Firm Value, Sales

= (AT Oper Margin

FRTTii -1)

AT Oper Margin = After-tax operating margin =--—-

Sales

RTR = Reinvestment Rate (RTRn is for stable growth period) kc = Cost of capital (hg: high growth and st: stable growth periods) g = Growth rate in operating income in high growth and stable growth periods Note that the determinants of the value to sales ratio remain the same as they were in the stable growth model - the growth rate, the reinvestment rate, the operating margin and the cost of capital - but the number of estimates increases to reflect the existence of a high growth period.

Illustration 20.3: Estimating the value to sales ratio for Coca Cola

Coca Cola has one of the highest operating margins of any large U.S. firm and it should command a high value to sales ratio, as a consequence. To estimate the value to sales ratio at which Coca Cola should trade at, we used the following inputs.

Table 20.3: Inputs for Estimating Value to Sales: Coca Cola

High Growth Period |
Stable Growth Period | |

Length |
10 years |
Forever after year 10 |

Growth Rate |
8.92% |
5% |

After-tax Operating Margin |
16.31% |
16.31% |

Cost of Capital |
9.71% |
8.85% |

Reinvestment Rate |
40% |
31.25% |

The return on capital during the high growth period is expected to be 22.30% and to drop to 16% during stable growth. Based upon these inputs, we can estimate the value to sales ratio for Coca Cola.

The return on capital during the high growth period is expected to be 22.30% and to drop to 16% during stable growth. Based upon these inputs, we can estimate the value to sales ratio for Coca Cola.

f(1 - 0.3125)(1.0892)10(1.05) _ (0.0885 - 0.05)(1.0971)10 ,

Based upon its fundamentals, you would expect Coca Cola to trade at 3.79 times revenues. The firm was trading at 5.9 times revenues in May 2001.

^frmmult.xls. This spreadsheet allows you to estimate the value to sales ratio for a stable growth or high growth firm, given its fundamentals.

The key determinant of revenue multiples is the profit margin - the net margin for price to sales ratios and operating margin for value to sales ratios. Firms involved in businesses that have high margins can expect to sell for high multiples of sales. However, a decline in profit margins has a two-fold effect. First, the reduction in profit margins reduces the revenue multiple directly. Second, the lower profit margin can lead to lower growth and hence lower revenue multiples.

The profit margin can be linked to expected growth fairly easily if an additional term is defined - the ratio of sales to book value, which is also called a turnover ratio. This turnover ratio can be defined in terms of book equity (Equity Turnover = Sales/ Book value of equity) or book capital (Capital Turnover = Sales/ Book value of capital). Using a relationship developed between growth rates and fundamentals, the expected growth rates in equity earnings and operating income can be written as a function of profit margins and turnover ratios.

For example, in the valuation of Unilever in Illustration 20.2, the expected growth rate of earnings is 8.67%. This growth rate can be derived from Unilever's net margin (5.82%) and sales/equity ratio (3.0485).

(Retention ratio )(Return on Equity ) =

Expected growth^y =

(Retention ratio )(Return on Equity ) =

Expected growth^y =

(Retention ratio )(Net Margin)(Sales/BV of Equity )

For growth in operating income, Expected growthFirm

(Reinvestment Rate )(Return on Capital ) Rate

- (Reinvestment Rate )(After -tax Operating Margin )(Sales/BV of Capital)

In the valuation of Coca Cola in Illustration 20.3, the expected growth rate of operating income is 8.92%. This growth rate can be derived from Coca Cola's after-tax operating margin (16.31%) and sales/capital ratio (1.37). Expected growthfirm

- (Reinvestment Rate)After - tax Operating Margin)(Sales/BV of Capital)

As the profit margin is reduced, the expected growth rate will decrease, if the sales do not increase proportionately.

Illustration 20.4: Estimating the effect of lower margins of price-sales ratios

Consider again the firm analyzed in Illustration 20.1. If the firm's profit margin declines and total revenue remains unchanged, the price/sales ratio for the firm will decline with it. For instance consider the effect if the firm's profit margin declines from 10% to 5%, and the sales/BV remains unchanged.

(Retention Ratio)(Profit Margin )(Sales/BV)

New Growth rate in first five years - (0.8)(0.05X2.50)

The new price sales ratio can then be calculated as follows:

0.115-0.10

PS=0.05

0.77

0.115-0.10

The relationship between profit margins and the price-sales ratio is illustrated more comprehensively in the following graph. The price-sales ratio is estimated as a function of the profit margin, keeping the sales/book value of equity ratio fixed.

Figure 20.2: P/S Ratios and Profit Margins

Profit Margin

This linkage of price-sales ratios and profit margins can be utilized to analyze the value effects of changes in corporate strategy as well as the value of a 'brand name'.

Every firm has a pricing strategy. At the risk of over-simplifying the choice, you can argue that firms have to decide whether they want to go with a low-price, high volume strategy (volume leader) or with a high price, lower volume strategy (price leader). In terms of the variables that link growth to value, this choice will determine the profit margin and turnover ratio to use in valuation.

You could analyze the alternative pricing strategies that are available to a firm by examining the impact that each strategy will have on margins and turnover and valuing the firm under each strategy. The strategy that yields the highest value for the firm is, in a sense, the optimal strategy.

Note that the effect of price changes on turnover ratios will depend in large part on how elastic or inelastic the demand for the firm's products are. Increases in the price of a product will have a minimal effect on turnover ratios if demand is inelastic. In this case, the value of the firm will generally be higher with a price leader strategy. On the other hand, the turnover ratio could drop more than proportionately if the product price in increased and demand is elastic. In this case, firm value will increase with a volume leader strategy.

Illustration 20.5: Choosing between a high-margin and a low-margin strategy. Assume that a firm has to choose between the two pricing strategies. In the first strategy, the firm will charge higher prices (resulting in higher net margins) and sell less (resulting in lower turnover ratios). In the second strategy, the firm will charge lower prices and sell more. Assume that the firm has done market testing and arrived at the following inputs:

High-Margin Low-Margin

Low Volume High Volume

Profit Margin 10% 5%

Sales/Book Value 2.5 4.0

Assume, in addition, that the firm is expected to pay out 20% of its earnings as dividends over the next five years, and 50% of earnings as dividends after that. The growth rate after year 5 is expected to be 8%. The book value of equity per share is $10. The cost of equity for the firm is 11.5%.

High Margin Strategy

Expected Growth rate in first five yearsHigh margin = (Profit Margin )(Sales/BV)(Retention ratio)

( ( ( )5 1 (0.2)('.20) ' - (L20) 5 5 = (0'0) 1 (U'5)j , (0.50)('.20)5(,.08)

Price/Sales Ratio High margin

Sales/Book ValueHigh margin = 2.50

PriceHigh margin = (Price/Sales)(Sales/BV)(BV of Equity )= (2.35)(2.5)(10)= $ 58.83

Low Margin Strategy

Expected Growth rate in first five yearsLow margin = (Profit Margin )(Sales/BV)(Retention ratio)

Price/Sales RatioLow margin =

Sales/Book ValueLow margin = 4.00

PriceLow margin = (Value/Sales )(Sales/BV)(BV of Equity)= (0.9966)(4)(10)= $39.86

The high margin strategy is clearly the better one to follow here, if the objective is value maximization.

Illustration 20.6: Examining the effects of moving to a lower-margin, higher volume strategy: Philip Morris in 1993

Philip Morris had sales of $59,131 million, earned $4,939 million in net income and had a book value of equity of $12,563 million in 1992. The firm paid 42% of its earnings as dividends in 1992. The beta for the stock was 1.10.

Based upon 1992 figures, the inputs for the price/sales ratio calculation would be: Profit Margin = 8.35% Beta for the stock = 1.10

Sales / Book Value of Equity = 4.71 Expected Return = 7% + 1.1 (5.5%)

Retention Ratio = 58%

Expected growth rate over next five years

= (Retention Ratio)(Profit Margin )(Sales/Book Value) = (0.58)(0.0835)(4.71)

Expected growth rate after five years = 6% Expected payout ratio after five years 65%

Price/Sales Ratioi992 Margins f

Sales/Book Valuei992 Margins = 4.71

In April 1993, Philip Morris announced that it was cutting prices on its Marlboro Brand of cigarettes because of increasing competition from low-priced competitors. This was viewed by many analysts as a precursor of further price cuts and as a signal of a move to a lower-margin strategy. Assume that the profit margin will decline to 7% from 8.35%, as a consequence. If we assume that the sales/book value of equity ratio will remain unchanged at 4.71, we can estimate the expected growth. Expected growth rate over next five years = (Retention Ratio )(Profit Margin)(Sales/Book Value ) = (0.58)(0.07)(4.71) = 19.11%

Expected growth rate after five years = 6% Expected payout ratio after five years = 65%

Price/Sales Ratioi992 Margins

As a consequence of the new lower-price strategy, the price-sales ratio will decline from 1.46 to 1.06. Unless the sales/book value ratio increases by an equivalent proportion (16.19%), the value of Philip Morris will decrease. In the case where profit margins decline by this magnitude and the sales/book value is not expected to increase, the value will decline by 27.41%.

The market reacted negatively to the announcement of price cuts and the stock price dropped approximately 20% on the announcement.

Pricing Strategy, Market Share and Competitive Dynamics

All too often, firms analyze the effects of changing prices in a static setting, where only the firm is acting and the competition stays still. The problem, though, is that every action (especially when it comes to pricing) generates reactions from competition and the net effects can be unpredictable.

Consider, for instance, a firm that cuts prices, hoping to increase market share and sales. If the competition does nothing, the firm may be able to accomplish its objectives. If, on the other hand, the competition reacts by also cutting prices, the firm may find itself with lower margins and the same turnover ratios that it had before the price cut - a recipe for lower firm value. In competitive industries, you have to assume that the latter will happen and plan accordingly.

There are some firms that have focused on maximizing market share as their primary objective function. The linkage between increased market share and market value is a tenuous one and can be examined using the profit-margin/revenue multiple framework developed above. If increasing market share leads to higher margins, either because of economies of scale driving down costs or increased market power driving out competitors, it will lead to higher value. If the increase in the market share is accompanied by lower prices and profit margins, the net effect on value can be negative.

One of the critiques of traditional valuation is that it fails to consider the value of brand names and other intangibles. Hiroyumi Itami, in his book "Mobilizing Invisible Assets", provides a summary of this criticism. He says:

"Analysts have tended to define assets too narrowly, identifying only those that can be measured, such as plant and equipment. Yet the intangible assets, such as a particular technology, accumulated consumer information, brand name, reputation and corporate culture, are invaluable to the firm's competitive power. In fact, these invisible assets are the only real source of competitive edge that can be sustained over time."

While this criticism is clearly overstated, the approaches used by analysts to value brand names are often ad-hoc and may significantly overstate or understate their value. Firms with well known brand names often sell for higher multiples than lesser-known firms. The standard practice of adding on a 'brand name premium', often set arbitrarily, in relationship to discounted cashflow value, can lead to erroneous estimates. Instead, the value of a brand name can be estimated using the approach that relates profit margins to price-sales ratios.

One of the benefits of having a well-known and respected brand name is that firms can charge higher prices for the same products, leading to higher profit margins and hence to higher price-sales ratios and firm value. The larger the price premium that a firm can charge, the greater is the value of the brand name. In general, the value of a brand name can be written as:

(V/S)b = Value-Sales ratio of the firm with the benefit of the brand name (V/S)g = Value-Sales ratio of the firm with the generic product

Illustration 20.7: Valuing a brand name using price-sales ratio

Consider two firms which produce similar products that compete in the same market place. Famous Inc. has a well-known brand name and has an after-tax operating profit margin of 10%, while NoFrills Inc. makes a generic version and has an after-tax operating margin of 5%. Both firms have the same sales-book capital ratio (2.50) and the cost of capital of 11.5%. In addition, both firms are expected to reinvest 80% of their operating income in the next five years and 50% of earnings after that. The growth rate after year 5 for both firms, is 8%.

Valuing Famous Expected growth ratepamous

= (Reinvestment Rate)(After - tax Operating Margin)(Sales/BV of Capital)

Value/Sales Ratiopamous

0.115-0.20

Valuing NoFrills Expected growth rateNoFrills

= (Reinvestment Rate)(After - tax Operating Margin)(Sales/BV of Capital) = (0.8)(0.05)(2.50)

Value/Sales RatioNoFrills

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