THE “BIG THREE” OF THE AUTO INDUSTRY: ANALYZING AND PREDICTING PERFORMANCE 2005 Mountain Plains Management Conference Session 3: Pedagogy October 14, 2005; 1:15 p.m. − 3:00 p.m.; Cedar City, Utah Professor Robert M. Hull (Corresponding Author) Nicholas Avey, MBA Student (Presenter) School of Business, Washburn University, 1700 SW College Avenue, Topeka, KS 66621 Phone: + 1-670 ‑ 231 ‑ 1010; FAX: + 785 ‑ 670 ‑ 1063 E ‑ mail addresses: email@example.com (R. Hull) & firstname.lastname@example.org (N. Avey) Published in Proceedings: Mountain Plains Management Conference, October 2005 Published in Working Paper Series: Washburn University Working Paper Series, October 2005
We analyze the financial performance of three leading automobile manufacturers (referred to as the “Big Three”). The analysis incorporates the use of leading finance web sites with traditional and newer financial ratio methods. The end purpose of the analysis is to estimate future profitability of the “Big Three.” From a pedagogical standpoint, the paper offers instructors a skill that will enable them to impart knowledge of an analytical approach for investing. This approach can be used by business students and practitioners alike when analyzing a firm’s performance. As a byproduct, this paper includes a class exercise that goes beyond just the “X’s and O’s” of financial ratio analysis by requiring students to integrate their financial ratio findings with online sources offering economic and industrial analysis and analysts’ predictions. Abstract JEL Classification:I22 (Financial Education); G10; G30 Key Words:Financial Analysis, Financial Ratio Analysis DuPont Model, ROE, “Big Three”
Purpose The purpose of this paper is to learn and apply the information found in (1) leading finance websites and (2) the methods of financial analysis. We do this in the context of analyzing firm performance for the “Big Three” of the automotive industry: Ford Motor Co., General Motors and DaimlerChrysler.
Choosing among the “Big Three”: Which will be the Best?
Major Focus A major focus of this paper’s analysis of “Big Three” performance involves financial ratio analysis. This focus is justified because investors make decisions based on what financial ratios indicate. All parties concerned with financial ratio analysis need to understand how accounting- base ratios can be used to assess relevant revenue and costs factors. A key tool used in this paper’s financial ratio analysis is the DuPont Model. By using this model, we are able to focus on how profitability, asset and leverage ratios impact a firm’s return on equity (ROE) separately and interactively. A healthy ROE is what stockholders’ desire. Even from a book standpoint, if ROE is not healthy for long periods of time, then a shareholder’s investment is underperforming.
Within our paper is a pedagogical application designed to help business students learn a professional tool of analysis by learning how ROE and other valuation metrics are influenced by various categories of financial ratios. This paper’s application provides a skill that teachers can use to impart knowledge (National Board for Professional Teaching Standards, 1998). The skill is imparted in the context of analyzing a firm’s performance through economic, industrial and financial ratio analyses and the use of finance websites. The end result is that educators can practice their profession at a higher level consistent with excellence in university teaching (Johnson, 1991; McKeachie, 1994).
Teaching outcomes from the application include: (1) students will delve deeper into financial ratio analysis by examining and comparing accounting variables drawn from financial statements; (2) students will apply the DuPont Model and other valuation metrics in conjunction with economic and industrial indicators to make predictions about investment possibilities; and, (3) students will become familiar with prominent financial websites including those that feature analysts’ predictions. TEACHING OUTCOMES
Organization of Paper Section I gives an introduction. Section II provides an analysis of the economic and industrial factors influencing investment in the automotive sector. Section III presents financial ratio methodologies and metrics that apply financial data for “Big Three” firms from 2000−2004. In particular, this section illustrates how the ROE is impacted through changes in variables encompassing profit management, asset management and debt management. Section IV offers a class exercise with questions and solutions. Section V provides summary statements.
Leading Indicators Two leading indicators to help us assess the growth of the economy are the Consumer Confidence Index (CCI) and Gross Domestic Product (GDP). The automotive industry is one of the last industries to follow the growth of the economy as consumers will wait until their incomes have increased from the growth. Two leading indicators used to analyze the automotive industry are the Durable Orders Index (DOI) and Automotive Sales Index (ASI). The overall conclusion from looking at four leading economic and industrial indicators is that there is a positive outlook for the automotive industry. Thus, investors can be optimistic about investing in the automotive sector.
FINANCIAL RATIO ANALYSIS Financial ratio analysis consists of various methodologies. In our paper, we discuss (1) long- standing traditional methods as epitomized by the DuPont Model and (2) relatively more recent valuation methods as represented by economic value added (EVA®), return on invested capital and free cash flow. Blumenthal (1998) and Firer (1999) indicates that traditional approaches typified by the DuPont Model will continue to dominate financial analysis for some time including the newer metrics like EVA. Financial ratios must be interpreted properly and cautiously because of inherent accounting-based limitations and unethical manipulation.
A Description of the DuPont Model Below we define the key DuPont ratios in Exhibits 1−4 and show their influence on ROE. Margin Management (Data from Income Statement): Net Profit Margin (NPM) = Net Income / Sales = NI / S (1) Asset Management (Data from Balance Sheet): Asset Turnover (AT) = Sales / Total Assets = S / TA (2) Debt Management (Data from Balance Sheet): Financial Leverage (FL) = Total Assets / Stockholders’ Equity = TA / E (3) where Financial Leverage can also be referred to as the Equity Multiplier (EM). When we multiply out the above three equations, we have: ROE = NPM * AT * FL = (NI / S)*(S/TA)*(TA/E). Canceling out from the denominators and numerators for “S” and “TA”, we get: ROE = NPM / E. (4)
Exhibit 5: Trend Analysis for Recent Valuation Metrics including EVA EExhibit 5 supplies trend analysis for recent valuation metrics. Below we define the relevant variables used in the metrics deployed. NOWC (Net Operating Working Capital) is Cash & Equivalents + Accounts Receivables + Inventories – Accounts Payables – Accrued Expenses. OLTA (Operating Long Term Assets) is Net Property, Plant & Equipment. TOC (Total Operating Capital or Invested Capital) is NOWC + OLTA. NOPAT (Net Operating Profit after Tax) is Operating Income (or EBIT) times (1−T) where T is the corporate tax rate estimated as Income Taxes divided by Pre-Tax Income. ROIC (Return on Invested Capital) is NOPAT divided by the prior year’s TOC. EVA (Economic Value Added) is NOPAT minus the quantity consisting of the WACC times the prior year’s TOC. FCF (Free Cash Flow) is NOPAT minus the quantity consisting of this year’s TOC minus the prior year’s TOC.
Inspecting Analysts’ Assessment Internet sites provide details to inspect analysts’ assessment and can be used in conjunction with financial ratio analysis to make predictions about investment possibilities. Sites include: http://finance.yahoo.com http://www.hoovers.com/free http://moneycentral.msn.com/home.asp
Class Exercise: Assessing the “Big Three” Having presented information on the state of the economy and auto industry in Section II and financial ratio analysis in Section III, we incorporate this information into a class exercise that includes analysts’ assessment. Question 1 asks for an economic and industrial analysis. In regards to Questions 2−4, we indicate that students are provided with the DuPont Model flow chart. This flow chart is found in Exhibit 1 and can also be sent electronically through contacting us at email@example.com. We can also supply Excel spreadsheets with data that computes results in Exhibits 2−5. We can give more details on liquidity, profitability, coverage, and asset management ratios, dividend data, and hand-outs with background information on the “Big Three” firms. The exercise is best done in groups given there are three firms to analyze. If done individually, the instructor can assign one of the three firms per student.
Question 1. Type in key search words (e.g., “leading indicators,” “consumer confidence index,” and so forth) to explore the internet for information on the economy and the auto industry. One website you may find is http://www.briefing.com. Click on the free “Silver Index” to find links related to Consumer Confidence (CCI), Gross Domestic Products (GDI), Durable Goods Orders (DGO), and Auto Sales (AS). Below we summarize its four key indices and links. CCI: http://www.briefing.com/Silver/Calendars/EconomicReleases/conf.htm GDP http://www.briefing.com/Silver/Calendars/EconomicReleases/gdp.htm DGO http://www.briefing.com/Silver/Calendars/EconomicReleases/durord.htm ASI http://www.briefing.com/Silver/Calendars/EconomicReleases/auto.htm After you accustom yourself with Internet resource materials, perform an economic and industrial analysis to help gain insight on the investment opportunities in the automobile industry. In your analysis, include your predictions for the auto industry.
Solution 1 Answers will change over time as economic and industry conditions change. An answer found at the time of this writing (August 2005) and which can be easily obtained from the internet links given above. Investing in the auto industry should give good payoffs in the future as the economy and industry outlook appears good. Consumer confidence, gross domestic product and durable order indices suggest that the economy is slowly gaining ground. The auto industrial outlook looks good as buyer discounts continued to lift summer 2005 auto sales. July 2005 sales exploded as General Motors’ employee-discounts' were replicated by Ford and DaimlerChrysler. This trend for the auto industry should continue given that personal income is up 7% and interest rates remain relatively low. Perhaps, most relevant, the automotive industry is one of the last industries to follow economic growth. Thus, given the expectations of an expansionary period in the economy, the upward movement in auto sales is likely to continue. We predict that the auto industry will make gains in the upcoming years making the automotive sector a good investment choice. For additional details see Section II on the “Analysis of the Economy and Industry.”
QUESTION 2 Using the DuPont Model flow chart provided, perform a DuPont ratio analysis of the Ford Motor Co. using financial statement data from one of the many online sources that exist. For example, you can go to one of the following (1) http://finance.yahoo.com, (2) http://www.hoovers.com/free, or (3) http://moneycentral.msn.com/home.asp. If you choose the latter, you can do the following. Go to http://moneycentral.msn.com/home.asp; type in “F” by “Name or Symbol” and hit the enter key; click on “Financial Results”; click on “Statements.” You will get the financial data needed to perform computations for the variables given in the DuPont Model flow chart. Money Central will give financial data for five years and that should be long enough to find a trend representative of Ford’s ROE. In your DuPont financial ratio analysis explain any changes in ROE over time in terms of margin management, asset management, and debt management. http://moneycentral.msn.com/home.asp
Solution 2 Exhibit 2 has numbers and conclusions based on financial data for Ford Motor Company from 2000−2004. The bottom of the Exhibit 2 gives conclusions on the roles of margin management, asset management, and debt management in explaining Ford’s change in ROE.
EXHIBIT 2: DuPont Analysis of Ford MotorCompany
Question 3. Repeat Question 2 using General Motors Corporation. “GM” is now the ticker symbol if you follow the sequence of steps given above for using the Money Central website. Solution 3. See Exhibit 3 for numbers and conclusions based on financial data for General Motors Corporation from 2000−2004. Question 3 Solution 3
EXHIBIT 3: DuPont Analysis of General Motors Corporation
Question 4. Repeat Question 2 using DaimlerChrysler Corporation. “DCX” is now the ticker symbol if you follow the sequence of steps given above for using the Money Central website. Solution 4. Exhibit 4 has numbers and conclusions based on financial data for Daimler-Chrysler Corporation from 2000−2004. Question 4 Solution 4
EXHIBIT 4: DuPont Analysis of DaimlerChrysler Corporation
Make a prediction as to the investment opportunities for the “Big Three” auto companies using your DuPont answers in the three previous questions. Using the same data gathered to generate the DuPont analysis, compute trends over time for the following valuation metrics: Return on Invested Capital, Economic Value Added and Free Cash Flow. You can assume a WACC of 10 percent for your computations. What do these metrics tell you? Do further internet research to find out what analysts are predicting. As an illustration, if you choose the Money Central website, you can type in the ticker symbol and then choose such categories as “Stock Rating,” “Earnings Estimates,” “Analyst Ratings” and “Insider Trading” to get information. Question 5
From the DuPont analysis found in Exhibits 2–4, we see that the ROE for Ford has shown a positive five-year trend increasing from 11.65% to 15.74% for 2000−2004. The trend for General Motors is discouraging falling from 15.81% to 7.59%. DaimlerChrysler’s trend has been steady but low (3.24% to 3.33%). The DuPont analysis suggests: Ford is #1; Daimler-Chrysler is #2; General Motors is #3. In regards to valuation metrics and analysts’ predictions, the next three overheads (from Exhibit 5) contain possible answers based on research at Money Central. As seen there, the trend analysis for valuation metrics give some mixed results. However, in Exhibit 5, one will find a number of categories that suggests ranking similar to the DuPont analysis. For example, StockScouter predicts the following: Ford is #1; DaimlerChrysler is #2; General Motors is #3. Solution 5
Exhibit 5. TREND ANALYSIS FOR VALUATION METRICS FOR FORD MOTOR COMPANY Ford Motor Company20042003200220012000 NOPAT (Net Operating Profit After Tax): Pre-Tax Income*(1–T) 9,6228,1676,6792,33812,850 ROIC (Return On Invested Capital): NOPAT / TOC prior year 5.79%5.95%19.64%5.69%29.01% EVA (Economic Value Added): NOPAT – (WACC*TOC prior year ) –6,992–5,5613,278–1,7698,419 FCF (Free Cash Flow)1,701–20,692–96,5959,40316,081 NOWC (Net Operating Working Capital)129,508124,14599,3448843,562 Operating Long Term Assets (Property, Plant & Equipment, net) 44,55141,99337,93533,12137,508 TOC (Total Operating Capital or Invested Capital)174,059166,138137,27934,00541,070 RANKING: #1. Valuation Metrics indicate mixed results but ROIC, EVA & FCF are a bit better the past 5 years than GM & DC. From http://moneycentral.msn.com/home.asp, we can gather information including the following as of August 2005. There have been 84 more major holders buying than selling. Institutional ownership is 41%. Earnings have been higher than expected and predictions indicate 5.9% increase over the next 5 years. For the most part, recommendations by analysts are “hold” but a few are “strong buy.” StockScouter’s rating is 8 on a scale of 10. We predict that Ford will exceed most other investments in the next 5 years (including GM & DC).
Exhibit 5. TREND ANALYSIS FOR VALUATION METRICS FOR GENERAL MOTORS CORP. General Motors Corporation2004200320022001 2000 NOPAT (Net Operating Profit After Tax): Pre-Tax Income*(1–T)20,54710,4017,6394,37210,665 ROIC (Return On Invested Capital): NOPAT / TOC prior year 8.22%5.41%4.27% 3.37%6.86% EVA (Economic Value Added): NOPAT – (WACC*TOC prior year )–4,450–8,829–10,231–8,598–4,882 FCF (Free Cash Flow) –8,747–47,272–5,966–44,62036,432 NOWC (Net Operating Working Capital) 240,246211,761154,326143,78695,725 Operating Long Term Assets (Property, Plant & Equipment, net)39,02038,21137,97334,90833,977 TOC (Total Operating Capital or Invested Capital) 279,266249,972192,299178,694129,702 RANKING #3. Valuation Metrics indicate mixed results but ROIC, EVA & FCF (like DC) appear to be slightly worse than Ford for the last five years. From http://moneycentral.msn.com/home.asp, we can gather information including the following as of August 2005. There have been 144 more major holders buying than selling. Institutional ownership is 80%. Earnings have been higher than expected and predictions indicate 5.2% increase over the next five years. For the most part, recommendations by analysts are for “hold” but a few are for a “strong sell.” StockScouter’s rating is 4 on a scale of 10. We predict that GM will perform at an average level for the next 5 years.
Exhibit 5. TREND ANALYSIS FOR VALUATION METRICS FOR DAIMLER CHRYSLER CORP. DaimlerChrysler Corporation20042003200220012000 NOPAT (Net Operating Profit After Tax): Pre-Tax Income*(1–T) 4,611–1,2126,0181182,325 ROIC (Return On Invested Capital): NOPAT / TOC prior year 2.51%–0.75%4.13%0.07%N.A. EVA (Economic Value Added): NOPAT – (WACC*TOC prior year ) –13,775–17,271–8,540–15,686N.A. FCF (Free Cash Flow)4,122–24,488–8,99412,569N.A. NOWC (Net Operating Working Capital)102,117111,82892,83676,80188,692 Operating Long Term Assets (Property, Plant & Equipment, net) 82,24072,04067,75668,77969,339 TOC (Total Operating Capital or Invested Capital)184,357183,868160,592145,580158,031 RANKING #2. Valuation Metrics indicate mixed results but ROIC, EVA & FCF (like GM) is a bit worse than Ford. From http://moneycentral.msn.com/home.asp, we can gather information including the following as of August 2005. There have been 5 more major holders buying than selling. Institutional ownership is 22%. Earnings have been higher than expected and predictions indicate 6.1% increase over the next 5 years. For the most part, recommendations by analysts are for “hold.” No analysts recommend selling. StockScouter’s rating is 6 on a scale of 10. We predict that DC will moderately exceed most other investments in the next 5 years.
Concluding Statements This paper has presented an approach to analyze financial performance. The approach has been incorporated within a class exercise so that instructors can impart an analytic skill. Summary results of the analysis found in Solutions 1–5 are given below. First, the economic and industrial outlook indicates the auto industry should provide investors with sound returns in the future. Second, the three DuPont analyses suggest that Ford has outperformed General Motors and DaimlerChrysler for the past five years in terms of ROE. In particular, the best trend belongs to Ford. Third, metric analyses reinforces the conclusions of DuPont analysis and also indicate that the performance for DaimlerChrysler has been both lower and less risky the last five years. Fourth, while precise forecasts can be a matter of opinion and what aspects are being emphasized, there is a consensus from internet sources that the auto industry will do well and that Ford is the best bet followed by DaimlerChrysler and then General Motors. Thus internet sources confirm the results of financial ratio analysis. Fifth, if expectations for General Motors are poorer, then market efficiency suggests that its stock price already reflects this. Thus, if one wants to be adventurous (and take on a little more risk), General Motors may yield a chance for greater returns as its stock price may react more positive as the markets become more buoyant.