4,626.172
Gain on sale of discontinued operations, net of taxes . . ... . . . . _ __ _

5,745.838

4,734.216
146.503

Net earnings .. ... .. ..... . . . . ..... . ... . . . . .... . . . .... . . $ 4,626.172

$ 5,745.838

$ 4,880.719

Earnings from continuing operations before taxes . . . . . . . . . .. .


Taxes on earnings from continuing operations . ...... .. ... . . .

a.
b.
c.

Compute net operating assets (NOA) fo r year-end 2010 .


Compute net operating profit after tax (NO PAT) fo r 20 I0 ass uming a federal and state statutory tax
rate of 35.4%.
Forecast Abbott Laboratories ' sales, NOPAT, and NOA fo r 2011 through 2014 using the fo llowing
assumptions:
Sales growth . . .... . . .... . . . .. . . .. . .. . . . ... . . ... . .

10%

Net operating profit margin (NOPM) .. .. . .. . .. . . ... ... .

14%
1.0

Nat operating asset turnover (NOAT), year-end . . . . . . . . . .

d.

e.

Forecast the terminal period value assuming a l % terminal period growth and using the NOPM and
NOAT assumptions above.
Estimate the value of a share of Abbott Laboratories' common stock using the residual operating
income (ROPI ) model as of December 3 1, 20 IO; assume a discount rate (WACC) of 7%, common
shares outstanding of 1,547 million, and net nonoperating obligations (NNO) of $12,06 1 million.
Abbott Laboratories (ABT) stock closed at $46 .88 on February 18, 2011 . How does your valuation
estimate compare with this closing price? What do you believe are some reasons for the difference?
What investment decision is suggested from your results?

P14-21. Forecasting and Estimating Share Value Using the ROPI Model (L02, 3)
Following are the income statement and balance sheet fo r Kellogg Company .

KELLIJCC 1:0.
(K)

KELLOGG COMPANY AND SUBSIDIARIES


Consolidated Statement of Income
For Year Ended

(In mlHlons)

2010

2009

Net sales . .. . .. ... ...... . .. . . . ..... . . . . .. . . . .. .. . . .. .... . $12,397


Cost of goods sold .... .. . . . . . .. ... ..... . . ...... . . . . .. .. . . .
7,108
Selling, general and administrative expense ..... . . .. . ....... . . .
3,299

2008

$12,575
7,184
3,390

$12,822
7,455
3,414

---

Operating profit . . .. ... .... .. . . . . . .... ... . ... . . . . .. . . .. . . .


Interest expense ... ... . .. ... .. .. . .. .. . . . . . . . . . . . .. . . ..... .
Other income (expense), net .. . . . . . .. .... ... . . . ... . . . . . . . .. .

1,990
248

2,001
295
(22)

1,953
308
(14)

Income before income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .


Income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

1,742
502

1,684
476

1,631
485

Net income . .. . .. . . .. .. .. ... . .. .. . . .. ..... . . . . ....... ... .


Net loss attributable to noncontrolling interests .... .. .. . .... . .

1,240
(7)

1,208
(4)

1,146
(2)

Net income attributable to Kellogg Company .. .. . . ... . . .. . .. .. . $ 1,247

$ 1,212

$ 1, 148

KELLOGG COMPANY AND SUBSIDIARIES


Consolldated Balance Sheet
(mllllons, except share data)

2010

Current assets
Cash and cash equivalents . . ... .... . . . . ... . . . . . ... .. . . .. . . .. .. .
Accounts receivable, net .... . . . .. ... . . . . . .. . . ..... .. .. .... .. . . .
Inventories . . . . ....... ... .. . . . . .. ... . . .. . . . . . . ... . ... ... . .. .
Other current assets . . . .. .. . ...... .. . . ... . . ... .. .. . ..... . .. ... .
Total current assets .. .. . . ...... . . .. .. ... .. . . ..... . .. . . . . . . . . .

444
1,190
1,056
225

334
1,093
910
221

2,915

2,558

. . . . .. . .. .. ... . . . ..... .. .. . .
. .. . ... .. .. . . . . . . ... . . . .. .. . .
. .... .. ... .. . . .. . . . . .. .. . . . . .
.. . .. . . . . . . .. . .. . . . . . .. ... . . .

3,128
3,628

1,456
720

3,010
3,643
1,458
531

Total assets . . .. . . . ... . . .. ..... .. . . . . . .. . . . ............ .... .

$11,847

$11 ,200

Property, net. .... ... . . . . . . . ... ..


Goodwill .. . .. . . .. ... . . .. . . .... .
Other intangibles, net .... . . .. ... ..
Other assets . . ... . .. . .. . . . . ... . .

continued

14-25

Module 14 I Operating-Income-Based Valuation

Module 14 I Operating-Income-Based Valuation

continued from prior page


Current liabilities
Current maturities of long-term debt . ...... .. .................... .
Notes payable . . . ............. . ... . . . ....... . .... . ...... . ... .
Accounts payable . .. . . .......... ..... ..... . . . .. .. . ... ....... . .
Other current liabilities .. . . . ... .... . . .. . ... .. .. . . ..... . ... . . . .. .

952

44

Tesco, PLC
Group Income Statement

1,149
1,039

44
1,077
1,166

Total current liabilities . .. . . ..... ... . . . . . . .. .. ........ . . . .. . . . .

3,184

2,288

Long-term debt .. . . . .. . ..... .... . .... . . ......... . .. .. . .. . .. . .


Deferred income taxes . ... . ... . .. .. . . . . . . . . ........ . ........ . . .
Pension liability .. . . .. . ...... ... . ......... . ..... . . . .. . ........ .
Other liabilities ... . .. . .. .... .... . ..... . .. .. ......... . .. . . . ... .
Equity
Common stock, $.25 par value, 1,000,000,000 shares authorized
Issued: 419,272 ,027 shares in 2010 and 419,058,168 shares in 2009 .. .

4,908
697
265
639

4,835
425
430
947

Capital in excess of par value ................... .. .. . ..... . .. . .


Retained earnings ............ .. . . . .... ... ........... . . .. .... .
Treasury stock at cost: 53,667,635 shares in 2010 and 37,678,215
shares in 2009 .. . . . .. . . ....... . . . . ... . . .......... . ... . .. ... .
Accumulated other comprehensive income (loss) . .. . ...... . ... ..... .

105
495
6,122
(2,650)

105
472
5,481
(1,820)

52weeks

52weeks

2011
m

2010
m

Continuing operations
Revenue (sales excluding VAl) . .. . . .. . . . .. . .. . ...... . . . .... . . . . . .
Cost of sales .. . ... .. . . ..... . ............. ... .. . . . .... . .... . . .

60,931
(55,871)

56,910
(52,303)

Gross profit. ;, . .. . ... .. ... .. ..... . .. . . . ... . . . .. . . , .. ... . ... . .. .


Administrative expenses .. .... . ... .... . ..... . ..... . .... . . . .... . .
Profit arising on property-related items . .. .......... . .. . .. . . . .. ... . .

5,060
(1,676)
427

4,607
(1 ,527)
377

Operating profit . . ... ... ... . .... . . ... .... ... .. . .... . . . .. ... .. . .
Share of post-tax profits of joint ventures and associates .. .. ... . .. . .. .
Finance income .. . . . .. ... .... .. ...... .. ... . . . . . . . ..... . ...... .
Finance costs ... ... .. . .. .... . ..... . .... ... . .. .. . ..... . .. ... .. .

3,811
57
150
(483)

3,457
33
265
(579)

Profit before tax . . .... .. ... .... ... . . .. ..... . ... .. .. ... .. . . . . .. .
Taxation . .. . . .. . .... . ... .. . .. .. .. .... .... .... . .... . .. . . . .... .

3,535
(864)

3,176
(840)

Year ended 28 Febnay 2011

(1,914)

(1,966)

Profit for the year .... . . . .... . . . ........ . ............. . .. . ..... .

2,671

.2,336

Total Kellogg Company equity ............ .. . . ................ .


Noncontrolling interests . . . .. .. . . . ........... .. .. . . .......... .. .

2,158
(4)

2,272
3

2,655

Total equity . ............. . ....... .. . .... . ........ .... . . . . . .

2,154

2,275

Attributable to:
Owners of the parent ...... . .. .. ... ..... ....... . .. . ... . ... . .. . . .
Non-controlling interests ... .. . . . ..... .. . . . . ............. . .. . ... .

16

2,327
9

Total liabilities and equity . ...... . .......... .. ........ .. .. . . . . .

$11,847

$11 ,200

2,671

2,336

Required

a.
b.
c.

d.

e.

Compute net operating assets (NOA) as of year-end 2010 .


Compute net operating profit after tax (NO PAT) for 20 IO , ass uming a federal and state statutory
tax rate of 36.4%.
Forecast Kellogg's sales, NOPAT,and NOA fo r 20 11 th rough 2014 using the fo llow ing assumptions:
Sales growth....... . . . .. . . . . .. ........... . ... . ...

4%

Net operating profit margin (NOPM). . . . . . . . . . . . . . . . . . .

11 %

Net operating asset turnover (NOAl), year-end . . . . . . . . . .

1.6

Forecast the terminal period value ass uming a I% terminal period growth and using the NOPM and
NOAT ass umptions above.
Estimate the value of a share of Kellogg common stock using the residual operating income (ROPI)
model ; assume a discount rate (WACC) of 6% , common shares outstanding of 365.6 million , and
net nonoperating obligations (NNO) of $5,456 million.
Kellogg's stock closed at $53.56 at February 28, 20 11 . How does your valuation estimate compare
with this closing price? What do you believe are some reasons for the diffe rence?

TESCO PLC
Group Balance Sheet
28 February 2011 ~ February 2010
m
m
Non-current assets
Goodwill and other intangible assets .... . . . . . . . . .... . ........ .
Property, plant and equipment .. . .. . .. ....... . .... . . . ...... . .
Investments in joint ventures and associates... . .. . . . .... . . .. . . .
Other investments . ..... . ..... .. . ... . . . . . .. .. . .. ....... .. .
Financial assets . . .. .. .. ........ . .. .. . . .. . . . ... . . . ... . ... .
Deferred tax assets .. .... .... . . . . .. . .... . . .. .. . . . .. . . . ... .
Total non-current assets . .. . . . . . .. ..... ... . . .. ... . ... .. . . . .
Current assets
Inventories ... .. . . . . . .... .. ... .. . . . .. ... .. . . ...... ... ... .
Trade and other receivables .. ... .. . . . ... ... . .. . ... . . .. ..... .
Financial assets . .. ... . ....... . .. . .. . ..... .. ... . ... . ..... .
Current tax assets .. . ... .. .. ........ . .. .. . . . .. . .... . ..... .
Short-term investments . ....... .. . . ..... . . . ... .. . .. ... . . . . .
Cash and cash equivalents .. .. . . . ..... . . . . . . .... . .. .. . .. . .
Non-current assets classified as held for sale .. . . . ... . ......... .

114-22.

Forecasting and Estimating Share Value Using the ROPI Model

(L02, 3)

Following are the income statement and balance sheet fo r Tesco, PLC , a UK-based grocery chain .
The company's financial statements are prepared in accordance with IFRS .

4,338
24,398
316
2,971
3,266
48

4,177
24,203
152
2,594
3,094
38

35,337

34,258

3,162
2,314
3,066
4
1,022
1,870

2,729
1,888
2,636
6
1,314
2,819

11,438
431

11,392
373

Total current assets . .... . .... .. ..... . ... . . . . . ...... . .. . .. .


Current liabilities
Trade and other payables . ... .... .. . . .. . ..... . . . . .. . . ...... .
Financial liabilities .. . .... .. . . ... .. . .. .. ... ...... .. .. . . . . .. .
Customer prepayments and deposits . . .. . . . .... .. ....... . .. . .
Current tax liabilities . .. ..... .. .. . . . ..... . ..... . .... ... .. . . .
Provisions .. .. .... . ..... . . . ... . . . ... . .. . .... ...... . .. .. .

11,869

11,765

(10,484)
(1,641)
(5,110)
(432)
(64)

(9,442)
(1 ,675)
(4,387)
(472)
(39)

Total current liabilities .. .. ... . ...... ... ... . . .. .. . .... . .... .

(17,731)

(16,015)

continued

14-26

14-27

Module 14 I Operating-Income-Based Valuation

Module 14 I Operating-Income-Based Valuation

continued from prior page

Non-current liabilities
Financial liabilities . ..... . . . .. .. ..... . . . .. . ........ . .. .. ... .
Post-employment benefit obligations . . ....... . ........ . ..... .
Deferred tax liabi lities . . . ... . ........... . .... .......... . ... .
Provisions . .......... .. .. . .......... .. ...... . ........... .

(10,289)
(1,356)
(1 ,094)
(113)

5.

(12,520)
(1,840)
(795)

(12,852)

(15,327)

402

Equ ity
Share capital. ......... ... . . . . . . ...... . . . . ... .. .... . . . ... .
Share premi um account ........ . ......... . ... . .. . ..... . . . . .
Other reserves .. . ... . ... . ...... . .. . . .. . .. . .... . .... .. . .. .
Retained earnings .. . ....... . .... . .... . ......... . . . . . .. . . .

4,896
40
11,197

399
4,801
40
9,356

Equity attributable to owners of the parent . . . . .... . ..... . . .. .. .


Non-controlli ng interests ..... . ... . . .. ...... . .. .. . ......... .

16,535
88

14,596
85

Total equity .... . ...... . .... ... .. . ............... . . . .. . . . .

16,623

14,681

Required
Compute net operating assets (NOA) as of year-end 2011.
b. Compute net operating profit after tax (NOPAT) for 2011, assuming a marginal tax rate of 25%.
c. Forecast Tesco 's sales , NO PAT, and NOA for 2012 throu gh 2015 using the following assumptions:

6.

future ~eriod income as the assets written off will not be depreciated and your company will have
a habl11ty account available to absorb future cash payments rather than recordin g them as expenses.
The CFO recon:ime~ds that your company increase its estimate of expected return on pension
investments. This will reduce pension ex pense and increase o perating profit , a component of net
operating profit after tax (NO PAT) and , thus , of RNOA .
The CF? recommends that your company share ownership of its outbound logistics (trucki ng division ) with ~nother company in a joint venture. This would have the effect of increasing throu ghput,
thus spreadin g overhead over a larger volume base, and wou ld remove the assets from your company's balance sheet since the joint ve nture would be accounted for as an equity method investment.

Eva luate each of the CFO's recommendations . In your evaluation, consider whether each recommendatio n will positively impact the operating performance of your company or whether it is cosmetic in
nature .

a.

Resu ~ts from the R OPI model be low yield a ~&G. stock val ue estimate of $51.62 as of August 10 , 20 11.

P&G s stock closed at $58.5 1 on that date . This estimate suggests that P&G 's stock is overvalued as of that
date .
Sales growth . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Net operating profit margin (NOPM)..... .. . . ..........
Net operating asset turnover (NOA1) .. . . ..... . ...... . .

6%
4.8%
3.8

Estimate the terminal period value assumi ng a 1% terminal period growth and using the NOPM and
NOAT assumptions, above.
d. Estimate the value of a share ofTesco's common stock (which trades on the London Stock Exchange)
using the residual operating income (ROPI) model ; assume a discount rate (WACC) of 8%, common
shares outstanding of 8,046.5 million , and net nonoperating obligations (NNO) of (608). (Note:
NNO is negative which means that Tesco has net nonoperating investments and financial assets.)
e. Tesco's stock price was 3.93 on April 19 , 201 1. How does your valuation estimate compare with
this closing price? What do you believe are some reasons for the difference?

Horizon Period

(In millions, except per share


values and discount factors)

ROPI (NOPAT - [NOA 8eg X rw]) . .....


Discount factor [1 /(1 + rwl~ . . .......
Present value of horizon ROPI .. .. . ..
Cum present value of horizon ROPI ...
Present value of terminal ROPI . . . ...
N~

Reported

2011
.

.
.
. $ 17,691
.
57,448

........................... .

97,247

Total firm value . .. . .. ... . .. . . . .... .


Less NNO .... .. ................. .

172,386
29,607

2012

2013

2014

2015

$5,001
0.92593
4,631

$5,241
0.85734
4,493

$5,482
0.79383
4,352

$5,734
0.73503
4,215

Terminal
Period
$5,471

Firm equity value . .... . .. ....... . .. $142 ,779


Shares outstanding (millions) ... ...... 2,765.7
Stock value per share .. . ......... ... $ 51 .62

014-23. Operating Improvement versus Financial Engineering (L03)


Assume that you are the CEO of a small publicly traded company. The operating performance of your
company has fa llen below market expectations, which is reflected in a depressed stock price. At your
direction , your CFO provides you with the following recommendations that are designed to increase
your company 's return on net operati ng assets (RNOA) and your operating cash flows , both of which
wi ll , presumably, result in improved financial performance and an increased stock price.

5,471 million )
00

10

aComputed as$ ~ ~ ~?i

or ($5,471 million/0.07) x 0.73503.

The P&G stock price chart, extending from 2007 thro ugh 201 1, fo llows.
$75

1.

To improve net cash flow from operating activities, the CFO recommends that your company
red uce inventories (raw material , work-in-progress , and fini shed goods) and receivables (through
selective credit granti ng and increased emphasis on collection of past due accounts).
2 . The CFO recommends that your company sell and lease back its office bui lding . The lease will be
structured so as to be classified as an operating lease under GAAP. The assets will , therefore , not
be included in the computation of net operating assets (NOA) , thus increasing RNOA .
3 . The CFO recommends that your company lengthen the time taken to pay accounts payable (lean
on the trade) to increase net cash flows from operating activities .
4. Because your company's operating performance is already depressed , the CFO recommends that
you take a " big bath ;" that is, write off all assets deemed to be impaired and accrue excessive
liabilities for future contingencies. The higher current period expense wi ll , then , result in higher

$70
$65
$60
$55
$50
$45
2007

2008

2009

2010

2011

$40

14-28