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Ratio Analysis and Valuation

Valuation theory

ROE disaggregation into RNOA and financial returns

Discounted free cash flows


Residual income
ROE - Identifying and Computing Operating Working Capital
and Operating Assets exercise
ROE Disaggregation (P&G) exercise
Pfizer (PFE) valuation exercise

Margin and Turnover


EVA

2005 by Robert F. Halsey, all rights reserved

Approaches to valuation
Dividend discount model:
d
d1
d2
d4
3
P0

(1 k e ) (1 k )2 (1 k )3 (1 k )4
e
e
e

From the statement of cash flows,


d = NI + depreciation + OperCL - OperCA - OperLTA + Debt

Substitute cash flows for d to yield the free cash flow to equity
model (FCFE) :
FCFE
FCFE1 FCFE 2
FCFE 4
3
P0

(1 k e ) (1 k )2 (1 k )3 (1 k )4
e
e
e
2005 by Robert F. Halsey, all rights reserved

Residual income model


First, define residual income (RI) as,

RIt It - ke * BVt-1

Next, assume clean surplus updating of


book value of stockholders equity:

BVt = BVt-1 + It - dt

Then, we can rewrite dividends as,

dt = (1+ke)BVt-1-BVt+RIt

Finally, substituting dt in the dividend discount model yields,


Residual
RI
RI 2
RI
RI1

3
4 income stock
V0 BV0

(1ke ) (1k )2 (1k )4 (1k )4


e
e
e

price model

2005 by Robert F. Halsey, all rights reserved

Source: Parker Center for Investment Research, Cornell Univ.


2005 by Robert F. Halsey, all rights reserved

FCF and RI models

The FCF and RI models are theoretically


equivalent since both are derived from the
dividend discount model. They will, therefore,
yield the same valuation in a steady state
(constant RNOA)
FCF defines value in terms of cash flows. RI
defines value in terms of accrual accounting
(earnings and book values)

2005 by Robert F. Halsey, all rights reserved

Lower terminal value for ROPI


version of RI model vs. DCF
5

5
5
=
+
(
)/(1
+
k
+
(
NOA
)/(1
+
k
k
*
NOA
)
)
V 0 NOA0 OI t w
V5
w
5
w
t -1
t=1

V 0 = FCF t 1 k w V 5 1 k w
5

TV is reduced by
NOA in RI model

t=1

RI results in less terminal value component. Why?


Source: Prof. Peter D. Easton, Notre Dame University
2005 by Robert F. Halsey, all rights reserved

Importance of ROE

k * BV

* BV ROE k * BV
RI I k * BV I e
e
e
BV
BV

So, given a level of book value, the spread


of ROE over the cost of capital (ke) is
central to the creation of shareholder
value.
2005 by Robert F. Halsey, all rights reserved

Spreads v. Market-to-Book For


Dow Jones Industrials
Market Value/Book Value

10

KO
PG

MMM

MRK
JNJ
WMT
IBM

MSFT

GE

DD

INTC

HD

AXP

UTX

MO

BA
CAT
HON
IP

AA

XOM

EK

MCD
DIS

GM

JPM

HPQ

SBC

0
-60

-50

-40

-30

-20

-10

ROE - Ke
2005 by Robert F. Halsey, all rights reserved

10

20

30

40

50

60

Source: Nissim and Penman, 2003


2005 by Robert F. Halsey, all rights reserved

ROE Disaggregation
ROE = RNOA + (FLEV * SPREAD)
NOPAT
Sales
RNOA
*
Sales
AvgNOA
=

2005 by Robert F. Halsey, all rights reserved

PM

* Turnover

Exercises

ROE - Identifying and Computing Operating Working


Capital and Operating Assets exercise

ROE Disaggregation (P&G) exercise

Pfizer (PFE) valuation exercise

2005 by Robert F. Halsey, all rights reserved

Cisco Systems, Inc

ROE Disaggregtion
P&G Profitability Ratios
Procter & Gamble

2003

49.0%
Gross profit margin ..............................
($21,236 /
$43,377)
30.9%
Operating expense
($13,383 /
margin....................................................
$43,377)
12.5%

2002

2001

47.8%

43.7%

46.1%

($19,249 /
$40,238)

($17,142 /
$39,244)

($18,437 /
$39,951)

31.2%

31.6%

31.2%

($12,571 /
$40,238)

($12,406 /
$39,244)

($12,483 /
$39,951)

11.3%

7.6%

9.5%

Net operating profit


($7,853.689) ($6,678.682) ($4,736.633)
margin1...................................................
/ $43,377)
/ $40,238
/ $39,244
1

1-$2,344/$7,530 1-$2,031/$6,383
After-tax %.................................................
= .689)
= .682

2005 by Robert F. Halsey, all rights reserved

2000

1-$1,694/$4,616
= .633

($5,954.64)
/ $39,951
1-$1,994/$5,536
= .64

ROE Disaggregtion
P&G Turnover Ratios
Procter & Gamble

2003

2002

14.16
Accounts receivable
($43,377 / [($3,038 +
turnover............................................................

2001

13.37

13.44

($40,238 / [($3,090 +
$2,931) / 2]

($39,244 / [($2,931 +
$2,910) / 2]

25.56
28.03
Average collection
period ...............................................................
($3,038/ [$43,377/ 365])
($3,090/ [$40,238/ 365])

27.26

$3,090) / 2]

6.24

($2,931/ [$39,244/ 365])

6.14

6.43

($20,989 / [$3,456 +
$3,384] / 2)

($22,102 / [$3,384 +
$3,490] / 2)

60.01
60.10
Average inventory
days outstanding ............................................
($3,640/ [$22,141/ 365])
($3,456/ [$20,989/ 365])

55.88

Inventory turnover ..........................................


($22,141 / [$3,640 +
$3,456] / 2)

1.52
Long-term operating
($43,377/([$28,486 +
asset turnover 1 ...............................................

1.46

1.55

$40,238 / ([$28,610 +
$26,498] / 2)

$39,244 / ([$26,498 +
2
$24,220 ] / 2)

1.74

1.87

$40,238 / ([$25,445 +
$20,759] / 2)

$39,244 / ([$20,759 +
2
$21,294 ] / 2)

$43,706 - $15,220 =

$40,776 - $12,166 =

$34,387 - $10,889 =

$28,486

$28,610

$26,498

$43,706 - $15,220 $1,396 - $2,291 =

$40,776 - $12,166 $1,077 - $2,088 =

$34,387 - $10,889 $894 - $1,845 =

$24,799

$25,445

$20,759

$28,610] / 2)

Long-term net
1.73
operating asset
($43,377/([$24799 +
turnover 2 .........................................................
$25,445] / 2)
1

Net long-term operating


assets
Net long-term net operating
assets

2005 by Robert F. Halsey, all rights reserved

($3,384/[$22,102/ 365])

ROE Disaggregtion
P&G ROE Components
Procter and Gamble

2003
1-($2,344/$7,530)
After-tax % ........................................................
= 0.689

2002
1-($2,031/$6,383)
= 0.682

2001
1-($1,694/$4,616)
= 0.633

Net operating profit after-tax


$7,853 0.689 =
(NOPAT)...........................................................
$5,411
$43,706 - $300 ($12,358 - $2,172) Net operating assets (NOA) 1 ..........................
$1,396 - $2,291 =
$29,533

$6,678 0.682 =
$4,554

$4,736 0.633 =
$2,998

$2,172 + $11,475 Net financial obligations (NFO)2 .....................


$300 = $13,347
Stockholders equity .......................................
$16,186

2005 by Robert F. Halsey, all rights reserved

$40,776 - $196 ($12,704 - $3,731)


- $1,077 - $2,088=

$34,387 - 212 ($9,846 - $2,233)


- $894 - $1,845 =

$28,442

$23,823

$3,731 + $11,201 $196 = $14,736

$2,233 + $9,792 $212 = $11,813

$13,706

$12,010

ROE Disaggregtion
P&G ROE Components
Procter and Gamble
1. Net operating profit margin
(NOPM)
2. Return on net operating
assets (RNOA)
3. Financial leverage (FLEV)

4. Net financial rate (NFR)

2003

2002

12.474%

11.318%

7.639%

($5411 / $43,377)

($4,554 / $40,238)

($2,998 / $39,244)

18.667%

17.427%

12.446%

$5,411 / ([$29,533 +
$28,442] / 2)

$4,554 / ([$28,442 +
$23,823] / 2)

$2,998 / ([$23,823 +
$24,355] / 2)

93.948%

103.239%

98.288%

([$13,347 + $14,736 ] / 2) /
([$16,186 + $13,706] / 2)

([$14,736 + $11,813] / 2) /
([$13,706 + $12,010] / 2)

([$11,813 + $12,068] / 2) /
([$12,010 + $12,287] / 2)

1.516%

0.636%

([$13,347 + $14,736] / 2)

($603 - $308) .682 /


([$14,736 + $11,813] / 2)

($794 - $674) .633 /


([$11,813 + $12,068] / 2)

17.082%

15.911%

11.810%

(18.667% - 1.585%)

(17.427% - 1.516%)

(12.446% - 0.636%)

34.698%

33.847%

24.052%

$5,186 /

$4,352 /

$2,922 /

([$16,186 + $13,706] / 2)

([$13,706 + $12,010] / 2)

([$12,010 + $12,287] / 2)

18.667% + (93.948% x
17.082%) = 34.715%

17.427% + (103.239% x
15.911%) = 33.853%

12.446% + (98.288% x
11.810%) = 24.054%

1.585%
($561 - $238) .689 /

5. Spread
6. Return on equity (ROE)

7. ROE formula computation

2005 by Robert F. Halsey, all rights reserved

2001

ROE Disaggregtion
P&G Liquidity and Solvency
Procter and Gamble

2003

2002

2001

2000

Current ratio (current


assets / current liabilities)

1.23

0.96

1.11

1.00

Quick ratio (quick assets /


current liabilities)

0.75

0.53

0.55

0.44

2003

2002

2001

2000

1.9

1.8

Procter and Gamble

Total liabilities-to-equity......................................
1.7
2.0
Times interest earned ..........................................
14.42
11.59

2005 by Robert F. Halsey, all rights reserved

6.81

8.67

ROE Disaggregtion
P&G Altman Z-Score
The Altman Z-Score for P&G as of 2003 is:
Z= 0.717 X1 + 0.847 X2 + 3.107 X3 + 0.420
X4 + 0.998 X5 = 2.12
where,
X1
X2
X3
X4
X5

=
=
=
=
=

Working capital/ Total assets


Retained earnings/Total assets
Earnings before interest and taxes /Total assets
Equity/ Total liabilities
Sales/ Total assets

0.717
0.847
3.107
0.420
0.998

x
x
x
x
x

0.065=0.047
0.313=0.265
0.185=0.575
0.588=0.247
0.992=0.990

Z-Score =2.124

P&Gs Z-score is in the gray areathe prediction is inconclusive.

2005 by Robert F. Halsey, all rights reserved

PG 5-Year Stock Price Trend

2005 by Robert F. Halsey, all rights reserved

Pfizer (PFE)
valuation exercise

Year
(in $ Million)
Beginning of the Year Balance Sheet
Beg Net Working Capital
Beg Net Long-Term Assets
Total Assets

Forecast Horizon
2004
2005

2006

2007

2008

Terminal Year
2009

6,084
87,034
93,118

8,396
120,107
128,503

9,529
136,321
145,851

10,816
154,725
165,541

12,276
175,613
187,889

12,706
181,759
194,465

13,150
188,121
201,271

Beg. Net Debt


Beg. Shareholders Equity
Total Net Capital

27,741
65,377
93,118

38,283
90,220
128,503

43,451
102,400
145,851

49,317
116,224
165,541

55,974
131,914
187,889

57,933
136,531
194,465

59,961
141,310
201,271

Income Statement for the Year


Sales
Net operating profits after tax (NOPAT)
Net interest after tax
Net income

54,226
10,174
1,387
8,787

62,359
11,700
1,914
9,786

70,778
13,280
2,173
11,107

80,333
15,073
2,466
12,607

91,178
17,108
2,799
14,309

94,369
17,706
2,897
14,810

97,672

Computations
NOPAT
Beginning net operating assets
WACC
Expected NOPAT
ROPI

10,174
93,118
0.0583
5,427
4,747

11,700
128,503
0.0583
7,490
4,211

13,280
145,851
0.0583
8,501
4,779

15,073
165,541
0.0583
9,648
5,424

17,108
187,889
0.0583
10,951
6,157

17,706
194,465
0.0583
11,334
6,372

Discount factor - based on WACC

0.9449

0.8929

0.8437

0.7972

0.7533

0.7118

4,747
4,486
4,486
206,159
93,118
$320,517
$27,741
$292,776
$38.38

4,211
3,760
8,245

4,779
4,032
12,277

5,424
4,325
16,602

6,157
4,638
21,240

6,372
4,536

10,174
-2,312
-33,073
-25,211

11,700
-1,133
-16,214
-5,647

13,280
-1,286
-18,403
-6,410

15,073
-1,460
-20,888
-7,275

17,108
-430
-6,146
10,532

17,706
-445
-6,362
10,900

-23,822
-23,822
352,656
$320,517
$27,741
$292,776
$38.38

-5,042
-28,865

-5,408
-34,273

-5,800
-40,073

7,934
-32,139

Residual Oparating Income (ROPI) model


Residual operating income
PV of residual operating income
Cumulative PV ROPI
Terminal value of abnormal NOPAT
Beg. book value of assets
Value of the firm - ROPI
Value of debt
Value of equity

Computations
NOPAT
Chg in working capital
Chg in long-term assets
Free Cash Flow to the Firm (FCFF)
Discounted Cash Flow (DCF) model
Present value of FCF to the firm (FCFF)
Cumulative PV FCFF
PV of Terminal Value
Value of the firm - FCFF
Value of debt
Value of equity

ROE Disaggregation
Empirical Findings
Definition:ROE = RNOA + LEV Spread
Median
12.2% 10.3% + 0.40 3.3%

Companies are, on average, conservatively financed


(LEV<1.0).
They earn, on average, a positive spread on
borrowed monies.
RNOA is, on average, approximately 84% of reported
ROE.
All industries that survive must earn a combination of
operating and financial returns that meet shareholder
expectations.

2005 by Robert F. Halsey, all rights reserved

Behavior Over Time


(Nissim and Penman 2001)

ROE

RNOA

NBC

2005 by Robert F. Halsey, all rights reserved

1963-1996

ROCE v. Ke (Nissim and Penman 2001)

2005 by Robert F. Halsey, all rights reserved

Margin vs. Turnover


Margin and Turnover Combinations for a Given RNOA
3.50

Retail

Restaurants

3.00

2.50
Aircraft

Apparel

Asset Turnover

Agriculture
2.00

Defense
Precious Metals
Electrical Equipment
Computers
Textiles
Construction
Construction Materials
Chemicals
Transportation
Banking
Healthcare
Autos & Trucks
Petroleum

1.50

Real Estate
Printing & Publishing

and Natural Gas

1.00

Tobacco

Beer & Liquor

Pharmaceuticals

Coal
Entertainment

RNOA=10.3%

Utilities

Communication

0.50

0.00
0.00

0.02

0.04

0.06

0.08
Profit Margin

2005 by Robert F. Halsey, all rights reserved

0.10

0.12

0.14

Margin and Turnover Exercise

NOPAT margin

NOPAT margin vs. NOA turnover


14.00%
12.00%
10.00%
8.00%
6.00%
4.00%
2.00%
0.00%
0.00

1.00

2.00

3.00

4.00

Net operating asset tunrover rate

2005 by Robert F. Halsey, all rights reserved

Compare RI with
Economic Value Added

TM

(EVA)

Under EVA,

MV = capital + PV of future EVA,


where EVA1 = NOPAT1 - kwacc*capital0
2005 by Robert F. Halsey, all rights reserved

EVA Exercise
Current Year
Revenues............................................................. $11,400
Cost of goods sold ............................................... (6,000)
Gross profit .........................................................
5,400
Selling, general and administrative expenses ........ (4,000)
Operating profit ...................................................
1,400
Interest expense...................................................
(400)
Pretax income......................................................
1,000
Tax expense ........................................................
(350)
Net income.......................................................... $ 650

Current
Year
Cash.................................$ 800
Accounts receivable.......... 1,200
Inventories ....................... 3,000
Total current assets ........... 5,000

Prior
Year
$ 500
1,000
2,500
4,000

Plant assets, net ................10,000


9,000
Total assets.......................
$15,000 $13,000

Current
Year
Accounts payable....................$ 800
Accrued liabilities................... 1,250
Total current liabilities ............ 2,050

Prior
Year
$ 700
1,000
1,700

Long-term debt ....................... 6,000


5,000
Total stockholders equity ....... 6,950
6,300
Total liabilities and equity.......$15,000 $13,000

EVA = $($1,400*[1-0.35]) ([$13,000-$1,700]10%) = $910 - $1,130 = ($220)

RNOA = 8.05% ($910/[$13,000-$1,700]) < 10%.


The deficit is 1.95% x $(13,000-1,700) = $(220) as above.
2005 by Robert F. Halsey, all rights reserved

EVA Exercise
Areas for Improvement

2005 by Robert F. Halsey, all rights reserved