Valuation: The DuPont Model Crocker H.

Liu

Crocker H. Liu, Stern School of Business

Estimation of Equity Growth:

Estimation of EPS Growth Quantitative
Management Expectations: Most Reliable Source DuPont Model: Fundamentals Historical Growth: ,, Trend "Naive"

Qualitative M. Porter's 5 Forces Other Drivers: * Economic Events * Mgmt Decisions

Crocker H. Liu, Stern School of Business

Where Does Cokes Revenue Come From?: The Starting Point for Analyzing Growth
Greater Africa Europe Net Sales 1997 1996 1995 Op Income 1997 1996 1995 Capital Exp (1) 1997 1996 1995 Op Assets (1) 1997 1996 1995
(1)The

Latin Middle & America Far East 11% 11% 11% 18% 18% 18% 7% 8% 9% 13% 12% 10% 23% 22% 22% 28% 30% 31% 18% 12% 9% 13% 12% 12%

North America 34% 32% 31% 24% 21% 19% 24% 27% 31% 37% 32% 28%

3% 3% 3% 3% 3% 4% 2% 3% 2% 3% 3% 3%

29% 32% 33% 27% 28% 28% 30% 38% 41% 20% 24% 35%

remaining percentage of capital expenditures and operating assets are allocated to corporate. 3

Crocker H. Liu, Stern School of Business

Other Factors Affecting Revenue: The Case of Coke (KO)

70 60 50 40 30 20 10 0

60 50 40 30 20 10 0

Avg U.S. Temperature (20 Cities)

Avg U.S. Temperature (20 Cities)

80 70 60 50 40 30 20 10 0

80 70 60 50 40 30 20 10 0

Gross Domestic Product

Disposable Income Per Capita

Crocker H. Liu, Stern School of Business

Other Factors Affecting Revenue: The Case of Coke (KO)

800 700 600 500 400 300 200 100 0 $Advertising Per Case Sold 80 70 60 50 40 30 20 10 0

$Advertising Per Case Sold

Crocker H. Liu, Stern School of Business

Past Growth : When History Is Not a Guide to the Future

n n

Fundamental change in the line of products made

Fundamental change in the manufacturing or sales policy

n n

Change in Management Loss of a special advantage

Expiration of patents or licensing contracts, exhaustion of natural resources

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Crocker H. Liu, Stern School of Business

Coke: Is it Still the R-E-A-L Thing?

n

Analysts Long Term EPS Growth Forecast (3-5 Years)

The expected annual increase in operating earnings over the next full business cycle (3-5 years) is 17% according to IBES.
n

Managements Expectations: (1997 Annual Report)

Looking ahead over the long term, we see ... earnings-per-share growth averaging in the upper teens (15-20%)...Our track record for the last five years (18% average compounded EPS growth from continuing operations), 10 years (19%) and 15 years (17%) is indicative of our expectations for the future.
7

Crocker H. Liu, Stern School of Business

Coke: Will History Repeat?

n Past History: Per Share Revenues Depreciation EBIT Net Income Time 1997 7.64 0.25 2.02 1.64 6.00 1996 7.48 0.19 1.58 1.38 5.00 1995 7.19 0.18 1.63 1.17 4.00 1994 6.34 0.16 1.45 0.98 3.00 1993 5.38 0.14 1.20 0.83 2.00 1992 5.00 0.12 1.06 0.62 1.00

Ways to obtain the growth rate: EPS97=EPS92(1+g)5 (1.64/0.62).2 - 1 g = 21.5% ln EPS = a + *Time = -.6084+.1876*Time g = [exp()] - 1 = 20.6%
Crocker H. Liu, Stern School of Business

Over What Time Period Should Historic Growth for Coke be Calculated?
1.4 1.35 1.339

1.3 EPS Growth 1.25

1.2 1.181

1.194 1.179

1.188

1.15

1.1

1.05 1993 1994 1995 1996 1997

If 4 years were used instead of 5 years, then growth is 18.6%

Crocker H. Liu, Stern School of Business

Cokes EPS Growth via Fundamentals

2. ROE Calculation:
EBIT (less) Int. Expense (less)Taxes Net Profits EBIT (less) Int. Expense Pretax profits Sales (less)COGS (less) Deprec. (less) SG&A EBIT Current Assets Fixed Assets Other Assets Total Assets (less) Current Liab. (less) LT Liab. Total Liabilities Equity 5,001.0 258.0 1,926.0 2,817.0 5,001.0 258.0 4,743.0 18,868.0 6,015.0 7,852.0 5,001.0 5,969.0 5,350.0 5,621.00 16,940.0 7,379.0 2,250.00 9,629.0 7,311.0 Net Profits
divided by

0.59 Tax Burden X 0.95 Int. Burden X 0.27 Profit Marg. X 1.11 TA Turnover X 2.32 Leverage 25.4% Sustainable Growth Rate

Pretax Profits
divided by

EBIT
divided by

38.5%
ROE

Sales
divided by

Total Assets
divided by

Equity 1 34.2% DPR 65.9% EPS Retention

Crocker H. Liu, Stern School of Business

10

Coke Fundamentals: Looking at Trends in the Components of Growth

0.720 0.700
0.965

TAX BURDEN
0.700

INTEREST BURDEN

0.680 0.660 0.640

0.669 0.662

0.666 0.651

0.960

0.959

0.955 0.950

0.620 0.600 0.580 0.560 0.540 1992 1993 1994 1995 1996 1997 0.598

0.950

0.949

0.945 0.941 0.940 0.941 0.942

0.935

0.930 1992 1993 1994 1995 1996 1997

EBIT MARGIN
30.0% 26.5% 1.20 25.0% 21.2% 20.0% 1.16 15.0% 1.14 1.12 10.0% 1.10 5.0% 1.08 0.0% 1992 1993 1994 1995 1996 1997 1.06 1992 1993 22.2% 22.9% 22.7% 21.1% 1.18 1.16 1.18 1.22

ASSET TURNOVER
1.20

1.16 1.15

1.11

1.11

1994

1995

1996

1997

LTM

Crocker H. Liu, Stern School of Business

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Coke Fundamentals: Looking at Trends in the Growth Components

LEVERAGE
3.00

ROE
0.480 0.465
2.63 2.32 2.26

2.85 2.62 2.65

2.78

0.460 0.449 0.440 0.448

2.50

2.00

0.425 0.420 0.419

1.50

0.400
1.00

0.393

0.380 0.360 0.340

0.50

0.00 1992 1993 1994 1995 1996 1997 LTM

1992

1993

1994

1995

1996

1997

PAYOUT
50.0% 45.2% 45.0% 41.0% 40.0% 35.0% 30.0% 39.8% 37.6% 36.2% 34.2%

30.0% 29.0% 28.0% 27.0% 26.0%

GROWTH
29.0%

27.0%

26.7% 25.9%

25.0% 20.0% 15.0% 10.0%

25.1% 25.0% 24.0% 23.0% 24.6%

5.0% 0.0% 1992 1993 1994 1995 1996 1997

22.0% 1992 1993 1994 1995 1996 1997

Crocker H. Liu, Stern School of Business

12

Coke: Is it Still the R-E-A-L Thing?

n

Qualitative Factors Affecting Future Performance: Roberto Goizueta, CEO, died of cancer in 1997 Strong dollar is causing weaker sales abroad Implementation of EVA as a performance benchmark (Impacts on beta, ke, and WACC) Strategy of buying underperforming bottlers, improving their performance, and then selling them to powerful anchor bottlers to further drive sales (Extraordinary Gains)

Crocker H. Liu, Stern School of Business

13

Cokes Future Growth ala Porter:

Threat of New Entrants (Low) * High Barriers: Brand Building * Large Retaliatory Threat Suppliers Bargaining Position (Low) * Commodity Inputs Existing Competitors Buyer's Bargaining Power (Fair) (Low) * Fast Growth = Room for More * Fragmented Buyers * "Training Ground" Effects Can Help * Obligated Bottlers Threat of Substitutes (Low) * Stable Elasticity of Demand * Little Technology Risk
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Crocker H. Liu, Stern School of Business

Consensus EPS and EPS Announcements: What Happens When Growth Estimates Differ
Earnings Surprises:
SUE = Actual EPS Expected EPS Analysts ' Estimates

Example: On June 10, 1996, First Call reported for Coke Est. EPS=.42. (EPS)=.01 Coke announced a reported EPS=.42 for 96Q2 so SUE = (.42-.42)/.01=0

Crocker H. Liu, Stern School of Business

15

Characteristics of High Growth vs. Stable Growth Firms

High Growth Firms usually Pay little or no dividends Have high risk Earn high return on capital Have a high net capital exp. Have low leverage Stable Growth Firms usually Pay high dividends Have average risk Earn ROC closer to WACC Have lower net capital exp Have leverage closer to industry average
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Crocker H. Liu, Stern School of Business

Length of Supernormal Growth Period

n

Length of time that barriers to entry and differential advantages remain in place Length of government restrictions e.g., cable TV monopolies Length of Patents (drug companies) Management expectations In Starbucks 1995 annual report, Starbucks stated its goal of opening 2000 coffee houses by the year 2000 after which management foresees a leveling off of growth due to market saturation.

Effective life of franchise executives e.g. Bill Gates

Crocker H. Liu, Stern School of Business

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Length of Supernormal Growth Period

n

Holts Growth Duration (T): Assuming that a growth stock g and a stable growth stock (S&P500) have similar risk and payout, the value of the stocks should be directly proportional to their earnings in year T
Current PE Stock ln Current PE Market 1+ g + Dividend Stock T * ln + Dividend 1+ g Market Yield Stock Yield Market

T = time when growth company begins to grow at same rate as the market Dividend Yield = Dividends per share/Price g = growth rate in earnings per share

Crocker H. Liu, Stern School of Business

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Information on Coke for Holts T

Crocker H. Liu, Stern School of Business

19

Whats the Supernormal Growth Period for Coke?

Coke has an implicit patent in the syrup formula. Price-EPS Expected Growth Rates Dividend Yields Beta PECoke = 50.36 gCoke =.17 DYCoke = .0017 Coke = .99 PESP500 = 26.02 gSP500 = .074 DYSP500 = .0145 SP500 = 1 (by definition)

Observe that the betas are similar and the dividend yield for Coke is in the same ball park as that for the S&P500 so the conditions for using this model as satisfied.
ln 50.36 /ln 1+.17 + .0017 T = 8.96 say 9 years 26.02 1+ .074 + .0145

Crocker H. Liu, Stern School of Business

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Caveats When Using Holts Implied Duration Model

n

Technique assumes equal risk May be acceptable when comparing a large firm to the SP500 but probably isnt valid when comparing a small firm to the SP500

Technique assumes that stocks with higher PE ratios have higher growth rates so that the PEG is around one (correctly valued) Technique assumes that the PE for the stock is greater than the PE for the market If this isnt the case, a meaningless negative duration value will obtain.

Crocker H. Liu, Stern School of Business

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