Professional Documents
Culture Documents
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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.
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$1 ,500
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$1 ,000
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$500
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14,000
13,000
12,000
11 ,000
10,000
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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.
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a.
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
14-2
Sales by
Segment
U.S. and
International Sales
for 10 Years
70
60
50
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:
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,.
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
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.
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.
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-
+ IV
1
1
= ---'----=-
14-3
14-4
14-5
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
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.
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
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.
"'
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
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
p:: ~e~d
I
I
EXHIBIT 14.1
tu~nover
t~e
$ 61,587
$64,050.48
(61,587
61 ,587
13,065
45,694
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)
$204,443
~~O J
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
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 .
$ 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
to
burden. In practice, analysts use spreadshe_ets to forecas t uture cas i
ows
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
(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.
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.
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:
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:
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 Extending the payment of low or no-cost payables (so long as the supplier relationships are
unharmed)
14-11
Management must also look at its long-term operating assets for opportunjties to reduce unnecessary operating assets, such as the:
Acquisition of production and administrative assets m partnership with other entities for
greater throughput
Advantages
Disadvantages
Performs Best
DCF
FCFF is intuitive
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
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
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]
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 .
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.
14-13
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
$ 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
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
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
$13 ,334
Income Statement
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
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.
"""-
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
$ 23,072
9,156
1,447
6,087
6,567
8,223
1,424
6,769
5,947
Total liabilities . ....... .. ...... .. .... . .... ... ........ . .... ... .. . ... . . ... .... .
$ 46,329
$44,094
continued
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
(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)
(7,854)
(7,598)
(4,187)
continued
14-14
14-15
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)
---
(6)
161
3,545
15,810
5,042
10,768
- - -
- --
$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.
Sales .. . ....... . . .
NOPAT .. . .. . . ... .
NOA . .. . . . ... . ...
Q 14-2.
Q 14-3 .
Q14-4.
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)
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?
~
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?
~
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
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.
(HAL}
:1
2010
2009
$ 1,398
3,924
653
257
714
$ 2,082
2,964
1,598
1,312
210
472
8,886
6,842
1,315
1,254
8,638
5,759
1,100
1,041
$18,297
$16,538
$ 1,139
1,940
716
266
636
2,757
3,824
487
842
2,889
3,824
462
606
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
b.
2008
$13,779
4,194
$ 10,832
3,843
$13,391
4,888
17,973
14,675
18,279
11,237
9,224
3,255
207
(5)
10,079
3,970
282
(62)
3,508
229
(10)
14,964
12,681
14,269
3,009
1,994
4,010
(297)
(57)
(285)
(27)
(128)
(33)
2,655
(853)
1,682
(518)
3,849
(1,211)
1,802
1,164
2,638
40
(9)
(423)
1,842
1,1 55
2,215
(7)
$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 %.
(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)
12,371
10,863
(4,771)
(5,002)
10,373
8,728
14
29
10,387
8,757
$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
Gain on sale
---
787
750
514
215
623
(HAL)
Revenue
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
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.
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
31 ,611
17,899
1,008
3,026
4,531
5,111
21,157
17,225
773
4,179
4,421
5,340
$63, 186
$53,095
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)
.
.
.
.
.
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
12,903
15,588
117
231
109
5,711
(147)
(23)
163
8,954
(1,380)
(376)
488
16,045
4,581
5,704
1,335
7,686
2,394
$11,464
$ 4,369
$ 5,292
---
172
1,883
2,448
773
593
1,722
9,327
190
2,077
926
1,236
7,591
193
2,049
555
1,003
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
333
32,919
393
26,318
38
2,290
2,888
1,007
622
2,482
49,430
41,704
- --
- --
$63,186
$53,095
Required
a.
b.
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
d.
e.
P14-19.
10%
26%
1.50
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?
(L02, 3)
Following are th e income statement and balance sheet fo r CVS Caremark .
CVS CAREMAl\K
(CVS)
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
$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
11,070
8,652
3,655
1,058
34
12,300
8,756
3,678
1,102
37
24,469
25,873
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
$96,413
$98,729
$87,472
76,156
78,349
69,182
20,257
14,092
20,380
13,942
18,290
12,244
6,165
536
6,438
525
6,046
509
5,629
2,190
5,913
2,205
5,537
2,193
3,439
(15)
3 ,708
(12)
3,344
(132)
3,434
3
3,696
3,212
$ 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
- --
---
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
22 ,317.529
23,313.891
continued
14-23
14-24
Required
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
$59,462.266
$52,416.623
$ 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
1,307 .723
2,044.970
442.140
211 .182
17,262.434
13,049.489
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
22 ,388.135
88.329
22 ,855.627
43.102
22,476.464
22,898.729
$59,462 .266
$52,416.623
2010
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
5,745.838
4,734.216
146.503
$ 5,745.838
$ 4,880.719
a.
b.
c.
10%
14%
1.0
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)
(In mlHlons)
2010
2009
2008
$12,575
7,184
3,390
$12,822
7,455
3,414
---
1,990
248
2,001
295
(22)
1,953
308
(14)
1,742
502
1,684
476
1,631
485
1,240
(7)
1,208
(4)
1,146
(2)
$ 1,212
$ 1, 148
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
$11,847
$11 ,200
continued
14-25
952
44
Tesco, PLC
Group Income Statement
1,149
1,039
44
1,077
1,166
3,184
2,288
4,908
697
265
639
4,835
425
430
947
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)
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)
(1,914)
(1,966)
2,671
.2,336
2,158
(4)
2,272
3
2,655
2,154
2,275
Attributable to:
Owners of the parent ...... . .. .. ... ..... ....... . .. . ... . ... . .. . . .
Non-controlling interests ... .. . . . ..... .. . . . . ............. . .. . ... .
16
2,327
9
$11,847
$11 ,200
2,671
2,336
Required
a.
b.
c.
d.
e.
4%
11 %
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.
(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
11,869
11,765
(10,484)
(1,641)
(5,110)
(432)
(64)
(9,442)
(1 ,675)
(4,387)
(472)
(39)
(17,731)
(16,015)
continued
14-26
14-27
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
16,535
88
14,596
85
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
Reported
2011
.
.
.
. $ 17,691
.
57,448
........................... .
97,247
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
5,471 million )
00
10
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