© 2005 by Robert F. Halsey, all rights reserved Ratio Analysis and Valuation Valuation theory Discounted free cash flows Residual income ROE disaggregation.

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© 2005 by Robert F. Halsey, all rights reserved Ratio Analysis and Valuation Valuation theory Discounted free cash flows Residual income ROE disaggregation into RNOA and financial returns 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: 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) :

© 2005 by Robert F. Halsey, all rights reserved RI t  I t - k e * BV t -1 First, define residual income (RI) as, BV t = BV t-1 + I t - d t Next, assume clean surplus updating of book value of stockholders’ equity: d t = (1+k e )BV t-1 -BV t +RI t Then, we can rewrite dividends as, Finally, substituting d t in the dividend discount model yields, Residual income stock price model Residual income 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 Source: Prof. Peter D. Easton, Notre Dame University TV is reduced by NOA in RI model RI results in less terminal value component. Why?

© 2005 by Robert F. Halsey, all rights reserved Importance of ROE So, given a level of book value, the spread of ROE over the cost of capital (k e ) 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 ROE - K e UTX MRK MO PG MMM T MCD GE BA C WMT XOM HON GM JNJ AXP EK MSFT HPQ IBM DD IPAA JPM INTC KO SBC DIS HD CAT Market Value/Book Value

© 2005 by Robert F. Halsey, all rights reserved Source: Nissim and Penman, 2003

© 2005 by Robert F. Halsey, all rights reserved = PM * Turnover ROE Disaggregation ROE = RNOA + (FLEV * SPREAD)

© 2005 by Robert F. Halsey, all rights reserved ROE - Identifying and Computing Operating Working Capital and Operating Assets exercise ROE Disaggregation (P&G) exercise Pfizer (PFE) valuation exercise Exercises

Cisco Systems, Inc

© 2005 by Robert F. Halsey, all rights reserved ROE Disaggregtion – P&G Profitability Ratios

© 2005 by Robert F. Halsey, all rights reserved ROE Disaggregtion – P&G Turnover Ratios

© 2005 by Robert F. Halsey, all rights reserved ROE Disaggregtion – P&G ROE Components

© 2005 by Robert F. Halsey, all rights reserved ROE Disaggregtion – P&G ROE Components

© 2005 by Robert F. Halsey, all rights reserved ROE Disaggregtion – P&G Liquidity and Solvency

© 2005 by Robert F. Halsey, all rights reserved ROE Disaggregtion – P&G Altman Z-Score

© 2005 by Robert F. Halsey, all rights reserved PG 5-Year Stock Price Trend

Pfizer (PFE) valuation exercise

© 2005 by Robert F. Halsey, all rights reserved ROE Disaggregation Empirical Findings Definition:ROE = RNOA + LEV × Spread Median 12.2% ≈ 10.3% × 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 ROCE v. K e (Nissim and Penman 2001)

© 2005 by Robert F. Halsey, all rights reserved Margin vs. Turnover

© 2005 by Robert F. Halsey, all rights reserved Margin and Turnover Exercise

© 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 EVA 1 = NOPAT 1 - k wacc *capital 0

© 2005 by Robert F. Halsey, all rights reserved EVA Exercise

© 2005 by Robert F. Halsey, all rights reserved EVA Exercise – Areas for Improvement