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Ratio Analysis and Valuation

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

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Ratio Analysis and Valuation

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  1. 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

  2. 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):

  3. 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 Residual income model Then, we can rewrite dividends as, dt = (1+ke)BVt-1-BVt+RIt Finally, substituting dt in the dividend discount model yields, Residual income stock price model

  4. Source: Parker Center for Investment Research, Cornell Univ.

  5. 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)

  6. Lower terminal value for ROPI version of RI model vs. DCF TV is reduced by NOA in RI model RI results in less terminal value component. Why? Source: Prof. Peter D. Easton, Notre Dame University

  7. Importance of ROE 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.

  8. 10 KO PG MMM 8 MRK JNJ WMT IBM 6 MSFT GE DD 4 INTC AXP UTX MO HD BA EK CAT XOM HON C MCD IP AA 2 DIS GM SBC JPM T HPQ 0 -60 -50 -40 -30 -20 -10 0 10 20 30 40 50 60 Spreads v. Market-to-Book For Dow Jones Industrials Market Value/Book Value ROE - Ke

  9. Source: Nissim and Penman, 2003

  10. ROE Disaggregation ROE = RNOA + (FLEV * SPREAD) = PM * Turnover

  11. Exercises ROE - Identifying and Computing Operating Working Capital and Operating Assets exercise ROE Disaggregation (P&G) exercise Pfizer (PFE) valuation exercise

  12. Cisco Systems, Inc

  13. ROE Disaggregtion – P&G Profitability Ratios

  14. ROE Disaggregtion – P&G Turnover Ratios

  15. ROE Disaggregtion – P&G ROE Components

  16. ROE Disaggregtion – P&G ROE Components

  17. ROE Disaggregtion – P&G Liquidity and Solvency

  18. ROE Disaggregtion – P&G Altman Z-Score

  19. PG 5-Year Stock Price Trend

  20. Pfizer (PFE) valuation exercise

  21. ROE DisaggregationEmpirical 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.

  22. Behavior Over Time(Nissim and Penman 2001) ROE RNOA NBC 1963-1996

  23. ROCE v. Ke(Nissim and Penman 2001)

  24. Margin vs. Turnover

  25. Margin and Turnover Exercise

  26. Compare RI with Economic Value Added TM (“EVA”) Under EVA, MV = capital + PV of future EVA, where EVA1 = NOPAT1 - kwacc*capital0

  27. EVA Exercise

  28. EVA Exercise – Areas for Improvement

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