Transcript Pure Leverage Increases: An Empirical Investigation

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 protected] (R. Hull)
& [email protected] (N. Avey)
Published in Proceedings:
Mountain Plains Management Conference, October 2005
Published in Working Paper Series:
Washburn University Working Paper Series, October 2005
Abstract
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.
JEL Classification:
Key Words:
I22 (Financial Education); G10; G30
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 accountingbase 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
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.
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) longstanding 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):
•
Asset Management (Data from Balance Sheet):
•
Debt Management (Data from Balance Sheet):
Net Profit Margin (NPM) = Net Income / Sales = NI / S (1)
Asset Turnover (AT) = Sales / Total Assets = S / TA (2)
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
 Exhibit 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 protected]. 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.
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
Expanded DuPont Analysis for Ford Motor Company from 2000 to 2004 (in billions of dollars)
Comparison Key:
2004
2000
Gross Profit
Sales
172
170
minus
35.8
Net Profit
2.53
minus
Net Profit
Margin
1.47%
29.7
2.17
divided by
Other Costs
Cost of Goods Sold
136
140
33.1
25.4
1.27%
Sales
Financial
Leverage
Return on
Equity
15.74%
11.65%
Return on
Assets
18.2
=
11.7
X
0.86%
0
0.76%
net profit
sales
12
172
10.
170
95
multiplied by
Cash
Sales
24
172
net profit
equity
total assets
equity
net profit
total assets
170
Asset Turnover
plus
Current Assets
0.59
0.60
divided by
Inventory
210
39
sales
total assets
Total Assets
plus
293
284
5
Fixed Assets
82
10.8
7.5
mm
plus
Accounts Receivable
117
6.3
plus
245
Other Current Assets
CONCLUSION FROM DUPONT ANALYSIS
The increase in the Return on Equity (ROE) is caused by the increase in the Net Profit Margin (NPM)
but more so by the positive effect from the increase in Financial Leverage (FL). The Asset Turnover is
almost the same indicating the asset management has no impact on the change in ROE. The firm needs to
continue to improve its margin management through increasing its sales or lowering its costs. While the effect
from debt management is positive due to multiplying a very large FL value by a positive Return on Assets, this
creates a highly risky situation since a negative NPM can cause a severely negative ROE.
59
21
Question 3
Solution 3
• 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.
EXHIBIT 3: DuPont Analysis of General Motors Corporation
Expanded DuPont Analysis for General Motors from 2000 to 2004 (in billions of dollars)
Comparison Key:
2004
2000
Gross Profit
minus
33.6
Net Profit
2.10
1.09%
39.0
minus
Net Profit
Margin
4.77
divided by
Sales
194
185
Other Costs
Cost of Goods Sold
160
146
31.5
34.2
2.58%
Sales
Return on
Equity
7.59%
15.81%
Return on
Assets
Financial
Leverage
17.3
=
10.0
X
0.44%
0
1.57%
net profit
sales
12
194
10.
185
95
multiplied by
Cash
Sales
35.9
194
net profit
equity
total assets
equity
net profit
total assets
185
Asset Turnover
Current Assets
0.40
0.61
divided by
Total Assets
plus
480
303
plus
Inventory
337
146
sales
total assets
10.3
Fixed Assets
143
157
12.2
10.9
plus mm
Accounts Receivable
221
100
plus
Other Current Assets
CONCLUSION FROM DUPONT ANALYSIS
The decrease in the Return on Equity (ROE) is caused largely by the fall in the net profit margin (NPM)
68
25
which has a greater effect than that caused by the decrease in the Asset Turnover. Leverage has risen
considerable so that debt management has prevented a greater decling in ROE. The firm needs to improve both
margin management (through increasing sales and/or lower costs) and asset management (through increasing
its sales relative to its investment in assets). While the effect from debt management is positive due to multiplying
a positive Return on Assets by a larger Financial Leverage (FL) value, this creates a risky situation if a negative NPM
ever results, as a large FL value would then cause a severely negative ROE.
Question 4
Solution 4
• 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.
EXHIBIT 4: DuPont Analysis of DaimlerChrysler Corporation
Expanded DuPont Analysis for Daimler Chrysler from 2000 to 2004 (in billions of dollars)
Comparison Key:
2004
2000
Gross Profit
Net Profit
1.52
0.79%
25.9
1.29
divided by
Financial
Leverage
3.33%
3.24%
Return on
Assets
5.45
=
4.70
X
0.61%
0
0.69%
Cost of Goods Sold
155
Other Costs
127
35.7
24.6
0.85%
net profit
sales
minus
37.2
minus
Net Profit
Margin
Return on
Equity
Sales
192
152
Sales
12
192
10.
152
95
multiplied by
Cash
Sales
10.5
192
net profit
equity
total assets
equity
net profit
total assets
152
Asset Turnover
plus
Inventory
Current Assets
0.78
0.81
divided by
142
22.7
94
sales
total assets
Total Assets
15.3
plus mm
plus
247
187
6.7
Fixed Assets
105
Accounts Receivable
86.3
66.7
plus
93
Other Current Assets
23
5
CONCLUSION FROM DUPONT ANALYSIS
The slight increase in the Return on Equity (ROE) results because the slight fall in the Net Profit Margin
(NPM) is dominated by a more positive effect from the increase in Financial Leverage (FL). The Asset Turnover
also has a very slight negative effect on ROE indicating asset management is even less of a factor than either margin
management or debt management. The firm would do well to improve all aspects of management. While its FL is less
than either Ford or General Motors, it is still high enough that a negative NPM can cause problems leading to a
potentially large negative ROE.
Question 5
• 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.
Solution 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.
Exhibit 5. TREND ANALYSIS FOR VALUATION
METRICS FOR FORD MOTOR COMPANY
Ford Motor Company
NOPAT (Net Operating Profit After Tax): Pre-Tax Income*(1–T)
ROIC (Return On Invested Capital): NOPAT / TOC prior
EVA (Economic Value Added): NOPAT – (WACC*TOC prior
year
year)
FCF (Free Cash Flow)
NOWC (Net Operating Working Capital)
Operating Long Term Assets (Property, Plant & Equipment, net)
TOC (Total Operating Capital or Invested Capital)
2004
2003
2002
2001
2000
9,622
8,167
6,679
2,338
12,850
5.79%
5.95%
19.64%
5.69%
29.01%
–6,992
–5,561
3,278
–1,769
8,419
1,701
–20,692
–96,595
9,403
16,081
129,508
124,145
99,344
884
3,562
44,551
41,993
37,935
33,121
37,508
174,059
166,138
137,279
34,005
41,070
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 Corporation
2004
2003
2002
2001
2000
NOPAT (Net Operating Profit After Tax): Pre-Tax Income*(1–T)
20,547
10,401
7,639
4,372
10,665
ROIC (Return On Invested Capital): NOPAT / TOC prior
8.22%
5.41%
4.27%
3.37%
6.86%
–4,450
–8,829
–10,231
–8,598
–4,882
–8,747
–47,272
–5,966
–44,620
36,432
240,246
211,761
154,326
143,786
95,725
39,020
38,211
37,973
34,908
33,977
279,266
249,972
192,299
178,694
129,702
EVA (Economic Value Added): NOPAT – (WACC*TOC prior
year
year)
FCF (Free Cash Flow)
NOWC (Net Operating Working Capital)
Operating Long Term Assets (Property, Plant & Equipment, net)
TOC (Total Operating Capital or Invested Capital)
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 Corporation
NOPAT (Net Operating Profit After Tax): Pre-Tax Income*(1–T)
ROIC (Return On Invested Capital): NOPAT / TOC prior
EVA (Economic Value Added): NOPAT – (WACC*TOC prior
year
year)
FCF (Free Cash Flow)
NOWC (Net Operating Working Capital)
Operating Long Term Assets (Property, Plant & Equipment, net)
TOC (Total Operating Capital or Invested Capital)
2004
2003
2002
2001
2000
4,611
–1,212
6,018
118
2,325
2.51%
–0.75%
4.13%
0.07%
N.A.
–13,775
–17,271
–8,540
–15,686
N.A.
4,122
–24,488
–8,994
12,569
N.A.
102,117
111,828
92,836
76,801
88,692
82,240
72,040
67,756
68,779
69,339
184,357
183,868
160,592
145,580
158,031
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.
Final Ranking
for “Big Three”
• #1
• #2
• #3
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.