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~ ~ ~ =
26
,
858
+ ( 0.269 - 0.09) x 26,858
1.09-1.054
Net debt
vioo7
$160,402 million
5,144
$155,258 million
$66.98 Value per share on 2,318 million shares
2007 2006 2005 2004 2003 2002
Core profit 20.7% 20.4% 21.4% 22.4% 21 .3% 22.1%
The $66.98 valuation suggests that the market price is a little
low, though this i s just a simple valuation. Observe how far we
get with just a few ingredients once financial statements have
been reformulat ed and analyzed to highlight the relevant
value drivers. And observe that an historical sales growth rate
is an input when asset turnovers are fairly stable, as they often
are. Given the stability of the ATO, the analysts asks whether
profit margins an d sales growth in the future wi ll be different
from the past.
margin
Asset turnover 1.30 1.32 1.36 1.32 1.32 1.35
Core RNOA 26.9% 26.9% 29.1 % 29.6% 28.1% 29.8%
Net operating assets $26,858
Net financial obligations 5,144
Common equity $21,714
Coke's core profit margin has declined somewhat over the
years, but its asset turnover is very stable. That means that net
operating assets grow at the same rate as sales. The average
annual sales growth rate over the five years up to 2007 was
5.4 percent (ignoring growth from acquisitions in 2007), and
this rate is in line with the rate analysts were forecasting for
the future. Using this growth rate for the NOA growth rate
along with 2007 core RNOA, Coke's value is calculated as
follows with a 9 percent required return:
You see how simple valuations can be used to challenge a
stock price. But there is another lesson here. Coke has a big
brand-name asset that is not in the balance sheet. Some claim
that because accountants do not record brand assets, it is diffi-
cult to value such firms. Not so. Valuation involves both the bal-
ance sheet and the income statement, and we see here that a
valuation with both is indeed plausible. The simple valuation
might be too simple, but you can see that modifying it with a
more intelligent forecast of future RNOA and growth will give
an intelligent valuation even with a deficient balance sheet.
490
Information in Analysts' Forecasts
Analysts are supposedly industry experts, so the consensus analyst forecast is one point of
reference to check on simple forecasts. Any difference could be attributed to the additional
information that analysts have relative to the financial statements. But there is one problem:
considerable research has shown that forecasts based on financial statement analysis are
often better predictors than analysts' forecasts. (The Web page for this chapter provides
details.) Analysts tend to be too optimistic in good times- particularly dming bubbles-
and too pessimistic in bad times. Warren Buffett said that the 1990s stock market bubble
was a chain letter and investment bankers were the postmen, but he could also have in-
cluded analysts who hyped stocks. Analysts' forecasts may contain additional information
over the financial statements, but they are also speculative. Two-year ahead forecasts are
particularly suspect, as are their intermediate-term EPS growth rates. The Nike valuation in
Box 15.3, based on analysts' forecasts, produced a price of$92.30, well above the $74 mar-
ket price at the time and well above our simple forecasts. One might see the simple fore-
casts as a check on analysts: Why are their forecasts so different from what we see in the fi-
nancial statements? Do their research reports, with its firm and industry analysis, point to
solid reasons for the difference? Or are the forecasts speculations that feed speculation in
the market price? The financial statements are used to challenge the market price, but they
can also be used to challenge your analyst.
Chapter 15 Anchoring on the Financial Stateme nts: Simple Forecasting and Simple Valuation 491
SIMPLE VALUATION AS AN ANALYSIS TOOL
Simple models provide a rough valuation, but they come to their fore as analysis tools.
Sensitivity Analysis
For the simple growth valuation of Nike, we set core RNOA equal to the 2010 number of
30.1 percent and the growth rate at the historical rate for net operating assets of 4.6 percent.
But the simple valuation formulas allow us to enter any values. Accordingly we can enter-
tain what the valuation might be under different scenarios for future profitability and
growth.
Setting different values for these features is cal led sensitivity analysis. This tests how a
valuation changes as inputs to a model change, how the valuation is sensitive to alternative
forecasts of the future. The simple valuation model gives the form in which to conduct sen-
sitivity analysis.
Sensitivity analysis involves varying forecasts of RNOA and growth and observing
the effect on the valuation. How does Nike's valuation in Box 15.2 change if we forecast
that future RNOA will be 25.0 percent rather than 30.1 percent? Or if we forecast growth
to be 3 percent rather than 4.6 percent? Indeed, we can construct a valuation grid that
gives per-share values for different combined forecast s of the two drivers:
Valuation Grid for Nike, Inc., 2010. Required Return for Operations: 9.1 Percent
25% 30% 33% 36%
0% 40.33 46.59 50.34 54.10
3% 50.12 59.46 65 06 70.66
4% 55.94 67.11 73.82 80.51
5% 64.60 78.50 86.83 95. 17
6% 78.85 97.23 108.25 119.28
The valuation grid can be three-dimensional to incorporate different estimates of the
required return. The two-dimensional grid here gives price per share, calculated for differ-
ent combinations ofRNOA and growth in NOA. If asset turnovers are forecasted to be con-
stant, growth in NOA is replaced by sales growth.
As well as answering "what-if" questions, the grid expresses our uncertainty. We might
be unsure about Nike's profitability in the future, so the grid displays the value of uncertain
outcomes: What could the value drop to, or increase to, under reasonable scenarios?
The valuation grid also indicates what combinations ofRNOA and growth in NOA jus-
tify the current price. A $74 price can be legitimized by forecasting RNOA of 30 percent
with a growth rate of about 4.6 percent or, alternatively, an RNOA of 25 percent and a
growth rate of 5 .5 percent. If we rule out a growth rate of 5 .5 percent as too high, we must
demand that Nike maintain an RNOA higher than 25 percent to justify its $74 price.
Reverse Engineering to Challenge the Market Price
Chapter 7 applied valuation models to challenge the market price. The technique was that
of reverse engineering. One version reverse engineers a valuation model to identify the
growth expectations implicit in the market price. Another version calculates the expected
return to buying at the market price.
The simple valuation model can be reverse engineered to infer
the forecast of growth in the market price. The simple enter-
prise valuation model is:
Net operating ass e ts (NOA
0
)
Forward residual i n come (Re01
1
)
Required return f o r operations
= $5,514 million
= $1, 158 million
= 9 .1 percent
ReOl 1
VNOA = NOA + ---
0 o PF- 9
The reverse engi n eering model is:
Setting the value at Nike's enterprise market value and inserting
the NOA and growth forecast for Re01
1
, one can calculate g:
1, 158
$3 1 ,446 = $5,514 + ---
1.091 -g
Enterprise market price
Summary
492
= Equity market price
- Net financial assets
= (484 million shares x
$74)- $4,370 million
= $31,446 million
The solution for g is 1.046, that is, a 4.6 percent growth rate.
The market is for e casting the same growth rate as the simple
growth valuation . This residual operating income growth rate
can be converted to an operating income growth rate follow-
ing the procedures in Chapter 7.
It should be clear that one can reverse engineer from a simple valuation model: Given
current price, current book value, and simple forecasts for the near term, what is the
growth that the market is forecasting? The only difference is that we are now working
with unlevered, enterprise valuation models rather than the levered versions in Chapter 7.
That makes sense for a growth forecast because it is growth from operations that gener-
ates value.
We will return to active, reverse engineering i n Chapter 19. For the moment, you can
ask the question: What is the growth rate we must see to justify the market price? After
reviewing our financial statement analysis, you can then ask: Is that rate reasonable?
Box 15.5 does so for Nike.
This chapter shows how simple forecasts can be developed from current and past finan-
cial statements utilizing financial statement analysis of Part Two of the book. With core
profitability identified, forecasts can be developed as if that core profitability is
sustainable. Add to core profitability a measure of growth, and the analyst has a simple
forecast. The simple forecasts yield simple valuations that give the analyst a first, quick-cut
feel for the valuation and quick enterprise P/B and P/E ratios.
The analyst who ignores information is at peril. The simple valuations will not work
well when information outside the financial statements indicates that future profitability
and growth will be different from current profitability and growth. The analyst calculates
the simple valuations as starting points but then turns to full-information forecasting (as in
the next chapter).
Notwithstanding, the simple valuations are an analysis tool to examine how valuations
are sensitive to different scenarios for future profitability and growth-for asking "what-
if" questions. And they lend themselves to reverse engineering to uncover the forecasts of
profitability and growth that are implicit in the market price. But, most importantly, simple
valuations serve as an anchor as the analyst engages in speculation about the future. A val-
uation that differs from a simple valuation must be justified with sound reasoning as to why
the future will be different from the past.
Chapter 15 Anchoring on the Financial Statements: Simple Forecasting and Simple Valuation 493
- . -
. . . .
Find the following on the Web page for this chapter: More coverage of sensitivity analysis.
More demonstrations of simple forecasts.
More applications of two-stage growth forecasting.
More on weighted-average forecasts and durable com-
petitive advantage.
More on anchoring long-term growth on the GDP
growth rate.
More on analysts' forecasts.
Key Concepts sensitivity analysis tests how value
changes with different forecasts of the
future or with different measures of
the required return. 491
The Analyst's Toolkit
Analysis Tools Page Key Measures
Simple forecasting 482
No-growth forecasting 483
Growth forecasting 484
Core residual operating
income
Core RNOA
simple forecasts involve forecasting from
information in the current financial
statements. 482
simple valuations are valuations
calculated from simple forecasts. 482
Page
483
483
Acronyms to Remember
AOIG abnormal growth in
operating income
Simple no-growth valuation Growth rate for cum-di vidend
CSE common shareholders'
equity
(equation 1 5 1) 483
Simple growth valuation
(equation 15.2) 485
Enterprise P/B multiplier
(equation 15.2b) 486
Enterprise P/E multiplier
(equation 15.3) 486
Weighted-average forecasts 488
Combining sales forecasts
with simple forecasts 489
Two-stage growth forecasting
(equation 15.5) 489
Valuation grid 491
operating income (G) 489
Growth rate in net operating
assets 485
Growth forecast of ReOI 484
No-growth forecast of ReOI 483
G (1 plus) growth rate in cum-
dividend operating
income
NOA net operating assets
01 operating income
ReOl residual operating
income
RNOA return on net operating
assets
494 Part Three Forecasting and Valuation Analysis
Concept
Questions
A Continuing Case: Kimberly-Clark Corporation
A Self-Study Exercise
You finally have arrived at the point to value Kim berly-Clark's shares. In this chapter, you
will carry out a simple valuation, limiting your inp uts to those from the financial statements
that you have diligently been analyzing. Then, in t he next chapter, you will carry out a full
pro forma analysis and valuation.
A SIMPLE VALUATION
Proceed to a simple valuation, using the required return for operations you have previously cal-
culated. Limit yourself solely to information you ha ve discovered in current and past financial
statements. Calculate enterprise price-to-book and enterprise PIE ratios from the information.
What does that info1mation imply the stock price s h ould be at the end of2010? Remember to
deduct the option overhang you calculated in the Continuing Case for Chapter 14. How does
your valuation compare with the market price (in M arch 2011) of $65 .24 per share?
REVERSE ENGINEERING AND SENSITIVITY ANALYSIS
The market price embeds expectations of future growth. Assuming Kimberly-Clark can
maintain future operating profitability at the level of current core RNOA, what growth rate
in residual operating income is the market proj e cting for the future? Would you say this
forecast is reasonable, given the history? What t o ols might you use to get better insights?
Now staii to experiment. What scenarios wou ld justify the market price? Do you see
these as reasonable scenarios? Do you see scena rios that would suggest that the stock is
underpriced or overpriced? Are these speculations consistent with what you know from the
financial statement history?
C 15.1. A valuation that simply capitalizes a forecast of operating income for the next year
implicitly assumes that residual operating income will continue as a perpetuity. Is
this correct?
Cl5.2. An analyst forecasts that next year's core operating income for a firm will be the
same as the current year's core operating income. Under what conditions is this a
good forecast?
Cl5.3. When is the forecasted growth rate in residual operating income the same as the
forecasted growth rate in sales?
Cl 5.4. Would you call a firm that is expected to have ahigh sales growth rate agrowth firm?
C 15 .5. The higher the anticipated return on net operating assets (RNOA) relative to the an-
ticipated growth in net operating assets, the higher will be the unlevered price-
to-book ratio. Is this correct?
Cl5.6. What is the effect of increasing the asset turnover (ATO) on enterprise price-to-
book, holding all else constant?
Exercises Drill Exercises
E15.1. A No-growth Forecast and a Simple Valuation (Easy)
An analyst calculates residual operating income of$35.7 million from financial statements
for 2012, using a required return for operations of 10 percent. She also forecasts residual
operating income at the same level for 2013 and years after on net operating assets of
$1,257 million at the end of2012.
Chapter 15 Anchoring on the Financial Stateme nts: Simple Forecasting and Simple Valuation 495
a. What is the analyst's forecast of operating income for 2013?
b. What is the value of the operations based on these forecasts?
c. What is the forward enterprise PIE ratio implied by the forecasts?
E1S.2. A Simple Growth Forecast and a Simple Valuation (Easy)
An analyst prepares the following reformulated balance sheet (in millions):
2012 2011
Net operating assets
Net financial obligations
Common shareholders' equity
$9,682
1,987
$7,695
$9,400
1,876
$7,524
Core operating income (after tax) for 2012 was $990 million. The required return for oper-
ations is 9 percent. For ease, use beginning-of-year balance sheet numbers where pertinent
in calculations.
a. What was the core return on net operating assets for 2012?
b. Prepare a growth forecast of operating income and residual operating income for 2013
based on this financial statement information.
c. Value the equity based on the information.
d. What is the intrinsic enterprise price-to-book ratio?
E1 S.3. Two-Stage Growth Valuation (Medium)
An analyst develops the following pro fonna at the end of2012 for a firm that uses a 9 per-
cent hurdle rate for its operations (in millions):
Operating income
Net operating assets
Net financial obligations
Common equity
2012A
$6,400
756
$5,644
2013E
$ 782
6,848
2014E
$ 868
7, 190
a. Forecast the cum-dividend operating income growth rate for 2014.
b. Using the two-stage growth model 15.5, value the equity with a long-tenn growth rate
of 4 percent.
c. What is the forward enterprise price/earnings ratio implied by the valuation?
E1S.4. Simple Valuation with Sales Growth Rates (Medium)
An analyst forecasts that the current core return on net operating assets of 15.5 percent will
continue indefinitely in the future with a 5 percent annual sales growth rate. She also
forecasts that the current asset turnover ratio of 2.2 will persist. Calculate the enterprise
price-to-book ratio ifthe required return for operations is 9.5 percent.
E1 S.S. Simple Forecasting and Valuation (Medium)
An analyst uses the following summary balance sheet to value a firm at the end of 2012
(in millions of dollars):
Net operating assets
Net financial obligations
Common shareholders' equity
2012 2011
4,572
1,243
3,329
3,941
1,014
2,927
496 Part Three Forecasting and Valuation Analysis
The analyst forecasts that the firm will earn a return on net operating assets (RNOA) of
12 percent in 2013 and a residual operating incom e of $91.4 million.
a. What is the required rate of return for operations that the analyst is using in his resid-
ual operating income forecast?
b. The analyst forecasts that the residual opera ting income in 2013 will continue as a
perpetuity. What value does this imply for the equity?
c. Calculate the forecast ofresidual earnings (on common equity) for 2013 that is implied
by these forecasts. The firm's after-tax cost of debt is 6.0 percent.
Applications
E15.6. Simple Valuation for General Mills, Inc. (Easy)
The following are from the financial statements for General Mills (in millions):
Net operating assets
Common equity
Core operating income (after tax)
2008 2007
$12,847
6,216
1,560
$12,297
5,31 9
There were 337.5 million shares outstanding at the end of fiscal year 2008 and they traded
at $60 each. Use a required return for operations of 8 percent in answering the following
questions:
a. What is General Mills's no-growth per-share valuation?
b. What is General Mills's per-share valuation based on growth forecasts from these
numbers?
Real World Connection
See Exercises El.5, E2.9, E3.8, E4.10, E6.8, El 1.9, El3.9, El4.15, and El 6.10.
E15.7. Simple Valuation for the Coca-Cola Company (Medium)
In early 2006, the 2,369 million outstanding shares of the Coca-Cola Company traded at
$48.91 each. The price-to-book ratio was 6.3 and the forward PIE was 19.3 based on ana-
lysts' consensus EPS forecast for 2007. An analyst extracted the following numbers from
Coke's financial statements (in millions of dollars):
2005
Sales 23, 104
Core operating income, after tax 4,944
Net operating assets (average for year) 17, 184
2004
21,742
4,870
16,563
2003
20,857
4,443
15, 735
2002
19,564
4,324
14,932
a. Calculate the core operating profit margin and asset turnover for each year
2002- 2005.
b. Calculate the average sales growth rate over the years 2003- 2005.
c. The firm reported common shareholders' equity at the end of2005 of $16,945 mil-
lion, along with $1,010 billion in net financi al obligations. Using the numbers you
calculated, estimate Coke's enterprise value at the end of 2005 and also the value
per share. Use a required return for operations of 10 percent. Box 15.4 will help
you.
Chapter 15 Anchoring on the Financial Statemen ts : Simple Forecasting and Simple Valuation 497
Real World Connection
See Exercises E4.7, E4.8, E12.7, E16.12, E17.7, and E20.4. Also see Minicases M4.1 ,
M5.2, and M6.2 for coverage of Coke.
E15.8. Reverse Engineering for Starbucks Corporation (Medium)
In January 2008, the 738.3 million outstanding shares of Starbucks Corporation traded at
$20 each. Analysts' consensus earning-per-share estimates of $1.03 for the fiscal year end-
ing September 30, 2008, gave the firm a forward PIE of 19.4. The firm reported earnings
per share for 2007 of $0.90, up from $0.74 a year earlier.
The following information was garnered from the firm's financial statements (in
millions):
2007 2006
Revenues
Core operating income (after tax)
Net operating assets
Net financial obligations
Common equity
$9,412
671
3,093
915
2, 178
$7,787
2,565
337
2,228
a. From these statements, calculate the following for 2007 (with beginning-of-period
balance sheet numbers in denominators where applicable):
( 1) Core operating profit margin
(2) Core return on net operating assets (core RNOA)
(3) Asset turnover
( 4) Growth rate for net operating assets
b. Using these numbers and a required return of9 percent, forecast residual operating in-
come (ReOI) for fiscal year 2008.
c. What is the stock market's implied rate of growth for residual operating income after
2008?
Real World Connection
Exercises on Starbucks are E9.8, El0.10, El2.9, and El3.8.
E15.9. A Simple Valuation and Reverse Engineering: IBM (Medium)
The following are key numbers from IBM's financial statements for 2004.
Net operating assets, end of year
Net financial obligations, end of year
Common equity, end of year
Common shares outstanding, end of year
Core return on net operating assets
Sales growth rate
18.8%
8.8%
$ 42, 104 million
12,357 million
29,747 million
1,645.6 million
IBM's shares traded at $95 when 2004 results were announced. Use a required return for
operations of 12.3 percent to answer the following questions:
a. Forecast operating income and residual operating income for 2005 if IBM maintains
the same core RNOA as in 2004.
498 Part Three Forecasting and Valuation Analysis
b. Calculate the per-share value of the equity ir IBM were to maintain this profitability in
the future and if residual earnings were to grow at the 2004 sales growth rate. Also
calculate the implied forward enterprise P/E ratio and the enterprise P/B ratio.
c. What growth rate in residual operating incorne would justify the current stock price if
you were sure that 12.3 percent was a reasonable required return?
Real World Connection
Exercises E6.9 and El4.14 deal with IBM, as does Minicase M13.3.
E15.10. Buffett's Acquisition of Burlington Northern Santa Fe (Medium)
In 2009, Warren Buffett announced that Berkshire Hathaway would acquire all of the
341 million outstanding shares of Burlington Nor thern Santa Fe (BNSF) railroad for $100
per share, a large premium from the current price. BNSF reported shareholders' equity of
$12,798 million in its most recent annual report, with $9,135 million in net financial oblig-
ations that Buffett would assume. The corresponding numbers for the prior year were
$1 1, 131 million and $9, 155 million. The income tatement reported $14,016 million in rev-
enue for the year that translated into $2, 113 million in after-tax core operating income.
a. On the basis of the current numbers, do you think the $100 per share bid can be justi-
fied? What growth rate is implied in the price? (Experiment with "reasonable" esti-
mates ofBuffett's required return.)
b. What might Buffett see to justify paying $100 per share? (Think: ATO).
E15.11. Comparing Simple Forecasts with Analysts' Forecasts: Home Depot, Inc.
(Medium)
Home Depot, the warehouse retailer, traded at $42 per share when its 2005 financial state-
ments were published. Analysts were forecasting $2.59 earnings per share for 2006 and
$2. 93 for 2007. There were 2, 185 million shares outstanding at the time. Below are income
statements for fiscal years 2003- 2005, along with information extracted from balance
sheets. Home Depot's combined federal and stat e statutory tax rate is 37.7 percent.
Develop forecasts of earnings for 2006 and 2007 from the financial statements. How
close are your forecasts to the analysts' forecasts?
THE HOME DEPOT, INC. AND SUBSIDIARIES
Consolidated Statements of Earnings
(In millions except per-share numbers)
Fiscal Year Ended
January 30, February 1,
2005 2004
Net sales $73,094 $64,816
Cost of merchandise sold 48,664 44,236
Gross profit 24,430 20,580
Operating expenses:
Selling and store operating 15, 105 12,588
General and administrative 1,399 1, 146
Total operating expenses 16,504 13,734
Operating income 7,926 6,846
Interest income (expense):
Interest and investment income 56 59
Interest expense (70) (62)
Interest, net (14) (3)
February 2,
2003
$58,247
40,139
18,108
11,276
1,002
12,278
5,830
79
(37)
42
Chapter 15 Anchoring on the Financial Statemen ts: Simple Forecasting and Simple Valuation 499
Earnings before provi sion for income taxes
Provi sion for income taxes
Net earnings
Weighted-average common shares
Basic earnings per share
Diluted weighted-average common shares
Diluted earnings per share
From the balance sheet (in millions):
Net operating assets
Net financial assets
Common equity
2005
$23,833
325
24, 158
$
$
$
7,912
2,911
5,001
2,207
2.27
2,216
2.26
2004
$20,886
1,521
22,407
$
$
$
6,843
2,539
4,304
2,283
1.88
2,289
1.88
2003
$18,820
982
19,802
5,872
2,208
$ 3,664
2,336
$ 1.57
---
$
2,344
1.56
2002
$16,753
1,329
18,082
E15.12. Valuation Grid and Reverse Engineering for Home Depot, Inc. (Medium)
a. Using the information in Exercise 15 .11, calculate the implied growth rate in residual
operating income that is implicit in the market price of $42 per share.
b. If you forecast that the growth rate in residual earnings after fiscal year 2006 will be the
GDP growth rate of 4 percent, what is the expected return to buying the stock at $42?
c. Prepare a valuation grid showing what the stock is worth for alternative forecasts of
return on net operating assets and growth in net operating assets.
Real World Connection
Home Depot is also discussed in E 15 .11 .
500 Part Three Forecasting and Valuation Analysis
Mini cases M15.1
Simple Forecasting and Valuation:
Procter & Gamble V
This case continues the financial statement analysis of Procter & Gamble Co. begun in
Minicase 10.l and developed further in Minica es 11.1, 12.1 , and 13.1. This fifth install-
ment focuses on forecasting and valuation, with further development in Minicase 16.1 in
the next chapter.
Financial statements for Procter & Gamble are presented in Exhibit 10.15 in Chapter I 0.
If you worked Mini case 10.1 , you will have reformulated the income statements and bal-
ance sheets to distinguish operating activities from financing activities. If you worked
Mi nicases M 12 .1 and 13 .1 , you wi 11 have reached an understanding of P &G's core prof-
itability and the factors that drive that profitability. If not, you should do so now.
To start, calculate residual core operating income for the years 2008 to 2010 and note
changes over time. Use a required equity return of8 percent but convert it to an unlevered
required return (for operations). In July 2010, just after the fiscal year ended, the 2,844 mil-
lion outstanding shares of P&G were trading at $62. What is the trend in residual operating
income? Does P&G appear to be a growth company? What drives the trend?
A. Develop forecasts of residual operating income for 2011 and growth thereafter based
solely on info1mation in the financial statements. Your analysis should include a no-
growth forecast, along with a forecast that includes growth. Consider a weighted-
average forecast that forecasts GDP growth in the long run. Do you think these forecasts
are applicable to P&G? Carry out a sensitivity analysis to changes in inputs by develop-
ing a valuation grid.
B. Analysts were forecasting $3.93 in earnings per share for fiscal year 2011 . How does
the analyst forecast compare with yours?
C. Calculate the (traded) enterprise price-to-book ratio and reconcile it to the levered
price-to-book ratio. Now calculate an intrinsic enterprise P/B using equation l 5.2b in
this chapter. Do you think the $62 price is reasonable?
Real World Connection
Minicases MIO. I, Ml 1.1 , M12. l , Ml3. l , and Ml6. l also cover Procter & Gamble.
M15.2
Simple Valuation, Reverse Engineering, and
Sensitivity Analysis for Cisco Systems, Inc.
Cisco Systems, Inc. (CSCO) , manufactures and sells networking and communications
equipment for transporting data, voice, and video and provides services related to that
equipment. Its products include routing and switching devices; home and office network-
ing equipment; and Internet protocol, telephony, security, network management, and
software services. The firm has grown organically but also through acquisition of other
networking and software firms. Cisco's Web site is at www.cisco.com.
Chapter 15 Anchoring on rhe Financial Sraremenrs: Simple Forecasring and Simple Valuarion 501
By any stretch of the imagination, Cisco Systems (CSCO) has been a strong growth
company. A darling of the Internet boom of the late 1990s, it was one of the few technol-
ogy companies tied to the Internet and telecommunications that prospered during that era.
Its products built the infrastructure of the Internet. While most Internet and telecommuni-
cations firms struggled and failed, their supplier, Cisco, capitalized on the new technology.
At one point in 2000, its market capitalization was over half a trillion dollars, the largest
market capitalization ofany firm, ever. Its PIE was over 130. The stock price increased from
$10 in 1995 to $77 in 2000, supported by sales growth from $2.0 billion in 1995 to
$18.9 billion in 2000.
However, with the subsequent collapse of the technology bubble and the demise of
telecommunications firms such as WorldCom, Qwest, and AT&T, growth slowed consider-
ably. Sales that peaked at $22.3 billion in fiscal year 2001 dropped to $18.9 billion by 2003
and recovered to the 2001 level only in 2004. The stock price also tumbled, reaching a low
of a little over $8 in late 2002 after the firm reported a net loss for the year. The stock price
recovered to $24 by 2004.
Subsequently, Cisco's sales grew, reaching $39.5 billion by 2008. However, from 2008
to 2010, sales remained flat, standing at $40.04 billion in 2010. Profit margins also declined
and EPS in 2010 of$1.36 was little changed from the $1.35 in 2008. Rivals Motorola and
Juniper Networks were gaining ground. Cisco 's diversification, via acquisitions, into cable
set-top boxes and videoconferencing equipment was not proving successful, with cable
companies cutting back on orders for the cable boxes and customers using Skype or Google
Talk to conference for free. Cisco suffered a precipitous decline in government orders dur-
ing 2010 as state governments cut budgets.
Cisco's 5,655 million shares traded at $20 by the end of 20 I 0 and were down further to
$15 by June 2011. On the next page are summary numbers from its financial statements
for 2008 to 2010.
Prepare simple valuations based on these statements. Use a required return of9 percent
for Cisco's operations. Then introduce some scenarios for the future- speculation about
sales growth and the level of profitability, for example- to see if the current price can be
justified or whether reasonable speculation might justify an even higher price. You might
also test how your valuations are sensitive to the required return you use. Also use reverse
engineering techniques to ask the question: What growth rate is the market forecasting?
A. Would you pay $15 for a share of Cisco Systems?
B. Would you attribute the drop in stock price from 2000 to 2002 to problems in Cisco's
operations?
C. Clearly the great Cisco is now challenged. Discuss the lesson here.
D. In 2010, Cisco announced that it would pay a dividend of$0.24 per share for the first
time. Why might Cisco be doing this? What effect do you think it had on the share
price?
E. In 2010, Cisco borrowed about $5 billion. The firm has a high level of financial
assets on its balance sheet; why would it borrow?
F. Goodwill on the 2010 balance sheet stood at $16,674 million, up from $12, 121 bil-
lion in 2007 because of acquisitions. Given that these acquisitions have not been
successful, what do you think might happen to the carrying value of the goodwill in
the future?
502 Part Three Forecasting and Valuation Analysis
CISCO SYSTEMS, INC.
Summary Reformulated ln ,come Statement s
(i n millions of dollars, except p er-share amounts)
2 010
Sales 4 0,040
Cost of sales 1 4,397
Gross Margin 25,643
Operating expenses 1 6,479
Core operating income before tax 9,164
Tax on operating income 1,557
Core operating income after tax 7,607
Net interest income after tax 160
Net income 7,767
Earnings per share $ 1.36
Summary Reformulated Balance Sheets
(in milli ons of dollars)
Net operating assets
Net financial assets
Common equity
2010
18,708
25,577
44,285
Real World Connection
2 009
1 3,971
24,706
38,677
2009
36, 117
13,023
- --
23,094
15,772
7,332
1,424
5,898
236
6,134
---
$ 1.05
2008
15,011
19,342
34,353
2008
39,540
14, 194
25,346
15,904
9,442
1,907
7,535
517
8,052
$ 1.35
2007
15,622
15,858
31,480
Mini case M7 . 1 is a reverse engineering study of Cisco, and Exercises E2. l and El 9.6 also
deal with the firm.