Equity Analysis and Valuation - Texas Tech...
Transcript of Equity Analysis and Valuation - Texas Tech...
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Equity Analysis and Valuation
Stephanie Berg
Aaron Gonzalez
Rachel Hilz
Roland Morgan
Sonya Wiley
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Table of Contents
Executive Summary ......................................................................................... 1
Industry Analysis ................................................................................................ 2
Accounting Analysis ............................................................................................ 3
Financial Analysis, Forecast Financials, and Cost of Capital Estimation ..................... 4
Valuations .......................................................................................................... 6
Business and Industry Analysis ....................................................................... 7
Business Overview .............................................................................................. 7
Industry Overview .............................................................................................. 8
Five Forces Model .......................................................................................... 10
Rivalry among Existing Firms ............................................................................. 12
Industry Growth Rate ..........................................................................................................13
Concentration and Balance of Competitors ............................................................................14
Differentiation .....................................................................................................................15
Switching Cost ....................................................................................................................15
Economies of Scale .............................................................................................................15
Learning Economies ............................................................................................................17
Fixed and Variable Costs ......................................................................................................18
Excess Capacity ..................................................................................................................18
Exit Barriers ........................................................................................................................19
Threat of New Entrants ..................................................................................... 21
Economies of Scale .............................................................................................................21
First Mover Advantage .........................................................................................................22
Access to Distribution Channels and Relationships .................................................................22
Legal Barriers ......................................................................................................................23
Threat of Substitute Products ............................................................................ 24
Customers Willingness to Switch ..........................................................................................28
Bargaining Power of Customers ......................................................................... 29
Price Sensitivity ...................................................................................................................29
Relative Bargaining Power ...................................................................................................29
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Customer Switching Costs ....................................................................................................31
Bargaining Power of Suppliers ........................................................................... 32
Price Sensitivity ...................................................................................................................32
Relative Bargaining Power ...................................................................................................33
Value Creation Analysis ................................................................................. 34
Research and Development ............................................................................... 34
Superior Product Variety .................................................................................... 35
Superior Product Quality ................................................................................... 35
Tight Cost Control System ................................................................................. 36
Firm Competitive Advantage Analysis ........................................................... 37
Research and Development ............................................................................... 37
Superior Product Variety .................................................................................... 38
Superior Product Quality ................................................................................... 38
Tight Cost Control System ................................................................................. 39
Formal Accounting Analysis ........................................................................... 40
Key Accounting Policies ..................................................................................... 41
Research and Development Expenses .........................................................................41
Goodwill ....................................................................................................................44
Defined Benefit Pension Plans .....................................................................................47
Litigation Expenses ....................................................................................................49
Accounting Flexibility ........................................................................................ 50
Research and Development Expenses .........................................................................50
Goodwill ....................................................................................................................51
Defined Benefit Pension Plans .....................................................................................51
Litigation Expenses ....................................................................................................52
Accounting Strategy .......................................................................................... 53
Research and Development Expenses .........................................................................53
Goodwill ....................................................................................................................54
Defined Benefit Pension Plans .....................................................................................55
Litigation Expenses ....................................................................................................55
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Quality of Disclosure ......................................................................................... 56
Research and Development Expenses .........................................................................57
Goodwill ....................................................................................................................57
Defined Benefit Pension Plans .....................................................................................58
Litigation Expenses ....................................................................................................59
Quantitative Accounting Measures and Disclosures .............................................. 60
Sales Manipulation Diagnostics ....................................................................................61
Expenses Manipulation Diagnostics .............................................................................67
Potential Red Flags ........................................................................................... 74
Undoing Accounting Distortions ......................................................................... 74
Financial Analysis and Forecasting Financials ............................................... 80
Liquidity Ratio Analysis ...................................................................................... 80
Current Ratio .............................................................................................................81
Quick Asset Ratio .......................................................................................................82
Working Capital Turnover ...........................................................................................83
Accounts Receivable Turnover ....................................................................................84
Day’s Sales Outstanding .............................................................................................85
Inventory Turnover ....................................................................................................86
Day’s Supply in Inventory ...........................................................................................87
Cash to Cash Cycle ....................................................................................................88
Profitability Ratio Analysis .................................................................................. 90
Gross Profit Margin ....................................................................................................90
Operating Expense Ratio ............................................................................................91
Operating Profit Margin ..............................................................................................92
Net Profit Margin .......................................................................................................93
Asset Turnover ..........................................................................................................94
Return on Assets .......................................................................................................95
Return on Equity ........................................................................................................96
Capital Structure Analysis .................................................................................. 98
Debt to Equity Ratio ...................................................................................................98
Times Interest Earned .............................................................................................. 100
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Debt Service Margin ................................................................................................. 101
Credit Risk ...................................................................................................... 102
Firm Growth Rate ............................................................................................ 102
Internal Growth Rate ............................................................................................... 103
Sustainable Growth Rate .......................................................................................... 104
Financial Statement Forecasting ................................................................. 106
Income Statement ........................................................................................... 106
Balance Sheet ................................................................................................. 110
Statement of Cash Flows .................................................................................. 115
Cost of Capital Estimation ........................................................................... 118
Cost of Equity .................................................................................................. 118
Regression Analysis Results .............................................................................. 119
Cost Debt ........................................................................................................ 121
Weighted Average Cost of Capital ..................................................................... 122
Valuation Analysis ....................................................................................... 123
Method of Comparables ................................................................................... 123
Price to Earnings Trailing .................................................................................. 124
Price to Earnings Forward ................................................................................. 125
Price to Book ................................................................................................... 126
Price Earnings Growth ...................................................................................... 127
Price over EBITDA ........................................................................................... 128
Price over Free Cash Flows ............................................................................... 129
Enterprise Value over EBITDA ........................................................................... 130
Discounted Dividends Model ............................................................................. 132
Discounted Free Cash Flows Model .................................................................... 135
Residual Income Model .................................................................................... 137
Abnormal Earnings Growth Model ..................................................................... 139
Long Run Residual Income Model ..................................................................... 141
Appendix ..................................................................................................... 144
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SNA ‐ NYSE (6/1/2008) Altman Z‐Score52 Week Range $38.39 ‐ $58.00 2003 2004 2005 2006 2007Revenue $22.74 billion Initial 3.02 2.77 3.03 3.64 3.33Market Capitalization $61.45 billionShares Outstanding 1.33 billion Market Price (6/1/2008) $44.13
Book Value Per Share Initial Revised Comparables Based Valuations Initial RevisedROE Trailing P/E 54.90 76.10ROA Forward P/E 47.00 65.50
P.E.G. 15.80 11.30Cost of Capital P/B 56.20 113.40Estimated R‐Squared Beta Alternate Estimate Ke P/EBITDA 47.00 72.003‐Month 0.307 1.20 0.131 P/FCF 49.00 ‐6‐Month 0.308 1.20 0.131 EV/EBITDA 42.30 ‐2‐Year 0.309 1.20 0.1315‐Year 0.310 1.20 0.13110‐Year 0.310 1.20 0.131 Intrinsic Valuations
Discounted Dividends 16.61Back Door Ke 10.9 Free Cash Flows 20.04Published Beta 0.85 Residual Income 26.7Cost of Debt 0.28 LR ROE RI 49.94WACC (BT) 0.11 A.E.G. 28.6
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Industry Analysis
Wyeth is a world leader in the pharmaceutical, consumer healthcare, and animal
healthcare industry. In 1860, John and Frank Wyeth opened a drug store in
Philadelphia, Pennsylvania called John Wyeth and Brother. Since then the company has
become a major supplier of pharmaceutical products to hospitals, doctors, pharmacies,
and wholesalers around the world. Wyeth is a leader in the immunization field, and
was the first to mass produce Penicillin. All of the products produced by Wyeth are
made in the United States, Puerto Rico and a total of 13 other countries. During the
past five years, Wyeth has increased their net revenue from 15.8 billion in 2003 to 22.4
billion in 2007, an increase of 41.32%. Wyeth comprises 5.5% of the total
Pharmaceutical Industry Market Capitalization.
The direct competitors in the industry to Wyeth are Pfizer, Eli Lilly, and Abbott. The
pharmaceutical industry is a highly competitive industry, so in order to capture market
share, a firm must compete on product differentiation, innovation, and tight cost
control. The large amounts of Research and Development invested by firms in the
industry, is an excellent measure of the value of product differentiation and innovation.
Major Drug Manufacturers must constantly produce new products that will benefit the
public, in order to grow the firm.
As a whole, the pharmaceutical industry has high competition among existing firms.
The switching costs for pharmaceutical firms are high because most of their net
working capital is tied up in R&D. Economies of scale are also high, so this makes
rivalry among existing firms high. Rivalry among existing firms is so high that the best
advantage a firm in this industry has is firm recognition. There is a low threat of new
entrants, because there is a great first mover advantage, as well as difficult barriers to
entry. The amount of capital needed to invest in R&D each year is so high, it would
take new entrants a long time to catch up to the existing firms. The industry has a high
threat of substitute products, because once a patent for a drug has expired, other firms
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will make a cheaper generic. Relative bargaining power of buyers is mixed, and
suppliers possess low bargaining power.
The key success factors in the pharmaceutical industry are Research and Development,
superior product variety, superior product quality, and tight cost control. The value
creation policies, if utilized, give firms an advantage in the market. Wyeth operates its
business based on these four key success factors.
Accounting Analysis
By evaluating the financial statements of a firm and their competitors, an analyst can
determine the degree of accounting that captures the underlying business reality. A
formal accounting analysis allows the analyst to evaluate a company based on the
amount and quality of disclosure on financial statements. Companies have the ability to
hide certain facts about the company, or present values that are misleading. A formal
accounting analysis highlights the key accounting policies a firm utilizes and then relates
them to the firm’s key success factors.
The key accounting policies used by firms within the pharmaceutical industry are
research and development, goodwill, defined pension plans, and litigation expenses. All
investments associated with research and development is expensed as GAAP requires.
Pharmaceutical companies obtain a large amount of goodwill and must test for
impairments in order to decide whether to amortize it or not. Managers have
accounting flexibility when it comes to deciding if goodwill should be written down or
not. Pension plans are either defined benefit or defined contribution plans, and firms
decide the appropriate discount rate to use. Firms in the pharmaceutical industry
identify possible litigation expenses and set reserves to cover them.
Wyeth’s overall accounting strategy is mixed. Research and development is well
documented in the 10-K. All expenses related to R&D are expensed immediately, so
the is no flexibility when it comes to these investments. Wyeth’s disclosure of goodwill
in their 10-K is mixed. They clearly state their policies pertaining to goodwill and
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impairments, and disclose the amount of goodwill obtained when purchasing a new
entity. However, the accounting for impairing goodwill is never stated. The pension
plan accounting clearly shows the logic behind the discount rates, and shows their
pension obligations. Litigation expense is very transparent and is of great quality.
After analyzing the sales and expense diagnostic ratios, we determined that there were
no red flags present. No questionable accounting practices were evident after the
analysis of the financials.
In order to have a better understanding of the value of Wyeth, restating the financial
records was necessary. We made adjustments to the Balance Sheet and Income
Statement to reflect what they would look like if R&D were an asset and if goodwill was
amortized. If R&D were listed as an asset and then capitalized, rather than expensed
the assets would increase, expenses would decrease, and net income and retained
earnings would increase. If goodwill was amortized 20% per year, the assets would
decrease expenses would increase, and net income and retained earnings would
decrease. R&D is a much larger value, so after restatement, the net change on the
financials followed the R&D trend.
Financial Analysis, Forecast Financials, and Cost of Capital Estimation
Through the use of liquidity, profitability, and capital structure ratios, an analysis of a
firm’s finances can be drawn. After computing these ratios for Wyeth and their
competitors, we were able to see if Wyeth deviated from the norms of the industry,
either positively or negatively. A firm’s financial strength, relative to competitors, is
expressed through the use of these ratios.
Liquidity ratios are used to determine a company’s ability to meet its short-term
obligations. The current ratio and quick ratio for Wyeth are consistently above 1,
suggesting that the firm is capable of meeting its short-term debt obligations by turning
assets into cash. Wyeth’s operating efficiency is above the industry average, and are
also managing their accounts receivable and inventory better than the industry average.
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Profitability ratios are used to evaluate the ability of a company to generate earnings in
relation to their associated revenues, income and assets. Wyeth consistently performs
close to the industry average on these ratios. Wyeth has found a way to generate
earnings through constant sales growth. Wyeth continues to earn profits and returns at
an industry average.
Capital structure analysis is a method performed to determine how a company finances
its assets. Wyeth has consistently lowered their debt to equity ratio over the last six
years, improving their leverage.
Understanding these ratios and analyzing them for Wyeth and their competitors allowed
us to accurately forecast Wyeth’s financial statements for the next ten years. The
Income Statement was the first statement to be forecasted. The first three years after
2007 were forecasted as a running average while a constant change was used for the
following years until 2018. The future sales growth percentages were calculated by
averaging the past five years of financials and using this percentage growth extended
until 2018. Sales growth was relatively steady for the past five years and this is the
reason why the average of sales growth was used. Ultimately, net sales were increased
by a constant percentage of 8.96%. The cost of goods sold for past couple of years
never changed by more than one percentage point. The forecasted cost of goods sold
is the average of the past six years. After calculating the gross profit by subtracting
cost of goods sold from net revenue, the selling, general and administrative expenses
were forecasted.
We used ratios that link the balance sheet with the income statement to forecast with
the most accuracy possible. Assets are linked to sales by the asset turnover ratio. We
estimated a constant asset turnover of .58 from 2008 to 2018. We forecasted the
current ratio to calculate the current assets and current liabilities for Wyeth from 2008
to 2018. We used a running average of the past six years, as our forecasted current
ratio due to the variability in the trend, of 2.16. To forecast values of current liabilities,
we multiplied the current asset values we forecasted by the forecasted current ratio.
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Retained earnings are calculated by using the beginning balances of retained earnings,
adding net income and subtracting dividends paid. In order to forecast dividends, we
must calculate the dividend payout ratio. Using past years’ net income, we were able to
divide dividends by net income and averaged these payout ratios to forecast them for
the next ten years at .46. Next, we had to use the forecasted net incomes and multiply
them by the respective year’s payout ratios to calculate the forecasted dividends.
Finally, we calculated forecasted retained earnings using the forecasted net income and
dividend amounts. Once we had the retained earnings forecasted, we could forecast
total shareholder’s equity. Adding the difference in the beginning and ending retained
earnings balances to the previous year’s total shareholder’s equity amount gave us the
current year’s forecasted total shareholder’s equity.
The cost of equity was calculated by finding the risk free rate on June 1 10-year
Treasury bill rate (June 1 is the date we are valuing the company), which was 3.98%.
We ultimately chose the 10-year Treasury bill with a 72 month regression. The Beta
was found to be 1.016. We used the CAPM formula to find Wyeth’s Ke (cost of equity)
to be 13.1%. Wyeth’s cost of debt was found to be 5.19%, and WACC before tax to be
11% and after tax, 10%.
Valuation Analysis
Method of comparables is the simple and fast way to value a company, but being a
simple form of measurement it is not reliable. There are eight different ratios based on
easy to find data. Occasionally some competitors were omitted from the industry
averages. The stock prices ranged between $42.33 - $56.26 per share for Wyeth
before restatement, and $65.58 – $113.41 after restatement. The method of
comparables proved to be an inaccurate measure based on the wide range of share
prices. These inaccuracies could occur because the valuations for these methods are
based on historical prices. The resulting indication of Wyeth’s value was unclear
because there was no consistent trend.
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The intrinsic valuation models proved to be a more accurate picture of the firm.
Intrinsic valuation models use the present value of future cash flows to determine share
price. Wyeth’s observed share price on June 2, 2008 was $44.13. The discounted
dividend model valued Wyeth at $16.61, but this value only reflects the value of the
firm based on dividends and so it is not very accurate. Based on 15% confidence
intervals we made the following chart.
50.76 or >= undervalued
37.51-50.75 fair valued
37.50 or < = overvalued
The discounted free cash flows model demonstrated that Wyeth’s share price is
estimated to be $22.42, and so Wyeth is again overvalued. The residual income model
showed an initial time consistent price of $28.94, and $14.30 using the restated
financial statements. Again, Wyeth was found to be overvalued. The abnormal
earnings growth model found an initial time consistent price of $27.29, and $19.12
using the restated financial statements. The results of the abnormal earnings growth
model are in agreement with the previous method findings that Wyeth is overvalued.
According to the long run residual model Wyeth is undervalued. Our final conclusion is
that Wyeth is overvalued based on the results of the majority of the models tested.
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Business and Industry Analysis
Business Overview
In 1860, John and Frank Wyeth opened a drug store in Philadelphia, Pennsylvania
called John Wyeth and Brother. The small drug store housed a research lab, where the
two manufactured medicines for doctors and eventually wrote a book on preparing
drugs. During the Civil War the pair made and distributed drugs for the Union soldiers.
The first major achievement for the company came when, “Henry Bower, an employee
of John Wyeth and Brother, developed the first rotary compressed tablet machines in
the United States for mass-producing medicines with unprecedented precision and
speed” (www.wyeth.com). In 1926, the firm became known as American Home
Products. In 1944, Wyeth was selected by the government, along with 22 other
companies, to manufacture Penicillin. Wyeth is now based out of Madison, New Jersey.
Wyeth has three divisions: Consumer Healthcare, Pharmaceuticals, and Animal Health.
“The Consumer Healthcare segment develops, manufactures, distributes and sells over-
the-counter health care products” (Wyeth 10-K). This segment is well-known for the
sale of Robitussin, Dimetapp, Advil, and Chapstick. “These products are generally sold
to wholesalers and retailers and are promoted primarily to consumers worldwide
through advertising” (Wyeth 10-K). “The Pharmaceuticals segment develops,
manufactures, distributes and sells branded human ethical pharmaceuticals,
biotechnology products, vaccines and nutrition products” (Wyeth 10-K). The majority of
the sale of these goods is to hospitals, doctors, pharmacies and wholesalers around the
world. “The Animal Health segment develops, manufactures, distributes and sells
animal biological and pharmaceutical products” (Wyeth 10-K). These products sold in
the Animal Health segment are targeted to veterinarians and other animal health
providers. All of the products produced by Wyeth are made in the United States, Puerto
Rico and a total of 13 other countries.
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During the past five years, Wyeth has increased their net revenue from 15.8 billion in
2003 to 22.4 billion in 2007, an increase of 41.32%. Wyeth comprises 5.5% of the
total Pharmaceutical Industry Market Capitalization. Wyeth continues to protect its
market share and products through the use of patents. Wyeth currently finds itself
protecting one of its most profitable drugs, Protonix, in a patent infringement suit with
Sandoz and their generic form of the drug. According to an article in the Wall Street
Journal dated May 21, 2008, “The suit seeks a court ruling that Sandoz has infringed
the Protonix I.V. patent and a permanent injunction barring Sandoz from selling a
generic version until the patent expires in 2010.” By protecting their market share,
Wyeth continues to be one of the major Pharmaceutical producers.
Industry Overview
The pharmaceutical industry is a growing sector where there is potential for large
amounts of profit. Improvements in technology have played a significant role in
improving medicine in the last century. With the baby boomer generation aging,
demand for more advanced and specialized medicine is increasing constantly. It is no
surprise that the increased expected life span of the population in the United States is a
direct result of improved healthcare practices and medicines.
These variables have caused this industry to expand in various areas including medical
instruments, nutritional supplements, over the counter medication and prescription
based drugs. The most prominent field in this industry is undoubtedly pharmaceuticals.
Companies that focus on the development and production of drugs receive most of their
revenue from pharmaceutical sales, especially those under patent protection. When
their important patents end, generic substitutes appear in the market and force prices
to decrease. This makes it imperative for drug manufacturers to develop a drug and
secure that patent as soon as possible.
It is crucial for those all important patents to be made before competitors. Because of
this, pharmaceutical companies spend millions of dollars in research and development.
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The costs of research and development have also increased substantially in the past
couple of years. According to PhRMA, the cost of developing a drug has increased from
802 million dollars in 2001 to 1,318 million in 2006. The time to develop a drug has
also increased to a period of 10-15 years. This span of time costs drug companies a
considerable amount of money, especially if the drug does finish the development cycle
or does not get approved by the FDA.
The United States Food and Drug Administration is the regulatory agency for the
pharmaceutical industry as well as other medical products, food and supplements. This
organization has the final say as to whether a drug is permitted to enter the market as
well as the developmental process and testing phases. Drug manufacturers have fallen
under strong scrutiny involving unsafe drugs as of late. According to the Wall Street
Journal, only 19 new drugs were approved by the FDA last year. This is the lowest
number since 1983. (WSJ) The pharmaceutical companies claim that the FDA has been
stricter lately but the FDA says it has not changed its standards.
This is just a small glimpse of the pharmaceutical industry. There are many
components but these are the most important. The expansion of the medicinal field,
research and development and regulatory concerns all play a big role in shaping this
industry.
The Five Forces Model
The five forces model, developed by Michael Porter, is an industry analysis tool used to
define the competitive forces of any given industry. The five forces model consists of
five major factors. First, the rivalry among existing firms which sets the basis of
competition within the industry. When opposition is strong, price setting becomes more
aggressive. Second, the threat of new entrants determines price in regards to the ease
of entering the industry. As barriers to entry increase price competition decreases. Next,
the threat of substitute products is an alternative option for the consumer that with
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fulfill their original “desire” at a lower cost. Substitute products are only made effective
by the customer’s willingness to switch. In addition, the bargaining power of buyers is
the degree a customer drives the market price. Finally, the bargaining power of
suppliers exists when the customer has few choices of substitutes in regards to
supplies. Once the five forces model is established for an industry it enables a company
to decide if they compete on basis of commodities in a cost leadership industry, or
specialization in a differentiation industry. Our analysis described in the following
sections show that the pharmaceuticals industry has aspects of both cost leadership
and differentiation. Using the five forces model, the following chart outlines the degree
of each competitive force for the pharmaceutical industry.
Five Forces Competition
Rivalry Among Existing Firms High
Threat of New Entrants Low
Threat of Substitute Products High
Bargaining Power of Buyers Mixed
Bargaining Power of Suppliers Low
Overall Mixed
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Competitive Force 1: Rivalry among Existing Firms
Porter’s Five Forces of Competition model outlines characteristics of an industry which
contribute to the high or low competition among existing firms. These particular
characteristics which define the high competition among players in the pharmaceuticals
industry include: industry growth rate (based on revenue), concentration of
competitors, differentiation, switching costs for the firm, economies of scale, learning
economies, fixed-variable costs, excess capacity, and exit barriers. The chart below
indicates each characteristic and whether it contributes to low, moderate or high rivalry
among the existing firms for the pharmaceuticals industry.
Industry Growth Rate Moderate
Concentration of Competitors Moderate
Differentiation High
Switching Costs High
Economies of Scale High
Learning Economies High
Fixed-Variable Costs High
Excess Capacity High
Exit Barriers High
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Industry Growth Rate
For the pharmaceuticals industry, a good indicator of industry growth is revenue growth
rate. High revenue growth rates for an industry indicate that there is low competition
for market share, therefore providing potential for high profitability. Revenue growth
from year-to-year is based on the number of drugs that are developed and sold in the
market.
Industry Revenue Growth
$0
$50,000
$100,000
$150,000
$200,000
$250,000
$300,000
$350,000
2003 2004 2005 2006 2007
(WSJ.com, Annual Earnings)
The past five years revenue data for the industry indicate that pharmaceuticals are
growing at an average rate of about 8.93%. Competition exists amongst firms in an
industry where there is constant growth. Pharmaceutical firms must compete for market
share by capitalizing on the opportunity for producing differentiated products.
Investment in research and development and the launch of new drugs is the only way a
firm can stay competitive in the industry. Pharmaceuticals are developing, protecting
and marketing new drugs to account for the older drugs that compete on price with
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generics as their patents expire. The industry growth increases pressures for innovation
and differentiation, as well as price competition.
Concentration and Balance of Competitors
Industries that are low-concentration can control price as there are fewer the number
of firms in that market. Highly concentrated industries have many players and
therefore, price must be an element of competitive strategy in order to be successful.
The top drug manufacturers in the pharmaceuticals industry which hold the most
market share of revenue comprise about 92.3% of the industry’s total market. The rest
of the market which comprises the rest of the market includes over 150 firms. There
are many firms in the pharmaceuticals industry, yet the extreme majority of its sales
volume lies with only a handful of firms. Moderate concentration exists in this industry
because in order to be successful, firms have to must take price control in their overall
competitive strategy; yet, at the same time, they must invest in research and
development to produce highly differentiated products.
Market Share
0%
10%
20%
30%
40%
50%
60%
2003 2004 2005 2006 2007
% o
f Ind
ustry
Sal
es
PFEABTWYELLY
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Differentiation
As patents expire and generics are launched into the market, firms must compete on
price for those specific products. Pharmaceuticals must perpetuate the cycle of revenue
growth by pushing newly patented drugs into the market to replace the loss of revenue.
When the volume of patented drugs sold in the market outweighs the volume of older
drugs which compete with generics, the industry grows. Product differentiation is the
core competitive strategy that perpetuates revenue growth. Research and development
is the vehicle which carries out this differentiation strategy. Money spent on R&D is
directly linked to revenue growth as a firm’s survival in the pharmaceuticals industry
relies continuous product differentiation. Industries that rely heavily on differentiation,
R&D, and a first mover advantage must continuously evolve and create, rather than cut
costs for a more homogenous product. For the pharmaceuticals industry, product
differentiation contributes to high competition.
Switching Costs
For highly differentiated industries, switching costs for the firm are typically high as
well. Pharmaceutical firms have most of their net working capital tied up in research
and development. Pending lawsuits also contribute to high switching costs for the firm.
Major drug manufacturers often file lawsuits against each other for patent infringement.
Also, many firms are filed suit against by customers as long-term effects of their drugs
are sometimes found to be harmful or possibly fatal. Switching costs contribute to high
competition amongst existing pharmaceutical firms in the industry.
Economies of Scale
Industries where growth is stable do not need to utilize economies of scale as their
fixed costs will help contribute to revenue growth as opposed to hindering it.
Economies of scale exist when a firm carries very little fixed costs and can adjust their
production capacity by minimizing or maximizing variable costs. When there is rapid
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revenue growth, firms must be able to utilize economies of scale in order to be
competitive in their industry. Firms in the pharmaceutical industry have economies of
scale in order to control production costs competitively as new products are pushed
through the pipeline and older patents expire. Production fluctuates in response to
newly marketed drugs, obsolescence of older drugs and lawsuits filed against or by the
firms. The following chart illustrates the amount of total assets held by four of the
industry’s leaders:
Industry Assets
0
5000000
10000000
15000000
2000000025000000
30000000
35000000
40000000
45000000
2002 2003 2004 2005 2006 2007
Tota
l Ass
ets Wyeth
Eli LillyPfizerAbbott
In order to be competitive, economies of scale must be utilized and therefore,
contribute to a high degree of pressure for existing firms in the pharmaceuticals
industry.
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Learning Economies
Learning curves for industries determine the ease with which a new firm can enter a
market. The steeper the curve, the more capital and time it takes firms to begin
competing in the market and eventually experience profitability.
This graph shows how new products contribute to price and volume growth, which
causes the overall growth of the industry. Drug manufacturers generally spend half or
more of their cost of goods on research and development. The research and
development scientists are the integral part of the success of a pharmaceutical firm.
Average time spent in the pipeline for a single drug, from research and development to
production, is about 10 to 15 years (PHRMA, annual report). Research and development
departments begin a project with 5,000 chemical compounds and out of those, only one
gets approved by the FDA for sale to customers. High investment in research and
development contribute to the high learning curves for the pharmaceuticals industry,
making pressure for competition high.
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Fixed-Variable Costs
Pharmaceutical companies carry much more variable than fixed costs as research and
development is the main component of the cost of goods manufactured. The chemical
compounds purchased for production are expensed as well as all research and
development. Research and development as a portion of cost of goods sold is about
50% or more for the pharmaceuticals industry. This means that fixed and overhead
costs account for the smaller percentage of the cost of goods, therefore pharmaceutical
firms carry a low fixed-to-variable cost ratio and can compete effectively on economies
of scale.
Excess Capacity
Firms that have excess capacity must counteract this loss of efficiency by creating new
products or creating new needs for customers so as to increase demand which
increases production. Pharmaceutical firms change their product mix fairly often. New
drugs that are created must efficiently take the place in production facilities of the older
drugs competing with generic brands whose demand has slowed. Pharmaceutical firms
must carefully manage the timing of beginning production on newer drugs so a gap
does not exist between them and the declining production of older drugs. The following
chart from Wyeth’s 10K (2007) illustrates how they keep track of the expiration of their
patents.
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Product Expiration
Year BENEFIX 2011rhBMP-2 2014EFFEXOR/EFFEXOR XR 2008ENBREL 2012LYBREL 2018PREMPRO 2015PROTONIX 2010RAPAMUNE 2014REFACTO 2010TORISEL 2014TYGACIL 2016ZOSYN 2007
Inefficient production can affect earnings as the release of newer drugs is delayed due
to problems with FDA approval, prototypes and trials. Drug manufacturers try to
counteract this gap by continuously researching and developing new drugs so that
patent expirations for approved drugs are staggered as well. Efficient expiration of
patents and release of new drugs is necessary to counteract excess capacity in the
pharmaceutical industry. Streamlining the development and production of drugs that
are in a firm’s pipeline, helps firms to control excess capacity, which contributes to a
high degree of competition amongst existing firms.
Exit Barriers
For any company, there are barriers to exit the industry including resources, debts and
equity. Some industries are easier to exit at a lower cost than others which contributes
to a lower degree of price competition. The drug manufacturing industry is highly
competitive and similarly the exit barriers are very high as well. Assets held by
pharmaceutical industries include production facilities and research and development
labs. Ongoing research increases exit barriers and therefore increases rivalry among
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existing firms. Research and development expense for the year only affects future cost
of goods sold expense, but from this chart we can see that money spent on R&D now is
almost the same amount, or close to, the amount for goods sold this year. When it
takes 10-15 years to produce one drug, high R&D expenses pressure firms to be
extremely competitive as they will not reap the benefits of those expenses until the
drug is created and can be sold. Ongoing lawsuits against the firm by customers or by
the firm for patent infringement are very costly, not only in terms of expenses, but
market share and corporate image of firms. Lawsuits can be long and costly, especially
for the pharmaceuticals industry. As an exit barrier, pending lawsuits are very costly
and contribute to a high degree of pressure on the firms to be competitive against
existing firms.
Conclusion
Analysis of the rivalry among existing firms for the major drug manufacturing industry
according to characteristics outlined in Porter’s Five Forces of Competition model
indicate that there is very high pressure for competition of existing firms.
Pharmaceutical companies must compete to stay alive in their industry in response to
the moderate to high pressure from industry growth rate, concentration of competitors,
product differentiation, switching costs for the firm, economies of scale, learning
economies, fixed-variable costs, excess capacity and exit barriers. Competitive
strategies that respond to these pressures will guide firms in the drug manufacturing
industry to success and stability.
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Competitive Force 2: Threat of New Entrants
The relative threat of new competitors is determined by how well a company can
overcome the obstacles of entering into an industry. These obstacles include
economies of scale, first mover advantage, access to channels of distribution and
relationships, and legal barriers. The complex nature of the pharmaceutical industry
makes it difficult for potential entrants to break through these barriers and be
successful.
Economies of Scale
Economies of scale pertains to the advantage existing companies have over new
entrants. In the pharmaceutical industry, a large amount of money is poured into the
research and development of a drug. According to the Pharmaceutical Research and
Manufacturers of America (PhRMA), the industry spent an estimated $58.8 billion on
research and development in 2007. The following figure illustrates the R&D process.
Figure (pharma.org Industry Profile 2008)
(Phrma.org 2008 Industry Profile)
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Through the development and clinical testing periods, the company must meet strict
guidelines set by the Federal Drug Administration. This entire process takes
approximately 10 to 15 years, with no guarantee that the drug will be approved.
PhRMA also states that “only two out of ten approved drugs actually bring in enough
revenue to recover their cost of development”. For a new company, the likelihood of
going into debt is a harsh reality. This demonstrates a major cost disadvantage new
firms face in comparison to already existing companies when trying to enter into this
industry.
First Mover Advantage
First mover advantage is a favorable position gained by being the first to occupy an
area of the market share. In the pharmaceutical industry, a company’s ability to be the
first to get a new drug out on the market is critical to their survival and success. As
previously mentioned, the process of developing a drug takes approximately 10 to 15
years. The new entrants will again find themselves at a competitive disadvantage.
Established companies already have years of experience and are consistently working
on new innovations. Not only do these new firms lack the years of experience of the
industry leaders, but they will also be constantly trying to catch up to the new drugs
that those companies have been researching and developing for quite some time. In
addition, the use of patents by existing companies on their products further increases
the difficulty of entering this industry.
Access to Channels of Distribution and Relationships
The pharmaceutical industry expends billions of dollars each year in marketing and
advertising. These companies have several effective routes of getting their product and
information to consumers through relationships they have established. These
affiliations include suppliers, distributors, retailers, insurance companies, and health
care providers. Information is also relayed through the television industry in direct-to-
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consumer (DTC) drug marketing. According to the article “New Rules on Drug Ads
Sought” in the Wall Street Journal, “In 2007, drug makers spent more than $5 billion on
direct-to-consumer ads; more than half of that was spent on television” (WSJ 5-08-
2008). Not only will the new firms lack these crucial alliances, but they will again be at
a cost disadvantage.
Legal Barriers
Legal barriers pertaining to this industry include strict FDA regulations, licensing rights,
patents, and the inevitable liability issues brought about by lawsuits.
After completing the clinical trials, the pharmaceutical companies must be granted
permission by the FDA to market their drug. If approved, the company may proceed
with the manufacturing and marketing of their product. However, the FDA might
require the company to do additional testing or reject it all together. For a new firm,
the risk of losing millions of dollars and years of research in the approval process alone
is a significant barrier of entry.
Patents are another form of legal barrier used in many industries. As defined by the
United States Patent and Trademark Office, a patent is “the right to exclude others from
making, using, offering for sale, or selling” the invention in the United States for a term
up to 20 years. As previously stated, this protection on products further increases the
difficulty of entering this industry.
There is always a risk of adverse side effects when taking any medication. Therefore,
high costs associated with lawsuits are a relevant issue that can deter potential new
entrants in the pharmaceutical industry.
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Conclusion
The threat of new competitors in the pharmaceutical industry is limited due to the
difficult barriers of entry. These barriers include economies of scale, first mover
advantage, access to channels of distribution and relationships, and legal barriers. The
current companies have invested large amounts of money and time in the research and
development, manufacturing, and marketing of their products. They have also gained
favorable positions in the industry through their years of experience and exclusive rights
to their inventions. In addition, these companies have formed crucial alliances that aid
in getting their product and information to the consumer. As is apparent, potential new
entrants pose little threat to the established firms of the pharmaceutical industry.
Competitive Force 3: Threat of Substitute Products
The threat of substitute products is included within the five-factor model because it is a
source of rivalry between competitors in every industry. The threat of substitutes is
imperative to address because it affects the customers willingness to switch to a
competitor’s products. Specifically, the pharmaceutical industry is one based on
knowledge, which makes it exceedingly competitive. Rivalry creates a close
competition; the top ten industry leaders are only separated by a mere 6%
differentiation in terms of market share (http://www.p-d-r.com/ranking/ranking.html).
With the pharmaceutical industry continuously showing profit it has driven those
already established companies to expand in market share, causing substitute products
to be more vastly available to the market.
The research and development sector determines the company’s future plans to expand
its product line and return an increase in profits. Over decades the pharmaceutical
industry has become more competitive, making diversity within the company a new
industry factor. Innovation is key every company strives to be the first to enter the
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market with a new product. FDA regulations allow protection for products in the form of
patents. A patent lasts for roughly 15-20 years, and after that the general market can
reproduce a patented product. Thus, when a patent expires price competition increases.
Since most cost incurred by the pharmaceutical industry is experienced in the research
and development department, $58.8 billion in 2007 (see figure A below), once a
product is already on the market a competitor can copy the formula without
experiencing the extensive R&D costs. The result of this process has not only increased
the amount of substitutes, but also controversy in the industry.
(phrma.org 2008 Industry Profile)
Consumer Healthcare Segment Substitutes
As mentioned earlier the pharmaceutical industry has begun to expand not only its
product lines, but also its companies target market. We are now seeing many forms of
divisions within the pharmaceutical industry. Lilly Eli & Co separates their company in
terms of principal products (subcategorizing them in divisions of purpose i.e.,
cardiovascular), animal health care, and other pharmaceuticals (Lilly & Eli Co 10k 2007).
Similar, Wyeth pharmaceutical divides their company between a consumer healthcare
section, a pharmaceutical segment, and an animal health segment. Each segment faces
its own set of substitute products.
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First, the consumer healthcare segment faces the largest possibility of substitutes.
Products included in Wyeth’s consumer division are commonly known items such as
Chapstick, Advil, Dimetapp, etc. these products are sold to wholesalers and retailers.
Substitutes for the before mentioned over the counter products are retailer stores own
label brands which are often offered at a discounted price. For instance, at CVS you can
buy a bottle of Advil for $5.69 or you can purchase CVS brand ibuprofen for $3.19
(cvs.com). With such options it comes down to the consumer’s choice. Also, one of
Pfizer Inc.’s over the counter drugs, Zyrtec Allergy, can be purchased at Wallgreens for
$22.99 or you can purchase Wallgreens brand for $14.99. They can choose the
established quality of Advil or Zyrtec or risk using a retail label brand, which has the
same results, but comes in a less attractive packaging cutting down cost. The
consumer’s healthcare sector is challenged to establish brand recognition and customer
loyalty to maintain sufficient revenues in their highly competitive division.
Animal Healthcare Segment Substitutes
Another area to examine is the obstacle in regards to the animal health care segment
and their specific substitutes. This sector is actually controlled by the veterinarians a
company would distribute their products too. Unlike a prescription distributed by a
doctor that is later filled at a pharmacy a veterinarian’s prescription is filled directly in
the clinic. Thus, the amount of money a pharmaceutical company invests in sales
representatives will largely effect who has control within the industry. Pfizer Inc.
contributed their animal healthcare sector to contribute $2.6 billion in revenue. This is
becoming a more competitive and profitable sector for the pharmaceutical industry. The
money and time spent educating sales representatives will make a larger impact when a
company is introducing a medicine to the market. The veterinarian can pick whichever
prescription he chooses, the more time spent promoting a specific drug or vaccine the
more convinced the doctor will be the product will work. Even though the customer is
not making the direct choice in prescription for their pet, substitutes are readily
available; awareness of product will be the key defendant of substitutes.
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Pharmaceutical Segment Substitutes
Finally, the pharmaceutical division faces the most controversial substitutes in the
industry. This sector is generally the most competitive because each company wants to
be the first to storm the market with a new product. Patents are necessary in the
prescription drug manufacturing industry. An average patent lasts for twenty years if it
is not available for renewal. According to PhRMA’s 2008 industry profile it estimates it
takes 10-15 years to research and develop a new drug (phrma.com 2). This means on
average once a new drug enters the market the developing manufacturer only has
exclusive control for 5-10 years. The prescription drug is most profitable when it is
under patent, and is not competing with any cheaper generic brands. In this economic
state of welfare the pharmaceutical industry faces two main substitution obstacles.
First, the substitute of private health care versus public heath care is a new obstacle the
industry is facing. With an election year approaching the discussion of government
funded or subsidized health care is a hot topic, which would result in cheaper
substitutions available for the public. Wyeth sites this as a competitive force in there
2007 10-K. The other issue is the increased efforts of competitors to try and introduce a
generic before a patent is up. The amount of lawsuits between pharmaceutical
companies and competing manufacturers has continued to increase the FTC is trying to
limit the number of issues that are actually brought to trial. According to the article
“Settlements to use Cheaper Drugs” in the Wall Street Journal, “In a 12-month period
that ended last Sept. 30, 14 of 33 agreements to settle patent litigation between brand-
name drug companies and generics included both a restriction on the generic
company's ability to market a drug and compensation to the generic manufacturer (WSJ
5-22-2008).” As substitutes become a bigger issue companies themselves will attempt
to release their own generic brand before anyone else can. Generic substitutes are
storming the industry taking away profit from leading competitors.
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Customer’s Willingness to Switch
Overall, we have concluded the threat of substitutes in regards to the pharmaceutical
industry is extremely high. The drug manufacturers must maintain a high sense of
quality encouraging customers to stick with their established brands. The
pharmaceutical industry has many sources of customers. Since most companies are
segmented each section has there own form of customers. For the healthcare segment
the customers are wholesalers, because they are responsible for distributing the
products to the market. The healthcare segment will face the largest issues with their
customers. Generic products are common on the market giving the customer the upper
hand. The animal healthcare section would include veterinarians and pet owners as
customers. Also, the prescription drug segment’s customers tend to be doctors and
patients alike. Customers must be persuaded with other benefits when cost is the only
deterrent. The pharmaceutical industry will always continue to grow. As technology
and knowledge increases it will only lead to better and more beneficial products. High
profits will occur when a company can maintain some sort of manufacturing advantage
to prevent customers from finding alternative solutions to their products.
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Competitive Force 4: Bargaining Power of Customers
The bargaining power of buyers greatly affects the business strategy of pharmaceutical
companies. The more power that buyers hold, the more likely the company will focus
on a low cost strategy in order to directly compete against competition. If buyers hold
little power, companies are at the liberty to pursue other business strategies. In this
industry, buyers consist of wholesalers, doctors, pharmacies, hospitals, retailers and
other healthcare institutions. The three main factors that determine the bargaining
power of buyers in the pharmaceutical industry include price sensitivity and relative
bargaining power.
Price Sensitivity
Price sensitivity is defined as how prices exclusively affect a customers desire to
purchase a product. The pharmaceutical industry is a highly competitive market with
price sensitive buyers. Companies, however, hold the power over buyers while patents
for their products are still in effect. The company that holds the patent for a drug owns
the sole rights to produce and distribute the drug. Since no one else can produce the
product, this is the opportune time for a drug company to recover expenses that have
been incurred during the development phase of the drug. Companies will tend to
increase the price of their drug, especially if it is popular among doctors and hospitals.
When the patent for the drug runs out, consumers gain the upper hand. It is at this
time when other companies make generic drugs that perform exactly the same but cost
a lot less. Generic drugs pose a major threat to large pharmaceutical companies by
providing consumers with alternatives that contain little switching costs. Healthcare
institutions such as insurance companies are likely to promote generic brands to reduce
their own costs and the costs of the public. While the United States has some of the
strongest patent policies in the world, other countries tend to be more forgiving and
generic products are more numerous. This is a significant issue for United States based
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pharmaceutical companies because a large percentage of sales results from foreign
consumers. Foreign consumers therefore tend to be more price sensitive and will favor
less expensive drugs.
Relative Bargaining Power
Relative bargaining power is based off many variables including number of buyers
relative to the number of suppliers, volume of purchases by individual buyers, number
of alternative products, and the costumer’s switching costs. The pharmaceutical
industry is highly specialized with few substitutes until the patent on a particular drug
expires. On the other hand the primary customers are very large agencies. These
agencies are able to dictate prices and essentially bully the pharmaceutical companies.
Secondly, government agencies pay very close attention to pharmaceutical activities
and regulate the market. The FDA has the power to tell a drug company how to go
about developing and introducing a drug into the market. Prices can also be controlled
by the FDA through programs such as Medicare and Medicaid. These healthcare
agencies try to find the best price for the public, forcing drug companies to reduce
prices further. The government has a lot of power in the drug industry.
Finally, insurance companies can dictate what medicine they will cover. In fact, there
are insurance companies that will not cover a certain type of medication unless it is the
less expensive generic brand, upon availability. This is yet another example of the
customers bargaining power over the industry.
Wholesalers, which represent a large portion of revenue for the most prominent
pharmaceutical companies purchase in bulk. This gives them an excuse to demand
lower prices from drug manufacturers. The drug companies can do nothing but accept
these decreasing prices in order to maintain these important customers.
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All of these examples show that customers in the pharmaceutical industry have a lot of
buying power. Large agencies, the government and wholesalers all play a role in
controlling the price of products.
Customer Switching Costs
Whether the customer is an individual in the doctor’s office or a large healthcare
agency, the switching costs are relatively high. This is because medicine is very
specialized and almost always focuses on a particular illness. Even when a patent
expires doctors are hesitant to prescribe generics because they are not familiar with the
side effects or efficiency of these cheaper products. In reference to Johnson and
Johnson’s new schizophrenia drug Invega, doctors are not comfortable prescribing it to
patients. The chairman of the psychiatry department at Columbia University’s medical
school told the wall street journal that Invega is “basically a me-too drug and the
company has not done the studies that would be required to really distinguish it.” (WSJ)
In the end the switching costs are too high for customers in the pharmaceutical market.
Conclusion
After analyzing the pharmaceutical market in regards to customer’s price sensitivity,
relative bargaining power and switching costs, it is apparent that the bargaining power
of customers is mixed. Price sensitivity is high among large buyers, which account for
the majority of buyers in this industry. Relative bargaining power is high, especially
when patents expire. Finally switching costs tend to be high, making this factor about
the pharmaceutical industry mixed.
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Competitive Force 5: Bargaining Power of Suppliers
The bargaining power of a supplier dictates the actual profits that suppliers and
customers can actually earn in an industry. The bargaining power of any supplier will
determine the input costs, such as labor, materials, and resources that a customer will
incur. When suppliers in a certain industry are scarce, they hold the power over the
customer firms. The number of suppliers available is not the only characteristic of a
supplier having high level of bargaining power. A supplier who possesses a specialty or
differentiated product is able to charge a premium to firms that need these inputs. The
bargaining power of suppliers means that they have the upper hand in negotiating
trade and shipping terms. The threat of forward integration by a supplier is also a
concern of the customer firm, because they do not want the supplier to move into their
industry when they already possess the inputs needed. When a supplier does not hold
these characteristics, they are forced to abide by the demands of the customer firm,
and thus are weak relative to the customer firm.
Price Sensitivity
Suppliers in the major drug manufacturing industry are somewhat price sensitive. The
majority of materials supplied in the drug manufacturing industry are commodities, so
they are dictated by the market. Firms have many companies that they can choose to
buy supplies from. The availability of inputs for firms in the pharmaceutical industry
creates substantial price competition among the suppliers. Switching costs for the
customers (pharmaceutical companies) are relatively low, knowing they will be able to
find another supplier with ease. However, the prices of products, such as chemicals,
are low in comparison to the pharmaceuticals total expenditures, so they will not
necessarily expend resources to find another supplier.
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Relative Bargaining Power
The bargaining power of suppliers in the pharmaceutical industry is minimal. The
products sold by suppliers are readily available, simple, and undifferentiated. The large
number of suppliers in the industry, paired with the undifferentiated product, takes
bargaining power away from the supplier and transfers it to the drug manufacturers.
Upon examination of the 10-K reports for the firms in this industry, it is clear that inputs
are purchased from several sources around the world. Suppliers will only have
bargaining power if they are able to prove that the quality of their raw materials
exceeds that of other suppliers, or if a pharmaceutical company is producing a product
that requires a scarce resource. Suppliers can gain bargaining power through forward
integration to become a pharmaceutical company.
Conclusion
The number of suppliers, the products they sell, the availability of the products, and the
switching cost incurred by their customers dictate the bargaining power of suppliers in
the pharmaceutical industry. The competition and fragmented nature of the chemical
industry is the main reason why suppliers have very little bargaining power.
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Value Creation Analysis
In a specialized industry it is important to identify the key success factors to create a
competitive advantage for your company. As we established earlier with the five forces
model the pharmaceutical industry competes on the basis of a mixed strategy, thus it
includes factors of both cost leadership and differentiation. To gain an advantage in the
industry a company should focus on; research and development, tight cost control,
superior product quality and variety. Research and development, although expensive,
allows a company to compete in terms of innovation creating value in new products.
Tight cost control keeps variable costs down allowing sales to be more profitable.
Quality and variety allows a company to obtain a loyal and satisfied customer base,
increasing overall company worth. Focusing on these four strategies enables a
pharmaceutical manufacturer to obtain a percentage of the market share.
Research and Development
To be competitive in the pharmaceutical industry, a firm must continually expend large
amounts of money into the research and development of new drugs. In 2007,
America’s pharmaceutical companies invested nearly $60 billion in R&D alone.
According to PhRMA, “This record R&D investment reflects the continued commitment
of America’s research companies to lead the world in the pursuit of new life saving and
life enhancing medicines.” The Congressional Budget Office has stated, “The
pharmaceutical industry is one of the most research intensive industries in the United
States. Pharmaceutical firms invest as much as five times more in research and
development, relative to their sales, than the average U.S. manufacturing firm.” As
stated earlier, developing a drug is a process that takes approximately 10 to 15 years,
with no guarantee that the drug will be approved. Although these costs are not
recognized as assets, they are the most valuable key to the success of the
pharmaceutical company. In order to stay competitive, “Companies need to have a full
pipeline of new products that are in different stages of development…you need to have
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those pipelines robust, the only way you’re going to develop those is by having the best
scientists and product development teams available” (WSJ 5-15-2008).
Superior product variety
To compete in the pharmaceutical industry more efficiently, companies have begun to
expand into other business sectors creating more diversified product lines. First, since
patents enable a company to have sole rights over a specific drug for a period of time,
research and development teams now focus on creating treatments for multiple
illnesses. For example, Abbott Laboratories has many divisions including manufacturing
of vascular, diagnostics, and nutritional products (Abbott 2007 10K). Similarly, Lilly & Eli
Co contains sectors in neurosciences, endocrinology, oncology, and cardiovascular (Lilly
2007 10-k). Also, once a patent expires, a company can no longer monopolize the
formula and manufacturing for a drug, so they lose the cost control. Attempting to
maintain market share they have expanded their target consumers. Companies like
Pfizer now contributes their animal hath care sector to growing 14% in 2007 and credit
them for $2.6 billion worth of revenue (Pfizer 2007 10-K). Overall, the pharmaceutical
industry continues to grow even with harsher regulations from the FDA and more
litigation battles companies are managing to expand their product and gain new
customers.
Superior Product Quality
The products made by pharmaceutical firms not only improve consumers’ health, but in
many cases, these drugs can save lives. Superior product quality is essential to the
sustainability of the drug manufacturing industry as human lives depend on it. The Food
and Drug Administration is responsible for making sure that every drug manufacturer
complies with their very strict guidelines so as to eliminate the risk of faulty or
unhealthy drugs being released in the market. Recently, the FDA announced that it is
hiring “1300 scientists and pharmacologists this year” to improve inspection its
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processes of all new drugs pending its approval (Mundy, par 1). The industry requires
that firms adhere to standards above the FDA’s in that failure to do so will result a
drastic loss of market share.
Tight Cost Control System
The competitiveness of the pharmaceutical industry drives companies to use a cost
control system. Reducing costs is a significant way for drug manufacturers to gain the
upper hand in among competitors. With inexpensive generic products stealing business
and increasing research and development costs, the larger pharmaceutical companies
must lower prices and find ways to reduce costs in order to improve profits. Some
ways that companies reduce costs include outsourcing production, closing down excess
facilities, reducing employees and lowering raw material costs. Drug manufacturers can
also improve their cost strategy by allocating resources to make strategic acquisitions.
These acquisitions have the potential to reduce costs and improve innovative
capabilities and the drug portfolio of companies. (Bio-Medicine.org)
Conclusion
Companies within the pharmaceutical industry use the above value creation policies to
give themselves an advantage in the market. The only way a firm can grow in the drug
sector is by focusing a lot of attention on research and development to improve its
product line. Product quality and variety are important in ensuring that customers are
getting a product that is effective for a specific illness and meetings standards set by
the FDA. Large companies that have shown continuous growth and profit follow all of
these strategies to ensure success in the pharmaceutical industry.
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Firm Competitive Advantage Analysis
Firm competitive advantage analysis is a part of the overall business strategy analysis.
It is the first step when attempting to analyze and value a corporation. It is followed by
an accounting analysis, financial analysis, and finally the prospective analysis. Firm
competitive advantage analysis is significant because it outlines the specific
expectations of the industry and whether the individual corporation is complying with
the success factors established. In regard to the pharmaceutical industry, there are four
key categories a pharmaceutical firm needs in order to be profitable; efficient research
and development, tight cost control, product quality and product variety. Major
competitors like Wyeth, Eli Lilly, Abbott, and Pfizer are industry leaders in these areas
which enables them to be profitable, as well as capture most of the market share.
Research and Development
The mission of Wyeth’s research and development is “focused on discovering,
developing, and bringing to the market new products to treat and/or prevent some of
the most serious health care problems” (Wyeth 10-K). Every year Wyeth consistently
invests more money into research and development. In 2005, they invested $2.75
billion; in 2006, $3.11 billion; and 2007, $3.26 billion. Of this amount, 93% were for
expenditures in the pharmaceuticals segment (Wyeth 10-K). An issue that could
possibly affect the future success of R&D for Wyeth is the outcome of the upcoming
presidential race of 2008. If Universal Health Care insurance programs are enacted,
they could possibly decrease potential returns from research and development
activities. Wyeth strongly supports research and development activities as one their
competitive advantages.
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Superior Product Variety
Wyeth excels in value creation in terms of superior product variety. Wyeth has three
manufacturing segments pharmaceuticals, consumer healthcare, and animal health
products. The pharmaceuticals division is responsible for roughly 95.5% of Wyeth’s
income before tax. The division has three main products, EFFEXOR (17% of net
revenue), ENBREL (14% of net revenue), and PREVNAR (11% of net revenue). The
consumer health care segment manages over the counter products ranging from
Chapstick to Centrum. Although this sector is not responsible for earning the most
revenue, it includes the most recognizable products Wyeth manufactures. Finally, the
animal health segment specials in vaccines like the WEST NILE – INNOVATOR and
parasite controls known as CYDECTIN. (Wyeth 10-K 2007) Not only does Wyeth have a
diverse product line it has multiple selling methods. Wyeth floods the market through
sells to pharmacies, hospitals, physicians, retailers, and wholesalers. Also, Wyeth’s
products are sold in over 145 countries worldwide. Overall, Wyeth diversifies not only
their products but their ability to sell them permitting larger overall profits.
Superior Product Quality
Wyeth is one of the top five competitors in the pharmaceuticals industry. They identify
product quality as one of the main factors that contributes to their competitive strategy
(10K). The industry requires that firms adhere to standards above the FDA’s in that
failure to do so will result a drastic loss of market share; therefore, Wyeth’s success as
an industry leader can be attributed to their superior product quality. Total quality
control and ever-evolving processes with specific checks and balances helps to keep
Wyeth’s products above the qualifications of the FDA. For their nutrition division, “every
batch…is subjected to nearly 800 quality checks before it is made available for sale”
(WyethNutrition.com). In order to keep the industry leader position they have, Wyeth
constantly tests the quality of “nearly every component from ingredients to packaging”
(WyethNutrition.com) to effectively utilize their competitive strategy.
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Tight Cost Control
Wyeth is following a tight cost control system by implementing a productivity initiative
called Project Springboard. This initiative has been used over the past couple of years
for innovation, cost saving, process excellence and accountability. Project Springboard
is being used primarily in the pharmaceutical segment of the company. Closure of
manufacturing facilities and layoffs has taken place because of the program. “In
addition we are improving our drug development process including establishing early
clinical development centers, improving logistics for shipping clinical materials and
instituting remote data capture.” (Wyeth 10-K) In 2008 Wyeth is starting a new
program called Project Impact. According to Wyeth’s 10-K, this program will redefine
their business model to facilitate long term growth and address short term fiscal issues.
Conclusion
By creating a competitive strategy which incorporates the four key success factors
identified for the pharmaceuticals industry, Wyeth has implemented these strategies
into all business activities to compete as one of the top five major drug manufacturers.
The industry demands that in order to be competitive and ultimately profitable, firms
must understand and utilize four key success factors: research and development,
superior product quality, superior product variety and tight cost control. These key
success factors have been integrated into every aspect of the firm, therefore continuous
focus and innovation in their competitive strategy will lead to further capture of market
share and leadership in their industry.
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Formal Accounting Analysis
Accounting analysis is used to identify the accounting strategies a firm implements. We
then evaluate the quality of disclosure of the financial statements of the firm and their
competitors, an analyst can determine the degree of accounting that captures the
underlying business reality. Generally Accepted Accounting Principles (GAAP) are the
accounting guidelines set forth by the Financial Accounting Standards Board (FASB) and
enforced by the Securities and Exchange Commission (SEC), for legal financial
reporting.
Flexibility in accounting allows managers to manipulate data that can create static in
accounting reporting. Managers might use accounting flexibility to meet debt
covenants set forth by their lenders, overstate earnings to receive monetary
compensation, adjust inventory reporting to receive special tax treatment, or increase
profits to make shareholders happy. The flexibility in accounting reporting allows
companies to potentially manipulate reports, so it is imperative that a formal accounting
analysis be done in order to have a clear understanding of the financial operations of a
firm.
A formal accounting analysis involves six steps that will improve the reliability of
conclusions that are drawn about a firm’s economic performance. The first step of a
formal accounting analysis is to identify a company’s principle accounting policies, which
will link a firm’s competitive strategy to the key success factors for the industry.
Identifying the accounting policies will determine how a company is managing risk and
their own success factors. The second step is to assess accounting flexibility by
determining areas where a firm’s managers are able to choose accounting policies and
estimates. After the areas of flexibility have been identified, analysts will evaluate the
accounting strategy to decide if a firm used flexibility to show or hide true performance.
The next step is to qualitatively and quantitatively evaluate the quality of a firm’s
disclosure on financial documents. The fifth step identifies potential “red flags”, areas
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that may include questionable accounting practices. The final step of a formal
accounting analysis is to undo accounting distortions, which include misleading
numbers. By restating these values, more accurate conclusions of a firm’s economic
status and activities can be drawn.
Key Accounting Policies
The accounting analysis begins with the identification of key accounting policies that
directly relate to the success factors of the industry. These policies confirm how a
company is managing and measuring those factors. As mentioned, the success factors
of the pharmaceutical industry include research and development, superior product
quality, superior product variety, and tight cost control. The accounting policies directly
related to these factors consist of research and development expenses, goodwill,
defined benefit pension plans, and litigation expenses. Firms in the pharmaceutical
industry must understand their key success factors and then relate their key accounting
policies in order to stay competitive in this industry.
Research and Development Expenses
The Statement of Financial Accounting Standards (SFAS) No. 2 states that all research
and development costs must be expensed as incurred. In the pharmaceutical industry,
significant amounts of money are spent on R&D because this leads to the discovery of
new products, which in part, determines the future success of a company. The chart
below shows the research and development expenses reported on the income
statements of Wyeth, Abbott, Eli Lilly, and Pfizer.
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Most products in this industry are a result of R&D expenditures. In many instances, the
benefits of R&D are not usually seen for a minimum of ten years, if ever. Although
R&D is classified as an expense due to GAAP regulations, the knowledge gained from
this process could be considered an intangible asset since its results are the new
products of the firm. The resulting products made possible by R&D are the driving
force behind sales in this industry.
In order to value a company within the pharmaceutical industry, it is necessary to find
the inherent value of these expenses. Because pharmaceutical companies spend
millions each year in R&D, the total expenses incurred are high which results in a lower
net income. When you expense these research costs, the unforeseen value that could
be created is lost. If this outlay was reported as an asset instead of an expense, the
firm would experience higher earnings because assets would increase and expenses
would decrease. When R&D is expensed, as GAAP requires, the impact of conservative
accounting is shown in the following situation:
If R&D were to be put into the asset account, it would make sense to depreciate these
assets at 20% per year. This chart shows the assets being depreciated at 20% and the
bottom line shows the R&D depreciation expense that would result per year. Having
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the R&D costs in the asset account would greatly increase the assets of the company
while decreasing the expenses. This results in higher earnings and higher owner’s
equity.
Goodwill
Goodwill is considered an intangible asset by the Financial Accounting Standards Board
(FASB) and is very difficult to account for. The excess between the purchase cost and
the fair value cost of net assets is the measure of goodwill. FASB defined how goodwill
should be recorded through Accounting Principles Board Opinion 17. This stated that
Goodwill was a finite asset (having a limited life) and should be amortized over a period
of time, no longer then 40 years (www.fasb.org). However, companies realized as
goodwill continued to grow it became a more significant percentage of their overall
assets, and by amortizing goodwill yearly it did not represent a proper economical
standing of the company. Thus, in June of 2001 the FASB issued Statement No. 142,
this altered the original method in which goodwill should be recorded. Now, goodwill is
not amortized but it is tested for impairments. The impairment test is required to be
done at least annually. Impairment occurs if the fair value is less than the carrying
amount (http://cpaclass.com/gaap/sfas/gaap-sfas-141.htm.) If impairment exists the
company is to reduce the carrying amount of goodwill and recognize the impairment
loss. If an impairment fails to be recognized this will cause the overall assets to be
overstated.
This table shows why the measurement of goodwill as an asset is so controversial.
Since the change by the FASB it has allowed management to practice a certain element
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of discretion. Management can fail to report impairments and it would significantly alter
their financial statements, ultimately overstating net income putting the company in a
better economical situation then what may be true.
In the pharmaceutical industry goodwill is a big part of a company’s overall assets. As
major pharmaceutical companies continue to grow they acquire possession over smaller
firms domestically and internationally. When they purchase these said companies they
pay an overall premium. This premium, known as Goodwill, covers items such as
research and development, established brand name, and patents on certain products.
Goodwill can be related to the key success factor of product quality. Goodwill increases
the more reputable a company’s products becomes. For instance, Wyeth’s goodwill is
high because of established product quality in their well known items like Chapstick and
Advil. As the industry grows and ventures to new markets, goodwill seems to follow.
* In Millions
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As shown in the graph above the percentage of goodwill follows a steady trend, when a
company gains a new entity they can experience a jump. In regards to Wyeth’s 2007
goodwill expense, they had an addition of $157 million from completing the acquisition
of a Japanese company once known as Takeda (Wyeth 2007 10-K). However, since
overall assets of the company also increased the change in percentage of goodwill to
assets actually showed a slight decrease. It was not because of any write-downs from
impairments. The footnotes in a company’s 10-K reveal imperative information about
goodwill, it will disclose how the company measures the asset. The graph shows
goodwill is still recognized as one of the largest assets for a company participating in
the pharmaceutical industry. If the goodwill was not impaired, assets would remain
high, and the true value of the firm would be hard to determine. If goodwill is
impaired, the assets would decrease, expenses would increase and lower net income as
well.
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Defined Benefit Pension Plans
With tens of thousands of employees, the profitability of pharmaceutical companies can
be affected by pension plan costs. Pension plans are fixed amounts of money paid to
past employees at regular intervals. Rising healthcare costs necessitate a well
organized pension plan system that will take into affect increases in inflation and
volatility in the market. Pension plans are liabilities recorded as the present value of
future payments given to employees. Discount rates are used to calculate the present
value of these payments. This rate is the primary way for individuals to know how
much the company owes in liabilities as a result of pension plans. As a general rule, if
the discount rate is too high the liabilities for the company will be understated.
Liabilities will be overstated if the discount rate is too low.
Pension Plan Discount Rate
2002 2003 2004 2005 2006 2007
Abbott 6.5% 5.8% 5.6% 5.5% 5.7% 6.2%
Eli Lilly 6.8% 6.2% 5.9% 5.8% 5.7% 6.4%
Pfizer 6.9% 6.3% 6.0% 5.8% 5.9% 6.5%
Wyeth 6.75% 6.25% 6.0% 5.69% 5.9% 6.45%
According to Wyeth’s 10-K, assumed discount rates are calculated by matching the
projected stream of benefit payments to the yields provided by high-quality corporate
bonds. The chart above shows that the average discount rate used by the prominent
pharmaceutical competitors is about 6.39% in 2007. The average inflation rate for
2007, according to the Department of Labor, is 2.8%. This demonstrates that returns
will be able to more than compensate for inflation increases. Finally the 2007 Treasury
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bond rate, which is considered the risk-free rate, is 4.0995. This shows that returns will
be greater than the risk-free rate. It is apparent that Abbott, Eli Lilly, Pfizer and Wyeth
are all estimating their discount rates in a similarly conservative fashion. Wyeth is
overstating its liabilities as can be seen in the chart below.
The disclosed expected rate of return for Wyeth’s pension plan assets is 9% for the
past three years. These rates of returns are derived on an annual basis from the
company and an outside investment consultant. Historical returns and forward-looking
factors are used in calculating the returns. Wyeth clearly states that these numbers
represent the best estimate of normalized capital market returns over the next decade
or more. In conclusion, companies in the drug manufacturing industry are using a
conservative approach in determining the present value of future benefit plan
payments.
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Litigation Expenses
Litigation expenses and the reserves established to protect patents are necessary to
accurately present financial position. Accounting policies for the disclosure, or accrual,
of litigation estimates are proscribed by the FASB in Statement No. 5, “Accounting for
Contingencies”. In regards to the disclosure of litigation reserves, firms must identify
and consider three elements: “the period in which the cause for action of the pending
litigation occurred, the degree of probability of an unfavorable outcome, and the ability
to make a reasonable estimate of the amount of loss” (FASB, Statement No. 5).
Disclosure of litigation estimates relates to the key success factor product quality.
Pharmaceutical firms are very susceptible to lawsuits from customers who have been
harmed by drugs that were manufactured by the firm. It is common in the drug
manufacturing industry for firms to be involved in several lawsuits at a time in which
they must defend the quality of their products. Usually a nationwide settlement is
reached, in which customers who can prove they have been harmed by the drug will be
awarded restitution. Treatment of the disclosure of litigation estimates regarding
consumer lawsuits against the firm is a key accounting policy for the pharmaceuticals
industry.
Product variety is one of the key success factors for firms in the pharmaceuticals
industry. Patents protect the drugs that firms produce; if they do not aggressively
defend these patents, revenue and subsequently, net income, can easily be affected. It
is very common for a firm to file a lawsuit against those who infringe upon its current
patents. Following in accordance with the FASB Statement No. 5, the industry discloses
the treatment of awarded settlements as outcomes are probable and amounts are
estimable. It is very important that firms in the pharmaceutical industry identify
litigation disclosure as a key accounting policy to be utilized in their accounting strategy.
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Conclusion
The key accounting policies confirm how a company is managing and measuring their
key success factors. The accounting policies related to those factors include research
and development expenses, goodwill, defined benefit pension plans, and litigation
expenses. The regulations associated with recording resources greatly influence the
amount of accounting flexibility allowed by firms.
Accounting Flexibility
Accounting flexibility is a measure of the firm’s right to choose accounting policies and
estimates. Accounting guidelines set forth by GAAP and FASB limit this freedom by
specifying how resources are to be classified. When a firm has little flexibility in its
accounting policy choices, the data is likely to be less informative for understanding the
firm. If firms have a high level of accounting flexibility, they can choose policies and
estimates which lead to a more accurate picture of the firm’s economics. All firms are
able to make choices along the lines of depreciation, inventory, and estimation of
pension policies. The flexibility in these areas provides firms with accounting policy
choices that can impact the financial reports.
Research and Development Expenses
There is no flexibility in accounting policies with regards to research and development.
GAAP sets forth that R&D is to be expensed as incurred. Initially, the knowledge gained
from research and development activities could be viewed as an intangible asset.
Palepu and Healy state, “The economic benefits from research and development are
generally considered highly uncertain—research projects may never deliver promised
new products, the products they generate may not be economically viable, or products
may be made obsolete by competitor’s research.” The fact that 1 out of 5,000
compounds are actually approved reinforces the SEC’s policy that R&D outlays should
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be expensed. Had those 4,999 failed expenditures been reported as assets, then the
expenses would have been significantly understated and assets overstated on the
balance sheet. Due to GAAP regulations, there is no accounting flexibility for research
and development.
Goodwill
The pharmaceutical industry deals with extraordinary amounts of goodwill, making it
imperative for analysts to pay attention to how goodwill is accounted for. Since the
change in 2001 by the FASB goodwill is no longer required to be amortized yearly, it is
now at management’s discretion to record impairments. Statement No. 142 has enabled
the accounting policy of goodwill to become extremely flexible. Whatever stance
management choices to take with accounting (i.e. aggressive or conservative) will affect
the overall financial statements. If goodwill is not impaired in a timely fashion it will
cause an overstatement of assets and net income. This flexibility can enable
management to create an altered perspective of the company from what may actually
exist. Overall, the footnotes in regards to goodwill should be closely examined in order
to recognize any “red flags” that might have occurred due to the high degree of
flexibility.
Defined Benefit Pension Plans
The present value of future benefit plan payments is calculated using a discount rate.
This discount rate is a number derived from managers based on data they have
available. Managers can easily choose this rate to reflect a conservative or aggressive
accounting strategy. Wyeth demonstrates that they are using a reasonable discount
rate and it is very similar to its competitors. They can very well change the rate to give
off an impression to investors that their liabilities are relatively low. This in turn will
reduce expenses and improve net income. On the other hand managers need to make
sure that pension payments do not fall below expected healthcare costs for a given
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year. There is an underlying pressure to meet this standard. In conclusion there the
discount rate is an arbitrary number derived from managers but there are boundaries
that this rate must follow giving pensions a moderate amount of flexibility.
Litigation Expenses
Pharmaceutical firms have very limited flexibility in the disclosure of litigation
contingencies. According to the FASB Statement No. 5, firms should disclose litigation to
the financial statements when the outcome is probable and amounts are reasonably
estimable. Managers calculate reasonable estimates based on information about specific
cases when they believe that a certain income is probable. If estimates for litigation
liabilities do not follow FASB guidelines, a firm can accrue too little expense or recognize
too little a non-current liability. When the courts decide on a settlement to be paid by a
firm that has manipulated their estimates to reflect higher earnings or lower liabilities,
the firm will not be able to meet their debt obligations. Research of the industry's top
competitors reveals that pharmaceutical firms follow the FASB statements regarding
“Accounting for Contingencies” (FASB.org), therefore providing for little flexibility in
accounting policies.
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Accounting Strategy
The accounting strategy that the managers of a firm use is based on the amount of
flexibility at their discretion. The amount of flexibility will allow the managers to either
hide or show the firm’s true performance through the accounting strategy they choose
to undertake. The two strategies are conservative and aggressive accounting methods.
Aggressive accounting is used when there is an opportunity to misconstrue accounting
statements to show only what the firm wants disclosed. Conservative accounting shows
the lower of cost or market values as opposed to their present fair values.
Research and Development Expenses
In any industry, the SEC prescribes that all financial reporting is done following the
rules of GAAP. GAAP mandates that all research and development expenses are
expensed immediately and not capitalized. Research and development is the driving
force behind the pharmaceutical industry, without it, growth of the industry and its
firms would level off. Investment in R&D is the largest expense incurred by firms in the
pharmaceutical industry. On average, substances will be in the R&D stages for ten to
fifteen years before they are approved, if ever. Once a firm receives approval for a
drug, they can receive a patent on the substance that will last up to 20 years. While
possessing the patent, it is important for a firm to use its market share to recapture the
R&D expenses for that product. Once the patent has expired, other drug
manufacturers will produce generic substances that will claim market share.
Since there is no flexibility in the reporting of research and development expenses, it is
difficult to determine the value of firms in the pharmaceutical industry. Pharmaceutical
companies show extremely high expenses, and thus report low net income. If
pharmaceutical companies were able to report R&D investment as an intangible asset,
then expenses would decrease and net income would increase, as well as owner’s
equity. In this hypothetical situation, liabilities and revenues would be left unchanged.
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Every year, firms in the pharmaceutical industry continue to spend billions of dollars on
R&D to ensure that they continue to be solvent and continue to hold or increase their
market share. The firms in this industry cannot deviate from the accounting strategy
set forth by GAAP regulations, and they will continue to expense R&D costs as they are
incurred. The real problem with having to expense such large amounts of money from
R&D is that it might trigger firms to start hiding other expenses that are incurred.
Because R&D is the foundation of this industry, and it must be expensed, firms wanting
to show a higher net income could choose to capitalize or underestimate other firm
related expenses.
Goodwill
As established earlier the flexibility in regards to goodwill enables management the
possibility to skew the overall financial view of the company. The best way to determine
if a company is sufficiently reporting goodwill impairments is to compare the process of
competitors in the same industry. The graph (refer to page 36) shows for the most part
a company’s goodwill to total assets ratio ranges between 10-20%. If the ratio seems
exceptional high it might be a sign that a company is taking an aggressive standpoint
failing to recognize impairments when they occur. If the ratio seems to be low the
company is probably using conservative accounting practices and writing down
impairments immediately. An unusual jump like in Eli Lilly might mean a possible
change in policy. According to Wyeth’s 10-K they follow the rules set by the FASB in
statement 142, no longer treating goodwill as a finite asset but they include it in their
intangible assets, and test annually for impairments (Wyeth 10-K 2007). They measure
impairment in the fourth quarter by calculating the fair value of each unit (i.e.
pharmaceuticals, animal heath, and consumer healthcare) and comparing it to the
carrying value of the unit. If the carrying value is greater than the fair value impairment
is recognized and the asset is written down. Wyeth’s 2007 10-K accounts for their
being no impairment recognized for both 2006 and 2007. However, goodwill increased
because of the company’s completed purchase of the Japanese company Takeda.
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Wyeth appears to be taking an “aggressive stance” revealing that it reports goodwill in
accordance to FASB, but leaving out any specific details.
Defined Benefit Pension Plans
The accounting strategy that Wyeth uses when discussing pension plans is adequate.
The company provides the proper information required by the GAAP including discount
rates, expected healthcare cost growth rates and estimated future benefit payments.
The beginning of the pension plan section of the Wyeth’s 10-K clearly explains the
defined benefit and defined contribution plans they offer employees and how each of
them operate. Later in this section the 10-K explains how and why different
calculations are made regarding pension obligations. Wyeth is a high disclosure
company because they clearly explain what they are doing with the pension funds and
follow conservative policies because discount rates are overstating liabilities.
Litigation Expenses
Product Liability Litigation
(In thousands) 2007.00 2006.00
Accrued expenses $1,458,309 $2,089,890
Other noncurrent liabilities 800,000 650,000
Total litigation accrual $2,258,309 $2,739,890
(Wyeth 10K, 2008)
In regards to litigation settlements, Wyeth discloses its estimates to an account called
“Total Litigation Accrual”. The estimate for “Total Litigation Accrual” consists of two
accounts: “Accrued Expenses” and “Other Non-Current Liabilities”. Wyeth's accounting
strategy is to slightly overestimate the amount of litigation liability to be disclosed
because the court ruling is decided after the estimates are made. Excess from previous
liability estimations is carried over in the “Other Non-Current Liabilities”. Wyeth
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efficiently estimates their litigation liabilities and discloses them accordingly; which is
why their accounting strategy allows them to be competitive as an industry leader.
Conclusion
Generally Accepted Accounting Principles regulate the amount of flexibility a company
has in their accounting policies and numbers. The amount of flexibility allowed
determines how accurately the firm is portrayed through their financial statements.
There is no freedom in reporting research and development because it is expensed
immediately and never capitalized. The accounting policy of goodwill, an intangible
asset, has become extremely flexible due to management’s discretion in recording
impairments. Defined benefit pension plans have moderate flexibility and high
disclosure through their explanation in the 10-K. Pharmaceutical firms have very limited
flexibility in the disclosure of litigation contingencies.
Quality of Disclosure
The amount and quality of information that a company’s managers choose to disclose,
is in direct proportion to the understanding of the reality of business activities.
Managers have several ways and reasons to disclose information from their SEC filings.
Analysis of the quality of disclosure on financial statements is a key component
necessary to draw conclusions about a firm’s economic status and activities. When a
manager chooses to only offer the minimum requirements for SEC filings, a concise
conclusion about the value of the firm cannot be inferred. In fact, minimum disclosure
could lead to investors and analysts to raise questions concerning what a firm might be
hiding. Quality is measured by the firm’s ability to disclose areas such as, adequately
explaining accounting policies in footnotes, portraying the firm’s key accounting policies,
explaining current performance, and the amount of additional disclosure that is not
required under GAAP.
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Research and Development
Pharmaceutical companies show their research and development expenses on the
income statements in their 10-K filings. All expenses related to R&D must be expensed
immediately, so there is no flexibility when it comes to expensing these investments. If
pharmaceutical companies were to cut their R&D investments, their entire industry
would no longer produce break through medicines, and their growth rates would come
to a halt. Although R&D is an expense, firms in this industry do not want to hide the
millions of dollars of R&D expenses on their financial statements. Research and
development expenses, in this industry, are very important to investors and analysts
because they are a measure of the steps that a firm is undertaking to claim a larger
market share, and in turn produce higher profit margins. These expenses are clearly
disclosed on each firm’s financial records, so the quality of disclosure of research and
development is documented well.
Goodwill
Wyeth’s disclosure of goodwill in their annual 10-K is very mixed. Wyeth very clearly
states their policy of goodwill and impairments. They efficiently disclose the amount of
goodwill breaking it into segments, showing additions and currency adjustments for all
three. It gives the reader a clear understanding of what segments are actually gaining
or possibly loosing. In addition, when they are purchasing new entities they release the
specific amount of new goodwill being contributed to that specific situation, like the
acquisition of Takeda. On the other hand, they outline how they measure for
impairment, but they never show the accounting behind it. Wyeth claimed in their 10-K
that goodwill in both 2006 and 2007 was free of impairment and would not experience
a write off. It would be beneficial to their investors if Wyeth forecasted the future
expectations the company has for goodwill. The fact that goodwill is not currently being
impaired, and the company is discrete on what they reveal makes it seem that
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management might be skewing the results. When analyzing the quality of Wyeth’s
accounting, goodwill is an area where a misrepresentation may exist.
Defined Benefit Pension Plans
The quality of disclosure for discount rates is decent. The reasoning behind
management’s selection of the discount rate is logical. Wyeth’s main competitors also
have pension discount rates that are within a tenth of a percent of Wyeth’s. After
taking into effect assumed healthcare trends and changes in inflation the discount rate
is a reliable piece of information that the company provided. At first glance it is easy to
mistaken pension benefits and other postretirement benefits as having a deficit but
after further investigation it is clearly stated that a new rule has been put in place for a
specific chart called “Recognition of funded status”.
SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other
Postretirement Plans” was issued in September 2006 and states that, “the recognition
of the funded status of defined benefit pension plans, retiree health care and other
postretirement benefit plans and postemployment benefit plans on the consolidated
balance sheet.” (Wyeth 10-K) SFAS No. 158 also says that overfunded plans are
recognized as an asset and underfunded plan is a liability. Secondly, this requires that
unrecognized prior service costs or credits and net actuarial gains and losses as well as
subsequent changes in the funded status be recognized as a component of
Accumulated other comprehensive income (loss) within stockholders’ equity.
Up until 2006 Net Recognized in chart “recognition of funded status” would transfer to
projected benefit obligations as of January 1st of the next year in chart “change in
benefit obligations”. Afterwards benefit obligation as of December 31st of 20X1 would
transfer to benefit obligation as of January 1st of 20X2. This is how the accounting
department computed unrecognized net actuarial loss, unrecognized service cost and
unrecognized net transition obligations prior to September 2006. In the reconciliation
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of funded status chart, pensions were labeled as a negative figure. The funded status
was labeled as a negative figure. Unrecognized net actuarial loss was a positive
number if investments declined in value. Finally unrecognized prior service costs were
positive if costs increased, adding to obligation of pensions.
This proves that the quality of disclosure is satisfactory and Wyeth clearly explains what
they are doing with their pension finances. Discount rates are fully clarified and other
various costs and unrecognized expenses are included.
Litigation Expenses
Wyeth discloses litigation liabilities in accordance with the FASB Statement No. 5
“Accounting for Contingencies”. In the pharmaceutical industry, it is sometimes difficult
to understand how accrued liabilities are estimated, especially an aggregate of all
pending litigation. As for their 10K’s, Wyeth provides extensive information regarding
the disclosure and current status of pending lawsuits. They include specific details
describing the legal action, parties and dollar amount of settlements estimated to be
paid (or which have already been paid) for each lawsuit. Wyeth’s quality of disclosure
related to litigation and estimating contingent liabilities are very transparent and of
great quality.
Conclusion
Analysis of the quality of disclosure on financial statements is a key component
necessary to draw conclusions about a firm’s economic status and activities. The
expenses of research and development are completely disclosed and well documented
on Wyeth’s income statement. The disclosure of goodwill in their annual 10-K was
mixed due to the lack of showing complete information on impairments. The quality of
disclosure is satisfactory on their pension finances; discount rates are fully clarified and
other various costs and unrecognized expenses are included. Pharmaceutical firms
have very limited flexibility in the disclosure of litigation contingencies.
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Quantitative Accounting Measures and Disclosures
After evaluating the quality of financial disclosure, it is imperative that a quantitative
analysis be discussed. GAAP sets forth certain accounting techniques and guidelines
firms must follow when preparing SEC filings, however, these are only minimum
standards. Therefore, a firm’s manager possesses a level of accounting flexibility at
their discretion. The ability to make estimates and hide certain facts is not a bad thing.
In fact, flexible accounting practices allow firms to stay keep trade secrets in an effort
to stay competitive in their industry. Managers use this capability to determine what an
appropriate level of information to disclose is. Accounting is a very powerful tool that
can be used to inform investors or hide the true financial state of a company from
them. By using diagnostic ratios, analysts can determine the what a company is doing
financially, beyond what is presented in the balance sheet, income statement,
statement of cash flows, and other accounting data presented in a firm’s 10-K. In
essence, quantitative accounting analysis allows an analyst to make the numbers
presented in these reports more meaningful for the purposes of valuing a company.
There are several ratios that an analyst can perform to find the underlying value of a
company’s financial operations. These ratios can be broken down into two sub
sections, sales manipulation diagnostics and the expense manipulation diagnostics.
Sales manipulation diagnostics use net sales as the numerator in all of the ratios.
These ratios will provide information about a firm’s income and provide indications of
possible “red flags.” Expense manipulation diagnostics are used to determine if a
company is manipulating their expenses. By performing these diagnostic ratios for
Wyeth, Abbott, Pfizer, and Eli Lilly, industry wide trends will appear and deviations will
be noted as possible “red flags” distorting accounting figures.
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Sales Manipulation Diagnostics
After establishing the possible flexibility in key accounting policies for the
pharmaceutical industry it is necessary to run certain ratios to uncover if any potential
“red flags” exist within an individual company. Sales manipulation diagnostics
specifically deal with net sales and how they may be affected by changes in different
current assets. To form the net sales to cash from sales, the net sales to accounts
receivable, and the net sales to inventory ratios we extracted important financial
statement information from six years worth of 10-Ks. To evaluate the specific
performance of Wyeth we compared their ratios over five years with their most similar
competitors: Abbott, Pfizer, and Eli Lilly. If any of Wyeth’s ratios appear different from
the industry’s this would be an indication that a distortion exists, and further
investigation would be required.
Net Sales/Cash from Sales
Net sales from cash sales ratio shows the amount of cash received for every dollar
worth of sales. For instance Wyeth shows in 2007 their ratio is .993, this means for
every dollar in the operating cycle they earn $.993 in cash. A profitable company would
want to keep this ratio as close to 1 as possible. The closer the ratio is to one means
they have a low accounts receivable balance, and their allowance for doubtful accounts
is minimal.
Out of the industry comparison Wyeth sets the bar, since 2003 they have managed to
keep their ratio in the .9 range, a desirable trait for any company. The fact that the
competitors are following the trend determines that the pharmaceutical industry relies
heavily on cash sales. With Wyeth having a diverse sales strategy, this ratio shows they
have developed good relationships with their wholesalers as well as their individual
retailers. They are receiving a lot of cash in a timely manner, and not relying on
accounts receivables to come due. Net sales from cash sales ratio for Wyeth do not
suggest suspicion of a “red flag” or any distortion present.
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Net Sales/Net Accounts Receivable
Net sales to accounts receivable ratio is the portion of sales that results in an increase
to the accounts receivable balance. As we discussed earlier the pharmaceutical industry
is one that relies heavily on cash sales. We can deduct that the net sales/accounts
receivable ratio should be low throughout the industry. This is a positive trend that will
provide companies with more liquid assets and fewer sales based on credit.
Overall, Wyeth’s ratio declines except for a slight jump in 2006 to 1007. This is because
of an overall increase to Wyeth’s 2007 accounts receivable, but is not significant
because they still follow within the trend of the industry. In 2006 and 2007 respectively
accounts receivables only accounted for 19.42% and 20.33% of total sales, meaning
the other 80.58% and 79.67% can most likely be contributed to cash sales. Wyeth’s net
sales to accounts receivable ratio closely mimics the ratio trend of the industry,
discouraging the possibility of any distortions present.
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Net Sales/Inventory
The ratio that is computed by dividing net sales by inventory determines how effective
the inventory is in generating revenue. If the ratio is too small compared to
competitors then the company is not making enough revenue for a given amount of
inventory. If the ratio is large then the company is using its inventory wisely and
efficiently. If the ratio is 1:1 then for every dollar that is placed in inventory will result
in a dollar’s worth of sales. The graph above shows that Wyeth, as well as its
competitors, has a relatively high amount of sales compared to inventory. This means
that firms in the pharmaceutical industry make a large amount of revenue for a small
amount of product. This is reasonable considering that prescription drugs are rather
expensive, especially if they are still protected by a patent. The figures that Wyeth
discloses do not result in a red-flag.
70
71
Conclusion
Sales ratios are calculated and review to find potential red-flags. Sales manipulation
diagnostics specifically deal with net sales and how they may be affected by changes in
different current assets. The ratios included net sales to cash from sales, the net sales
to accounts receivable, and the net sales to inventory. No red-flags can be seen from
these sales ratios.
Sales Manipulation Diagnostics Wyeth 2003 2004 2005 2006 2007 Net Sales/Cash from Sales 0.926 0.985 0.988 0.976 0.993Net Sales/Net Accounts Receivable 6.266 6.202 6.189 5.749 6.072 Net Sales/Inventory 6.571 7.005 8.037 8.204 7.380 Net Sales/Unearned Revenue N/A N/A N/A N/A N/ANet Sales/Warranty Liabilities N/A N/A N/A N/A N/A Abbott 2003 2004 2005 2006 2007 Net Sales/Cash from Sales 0.8962 0.8913 0.8937 0.9939 0.8829Net Sales/Net Accounts Receivable 5.2153 5.3245 7.7195 5.3121 5.2385Net Sales/Inventory 6.3103 7.5101 8.7876 8.0089 8.7802Net Sales/Unearned Revenue N/A N/A N/A N/A N/ANet Sales/Warranty Liabilities N/A N/A N/A N/A N/A Pfizer 2003 2004 2005 2006 2007 Net Sales/Cash from Sales 0.7824 0.871 1.0243 1.0644 0.999Net Sales/Net Accounts Receivable 5.1802 5.6065 5.2533 5.1502 4.919Net Sales/Inventory 7.8498 7.8853 8.4945 9.1232 7.9231Net Sales/Unearned Revenue N/A N/A N/A N/A N/ANet Sales/Warranty Liabilities N/A N/A N/A N/A N/A Eli Lilly 2003 2004 2005 2006 2007 Net Sales/Cash from Sales 0.893 0.916 0.949 0.938 0.864Net Sales/Net Accounts Receivable 6.747 6.731 6.331 6.826 6.969Net Sales/Inventory 6.4098 6.0473 7.7983 6.9114 7.3834Net Sales/Unearned Revenue N/A N/A N/A N/A N/ANet Sales/Warranty Liabilities N/A N/A N/A N/A N/A
72
Expense Manipulation Diagnostics
Expense manipulation diagnostics are used to show the trends of each firm in the
industry. These ratios allow for the comparison of the firms and indicate any deviations
from the industry norm. Any variation found from the norm signals a possible red flag.
To evaluate the specific performance of Wyeth, we compared their ratios over five
years with their most similar competitors: Abbott, Pfizer, and Eli Lilly.
Asset Turnover
Asset turnover measures the amount of sales that are generated for every dollar of
assets. This ratio calculates the efficiency of a firm’s ability to make revenue from
assets as well as determining price strategies. Usually the raw asset turnover ratio will
be around one. Special attention should be made for years where the ratio jumps a
considerable amount or falls too fast. A large jump in ratios from one year to the next
is indicative of a problem in accounting calculations. As the graph above shows, the
raw asset turnover ratio for Wyeth is relatively steady without changing by more than a
tenth. This demonstrates that the revenue is sufficiently explained by the amount of
assets that Wyeth possesses. In conclusion Wyeth’s raw asset turnover does not
represent any abnormalities. The asset turnover change represents the change in sales
from one year to the next over the change in assets from one year to the next. The
asset turnover change chart shows these figures with their respective companies.
73
74
CFFO/OI
The cash flow from operations ratio is calculated by dividing the cash flow from
operations by operating income. This ratio gives one a basic understanding of the
company’s quality of earnings. It is relatively easy to report satisfactory income without
showing a decent amount of cash increases. If there are large changes from year to
year it could be derived from noncash expenses. The graph above shows that Wyeth’s
ratio changes from year to year but not by a large number. This ratio follows the trend
of other competitors in the pharmaceutical industry and a significant jump from one
year to the next is not evident. This shows that operating income sufficiently explains
the cash flow from operations figure that is reported in Wyeth’s statements and no red-
flags are present.
75
CFFO/NOA
The ratio above explains how effective a company is in making cash from the
equipment at hand. It is calculated by dividing cash flow from operations by net
operating assets. Net operating assets are derived from adding together plant,
property and equipment less depreciation expenses. The higher this ratio is the more
efficient the company is in regards to using these operating assets. Wyeth’s
information has disclosed that they are not very efficient with their equipment
compared to similar competitors in the pharmaceutical industry. The change graph
shows the difference between the changes in cash flow from operations between two
years divided by the change in net operating assets for those two years.
76
77
Conclusion Expense ratios are calculated and reviewed to find potential red-flags. Three ratios
were used including the net asset turnover and the relationship between cash flows
from operations and net operating assets as well as operating income. All of these
measurements show that Wyeth is very similar to its competitors. While some of the
ratios for Wyeth appear to be lower than competitors in this industry they at stable
levels and any large fluctuations do not exist. No red-flags can be seen from these
expense ratios.
78
Wyeth 2003 2004 2005 2006 2007Asset Turnover(Raw) 0.511 0.516 0.523 0.558 0.524Asset Turnover(Change) 0.254 0.580 0.632 2.501 0.328CFFO/OI(Raw) 0.787 0.694 0.528 0.632 0.967CFFO/OI(Change) 22.01 -0.072 -1.716 1.3 2.837CFFO/NOA(Raw) 15.92 15.33 13.25 18.37 32.24CFFO/NOA(Change) -1.13 -6.63 51.55 -2829.89 517.84Total Accruals/Change in Sales(Raw) 0.679 1.091 0.933 0.591 0.615Total Accruals/Change in Sales(Change) -3.596 -3.394 -22.094 2.742 0.923Pension Expenses/SG&A(Raw) 0.067 0.07 0.071 0.073 0.078Pension Expenses/SG&A(Change) 1.497 3.704 1.852 1.677 0.698Other Employment Expenses/SG&A(Raw) 0.024 0.021 0.025 0.022 0.024Other Employment Expenses/SG&A(Change) 0.959 -0.063 0.502 -0.005 1.08
Abbott 2003 2004 2005 2006 2007Asset Turnover(Raw) 0.664 0.684 0.767 0.621 0.653Asset Turnover(Change) 1.124 0.88 7.112 0.02 0.972CFFO/OI(Raw) 1.138 1.105 1.157 2.577 1.132CFFO/OI(Change) 1.508 0.996 1.598 -0.093 -0.031CFFO/NOA(Raw) 0.54 0.72 0.84 0.76 0.69CFFO/NOA(Change) -0.59 -3.36 -156.64 0.23 -0.14Total Accruals/Change in Sales(Raw) 0.316 0.446 0.63 25.595 0.459Total Accruals/Change in Sales(Change) 0.004 1.21 0.528 0.657 0.573Pension Expenses/SG&A(Raw) 0.001 0.001 0.001 0.001 0.001Pension Expenses/SG&A(Change) -2.051 2.255 1.016 1.514 1.255Other Employment Expenses/SG&A(Raw) N/A N/A N/A N/A N/AOther Employment Expenses/SG&A(Change) N/A N/A N/A N/A N/A
Eli Lilly 2003 2004 2005 2006 2007Asset Turnover(Raw) 0.58 0.557 0.596 0.715 0.696Asset Turnover(Change) 0.571 0.4 -2.752 -0.398 0.609CFFO/OI(Raw) 1.041 0.784 0.524 0.964 1.073CFFO/OI(Change) 9.052 -4.953 94.644 4.325 1.74CFFO/NOA(Raw) 1.793 2.631 4.135 2.05 1.664CFFO/NOA(Change) 0.791 -1.302 -0.378 0.116 0.359Total Accruals/Change in Sales(Raw) 0.722 0.831 0.04 1.255 0.748Total Accruals/Change in Sales(Change) -0.075 3.264 -0.347 2.637 0.153Pension Expenses/SG&A(Raw) 0.114 0.123 0.132 0.128 0.107Pension Expenses/SG&A(Change) 1.953 2.26 5.98 -0.368 0.376Other Employment Expenses/SG&A(Raw) 0.024 0.026 0.032 0.035 0.028Other Employment Expenses/SG&A(Change) 0 0.05 0.151 0.071 0.001
Pfizer 2003 2004 2005 2006 2007Asset Turnover(Raw) 0.383 0.427 0.436 0.419 0.42Asset Turnover(Change) N/A 1.234 0.221 1.45 -0.169CFFO/OI(Raw) 0.933 0.801 0.837 1.003 0.992CFFO/OI(Change) 5.926 0.591 0.577 -46.902 1.04CFFO/NOA(Raw) 0.645 0.889 0.862 1.058 0.849CFFO/NOA(Change) N/A 20.205 1.241 -6.247 4.723Total Accruals/Change in Sales(Raw) 0.627 0.64 -5.458 -0.595 110.83Total Accruals/Change in Sales(Change) N/A -1.598 0.364 -6.584 -3.764Pension Expenses/SG&A(Raw) 0.067 0.072 0.093 0.098 0.093Pension Expenses/SG&A(Change) N/A 0.99 1.081 2 -2.825Other Employment Expenses/SG&A(Raw) 0.009 0.009 0.01 0.011 0.011Other Employment Expenses/SG&A(Change) N/A 0.011 0.001 0.083 -0.135
Expense Manipulation Ratios
79
Potential Red Flags
Red flags are signals pointing to questionable accounting practices. When red flags
appear, they indicate that certain items have been distorted and that further evaluation
of material facts and estimates are needed. After analyzing the sales and expense
diagnostic ratios we determined that there were no red flags present. There were no
questionable practices involving the key accounting policy of research and development.
R&D was expensed in compliance with SEC regulations. The analysis of R&D as an
asset is a theory that represents the value added to a firm by investments in research
and development.
Undoing Accounting Distortions
Financial filings with the SEC and financial statements used for the purpose of investor
education portray the economic activities to the user. It is imperative that these
statements represent factual numbers, precise estimates, and a good amount of
disclosure in order for accurate conclusions about the firm’s economic status to be
drawn.
Goodwill Restatement
Wyeth clearly follows the rules established by the FASB in regards to impairing goodwill.
However, since they have not recognized any impairment for the last two years we
have chosen to amortize the intangible asset. Since the pharmaceutical industry is one
based on knowledge we recognize that the goodwill for a company should be relatively
substantial. Patents are finite, over time individual companies loose their monopoly on
certain products and goodwill should be impaired for this instance.
We have chosen to amortize goodwill at a rate of 20%. We took the 20% of the original
amount of goodwill to get the amortization expense for 2002. For the following years
we took 20% from the difference in goodwill and added the total amount of the
previous year’s amortization expense. The 2003 goodwill amortization expense was
80
calculated as (goodwill t-1 * .20) + ((goodwill t – goodwill t-1) *.20). By amortizing
goodwill it reduced the overall percentage goodwill was of total assets that were
discussed earlier. This graph shows the extreme difference in Wyeth’s total assets by
simply expensing a percentage of goodwill. Clearly since Wyeth is continuing to
purchase new entities goodwill should not always be amortized. Our method of
restatement is aggressive compared to Wyeth’s current accounting standards. We
believe Wyeth should adapt a moderate stance in regards to amortizing goodwill.
Goodwill as a percentage of total assets
0.00%
2.00%
4.00%
6.00%
8.00%
10.00%
12.00%
14.00%
2002 2003 2004 2005 2006
Restated Goodwill/TotalAssetsGoodwill/Total Assets
Research and Development Restatement
It was determined that research and development is the driving force behind the
pharmaceutical industry. If the costs associated with research and development were
placed in the asset account and then depreciated 20% per year, assets would increase,
and expenses would decrease creating an increased net income. The table below
shows the adjusted net income if R&D expenses were capitalized.
81
We have chosen to depreciate R&D at a rate of 20%. We took the 20% of the original
amount of R&D to find the R&D depreciation expense for 2002. For the following years
we took 20% from the difference in R&D and added the total amount of the previous
year’s depreciation expense. The 2003 R&D depreciation expense was calculated as
(R&D t-1 * .20) + ((R&D t – R&D t-1) *.20).
The net income of Wyeth would increase if the expenses in R&D were able to be on the
balance sheet in the asset section. Since the net income has increased, the owner’s
equity section of the balance sheet would increase as well. This would represent a
favorable statistic to investors as well as analysts. The assets of the company would
also be increased, changing the expense and revenue diagnostics.
The following Income Statements and Balance Sheets show the effects of restating
Goodwill and Research and Development. Notice that total assets as well as net income
increase after restating R&D and Goodwill.
82
Wyeth Balance Sheets 2002 2003 2004 2005 2006 2007Assets:Cash and cash equivalents 2,943,604 6,069,794 4,743,570 7,615,891 6,778,311 10,453,879 Marketable securities 1,003,275 1,110,297 1,745,558 618,619 1,948,931 2,993,839 Accounts Receivable 2,379,819 2,529,613 2,798,565 3,030,580 3,383,341 3,528,009 Inventories 1,992,724 2,412,184 2,478,009 2,333,543 2,480,459 3,035,358 Other current assets including deferred taxes 1,776,330 2,840,354 2,672,327 4,446,208 2,923,199 2,972,513
Property, plant and equipment:Land 173,743 182,849 187,732 177,507 177,188 182,250 Buildings 3,401,490 4,130,838 4,630,910 6,492,605 7,154,928 7,921,068 Machinery and equipment 3,782,533 4,184,292 4,657,716 4,860,953 5,491,987 6,170,239 Construction in progress 2,477,219 3,188,273 3,600,993 1,516,033 1,659,391 1,947,624 Total PP&E 7,235,692 8,661,051 9,524,350 9,353,353 10,146,259 11,072,158 Goodwill 3,745,749 3,817,993 3,856,410 3,836,394 3,925,738 4,135,002 Other intangibles, net of accumulated amort. 145,915 133,134 212,360 279,720 356,692 383,558 Other assets including deferred taxes 3,309,537 3,457,502 5,598,555 4,326,818 4,535,785 4,142,966 Total Non-Current Assets 14,436,893 16,069,680 19,191,675 17,796,285 18,964,474 19,733,684
Total Assets 26,042,592 31,031,922 33,629,704 35,841,126 36,478,715 42,717,282 Liabilities:Loans payable 804,894 1,512,845 330,706 13,159 124,225 311,586 Trade accounts payable 672,633 1,010,749 949,251 895,216 1,116,754 1,268,600 Accrued expenses 3,798,500 5,461,835 7,051,557 8,759,136 5,679,141 5,333,528 Accrued taxes 209,479 444,081 204,028 280,450 301,728 410,565 Total Current Liabilities 5,485,506 8,429,510 8,535,542 9,947,961 7,221,848 7,324,279
Long-term debt 7,546,041 8,076,429 7,792,311 9,231,479 9,096,743 11,492,881 Accrued postretirement benefit obligations 965,081 1,007,540 1,024,239 1,104,256 1,600,751 1,676,126 Other noncurrent liabilities 3,890,052 4,224,062 6,429,709 3,563,061 3,100,205 3,511,621 Total Liabilities 17,886,680 21,737,541 23,781,801 23,846,757 21,019,547 24,004,907
Stockholders EquityCommon stock 442,019 444,151 445,031 447,783 448,417 445,929 Additional paid-in capital 4,582,773 4,764,390 4,817,024 5,097,228 6,142,277 7,125,544 Retained earnings 3,286,645 4,112,285 4,118,656 6,514,046 8,734,699 10,417,606 Accumulated other comprehensive income (155,571) (26,487) 467,152 (64,725) (672,666) 221,433 Total Stockholders Equity 8,155,912 9,294,381 9,847,903 11,994,369 14,652,755 18,210,535
Total Liabilities and Stockholders Equity 26,042,592 31,031,922 33,629,704 35,841,126 36,478,715 42,717,282
Asset Turnover (Raw) N/A 1 1 1 1 1
Total Current Assets 11,605,699 14,962,242 14,438,029 18,044,841 17,514,241 22,983,598 Current Ratio 2 2 2 2 2 3
Dividends paid (1,219,173) (1,223,158) (1,227,034) (1,259,398) (1,358,769) (1,423,494) Net Income 4,447,205 2,051,192 1,363,844 3,656,298 4,196,706 4,615,960
83
Wyeth Restated Balance Sheets 2002 2003 2004 2005 2006 2007Assets:Cash and cash equivalents 2,943,604 6,069,794 $4,743,570 $7,615,891 $6,778,311 $10,453,879Marketable securities 1,003,275 1,110,297 1,745,558 618,619 1,948,931 2,993,839Accounts Receivable 2,379,819 2,529,613 2,798,565 3,030,580 3,383,341 3,528,009Inventories 1,992,724 2,412,184 2,478,009 2,333,543 2,480,459 3,035,358Other current assets including deferred taxes 1,776,330 2,840,354 2,672,327 4,446,208 2,923,199 2,972,513Total Current Assets 11,605,699 14,962,242 14,438,029 18,044,841 17,514,241 22,983,598Property, plant and equipment:Land 173,743 182,849 187,732 177,507 177,188 182,250Buildings 3,401,490 4,130,838 4,630,910 6,492,605 7,154,928 7,921,068Machinery and equipment 3,782,533 4,184,292 4,657,716 4,860,953 5,491,987 6,170,239Construction in progress 2,477,219 3,188,273 3,600,993 1,516,033 1,659,391 1,947,624Total PP&E 7,235,692 8,661,051 9,524,350 9,353,353 10,146,259 11,072,158Goodwill after amortization 2,996,599 3,054,394 3,085,128 3,069,115 3,140,590 3,308,002 Other intangibles, net of accumulated amort. 145,915 133,134 212,360 279,720 356,692 383,558Other assets including deferred taxes 3,309,537 3,457,502 5,598,555 4,326,818 4,535,785 4,142,966Research and Development 1,664,152 1,674,824 1,968,488 2,199,512 2,487,248 2,605,428Total Non-Current Assets 25,186,880 28,667,157 33,466,232 32,275,616 35,150,068 37,733,293
Total Assets 36,792,579 43,629,399 47,904,261 50,320,457 52,664,309 60,716,891Sales 14,584,035 15,850,632 17,358,028 18,755,790 20,350,655 22,399,798TAT 0.43 0.40 0.39 0.40 0.43
Liabilities:Loans payable 804,894 1,512,845 $330,706 $13,159 $124,225 $311,586Trade accounts payable 672,633 1,010,749 949,251 895,216 1,116,754 1,268,600Accrued expenses 3,798,500 5,461,835 7,051,557 8,759,136 5,679,141 5,333,528Accrued taxes 209,479 444,081 204,028 280,450 301,728 410,565Total Current Liabilities 5,485,506 8,429,510 8,535,542 9,947,961 7,221,848 7,324,279
Current Ratio 2.12 1.77 1.69 1.81 2.43 3.14
Long-term debt 7,546,041 8,076,429 7,792,311 9,231,479 9,096,743 11,492,881Accrued postretirement benefit obligations 965,081 1,007,540 1,024,239 1,104,256 1,600,751 1,676,126Other noncurrent liabilities 3,890,052 4,224,062 6,429,709 3,563,061 3,100,205 3,511,621Total Liabilities 17,886,682 21,737,543 23,781,803 23,846,759 21,019,549 24,004,910
Stockholders EquityCommon stock 442,019 444,151 445,031 447,783 448,417 445,929Additional paid-in capital 4,582,773 4,764,390 4,817,024 5,097,228 6,142,277 7,125,544Retained earnings 14,036,678 16,709,804 18,393,253 20,993,414 25,726,734 28,919,078Accumulated other comprehensive income (155,571) (26,487) 467,152 (64,725) (672,666) 221,433Total Stockholders Equity 18,905,899 21,891,858 24,122,460 26,473,700 31,644,762 36,711,984
84
Wyeth Incom
e Statements
20022003
20042005
20062007
Net Revenue14,584,035
15,850,632
17,358,028
18,755,790
20,350,655
22,399,798
Cost of goods sold
3,918,387
4,377,086
4,947,269
5,431,200
5,587,851
6,313,687
Gross Profit
10,665,648
11,473,546
12,410,759
13,324,590
14,762,804
16,086,111
Selling, general and administrative expenses
5,010,507
5,468,174
5,799,791
6,117,706
6,501,976
6,753,698
Research and development expenses
2,080,191
2,093,533
2,460,610
2,749,390
3,109,060
3,256,785
Operating Incom
e(EBITDA)3,574,950
3,911,839
4,150,358
4,457,494
5,151,768
6,075,628
Interest expense, net
202,052
103,140
110,305
74,756
(6,646)
(90,511)
Other incom
e, net(382,931)
(332,264)
(330,100)
(397,851)
(271,490)
(290,543)
G
ains related to Imm
unex/Amgen com
mon stock transactions
(4,082,216)
(860,554)
-
-
-
-
Diet drug litigation charges1,400,000
2,000,000
4,500,000
-
-
-
Special charges
340,800
639,905
-
-
-
-
Income before federal and foreign taxes
6,097,245
2,361,612
(129,847)
4,780,589
5,429,904
6,456,682
Provision for federal and foreign taxes1,650,040
310,420
(1,363,844)
1,124,291
1,233,198
1,840,722
Net Incom
e4,447,205
2,051,192
1,363,844
3,656,298
4,196,706
4,615,960
Wyeth
Restated
Inco
me S
tatemen
ts2
00
22
00
32
00
42
00
52
00
62
00
7 N
et Revenue
14,584,035
15,850,632
17,358,028
18,755,790
20,350,655
22,399,798
Cost of goods sold
3,918,387
4,377,086
4,947,269
5,431,200
5,587,851
6,313,687
Gross Profit
10,665,648
11,473,546
12,410,759
13,324,590
14,762,804
16,086,111
Selling, general and administrative expenses
5,010,507
5,468,174
5,799,791
6,117,706
6,501,976
6,753,698
Operating Incom
e5,655,141
6,005,372
6,610,968
7,206,884
8,260,828
9,332,413
Interest expense, net
202,052
103,140
110,305
74,756
(6,646)
(90,511)
Research and developm
ent depreciation expense416,038
418,706
492,122
549,878
621,812
651,357
G
oodwill am
ortization expense749,150
763,599
771,282
767,279
785,148
827,000
O
ther income, net
(382,931)
(332,264)
(330,100)
(397,851)
(271,490)
(290,543)
Gains related to Im
munex/Am
gen comm
on stock transactions(4,082,216)
(860,554)
-
-
-
-
D
iet drug litigation charges1,400,000
2,000,000
4,500,000
-
-
-
Special charges
340,800
639,905
-
-
-
-
Income before federal and foreign taxes
6,097,245
2,361,612
(129,847)
4,780,589
5,429,904
6,456,682
Provision for federal and foreign taxes1,650,040
310,420
(1,363,844)
1,124,291
1,233,198
1,840,722
Net Incom
e5,362,208
2,962,420
2,431,203
5,088,531
5,898,806
6,394,388
85
Financial Analysis and Forecasting Financials
Now that the pharmaceutical industry has been analyzed, key success factors identified
and important accounting policies reviewed one must delve further into the company to
determine its value. Analyzing the financial statements of Wyeth and its competitors
involves three steps that include ratio analysis, forecasting and calculating the cost of
capital. The ratio analysis involves studying liquidity, profitability and capital structure
ratios for the firm and its competitors in the drug manufacturing industry. The ratios in
this initial step are compared with the industry. These ratios along with the common
sized financial statements will allow one to forecast specific items. The forecasts will
provide potential results for the firm. Finally, interest rates and pricing data will be
used to calculate the cost of equity.
Liquidity Ratio Analysis
Liquidity ratios are used to determine a company’s ability to meet its short-term
obligations. Liquidity refers to how quickly the assets of a firm can be converted into
cash. The liquidity ratios used in this analysis include the current ratio, quick asset
ratio, working capital turnover, accounts receivable turnover, days’ sales outstanding,
inventory turnover, days’ supply in inventory, and cash to cash cycle. For this analysis,
we compared Wyeth with three other competitors in the pharmaceutical industry.
86
Current Ratio
The current ratio is calculated by dividing total current assets by total current liabilities.
The purpose of this ratio is to illustrate the capability of a firm to pay off its short term
debt with funds that can be turned into cash relatively easily. If this ratio is equal or
greater than one then the company can pay off its obligations quickly and without
issues. When the current ratio is lower than one then the firm likely has a liquidity
problem. As the chart above shows, Wyeth has a very high current ratio since 2002
with an upward trend starting in 2004. The reasons for the large jumps in the past two
years include a 30% decrease in liabilities from 2005 to 2006 and a 30% increase in
assets from 2006 to 2007. Compared to the average of Wyeth and its competitors
Wyeth consistently shows higher current ratios. Over the past seven years the current
ratio of Wyeth demonstrates that this firm is very liquid over time. Wyeth has plenty of
easy to convert assets that will satisfy current obligations.
87
Quick Asset Ratio
The quick asset ratio measures the liquidity of a company in a similar fashion to the
current ratio. This ratio is measured by adding cash, securities and accounts receivable
and dividing this sum by the current liabilities. Analysts use this ratio because it gives a
more realistic image of the firm’s ability to repay its debts with specific assets that can
be turned into cash fast rather than the entire current asset figure that is used in the
current ratio formula. Inventory is the notable asset item left out of the quick asset
ratio. Many companies that produce consumer goods will have a large sum of money
invested in inventory. If the quick asset ratio is much lower than the current ratio, then
the company might be relying too much on inventory figures, which might their worth
before they are sold. The above chart shows that even with inventory taken out of the
equation; Wyeth is still able to pay off its liabilities without trouble.
88
Working Capital Turnover
Working capital is calculated by subtracting current assets by current liabilities. This
figure gives individuals the amount of funds the company is using to generate sales. If
the sales figure is divided by working capital, this ratio will determine how effective the
company is in generating sales from operations. The working capital ratio should be at
least one. If it is higher then the firm is very effective in generating sales with the
funds for operations they possess. As can be seen in the graph above, Wyeth and its
competitors have relatively stable working capital turnover ratios. Wyeth’s lowest
working capital turnover ratio was in 2007 when it dropped to 1.4. This is credited to
an increase in current assets in 2007 which increases the denominator in the equation.
Abbott’s low ratio in 2006 is attributed to a large amount of liabilities that were added
to the balance sheet.
89
Accounts Receivable Turnover
Accounts receivable turnover demonstrates how effective the firm is in collecting
receivables. All of the companies in the pharmaceutical industry have a significant
amount within accounts receivables so the possibility of operating solely on cash is not
present. High receivables turnover signifies that the company collects money owed to
the firm very quickly. When the receivables turnover is low special attention should be
taken to address why collections are not being made because this is potential revenue
being lost. This ratio is measured by dividing sales by accounts receivables. All of
these pharmaceutical firms have a high accounts receivable turnover ratio indicating
that all of them are efficient in collecting receivables. Wyeth consistently has a
receivables turnover ratio above six since 2002.
90
Day’s Sales Outstanding
The day’s sales outstanding ratio measures the number of days it takes a company to
collect on their accounts receivables. This is simply calculated by dividing the
receivables turnover by 365. A company would desire the ratio to stay relatively low,
because it is a sign that liquidity can be easily created. Wyeth’s 2007 days sales
outstanding ratio is 57.6, which are much lower, then the industry’s average of 63.5. 58
days might seem like a lot of time to collect on receivables. However, if Wyeth’s
receivable terms were established as net 60, requiring their customers to send payment
within 60 days of the sell then they would be operating efficiently. Although Wyeth is
not the lowest in the industry it is closely following the industry trend without any rapid
changes, proving Wyeth is receiving cash quickly enough for the industry standards.
91
Inventory Turnover
The inventory turnover ratio is a component of measuring a company’s overall
operating efficiency. The formula to calculate the inventory turnover is: cost of goods
sold over inventory. The higher the ratio the more productive a company is with
managing their inventory. Overall, the pharmaceutical industry maintains a low
inventory turnover ratio. Abbott has consistently been the industry leader in this
aspect, but Wyeth has once again followed the overall trend. The lower ratio may be
contributed to pharmaceutical companies keeping a high amount of inventory on hand.
Since drug manufactures go through extensive R&D and long testing trials, once they
receive the patent on a specific drug they more then likely mass produce it so they can
start the developing process of a new drug. This would keep the costs of goods sold
constant over time, but would result in an excess of inventory, making the ratio lower.
Since Wyeth is above most of their competitors and only experienced a 0.2 drop from
2006-2007 it seems they are managing their inventory moderately.
92
Day’s Supply in Inventory
Day’s supply of inventory is the assessment, in terms of days, it takes inventory to be
sold and become collectables in accounts receivable. This is measured by simply
dividing the inventory turnover ratio by 365. A company’s day’s supply of inventory
should relatively be the opposite of their inventory turnover. Thus, since Abbott had
the highest inventory turnover they have the lowest day’s supply of inventory. Wyeth
once again will follow the overall industry trend, but is now downward slopping. The
recent jump from 2006 to 2007 from 162 to 175.5 days shows Wyeth’s inventory has
increased and is not being sold as quickly, and should be taken notice of.
93
Cash to Cash Cycle
The cash to cash cycle is simply the amount of time it takes a company to earn 1 dollar
of revenue for every dollar they put into their inventory. A company’s cash to cash cycle
is their day’s supply of inventory plus their day’s sales outstanding. This sums up the
importance of all the operating efficiency measurements and gives a better
understanding of what a company is overall achieving. Once again Abbott has been
leading the industry over the pass six years averaging a 169 day cash to cash cycle
were adversely Pfizer has averaged 317 days. In regards to Wyeth they continue the
pattern of following the industry’s trend. They are slightly below the industry’s 6 year
average of 250 days with an average 236 day cash to cash cycle. They are
outperformed by Abbott, but are second in the overall industry, meaning the amount of
time to receive revenue from sales is proficient.
94
Conclusion
The current ratio and quick ratio for Wyeth are consistently above 1, suggesting that
the firm is capable of meeting its short term debt obligation by turning their assets into
cash. Wyeth, therefore, has no problem with liquidity. The working capital turnover for
Wyeth is always positive, around 1, showing that the firm effectively generates revenue
through the use of their working capital. Inventory turnover and accounts receivable
turnover measure the firm’s operating efficiency. These ratios show that Wyeth has
operating efficiency above the industry average, and are managing their accounts
receivable and inventory better than the industry. Wyeth does not possess the lowest
day’s sales outstanding in the industry, but they are doing a good job of managing their
receivables. Wyeth overall has done well by industry standards in managing their days
supply of inventory, but the jump from 162 days in 2006 to 175.5 days in 2007,
indicates that they are not pushing inventories through the cycle as well as they have in
the past. After analyzing Wyeth’s cash to cash cycle, it is evident that Abbott does a
better job of converting inventory to sales and then receiving the cash. However,
Wyeth still performs above the industry average.
95
Profitability Ratio Analysis
Profitability ratios are used to evaluate the ability of a company to generate earnings in
relation to their associated revenues, incomes and assets. The profitability ratios used
for this analysis include the gross profit margin, operating expense ratio, operating
profit margin, net profit margin, asset turnover ratio, return on assets, and return on
equity. For this analysis, we compared Wyeth with three other competitors in the
pharmaceutical industry for the years 2002 through 2007.
Gross Profit Margin
Gross profit margin is calculated by dividing a firm’s gross profit by its sales. Gross
profit is found by subtracting cost of goods sold from net sales. This ratio is used to
determine how profitable a company’s operating activities are, excluding the associated
costs. A high gross profit margin indicates that a firm has the ability to make a profit
on its sales, as long as they manage their costs. As seen in the chart below, Wyeth’s
gross profit margin stayed consistent with the industry average. Two of Wyeth’s main
competitors, Pfizer and Eli Lilly, have continually had a higher gross profit margin.
Wyeth has maintained an overall average of 72.1% throughout the past six years.
96
Operating Expense Ratio
The operating expense ratio is found by dividing the selling, general, and administrative
expenses by net sales. This ratio indicates what proportion of a company’s sales are
being spent on operating expenses. For this ratio, a smaller percentage is best because
it suggests that a firm has a greater ability to generate a profit, due to lower operating
expenses, should their earnings decrease. As illustrated below, Wyeth’s operating
expense ratio was the most unfavorable because it remained the highest among its
competitors from 2002 to 2006. Overall, Abbott performed the best with the lowest
ratio among the industry.
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Operating Profit Margin
Operating profit margin is calculated by dividing income from operations by sales. This
ratio is another way of measuring management’s efficiency within a company. A firm
with a higher operating profit margin tends to have lower fixed costs and operating
expenses. The chart below shows that despite a few up and downs, Pfizer has overall
outperformed the industry in its operating profit margin. Wyeth and Eli Lilly exhibited
similar ratio patterns and were both below the industry average for several years.
However, Wyeth did show an increase above Eli Lilly and nearly matched Pfizer’s
margin in 2007. Abbott’s operating profit margin remained below its industry
competitors throughout the last six years.
98
Net Profit Margin
Net profit margin is computed by dividing net income by sales. This ratio indicates how
much profit a company makes for every dollar of sales they generate. In relation to
competitors, the higher the net profit margin, the better. This ratio could be considered
one of the most important, as it is directly tied to earnings of company and its
performance. Looking at the chart below, Pfizer appears to have unstable earnings
with its sales. Abbott’s net profit margin steadily went down from 2002 to 2006, but
then showed an increase in 2007. Eli Lilly and Wyeth again showed similar trends
throughout the six years. In 2007, Wyeth closed out the year with the highest net
profit margin among its competitors at 20.7%. The restatement shown for Wyeth was
the result of recording research and development as an asset, depreciating it over a five
year term, and amortizing goodwill. This action raised the net income, which in turn
raised the net profit margin. There was however a decrease in 2007 due to the large
amounts of R&D being written off simultaneously that year.
99
Asset Turnover
Asset turnover is calculated by taking net sales of the current year over total assets of
the previous year. This ratio measures how efficiently a firm generates net revenue
using its assets. For this analysis, a higher ratio is indicative of better performance. As
illustrated in the chart, the industry generated an overall average of $0.62 in sales for
every $1 of assets. In comparison to the other firms, Abbott achieved a superior asset
turnover from 2002-2006. Pfizer trailed in the industry with an average of $0.42 in
sales for every $1 of assets. Without restatement of the total assets, Wyeth’s turnover
was consistent with that of the industry. By restating this ratio, we are theoretically
increasing the total assets of Wyeth by no longer expensing R&D, but rather classifying
it as an asset and depreciating it over a five year life. In doing this, Wyeth’s asset
turnover greatly decreased to an average of $0.40 in sales for every $1 of assets. The
amount of goodwill that is depreciated each year does not significantly impact the asset
turnover ratio.
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Return on Assets
Return on assets is found by taking the net income of the current year over the total
assets of the previous year. This ratio indicates the amount of profit that results from
each dollar of invested capital. The more efficiently a company uses the resources at
its disposal, increases the potential ROA. The industry had an overall average of
10.8%. Upon restating R&D and goodwill, the overall return on assets for Wyeth
decreased significantly due to the addition to assets.
101
Return on Equity
Return on equity is calculated by taking the net income of the current year and dividing
it by the owners’ equity from the previous year. This ratio indicates how much money
has been earned through the money the shareholders’ have invested in the company.
Typically a higher return signals that a firm is growing. In 2005, the spike in Wyeth’s
return on equity could be contributed to a new product reaching the market. As Wyeth
continues to be above the industry average from 2005 to 2007, it is likely that they
have gained a larger share of the market resulting in higher profitability. As can be
seen, the return on equity for the pharmaceutical industry has large fluctuations. This
could be attributed to the utilization of retained earnings and the release of new
products. Through the restatement of owners’ equity, Wyeth shows a significant drop
due to the large amounts of retained earnings from the increased net income.
102
Conclusion
Profitability ratios are used to evaluate the ability of a company to generate earnings in
relation to their associated revenues, incomes and assets. After calculating these
ratios, it is evident that Wyeth consistently performs close to the industry average. The
charts show that Wyeth never really has any large dips or spikes in relation to their
ability to generate earnings and manage expenses. Wyeth has found a way to
generate income through constant sales growth. Overall, Wyeth continues to earn
profits and returns at an industry average.
103
Capital Structure Analysis
Capital structure analysis is a method performed to determine how a company finances
its assets. The liabilities and owner’s equity are analyzed in order to determine if the
firm uses debt or equity to finance its ongoing activities, such as acquiring new assets.
Use of the ratios related to capital structure analysis focus on two specific areas, the
amount of debt relative to the owner’s equity and the ability to meet interest payments.
Three ratios were used to determine the capital structure of Wyeth relative to its
competitors. These ratios were debt to equity ratio, times interest earned, and debt
service margin.
Debt to Equity Ratio
The debt to equity ratio explains how a company finances its operations. By dividing
total liabilities by total equity a business can determine whether they rely more on their
own capital or by borrowing money. The lower the debt to equity ratio the better the
company stands financially. As the ratio approaches one, it would show a company to
have a balanced capital structure. The graph shows Wyeth has the highest debt to
equity ratio compared to the industry; this may be alarming to future and current
investors. Since a company must pay their debts before their shareholders receive any
benefits this may discourage potential investors, because they would see a decrease in
dividends. Wyeth has been consistently improving their debt to equity ratio; Wyeth’s
six-year average was 1.93 but is currently 1.3. Wyeth is being outperformed by the
industry but is striving to cut back on debt financing. The debt to equity ratio for
Wyeth dropped significantly after the restatement of R&D and goodwill because owners’
equity increased due to larger retained earnings. Therefore, Wyeth’s overall risk
decreased through the restatement.
104
105
Times Interest Earned
Times Interest Earned demonstrates the company’s portion of operating income that
covers that period’s interest expense. The ratio is calculated by dividing income from
operations by the current portion owed of long-term debt. This ratio can constantly
change due to shifting interest rates, acquiring new debt, and completing payments on
older loans.
Unfortunately due to the volatile debt to equity trend of Pfizer the industry average is
inadequate in comparing other companies. Wyeth has a five-year average of 11.08,
meaning they earn 11 times more then what they pay in interest. Wyeth has displayed
a downward trend, which is unfavorable and should attempt to lower their interest
expense. This ratio discloses imperative information for an individual company. A spike
does not necessarily mean the company is in peril, but it might have acquired new
territory forcing them to get a new loan. On the other hand a decrease might simply
mean a company has finished payments on a older loan, the 10-k should be examined
to explain each individual move.
106
Debt Service Margin
The debt service margin is calculated by taking operating cash flows of the current
period divided by current notes payable from the previous period. This measure shows
the ability to pay debt by using cash flows generated from operations of the firm.
Wyeth’s spike in 2005 is due to less current notes payable on the balance sheet. After
2002, Wyeth restructured their debt and from there on their debt service margin was
above one. This means they always had enough cash from their current operations to
cover the current portion of their debt obligations.
Conclusion
Capital structure analysis ratios are used to determine the means of financing a
company, either through debt or equity. Over a six year period, Wyeth has consistently
lowered their debt to equity ratio, improving their leverage. Wyeth has the highest
debt to equity ratio among their competitor’s but are improving their standing. The
debt service margin for Wyeth shows that they have performed similarly to their
107
competitors over the last six years, except for a spike in 2005. This could be attributed
to having much less current notes payable on their books.
Credit Risk
The Altman Z-Score is used to predict the likelihood of a company defaulting on a loan.
This model uses five financial ratios which measure liquidity, cumulative profitability,
return on assets, market leverage, and sales generating potential of assets. Each of
these ratios is weighted based on their degree of relevance; the result is a score that
predicts the probability of a firm defaulting on a loan. There are three ranges a
company’s score may fall relative to risk:
Z‐Score Levels of Risk
Z > 2.67 low
1.81 ≤ Z ≤ 2.67 neutral
Z < 1.81 high
Formula for calculating the Altman Z-Score:
Z-Score = 1.2(net working capital/total assets) + 1.4(retained earnings/total assets) + 3.3(earnings before interest and taxes/total
assets) + 0.6(market value of equity/book value of total liabilities) + 1.0(sales/total assets)
108
As the chart indicates, all of the firms in this industry have remained in the low credit
risk range throughout the past six years by maintaining a z-score greater than 2.67.
Internal Growth Rate
The rate of growth of a firm is extremely important when analyzing the reliability of a
company. Growth is essential if a company is willing to successfully compete in the
industry. The two most widely used growth rates include the internal growth rate and
the sustainable growth rate. The internal growth rate measures the company’s ability
to grow without outside funding. The sustainable growth rate illustrates how much a
firm can grow without increasing the leverage already being used.
The internal growth rate is calculated by multiplying the return on assets by one minus
the dividend payout rate. This growth rate signifies the highest rate that a firm can
grow without borrowing funds from an outside source. The chart above shows that
Wyeth’s growth rate reduced to 8.3% before rising up past the industry average of
12.8% in 2006. Wyeth, along with all of its competitors, has been steadily increasing
dividend payments over the past several years. This indicates that the net income of
these pharmaceutical companies has been increasing at a greater rate than dividend
payouts. The chart also illustrates a convergence around 15% for Wyeth and its
109
competitors. Due to capitalized research and development net income has increased
but total assets have increased by a greater amount. This causes the multiplier to
decrease making the internal growth rate decrease.
Sustainable Growth Rate
The sustainable growth rate measures the highest growth that a company can perform
with the leverage it is already using. Once this growth rate increases above this level,
more borrowing will need to ensue. This measurement is calculated by multiplying the
internal growth rate by one plus the debt to equity ratio of the previous year.
According to the above graph, Wyeth’s stated sustainable growth rate is able to sustain
a higher level of growth compared to its competitors for every year except 2004. After
using restated figures, the growth rate deceases for the same reasons as the internal
growth rate decrease. Total assets have increased by a greater amount than net
income. As with the internal growth rate, a convergence to about three percent seems
to be taking place. A convergence seems to be focused around 30% in this growth
rate.
110
2003 2004 2005 2006 2007
Internal Growth Rate 0.126 0.083 0.146 0.155 0.166
Industry IGR 0.145 0.123 0.128 0.152 0.148
Sustainable Growth Rate 0.401 0.279 0.499 0.463 0.403
Industry SGR 0.370 0.274 0.306 0.336 0.300
Conclusion
After reviewing Wyeth’s liquidity, profitability, and capital structure analyses, it is
evident that they mostly perform at about the same level as their closest competitors.
Wyeth’s area of strength is the ability to cover liabilities with current assets as well as
receiving payment for sales. In terms of profitability, Wyeth performs about the same
as the industry. Over the past six years Wyeth has decreased their debt to equity ratio
showing that that they are now financing more of their activities with equity rather than
debt. The internal growth rate for Wyeth shows that the company has been growing
steadily over the past three years. The sustainable growth rate indicates that the
growth rate is slowly declining after a large increase in 2004. Wyeth continues to be a
leader in the pharmaceutical industry by consistently changing their debt structuring to
finance more endeavors through equity and producing earnings.
111
Financial Statement Forecasting
Income Statement
The income statement is the first financial statement that is used when forecasting a
company. This financial statement reflects revenues and expenses and therefore is the
simplest statement to forecast. Past income statements have been spliced onto one
spreadsheet and analyzed for red-flags that would have an effect on forecasting. Then
a common sized income statement is made using these figures. Forecasted figures
were placed in this common sized statement in the form of percentages. The first three
years after 2007 were forecasted as a running average while a constant change was
used for the following years until 2018. This was done because of the obvious
fluctuations that take place from year to year.
Net revenue is the first item to be forecasted because it is easily the most significant.
This item was forecasted using sales growth forecasts. The future sales growth
percentages were calculated by averaging the past five years of financials and using
this percentage growth extended until 2018. Sales growth was relatively steady for the
past five years and this is the reason why the average of sales growth was used.
Ultimately, net sales were increased by a constant percentage of 8.96%. The highest
growth rate was 10.07% and the lowest was 8.05 so the rate we decided upon is
relatively conservative. This figure is used to help forecast the rest of the income
statement and therefore, the rest of the financial statements so it was decided that this
figure should be of a conservative number.
The next item on the income statement that was forecasted is the cost of goods sold.
This line item is very important for any company that is producing products to sell. The
cost of goods sold for past couple of years never changed by more than one percentage
point. The forecasted cost of goods sold is the average of the past six years. The
lowest year was in 2002 with 26.87% of total revenue while the highest cost of goods
sold was in year 2005 with 28.96%.
112
After calculating the gross profit by subtracting cost of goods sold from net revenue,
the selling, general and administrative expenses were forecasted. Over the past couple
of years there was a steady decreasing trend regarding this line item. The forecasted
figures were calculated by taking the percentage change of the previous year and using
that figure for the following year. This change became constant after the third year of
forecasting.
Research and development is one of the most important elements within Wyeth, let
alone any pharmaceutical company. The item was forecasted by taking the average of
the past three years of the year being forecasted. This is due to the fact that the trend
over the past six years did not seem like a reasonable figure to use. Because of this,
research and development was observed from a more recent perspective.
After calculating the operating income by subtracting the forecasted selling, general and
administrative expenses and research and development from gross profit, net income
was the final line item to be forecasted. The percentage of net income to net revenue
was extremely erratic from 2002 to 2004; however the years 2005 to 2007 represented
very stable percentages. In fact, there was only a .01% change from 2006 to 2007.
This information is the reason why net income was forecasted by taking the average of
the past three years of the year being forecasted. As with the rest of the line items on
the income statement, forecasted net income became constant after the third year.
113
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-
-
-
-
-
-
P
rovi
sion
for
fede
ral a
nd f
orei
gn ta
xes
1,65
0,04
0
31
0,42
0
(1
,363
,844
)
1,
124,
291
1,23
3,19
8
1,84
0,72
2
-
-
-
-
-
-
-
-
-
-
-
N
et In
com
e4,
447,
205
2,05
1,19
2
1,
363,
844
3,65
6,29
8
4,
196,
706
4,
615,
960
4,94
0,39
3
5,44
9,46
2
5,
925,
209
6,45
6,34
3
7,03
5,08
8
7,
665,
712
8,35
2,86
4
9,10
1,61
2
9,
917,
478
10
,806
,478
11,7
75,1
68
Wy
eth
In
com
e S
tate
men
t
in m
illio
ns20
0220
0320
0420
0520
0620
0720
0820
0920
1020
1120
1220
1320
1420
1520
1620
1720
18
Ann
ual S
ales
Gro
wth
N/A
8.68
%9.
51%
8.05
%8.
50%
10.0
7%8.
96%
8.96
%8.
96%
8.96
%8.
96%
8.96
%8.
96%
8.96
%8.
96%
8.96
%8.
96%
Net
Rev
enue
100.
00%
100.
00%
100.
00%
100.
00%
100.
00%
100.
00%
100.
00%
100.
00%
100.
00%
100.
00%
100.
00%
100.
00%
100.
00%
100.
00%
100.
00%
100.
00%
100.
00%
C
ost o
f goo
ds s
old
26.8
7%27
.61%
28.5
0%28
.96%
27.4
6%28
.19%
28.2
8%28
.22%
28.0
3%28
.03%
28.0
3%28
.03%
28.0
3%28
.03%
28.0
3%28
.03%
28.0
3%
Gro
ss P
rofit
73
.13%
72.3
9%71
.50%
71.0
4%72
.54%
71.8
1%71
.72%
71.7
8%71
.97%
71.9
7%71
.97%
71.9
7%71
.97%
71.9
7%71
.97%
71.9
7%71
.97%
S
ellin
g, g
ener
al a
nd a
dmin
istr
ativ
e ex
pens
es34
.36%
34.5
0%33
.41%
32.6
2%31
.95%
30.1
5%28
.45%
26.8
5%25
.34%
25.3
4%25
.34%
25.3
4%25
.34%
25.3
4%25
.34%
25.3
4%25
.34%
R
esea
rch
and
deve
lopm
ent e
xpen
ses
14.2
6%13
.21%
14.1
8%14
.66%
15.2
8%14
.54%
14.8
3%14
.88%
14.7
5%14
.75%
14.7
5%14
.75%
14.7
5%14
.75%
14.7
5%14
.75%
14.7
5%
Ope
ratin
g In
com
e24
.51%
24.6
8%23
.91%
23.7
7%25
.31%
27.1
2%28
.45%
30.0
5%31
.88%
31.8
8%31
.88%
31.8
8%31
.88%
31.8
8%31
.88%
31.8
8%31
.88%
In
tere
st e
xpen
se, n
et1.
39%
0.65
%0.
64%
0.40
%-0
.03%
-0.4
0%
O
ther
inc
ome,
net
-2.6
3%-2
.10%
-1.9
0%-2
.12%
-1.3
3%-1
.30%
G
ains
rel
ated
Im
mun
ex/A
mge
n C
.S. t
rans
actio
ns-2
7.99
%-5
.43%
0.00
%0.
00%
0.00
%0.
00%
D
iet
drug
litig
atio
n ch
arge
s9.
60%
12.6
2%25
.92%
0.00
%0.
00%
0.00
%
S
peci
al c
harg
es2.
34%
4.04
%0.
00%
0.00
%0.
00%
0.00
%
In
com
e be
fore
fede
ral a
nd fo
reig
n ta
xes
41.8
1%14
.90%
-0.7
5%25
.49%
26.6
8%28
.82%
P
rovi
sion
for
fede
ral a
nd f
orei
gn ta
xes
11.3
1%1.
96%
-7.8
6%5.
99%
6.06
%8.
22%
Net
Inc
ome
30.4
9%12
.94%
7.86
%19
.49%
20.6
2%20
.61%
20.2
4%20
.49%
20.4
5%20
.45%
20.4
5%20
.45%
20.4
5%20
.45%
20.4
5%20
.45%
20.4
5%
Act
ual
Fin
anci
al S
tate
men
tsF
orec
aste
d F
ina
ncia
l St
atem
ents
Act
ual
Fin
anci
al S
tate
men
tsF
orec
aste
d F
ina
ncia
l St
atem
ents
114
Wy
eth
Res
tate
d I
nco
me
Sta
tem
ent
in m
illio
ns20
0220
0320
0420
0520
0620
0720
0820
0920
1020
1120
1220
1320
1420
1520
16
N
et R
even
ue14
,584
,035
15,8
50,6
32
17
,358
,028
18,7
55,7
90
20
,350
,655
22,3
99,7
98
24
,407
,710
26,5
95,6
10
28
,979
,633
31,5
77,3
59
34,4
07,9
44
37
,492
,263
40,8
53,0
59
44
,515
,115
48,5
05,4
38
C
ost o
f goo
ds s
old
3,91
8,38
7
4,37
7,08
6
4,94
7,26
9
5,43
1,20
0
5,58
7,85
1
6,31
3,68
7
6,90
1,46
2
7,50
5,10
9
8,12
4,38
9
8,85
2,65
7
9,64
6,20
7
10,5
10,8
90
11
,453
,083
12,4
79,7
35
13
,598
,414
Gro
ss P
rofit
10,6
65,6
48
11
,473
,546
12,4
10,7
59
13
,324
,590
14,7
62,8
04
16
,086
,111
17,5
06,2
47
19
,090
,501
20,8
55,2
43
22
,724
,702
24
,761
,737
26,9
81,3
73
29
,399
,975
32,0
35,3
81
34
,907
,023
S
ellin
g, g
ener
al a
nd a
dmin
istr
ativ
e ex
pens
es5,
010,
507
5,
468,
174
5,
799,
791
6,
117,
706
6,
501,
976
6,
753,
698
6,
944,
780
7,
141,
269
7,
343,
317
8,
001,
570
8,
718,
828
9,
500,
382
10
,351
,993
11,2
79,9
43
12
,291
,074
Ope
ratin
g In
com
e5,
655,
141
6,
005,
372
6,
610,
968
7,
206,
884
8,
260,
828
9,
332,
413
10
,561
,467
11,9
49,2
32
13
,511
,926
14,7
23,1
32
16
,042
,909
17,4
80,9
91
19,0
47,9
82
20
,755
,438
22,6
15,9
49
In
tere
st e
xpen
se, n
et20
2,05
2
10
3,14
0
11
0,30
5
74
,756
(6,6
46)
(9
0,51
1)
R
esea
rch
and
deve
lopm
ent d
epre
ciat
ion
expe
nse
416,
038
418,
706
492,
122
549,
878
621,
812
651,
357
759,
427
885,
426
1,03
2,33
2
1,12
4,15
4
1,22
4,92
3
1,33
4,72
5
1,45
4,36
9
1,58
4,73
8
1,72
6,79
4
G
oodw
ill a
mor
tizat
ion
expe
nse
749,
150
763,
599
771,
282
767,
279
785,
148
827,
000
O
ther
inc
ome,
net
(382
,931
)
(3
32,2
64)
(330
,100
)
(397
,851
)
(271
,490
)
(2
90,5
43)
G
ains
rel
ated
Im
mun
ex/A
mge
n C
.S. t
rans
actio
ns(4
,082
,216
)
(8
60,5
54)
-
-
-
-
D
iet
drug
litig
atio
n ch
arge
s1,
400,
000
2,
000,
000
4,
500,
000
-
-
-
S
peci
al c
harg
es34
0,80
0
63
9,90
5
-
-
-
-
Inco
me
befo
re f
eder
al a
nd f
orei
gn ta
xes
6,09
7,24
5
2,36
1,61
2
(129
,847
)
4,78
0,58
9
5,42
9,90
4
6,45
6,68
2
P
rovi
sion
for
fede
ral a
nd f
orei
gn ta
xes
1,65
0,04
0
310,
420
(1,3
63,8
44)
1,12
4,29
1
1,23
3,19
8
1,84
0,72
2
Net
Inc
ome
5,36
2,20
8
2,96
2,42
0
2,43
1,20
3
5,08
8,53
1
5,89
8,80
6
6,39
4,38
8
6,88
8,09
3
7,60
2,21
6
8,24
4,90
7
2,00
8,57
8
2,18
8,62
6
2,38
4,81
4
2,59
8,58
8
2,83
1,52
4
3,08
5,34
1
Wy
eth
Res
tate
d I
nco
me
Sta
tem
ent
in m
illio
ns20
0220
0320
0420
0520
0620
0720
0820
0920
1020
1120
1220
1320
1420
1520
16
Ann
ual S
ales
Gro
wth
N/A
8.68
%9.
51%
8.05
%8.
50%
10.0
7%8.
96%
8.96
%8.
96%
8.96
%8.
96%
8.96
%8.
96%
8.96
%8.
96%
N
et R
even
ue10
0.00
%10
0.00
%10
0.00
%10
0.00
%10
0.00
%10
0.00
%10
0.00
%10
0.00
%10
0.00
%10
0.00
%10
0.00
%10
0.00
%10
0.00
%10
0.00
%10
0.00
%
C
ost o
f goo
ds s
old
26.8
7%27
.61%
28.5
0%28
.96%
27.4
6%28
.19%
28.2
8%28
.22%
28.0
3%28
.03%
28.0
3%28
.03%
28.0
3%28
.03%
28.0
3%
Gro
ss P
rofit
73.1
3%72
.39%
71.5
0%71
.04%
72.5
4%71
.81%
71.7
2%71
.78%
71.9
7%71
.97%
71.9
7%71
.97%
71.9
7%71
.97%
71.9
7%
S
ellin
g, g
ener
al a
nd a
dmin
istr
ativ
e ex
pens
es34
.36%
34.5
0%33
.41%
32.6
2%31
.95%
30.1
5%28
.45%
26.8
5%25
.34%
25.3
4%25
.34%
25.3
4%25
.34%
25.3
4%25
.34%
Ope
ratin
g In
com
e38
.78%
37.8
9%38
.09%
38.4
2%40
.59%
41.6
6%43
.27%
44.9
3%46
.63%
46.6
3%46
.63%
46.6
3%46
.63%
46.6
3%46
.63%
In
tere
st e
xpen
se, n
et1.
39%
0.65
%0.
64%
0.40
%-0
.03%
-0.4
0%
R
esea
rch
and
deve
lopm
ent d
epre
ciat
ion
expe
nse
2.85
%2.
64%
2.84
%2.
93%
3.06
%2.
91%
3.11
%3.
33%
3.56
%3.
56%
3.56
%3.
56%
3.56
%3.
56%
3.56
%
G
oodw
ill a
mor
tizat
ion
expe
nse
5.14
%4.
82%
4.44
%4.
09%
3.86
%3.
69%
O
ther
inc
ome,
net
-2.6
3%-2
.10%
-1.9
0%-2
.12%
-1.3
3%-1
.30%
G
ains
rel
ated
Im
mun
ex/A
mge
n C
.S. t
rans
actio
ns-2
7.99
%-5
.43%
0.00
%0.
00%
0.00
%0.
00%
D
iet
drug
litig
atio
n ch
arge
s9.
60%
12.6
2%25
.92%
0.00
%0.
00%
0.00
%
S
peci
al c
harg
es2.
34%
4.04
%0.
00%
0.00
%0.
00%
0.00
%
Inco
me
befo
re f
eder
al a
nd f
orei
gn ta
xes
41.8
1%14
.90%
-0.7
5%25
.49%
26.6
8%28
.82%
P
rovi
sion
for
fede
ral a
nd f
orei
gn ta
xes
11.3
1%1.
96%
-7.8
6%5.
99%
6.06
%8.
22%
Net
Inc
ome
36.7
7%18
.69%
14.0
1%27
.13%
28.9
9%28
.55%
28.2
2%28
.58%
28.4
5%6.
36%
6.36
%6.
36%
6.36
%6.
36%
6.36
%
Act
ual
Fin
anci
al S
tate
men
tsFo
reca
sted
Fin
anci
al S
tate
men
ts
Act
ua
l F
ina
nci
al
Sta
tem
ents
Fo
reca
sted
Fin
anci
al
Sta
tem
ents
115
Balance Sheet
The balance sheet was the second financial statement to be forecasted. Although it was
more difficult to forecast than the income statement, it is not as difficult as the
statement of cash flows. We used ratios that link the balance sheet with the income
statement to forecast with the most accuracy possible. Also, we created a common-size
balance sheet to observe and critically analyze trends that would support our forecasts.
Assets are the first item on the balance sheet and linked to sales by the asset turnover
ratio. Total asset turnover is the strongest ratio that links the income statement with
the balance sheet. We forecasted the asset turnover as an average of the past six
years’ turnovers because of the variability in the trend. We estimated a constant asset
turnover of .58 from 2008 to 2018. In order to calculate forecasted total assets each
year, we simply took the asset turnover divided by the forecasted sales for the next
year. Once we had total assets, we could forecast the common-size balance sheet to
calculate forecasted values of current and non-current assets. We calculated running
averages for accounts receivable, inventories, and non-current liabilities on the
common-size balance sheets. Then we simply multiplied these common-size amounts
by the value of total assets we forecasted, as each item is in percentage of total assets
in common-size form.
Next, we forecasted the current ratio to calculate the current assets and current
liabilities for Wyeth from 2008 to 2018. We used a running average of the past six
years, as our forecasted current ratio due to the variability in the trend, of 2.16. To
forecast values of current liabilities, we multiplied the current asset values we
forecasted by the forecasted current ratio.
116
Wye
th B
alan
ce S
heet
s20
0220
0320
0420
0520
0620
0720
0820
0920
1020
1120
1220
1320
1420
1520
1620
1720
18As
sets
:C
ash
and
cash
equ
ival
ents
2,94
3,60
46,
069,
794
4,74
3,57
07,
615,
891
6,77
8,31
110
,453
,879
Mar
keta
ble
secu
ritie
s1,
003,
275
1,11
0,29
71,
745,
558
618,
619
1,94
8,93
12,
993,
839
Acco
unts
Rec
eiva
ble
2,37
9,81
92,
529,
613
2,79
8,56
53,
030,
580
3,38
3,34
13,
528,
009
3,81
2,10
74,
110,
512
4,51
0,45
34,
938,
528
5,39
7,47
65,
809,
007
6,36
3,43
16,
930,
726
7,56
1,19
38,
241,
101
0In
vent
orie
s1,
992,
724
2,41
2,18
42,
478,
009
2,33
3,54
32,
480,
459
3,03
5,35
83,
192,
195
3,44
2,10
53,
693,
935
3,99
1,63
64,
396,
284
4,81
7,12
15,
245,
106
5,69
7,49
46,
196,
626
6,75
4,59
60
Oth
er c
urre
nt a
sset
s in
clud
ing
defe
rred
taxe
s1,
776,
330
2,84
0,35
42,
672,
327
4,44
6,20
82,
923,
199
2,97
2,51
3
Pro
perty
, pla
nt a
nd e
quip
men
t:La
nd17
3,74
318
2,84
918
7,73
217
7,50
717
7,18
818
2,25
0Bu
ildin
gs3,
401,
490
4,13
0,83
84,
630,
910
6,49
2,60
57,
154,
928
7,92
1,06
8M
achi
nery
and
equ
ipm
ent
3,78
2,53
34,
184,
292
4,65
7,71
64,
860,
953
5,49
1,98
76,
170,
239
Con
stru
ctio
n in
pro
gres
s2,
477,
219
3,18
8,27
33,
600,
993
1,51
6,03
31,
659,
391
1,94
7,62
4To
tal P
P&
E7,
235,
692
8,66
1,05
19,
524,
350
9,35
3,35
310
,146
,259
11,0
72,1
5812
,104
,398
13,1
51,0
8214
,270
,131
15,4
33,9
7516
,902
,538
18,3
30,9
1620
,098
,068
21,8
70,2
3423
,804
,934
25,9
24,2
580
Goo
dwill
3,74
5,74
93,
817,
993
3,85
6,41
03,
836,
394
3,92
5,73
84,
135,
002
Oth
er in
tang
ible
s, n
et o
f acc
umul
ated
am
ort.
145,
915
133,
134
212,
360
279,
720
356,
692
383,
558
Oth
er a
sset
s in
clud
ing
defe
rred
taxe
s3,
309,
537
3,45
7,50
25,
598,
555
4,32
6,81
84,
535,
785
4,14
2,96
6To
tal N
on-C
urre
nt A
sset
s14
,436
,893
16,0
69,6
8019
,191
,675
17,7
96,2
8518
,964
,474
19,7
33,6
8422
,706
,521
24,0
36,5
8026
,206
,021
28,5
55,1
2131
,114
,794
33,9
03,9
1536
,943
,053
40,2
54,6
1743
,863
,030
47,7
94,9
000
Tota
l Ass
ets
26,0
42,5
9231
,031
,922
33,6
29,7
0435
,841
,126
36,4
78,7
1542
,717
,282
44,3
26,0
1648
,299
,388
52,6
28,9
3157
,346
,574
62,4
87,1
0568
,088
,431
74,1
91,8
5980
,842
,396
88,0
89,0
8695
,985
,367
0Li
abili
ties:
Loan
s pa
yabl
e80
4,89
41,
512,
845
330,
706
13,1
5912
4,22
531
1,58
6Tr
ade
acco
unts
pay
able
672,
633
1,01
0,74
994
9,25
189
5,21
61,
116,
754
1,26
8,60
0A
ccru
ed e
xpen
ses
3,79
8,50
05,
461,
835
7,05
1,55
78,
759,
136
5,67
9,14
15,
333,
528
Accr
ued
taxe
s20
9,47
944
4,08
120
4,02
828
0,45
030
1,72
841
0,56
5To
tal C
urre
nt L
iabi
litie
s5,
485,
506
8,42
9,51
08,
535,
542
9,94
7,96
17,
221,
848
7,32
4,27
910
,009
,563
11,2
33,3
8512
,233
,486
13,3
30,0
9214
,524
,998
15,8
27,0
1417
,245
,744
18,7
91,6
4720
,476
,125
22,3
11,5
990
Long
-term
deb
t7,
546,
041
8,07
6,42
97,
792,
311
9,23
1,47
99,
096,
743
11,4
92,8
81Ac
crue
d po
stre
tirem
ent b
enef
it ob
ligat
ions
965,
081
1,00
7,54
01,
024,
239
1,10
4,25
61,
600,
751
1,67
6,12
6O
ther
non
curr
ent l
iabi
litie
s3,
890,
052
4,22
4,06
26,
429,
709
3,56
3,06
13,
100,
205
3,51
1,62
1To
tal L
iabi
litie
s17
,886
,680
21,7
37,5
4123
,781
,801
23,8
46,7
5721
,019
,547
24,0
04,9
0719
,663
,385
16,5
69,5
0813
,249
,970
9,68
1,31
35,
850,
715
1,74
4,20
5-2
,653
,440
-7,3
58,8
09-1
2,38
9,97
5-1
7,76
6,63
5-1
28,0
99,7
16
Sto
ckho
lder
s E
quity
Com
mon
sto
ck44
2,01
944
4,15
144
5,03
144
7,78
344
8,41
744
5,92
9Ad
ditio
nal p
aid-
in c
apita
l4,
582,
773
4,76
4,39
04,
817,
024
5,09
7,22
86,
142,
277
7,12
5,54
4R
etai
ned
earn
ings
3,28
6,64
54,
112,
285
4,11
8,65
66,
514,
046
8,73
4,69
910
,417
,606
16,8
69,7
0223
,936
,951
31,5
86,0
3339
,872
,332
48,8
43,4
6058
,551
,297
69,0
52,3
7080
,408
,276
92,6
86,1
3210
5,95
9,07
212
0,30
6,78
7Ac
cum
ulat
ed o
ther
com
preh
ensi
ve in
com
e-1
55,5
71-2
6,48
746
7,15
2-6
4,72
5-6
72,6
6622
1,43
3To
tal S
tock
hold
ers
Equ
ity8,
155,
912
9,29
4,38
19,
847,
903
11,9
94,3
6914
,652
,755
18,2
10,5
3524
,662
,631
31,7
29,8
8039
,378
,962
47,6
65,2
6156
,636
,389
66,3
44,2
2676
,845
,299
88,2
01,2
0510
0,47
9,06
111
3,75
2,00
112
8,09
9,71
6
Tota
l Lia
bilit
ies
and
Stoc
khol
ders
Equ
ity26
,042
,592
31,0
31,9
2233
,629
,704
35,8
41,1
2636
,478
,715
42,7
17,2
82
Div
iden
ds p
aid
-1,2
19,1
73-1
,223
,158
-1,2
27,0
34-1
,259
,398
-1,3
58,7
69-1
,423
,494
-1,5
11,7
03-1
,617
,787
-1,7
23,8
72-1
,829
,956
-1,9
36,0
40-2
,042
,125
-2,1
48,2
09-2
,254
,294
-2,3
60,3
78-2
,466
,462
-2,5
72,5
47
Net
Inco
me
4,44
7,20
52,
051,
192
1,36
3,84
43,
656,
298
4,19
6,70
64,
615,
960
4,94
0,39
35,
449,
462
5,92
5,20
96,
456,
343
7,03
5,08
87,
665,
712
8,35
2,86
49,
101,
612
9,91
7,47
810
,806
,478
11,7
75,1
68
117
Wye
th C
omm
on S
ize
Bal
ance
She
ets
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
2018
Asse
ts:
Cas
h an
d ca
sh e
quiv
alen
ts11
.30%
19.5
6%14
.11%
21.2
5%18
.58%
24.4
7%M
arke
tabl
e se
curit
ies
3.85
%3.
58%
5.19
%1.
73%
5.34
%7.
01%
Acco
unts
Rec
eiva
ble
9.14
%8.
15%
8.32
%8.
46%
9.27
%8.
26%
8.60
%8.
51%
8.57
%8.
61%
8.64
%8.
53%
8.58
%8.
57%
8.58
%8.
59%
8.58
%In
vent
orie
s7.
65%
7.77
%7.
37%
6.51
%6.
80%
7.11
%7.
20%
7.13
%7.
02%
6.96
%7.
04%
7.07
%7.
07%
7.05
%7.
03%
7.04
%7.
05%
Oth
er c
urre
nt a
sset
s in
clud
ing
defe
rred
taxe
s6.
82%
9.15
%7.
95%
12.4
1%8.
01%
6.96
%To
tal C
urre
nt A
sset
s44
.56%
48.2
2%42
.93%
50.3
5%48
.01%
53.8
0%48
.77%
50.2
3%50
.21%
50.2
1%50
.21%
50.2
1%50
.21%
50.2
1%50
.21%
50.2
1%50
.21%
Prop
erty
, pla
nt a
nd e
quip
men
t:La
nd0.
67%
0.59
%0.
56%
0.50
%0.
49%
0.43
%Bu
ildin
gs13
.06%
13.3
1%13
.77%
18.1
1%19
.61%
18.5
4%M
achi
nery
and
equ
ipm
ent
14.5
2%13
.48%
13.8
5%13
.56%
15.0
6%14
.44%
Con
stru
ctio
n in
pro
gres
s9.
51%
10.2
7%10
.71%
4.23
%4.
55%
4.56
%To
tal P
P&E
27.7
8%27
.91%
28.3
2%26
.10%
27.8
1%25
.92%
27.3
1%27
.23%
27.1
1%26
.91%
27.0
5%26
.92%
27.0
9%27
.05%
27.0
2%27
.01%
27.0
2%G
oodw
ill14
.38%
12.3
0%11
.47%
10.7
0%10
.76%
9.68
%O
ther
inta
ngib
les,
net
of a
ccum
ulat
ed a
mor
t.0.
56%
0.43
%0.
63%
0.78
%0.
98%
0.90
%O
ther
ass
ets
incl
udin
g de
ferr
ed ta
xes
12.7
1%11
.14%
16.6
5%12
.07%
12.4
3%9.
70%
Tota
l Non
-Cur
rent
Ass
ets
55.4
4%51
.78%
57.0
7%49
.65%
51.9
9%46
.20%
51.2
3%49
.77%
49.7
9%49
.79%
49.7
9%49
.79%
49.7
9%49
.79%
49.7
9%49
.79%
49.7
9%
Tota
l Ass
ets
100.
00%
100.
00%
100.
00%
100.
00%
100.
00%
100.
00%
100.
00%
100.
00%
100.
00%
100.
00%
100.
00%
100.
00%
100.
00%
100.
00%
100.
00%
100.
00%
100.
00%
Liab
ilitie
s:Lo
ans
paya
ble
4.50
%6.
96%
1.39
%0.
06%
0.59
%1.
30%
Trad
e ac
coun
ts p
ayab
le3.
76%
4.65
%3.
99%
3.75
%5.
31%
5.28
%A
ccru
ed e
xpen
ses
21.2
4%25
.13%
29.6
5%36
.73%
27.0
2%22
.22%
Accr
ued
taxe
s1.
17%
2.04
%0.
86%
1.18
%1.
44%
1.71
%To
tal C
urre
nt L
iabi
litie
s30
.67%
38.7
8%35
.89%
41.7
2%34
.36%
30.5
1%0.
5090
4578
0.67
7955
243
0.92
3284
045
1.37
6888
862
2.48
2601
986
9.07
4055
099
-6.4
9939
1167
-2.5
5362
6238
-1.6
5263
6469
-1.2
5581
460
Long
-term
deb
t42
.19%
37.1
5%32
.77%
38.7
1%43
.28%
47.8
8%A
ccru
ed p
ostre
tirem
ent b
enef
it ob
ligat
ions
5.40
%4.
64%
4.31
%4.
63%
7.62
%6.
98%
Oth
er n
oncu
rren
t lia
bilit
ies
21.7
5%19
.43%
27.0
4%14
.94%
14.7
5%14
.63%
Tota
l Lia
bilit
ies
100.
00%
100.
00%
100.
00%
100.
00%
100.
00%
100.
00%
100.
00%
100.
00%
100.
00%
100.
00%
100.
00%
100.
00%
100.
00%
100.
00%
100.
00%
100.
00%
100.
00%
Stoc
khol
ders
Equ
ityC
omm
on s
tock
5.42
%4.
78%
4.52
%3.
73%
3.06
%2.
45%
Addi
tiona
l pai
d-in
cap
ital
56.1
9%51
.26%
48.9
1%42
.50%
41.9
2%39
.13%
Ret
aine
d ea
rnin
gs40
.30%
44.2
4%41
.82%
54.3
1%59
.61%
57.2
1%68
.40%
75.4
4%80
.21%
83.6
5%86
.24%
88.2
5%89
.86%
91.1
6%92
.24%
93.1
5%93
.92%
Acc
umul
ated
oth
er c
ompr
ehen
sive
inco
me
-1.9
1%-0
.28%
4.74
%-0
.54%
-4.5
9%1.
22%
Tota
l Sto
ckho
lder
s Eq
uity
100.
00%
100.
00%
100.
00%
100.
00%
100.
00%
100.
00%
100.
00%
100.
00%
100.
00%
100.
00%
100.
00%
100.
00%
100.
00%
100.
00%
100.
00%
100.
00%
100.
00%
118
Wye
th R
esta
ted
Bal
ance
Sh
eets
200
22
003
20
04
200
52
006
200
72
00
820
09
201
02
011
20
122
01
320
14
201
52
016
20
172
01
8As
sets
:Ca
sh a
nd c
ash
equi
vale
nts
2,94
3,60
46,
069,
794
4,74
3,57
07,
615,
891
6,77
8,31
110
,453
,879
Mar
keta
ble
secu
ritie
s1,
003,
275
1,11
0,29
71,
745,
558
618,
619
1,94
8,93
12,
993,
839
Acco
unts
Rec
eiva
ble
2,37
9,81
92,
529,
613
2,79
8,56
53,
030,
580
3,38
3,34
13,
528,
009
3,608,243
3,948,585
4,325,880
4,737,587
5,167,040
5,574,086
6,105,924
6,648,150
7,251,189
7,903,114
8,606,725
Inve
ntor
ies
1,99
2,72
42,
412,
184
2,47
8,00
92,
333,
543
2,48
0,45
93,
035,
358
3,022,698
3,308,078
3,543,843
3,830,669
4,210,913
4,624,005
5,035,000
5,467,519
5,945,010
6,480,354
7,073,722
Oth
er c
urre
nt a
sset
s in
clud
ing
defe
rred
tax
es1,
776,
330
2,84
0,35
42,
672,
327
4,44
6,20
82,
923,
199
2,97
2,51
3To
tal C
urr
ent
Ass
ets
11,6
05,6
9914
,962
,242
14,4
38,0
2918
,044
,841
17,5
14,2
4122
,983
,598
20,136,619
21,788,228
23,741,319
25,869,484
28,188,417
30,715,219
33,468,522
36,468,631
39,737,669
43,299,743
47,181,119
Prop
erty
, pl
ant
and
equi
pmen
t:La
nd17
3,74
318
2,84
918
7,73
217
7,50
717
7,18
818
2,25
0Bu
ildin
gs3,
401,
490
4,13
0,83
84,
630,
910
6,49
2,60
57,
154,
928
7,92
1,06
8M
achi
nery
and
equ
ipm
ent
3,78
2,53
34,
184,
292
4,65
7,71
64,
860,
953
5,49
1,98
76,
170,
239
Cons
truc
tion
in p
rogr
ess
2,47
7,21
93,
188,
273
3,60
0,99
31,
516,
033
1,65
9,39
11,
947,
624
Tota
l PP&
E7,
235,
692
8,66
1,05
19,
524,
350
9,35
3,35
310
,146
,259
11,0
72,1
5811,409,163
12,536,211
13,537,205
14,057,265
15,317,355
16,690,398
18,186,521
19,816,755
21,593,124
23,528,725
25,637,834
Goo
dwill
aft
er a
mor
tizat
ion
2,996,599
3,054,394
3,085,128
3,069,115
3,140,590
3,308,002
Oth
er in
tang
ible
s, n
et o
f ac
cum
ulat
ed a
mor
t.14
5,91
513
3,13
421
2,36
027
9,72
035
6,69
238
3,55
8O
ther
ass
ets
incl
udin
g de
ferr
ed t
axes
3,30
9,53
73,
457,
502
5,59
8,55
54,
326,
818
4,53
5,78
54,
142,
966
Rese
arch
and
Dev
elop
men
t1,
664,
152
1,67
4,82
41,
968,
488
2,19
9,51
22,
487,
248
2,60
5,42
8To
tal N
on-C
urre
nt A
sset
s25
,186
,880
28,6
67,1
5733
,466
,232
32,2
75,6
1635
,150
,068
37,7
33,2
9339
,396
,079
44,0
97,6
6048
,050
,562
52,3
57,8
0057
,051
,139
62,1
65,1
8767
,737
,657
73,8
09,6
4180
,425
,916
87,6
35,2
7395
,490
,874
Tota
l Ass
ets
36,7
92,5
7943
,629
,399
47,9
04,2
6150
,320
,457
52,6
64,3
0960
,716
,891
59,532,697
65,885,888
71,791,880
78,227,284
85,239,556
92,880,406
101,206,179
110,278,272
120,163,586
130,935,015
142,671,993
Sal
es14
,584
,035
15,8
50,6
3217
,358
,028
18,7
55,7
9020
,350
,655
22,3
99,7
9824,407,710
26,595,610
28,979,633
31,577,359
34,407,944
37,492,263
40,853,059
44,515,115
48,505,438
52,853,452
57,591,220
TAT
00
00
00
00
00
00
00
00
Liab
ilitie
s:Lo
ans
paya
ble
804,
894
1,51
2,84
533
0,70
613
,159
124,
225
311,
586
Trad
e ac
coun
ts p
ayab
le67
2,63
31,
010,
749
949,
251
895,
216
1,11
6,75
41,
268,
600
Accr
ued
expe
nses
3,79
8,50
05,
461,
835
7,05
1,55
78,
759,
136
5,67
9,14
15,
333,
528
Accr
ued
taxe
s20
9,47
944
4,08
120
4,02
828
0,45
030
1,72
841
0,56
5To
tal C
urr
ent
Liab
iliti
es5,
485,
506
8,42
9,51
08,
535,
542
9,94
7,96
17,
221,
848
7,32
4,27
98,188,836
8,147,966
8,611,179
9,383,082
10,224,179
11,140,672
12,139,318
13,227,483
14,413,191
15,705,186
17,112,994
Cu
rren
t R
atio
22
22
23
23
33
33
33
33
3
Long
-ter
m d
ebt
7,54
6,04
18,
076,
429
7,79
2,31
19,
231,
479
9,09
6,74
311
,492
,881
Accr
ued
post
retir
emen
t be
nefit
obl
igat
ions
965,
081
1,00
7,54
01,
024,
239
1,10
4,25
61,
600,
751
1,67
6,12
6O
ther
non
curr
ent
liabi
litie
s3,
890,
052
4,22
4,06
26,
429,
709
3,56
3,06
13,
100,
205
3,51
1,62
1To
tal L
iabi
litie
s17
,886
,682
21,7
37,5
4323
,781
,803
23,8
46,7
5921
,019
,549
24,0
04,9
1016,624,286
16,303,253
15,028,406
17,625,277
20,512,882
23,726,794
27,305,770
31,292,045
35,731,639
40,674,696
46,175,856
Sto
ckho
lder
s Eq
uity
Com
mon
sto
ck44
2,01
944
4,15
144
5,03
144
7,78
344
8,41
744
5,92
9Ad
ditio
nal p
aid-
in c
apita
l4,
582,
773
4,76
4,39
04,
817,
024
5,09
7,22
86,
142,
277
7,12
5,54
4Re
tain
ed e
arni
ngs
14,0
36,6
7816
,709
,804
18,3
93,2
5320
,993
,414
25,7
26,7
3428
,919
,078
35,115,505
41,789,729
48,970,568
52,809,102
56,933,767
61,360,706
66,107,503
71,193,321
76,639,041
82,467,413
88,703,231
Accu
mul
ated
oth
er c
ompr
ehen
sive
inco
me
-155
,571
-26,
487
467,
152
-64,
725
-672
,666
221,
433
Tota
l Sto
ckh
olde
rs E
quit
y18
,905
,899
21,8
91,8
5824
,122
,460
26,4
73,7
0031
,644
,762
36,7
11,9
8442,908,411
49,582,635
56,763,474
60,602,008
64,726,673
69,153,612
73,900,409
78,986,227
84,431,947
90,260,319
96,496,137
119
Wye
th R
esta
ted
Com
mon
Siz
e B
alan
ce S
hee
ts2
002
200
320
04
200
520
06
200
720
08
200
92
01
02
011
20
122
013
20
142
015
20
162
017
201
8As
sets
:Ca
sh a
nd c
ash
equi
vale
nts
8.00%
13.91%
9.90%
15.13%
12.87%
17.22%
Mar
keta
ble
secu
ritie
s2.73%
2.54%
3.64%
1.23%
3.70%
4.93%
Acco
unts
Rec
eiva
ble
6.47%
5.80%
5.84%
6.02%
6.42%
5.81%
6.06%
5.99%
6.03%
6.06%
6.06%
6.00%
6.03%
6.03%
6.03%
6.04%
6.03%
Inve
ntor
ies
5.42%
5.53%
5.17%
4.64%
4.71%
5.00%
5.08%
5.02%
4.94%
4.90%
4.94%
4.98%
4.97%
4.96%
4.95%
4.95%
4.96%
Oth
er c
urre
nt a
sset
s in
clud
ing
defe
rred
tax
es4.83%
6.51%
5.58%
8.84%
5.55%
4.90%
Tota
l Cu
rren
t A
sset
s31.54%
34.29%
30.14%
35.86%
33.26%
37.85%
33.82%
33.07%
33.07%
33.07%
33.07%
33.07%
33.07%
33.07%
33.07%
33.07%
33.07%
Prop
erty
, pla
nt a
nd e
quip
men
t:La
nd0.47%
0.42%
0.39%
0.35%
0.34%
0.30%
Build
ings
9.25%
9.47%
9.67%
12.90%
13.59%
13.05%
Mac
hine
ry a
nd e
quip
men
t10.28%
9.59%
9.72%
9.66%
10.43%
10.16%
Cons
truc
tion
in p
rogr
ess
6.73%
7.31%
7.52%
3.01%
3.15%
3.21%
Tota
l PP&
E19.67%
19.85%
19.88%
18.59%
19.27%
18.24%
19.16%
19.03%
18.86%
17.97%
17.97%
17.97%
17.97%
17.97%
17.97%
17.97%
17.97%
Goo
dwill
aft
er a
mor
tizat
ion
8.14%
7.00%
6.44%
6.10%
5.96%
5.45%
Oth
er in
tang
ible
s, n
et o
f ac
cum
ulat
ed a
mor
t.0.40%
0.31%
0.44%
0.56%
0.68%
0.63%
Oth
er a
sset
s in
clud
ing
defe
rred
tax
es9.00%
7.92%
11.69%
8.60%
8.61%
6.82%
Res
earc
h an
d D
evel
opm
ent
4.52%
3.84%
4.11%
4.37%
4.72%
4.29%
Tota
l Non
-Cur
rent
Ass
ets
68.46%
65.71%
69.86%
64.14%
66.74%
62.15%
66.18%
66.93%
66.93%
66.93%
66.93%
66.93%
66.93%
66.93%
66.93%
66.93%
66.93%
Tota
l Ass
ets
100.00%
100.00%
100.00%
100.00%
100.00%
100.00%
100.00%
100.00%
100.00%
100.00%
100.00%
100.00%
100.00%
100.00%
100.00%
100.00%
100.00%
Liab
ilitie
s:Lo
ans
paya
ble
4.50%
6.96%
1.39%
0.06%
0.59%
1.30%
Trad
e ac
coun
ts p
ayab
le3.76%
4.65%
3.99%
3.75%
5.31%
5.28%
Accr
ued
expe
nses
21.24%
25.13%
29.65%
36.73%
27.02%
22.22%
Accr
ued
taxe
s1.17%
2.04%
0.86%
1.18%
1.44%
1.71%
Tota
l Cu
rren
t Li
abili
ties
30.67%
38.78%
35.89%
41.72%
34.36%
30.51%
49.26%
49.98%
57.30%
53.24%
49.84%
46.95%
44.46%
42.27%
40.34%
38.61%
37.06%
Long
-ter
m d
ebt
42.19%
37.15%
32.77%
38.71%
43.28%
47.88%
Accr
ued
post
retir
emen
t be
nefit
obl
igat
ions
5.40%
4.64%
4.31%
4.63%
7.62%
6.98%
Oth
er n
oncu
rren
t lia
bilit
ies
21.75%
19.43%
27.04%
14.94%
14.75%
14.63%
Tota
l Lia
bili
ties
100.00%
100.00%
100.00%
100.00%
100.00%
100.00%
100.00%
100.00%
100.00%
100.00%
100.00%
100.00%
100.00%
100.00%
100.00%
100.00%
100.00%
Stoc
khol
ders
Equ
ity
Com
mon
sto
ck2.34%
2.03%
1.84%
1.69%
1.42%
1.21%
Addi
tiona
l pai
d-in
cap
ital
24.24%
21.76%
19.97%
19.25%
19.41%
19.41%
Ret
aine
d ea
rnin
gs74.24%
76.33%
76.25%
79.30%
81.30%
78.77%
81.84%
84.28%
86.27%
87.14%
87.96%
88.73%
89.45%
90.13%
90.77%
91.37%
91.92%
Accu
mul
ated
oth
er c
ompr
ehen
sive
inco
me
‐0.82%
‐0.12%
1.94%
‐0.24%
‐2.13%
0.60%
Tota
l Sto
ckh
olde
rs E
quit
y100.00%
100.00%
100.00%
100.00%
100.00%
100.00%
100.00%
100.00%
100.00%
100.00%
100.00%
100.00%
100.00%
100.00%
100.00%
100.00%
100.00%
Net
In
com
e6,111,358
2,482,981
1,540,741
3,701,944
3,980,210
4,095,832
4,684,724
5,056,437
5,456,967
2,008,578
2,188,626
2,384,814
2,598,588
2,831,524
3,085,341
3,361,911
3,663,271
Div
iden
ds p
aid
(1,2
19,1
73)
(1,2
23,1
58)
(1,2
27,0
34)
(1,2
59,3
98)
(1,3
58,7
69)
(1,4
23,4
94)
(1,511,703)
(1,617,787)
(1,723,872)
(1,829,956)
(1,936,040)
(2,042,125)
(2,148,209)
(2,254,294)
(2,360,378)
(2,466,462)
(2,572,547)
120
Statement of Cash Flows
The statement of cash flows is always forecasted last because it is the most difficult of
the financial statements. There are only a few categories that can actually be
forecasted. We looked at the three major sections separately and managed to forecast
an important element for each one.
First, we looked at the operating income section. We compared three ratios that
involved the cash flows provided from operations: CFFO/sales, CFFO/operating income,
and CFFO/Net Income. We chose CFFO/Sales because it had the most noticeable trend.
We then forecasted the ratio by taking the 6-year average and found it to be 0.18. That
allowed us to take our forecasted sales and multiply it by 0.18 to find that year’s cash
flows from operations. Next, we forecasted the cash flows from investing by finding the
change in the property, plant, and equipment and adding it to the previous year’s cash
flows from investing. Finally, the only aspect of the financing section we can forecast
was the dividends paid which was calculated while forecasting the balance sheet. We
found a noticeable trend with Wyeth’s historical dividend payments. They have four
yearly payments; the last is in November which is increased consistently by two cents.
We forecasted out our dividends per share by the previous mentioned trend. This
enabled us to find the forecasted dividends paid by multiplying Wyeth’s dividends per
share by their 2007 shares outstanding. On the common size statement of cash flows
we forecasted CFFO, CFFI, and CFFF to all be 100% because any element in the
individual sections would be expressed as a percentage of that relative cash flow.
121
Wye
th S
tate
men
t of C
ash
Flow
s20
0220
0320
0420
0520
0620
0720
0820
0920
1020
1120
1220
1320
1420
1520
1620
1720
18Op
erat
ing A
ctivit
iesNe
t Inc
ome
4,44
7,20
5
2,05
1,19
2
1,23
3,99
7
3,65
6,29
8
4,19
6,70
6
4,61
5,96
0
4,94
0,39
3
5,44
9,46
2
5,92
5,20
9
6,45
6,34
3
7,03
5,08
8
7,66
5,71
2
8,35
2,86
4
9,10
1,61
2
9,91
7,47
8
10,8
06,4
78
11,7
75,1
68
Adjus
tmen
ts to
reco
ncile
net
inco
me
tone
t cas
h pr
ovide
d by
ope
ratin
g ac
tivitie
s:Di
et d
rug
litiga
tion
paym
ents
(1,3
07,0
13)
(4
34,1
67)
(8
50,2
00)
(1,4
53,7
33)
(2
,972
,700
)
(481
,581
)
Seve
nth
Amen
dmen
t sec
urity
fund
(dep
osit)
/refu
ndN/
AN/
AN/
A(1
,250
,000
)
400,
000
N/A
Diet
Dru
g Lit
igatio
n ch
arge
s1,
400,
000
2,
000,
000
4,
500,
000
N/
AN/
AN/
A
Gains
relat
ed to
Imm
unex
/Am
gen
com
mon
stoc
k tra
nsac
tions
(4,0
82,2
16)
(8
60,5
54)
N/
AN/
AN/
AN/
ATa
x on
repa
triat
ionN/
AN/
AN/
A17
0,00
0
N/
AN/
ASp
ecial
Cha
rges
340,
800
639,
905
N/A
N/A
N/A
N/A
Net g
ains o
n sa
les a
nd d
ispos
itions
of a
sset
s(3
29,3
64)
(343
,064
)
(156
,175
)
(1
27,2
28)
(28,
545)
(59,
851)
Depr
eciat
ion46
1,55
4
50
5,70
2
58
1,56
7
74
9,16
3
76
1,69
0
84
2,72
5
Am
ortiz
ation
23,1
46
32,1
81
40
,832
37
,710
41
,350
75
,954
Stoc
k-ba
sed
com
pens
ation
N/A
20,6
09
24
,634
10
8,53
4
39
3,33
0
36
7,52
9
Ch
ange
in d
efer
red
incom
e ta
xes
1,10
9,53
5
(433
,994
)
(1,4
70,5
32)
54
2,92
0
63
0,13
1
75
6,68
7
Pe
nsion
pro
vision
(405
,000
)
30
2,38
3
29
4,83
8
31
7,04
7
35
4,53
1
33
8,77
9
Pe
nsion
cont
ribut
ions
(909
,602
)
(2
30,7
87)
(4
07,6
00)
(328
,895
)
(2
71,9
09)
(330
,749
)
Chan
ges i
n wo
rking
capit
al, n
et:
Acco
unts
rece
ivable
271,
988
69,6
28
(1
30,3
25)
(357
,582
)
(2
38,7
64)
(1,6
24)
In
vent
ories
(185
,611
)
(2
45,4
53)
4,
295
7,
410
(7
,910
)
(337
,173
)
Othe
r cur
rent
ass
ets
(124
,738
)
48
,870
38,4
03
16,9
58
(39,
037)
(181
,456
)
Trad
e ac
coun
ts pa
yable
and
acc
rued
exp
ense
s(2
50,8
87)
469,
661
(144
,161
)
18
5,32
6
70
,868
16
9,51
4
Ac
crue
d ta
xes
(33,
214)
115,
990
(145
,322
)
15
,719
(7
,536
)
60,3
79
Ot
her i
tem
s, ne
t(2
40,8
53)
(188
,395
)
(172
,086
)
61
,994
(2
7,82
8)
40
,586
Net C
ash
Prov
ided
by O
pera
ting
Activ
ities
185,
730
2,91
1,10
3
2,87
8,74
3
2,35
1,64
1
3,25
4,37
7
5,87
5,67
9
4,37
9,28
1
4,77
1,83
9
5,19
9,58
5
5,66
5,67
4
6,17
3,54
4
6,72
6,93
8
7,32
9,93
9
7,98
6,99
3
8,70
2,94
5
9,48
3,07
4
10,3
33,1
34
CFFO
/Sale
s0.
010.
180.
170.
130.
160.
260.
180.
180.
180.
180.
180.
180.
180.
180.
180.
180.
18
Inve
sting
Acti
vities
Purc
hase
s of i
ntan
gibles
and
pro
perty
,pla
nt a
nd e
quipm
ent
(1,9
31,8
79)
(1
,908
,661
)
(1
,255
,275
)
(1,0
81,2
91)
(1
,289
,784
)
(1,3
90,6
68)
1,03
2,24
0
1,04
6,68
4
1,11
9,04
9
1,16
3,84
4
1,46
8,56
3
1,42
8,37
7
1,76
7,15
2
1,77
2,16
6
1,93
4,70
0
2,11
9,32
4
N/A
Proc
eeds
from
sales
of a
sset
s79
8,27
4
40
2,69
2
35
1,87
3
36
5,18
4
69
,235
12
1,71
6
Pu
rcha
se o
f add
itiona
l equ
ity in
tere
stin
affili
ate
(92,
725)
(102
,187
)
(2
21,6
55)
Pu
rcha
ses o
f mar
keta
ble se
curit
ies(2
,235
,872
)
(1,2
72,9
95)
(2,3
45,3
54)
(6
51,0
97)
(2,2
39,0
22)
(2
,534
,216
)
Pr
ocee
ds fr
om sa
les a
nd m
atur
ities o
f mar
keta
blese
curit
ies2,
532,
538
1,
217,
114
1,
697,
864
1,
777,
005
91
5,33
9
1,
422,
488
Ne
t Cas
h Pr
ovide
d by
/(Use
d fo
r) In
vesti
ngAc
tivitie
s3,
419,
015
18
,067
(1,5
50,8
92)
31
7,07
6
(2
,646
,419
)
(2,6
02,3
35)
(3,6
34,5
75)
(4
,681
,259
)
(5,8
00,3
08)
(6
,964
,152
)
(8,4
32,7
15)
(9
,861
,093
)
(11,
628,
245)
(13,
400,
411)
(15,
335,
111)
(17,
454,
435)
N/A
Fina
ncing
Acti
vities
Proc
eeds
from
issu
ance
of l
ong-
term
deb
t5,
820,
000
1,
500,
000
2,
500,
000
Re
paym
ents
of lo
ng-te
rm d
ebt
(250
,000
)
(6
91,0
87)
(1
,500
,000
)
(328
,187
)
(1
2,10
0)
(1
20,8
06)
Ot
her b
orro
wing
tran
sacti
ons,
net
(13,
797)
(76,
522)
(6,5
87)
82
,125
47
,334
(5
,717
)
Divid
ends
paid
(1,2
19,1
73)
(1
,223
,158
)
(1
,227
,034
)
(1,2
59,3
98)
(1
,358
,769
)
(1,4
23,4
94)
(1,511,703)
(1,617,787)
(1,723,872)
(1,829,956)
(1,936,040)
(2,042,125)
(2,148,209)
(2,254,294)
(2,360,378)
(2,466,462)
(2,572,547)
Purc
hase
s of c
omm
on st
ock f
or T
reas
ury
(113
,927
)
(6
64,5
79)
(1,3
16,7
34)
Exer
cises
of s
tock
opt
ions
215,
370
126,
895
57,4
73
234,
992
515,
853
716,
896
Net C
ash
Prov
ided
by/(U
sed
for)
Fina
ncing
Activ
ities
(2,4
11,5
87)
16
8,98
3
(2
,676
,148
)
229,
532
(1,4
72,2
61)
35
0,14
5
Divid
end
grow
th ra
te0.
075
0.07
00.
066
0.06
20.
058
0.05
50.
052
0.04
90.
047
0.04
50.
043
Divid
ends
per
shar
e0.
920.
920.
920.
941.
011.
061.
141.
221.
31.
381.
461.
541.
621.
71.
781.
861.
94
122
Wyeth
Com
mon S
ize St
ateme
nt of
Cash
Flow
s20
0220
0320
0420
0520
0620
0720
0820
0920
1020
1120
1220
1320
1420
1520
1620
1720
18Op
eratin
g Acti
vities
Net In
come
2394
.45%
70.46
%42
.87%
155.4
8%12
8.96%
78.56
%11
2.81%
114.2
0%11
3.96%
113.9
6%11
3.96%
113.9
6%11
3.96%
113.9
6%11
3.96%
113.9
6%11
3.96%
Adjus
tmen
ts to
recon
cile n
et inc
ome t
o0.0
0%0.0
0%0.0
0%0.0
0%0.0
0%0.0
0%ne
t cas
h prov
ided b
y ope
rating
activ
ities:
0.00%
0.00%
0.00%
0.00%
0.00%
0.00%
Diet d
rug lit
igatio
n pay
ments
-703.7
2%-14
.91%
-29.53
%-61
.82%
-91.34
%-8.
20%
Seve
nth Am
endm
ent s
ecuri
ty fun
d (de
posit
)/refun
d0.0
0%0.0
0%0.0
0%-53
.15%
12.29
%0.0
0%Die
t Drug
Litig
ation
charg
es75
3.78%
68.70
%15
6.32%
0.00%
0.00%
0.00%
Gain
s rela
ted to
Immu
nex/A
mgen
comm
on st
ock t
ransa
ction
s-21
97.93
%-29
.56%
0.00%
0.00%
0.00%
0.00%
Tax o
n rep
atriat
ion0.0
0%0.0
0%0.0
0%7.2
3%0.0
0%0.0
0%Sp
ecial
Cha
rges
183.4
9%21
.98%
0.00%
0.00%
0.00%
0.00%
Net g
ains o
n sale
s and
disp
ositio
ns of
asse
ts-17
7.33%
-11.78
%-5.
43%
-5.41
%-0.
88%
-1.02
%De
precia
tion
248.5
1%17
.37%
20.20
%31
.86%
23.41
%14
.34%
Amort
izatio
n12
.46%
1.11%
1.42%
1.60%
1.27%
1.29%
Stock
-base
d com
pens
ation
0.00%
0.71%
0.86%
4.62%
12.09
%6.2
6%Ch
ange
in de
ferred
inco
me ta
xes
597.3
9%-14
.91%
-51.08
%23
.09%
19.36
%12
.88%
Pens
ion pr
ovisio
n-21
8.06%
10.39
%10
.24%
13.48
%10
.89%
5.77%
Pens
ion co
ntribu
tions
-489.7
4%-7.
93%
-14.16
%-13
.99%
-8.36
%-5.
63%
Chan
ges i
n work
ing ca
pital,
net:
0.00%
0.00%
0.00%
0.00%
0.00%
0.00%
Acco
unts
receiv
able
146.4
4%2.3
9%-4.
53%
-15.21
%-7.
34%
-0.03
%Inv
entor
ies-99
.94%
-8.43
%0.1
5%0.3
2%-0.
24%
-5.74
%Ot
her c
urren
t ass
ets-67
.16%
1.68%
1.33%
0.72%
-1.20
%-3.
09%
Trade
acco
unts
paya
ble an
d acc
rued e
xpen
ses
-135.0
8%16
.13%
-5.01
%7.8
8%2.1
8%2.8
9%Ac
crued
taxe
s-17
.88%
3.98%
-5.05
%0.6
7%-0.
23%
1.03%
Othe
r item
s, ne
t-12
9.68%
-6.47
%-5.
98%
2.64%
-0.86
%0.6
9%Ne
t Cas
h Prov
ided b
y Ope
rating
Activ
ities
100.0
0%10
0.00%
100.0
0%10
0.00%
100.0
0%10
0.00%
100.0
0%10
0.00%
100.0
0%10
0.00%
100.0
0%10
0.00%
100.0
0%10
0.00%
100.0
0%10
0.00%
100.0
0%
Inves
ting A
ctivit
iesPu
rchas
es of
intan
gibles
and p
ropert
y,pla
nt an
d equ
ipmen
t-56
.50%
-1056
4.35%
80.94
%-34
1.02%
48.74
%53
.44%
-28.40
%-22
.36%
-19.29
%-16
.71%
-17.42
%-14
.48%
-15.20
%-13
.22%
-12.62
%-12
.14%
N/A
Proc
eeds
from
sales
of as
sets
23.35
%22
28.88
%-22
.69%
115.1
7%-2.
62%
-4.68
%Pu
rchas
e of a
dditio
nal e
quity
inter
est
0.00%
0.00%
0.00%
0.00%
0.00%
0.00%
in aff
iliate
0.00%
0.00%
0.00%
-29.24
%3.8
6%8.5
2%Pu
rchas
es of
mark
etable
secu
rities
-65.40
%-70
45.97
%15
1.23%
-205.3
4%84
.61%
97.38
%Pr
ocee
ds fro
m sa
les an
d matu
rities
of m
arketa
ble0.0
0%0.0
0%0.0
0%0.0
0%0.0
0%0.0
0%se
curiti
es74
.07%
6736
.67%
-109.4
8%56
0.44%
-34.59
%-54
.66%
Net C
ash P
rovide
d by/(
Used
for) I
nves
ting
0.00%
0.00%
0.00%
0.00%
0.00%
0.00%
Activ
ities
100.0
0%10
0.00%
100.0
0%10
0.00%
100.0
0%10
0.00%
100.0
0%10
0.00%
100.0
0%10
0.00%
100.0
0%10
0.00%
100.0
0%10
0.00%
100.0
0%10
0.00%
N/A
Finan
cing A
ctivit
iesPr
ocee
ds fro
m iss
uanc
e of lo
ng-te
rm de
bt0.0
0%34
44.13
%0.0
0%65
3.50%
0.00%
713.9
9%Re
paym
ents
of lon
g-term
debt
10.37
%-40
8.97%
56.05
%-14
2.98%
0.82%
-34.50
%Ot
her b
orrow
ing tra
nsac
tions
, net
0.57%
-45.28
%0.2
5%35
.78%
-3.22
%-1.
63%
Divide
nds p
aid50
.55%
-723.8
3%45
.85%
-548.6
8%92
.29%
-406.5
4%Pu
rchas
es of
comm
on st
ock f
or Tre
asury
4.72%
0.00%
0.00%
0.00%
45.14
%-37
6.05%
Exerc
ises o
f stoc
k opti
ons
-8.93
%75
.09%
-2.15
%10
2.38%
-35.04
%20
4.74%
Net C
ash P
rovide
d by/(
Used
for) F
inanc
ing0.0
0%0.0
0%0.0
0%0.0
0%0.0
0%0.0
0%Ac
tivitie
s10
0.00%
100.0
0%10
0.00%
100.0
0%10
0.00%
100.0
0%
123
Cost of Capital Estimation
Cost of Equity
The final step of analyzing a company is to perform certain economical valuations to
determine if the company is fair valued, undervalued, or overvalued. A key variable to
the cost of capital estimations is their cost of equity, thus we calculated this factor first.
The cost of equity can be described, as the required rate of return a company should
make in order to please potential investors.
The cost of equity is most commonly calculated by a formula known as the Capital
Asset Pricing Model; we will refer to this as CAPM. CAPM has three individual elements:
a risk free rate, beta, and the market risk premium. In order to find the risk free rate
we used the June 1 10-year Treasury bill rate (June 1 is the date we are valuing the
company), which was 3.98%. Next, beta is found my running regression analyses
through excel using stock returns and market risk premiums. As for the market risk
premium we found the difference between the market return and the risk free rate that
is the minimum return an investor desires. The final formula for CAPM is: Rft + Bj(Rmt-
Rft).
Running the regression analysis for Beta is the most intricate part of calculating CAPM.
We ran the same analysis for 72, 68, 48, 36, and 24 months so we could find five
points on the yield curve. We also did the same regression for 3 month, 6 month, 2
year, 5 year, and 10-year treasury bills. The different market risk premiums were used
as our x-variable and the y-variables were Wyeth’s historical monthly returns. We used
a 95% confidence interval; meaning we are 95% confident that our beta lies within the
lower and upper bounds. When selecting the Beta to use we selected the Beta with the
highest adjusted R^2 per regression. The adjusted R^2 is the explanatory power the
Beta possesses. The bolded line in each regression represents the Beta chosen for that
particular Treasury bill rate. Our analysis yielded the following statistics:
124
3-Month Regression:
Months Beta Adj R^2 Raw CAPM Size Adj Adj Ke Lower Upper
72 1.200 0.307 0.1238 0.007 0.131 0.781 1.620
60 0.575 0.045 0.0800 0.007 0.087 -0.016 1.166
48 0.760 0.089 0.0930 0.007 0.100 0.114 1.406
36 0.841 0.093 0.0987 0.007 0.106 0.042 1.640
24 1.024 0.140 0.1115 0.007 0.118 0.050 1.997
6-Month Regression:
Months Beta Adj R^2 Raw CAPM Size Adj Adj Ke Lower Upper
72 1.201 0.308 0.1239 0.007 0.131 0.781 1.620
60 0.575 0.045 0.0800 0.007 0.087 -0.016 1.166
48 0.760 0.089 0.0930 0.007 0.100 0.114 1.407
36 0.842 0.093 0.0988 0.007 0.106 0.043 1.642
24 1.026 0.141 0.1116 0.007 0.119 0.052 2.000
2-Year Regression:
Months Beta Adj R^2 Raw CAPM Size Adj Adj Ke Lower Upper
72 1.202 0.309 0.124 0.007 0.131 0.783 1.621
60 0.578 0.046 0.080 0.007 0.087 -0.014 1.170
48 0.758 0.088 0.093 0.007 0.100 0.111 1.405
36 0.842 0.093 0.099 0.007 0.106 0.042 1.642
125
24 1.027 0.141 0.112 0.007 0.119 0.052 2.002
5-Year Regression:
Months Beta Adj R^2 Raw CAPM Size Adj Adj Ke Lower Upper
72 1.200 0.310 0.124 0.007 0.131 0.784 1.622
60 0.584 0.047 0.081 0.007 0.088 -0.008 1.176
48 0.754 0.088 0.093 0.007 0.100 0.108 1.401
36 0.839 0.092 0.099 0.007 0.106 0.041 1.638
24 1.022 0.140 0.111 0.007 0.118 0.049 1.994
10-Year Regression:
Months Beta Adj R^2 Raw CAPM Size Adj Adj Ke Lower Upper
72 1.204 0.310 0.124 0.007 0.131 0.785 1.622
60 0.587 0.047 0.081 0.007 0.088 -0.006 1.179
48 0.751 0.087 0.092 0.007 0.099 0.106 1.397
36 0.836 0.092 0.098 0.007 0.105 0.040 1.633
24 1.016 0.139 0.111 0.007 0.118 0.046 1.987
After selecting the proper Beta for each regression we were able to calculate the cost of
equity by using the previous discussed CAPM formula. Although are results were very
close we ultimately chose the 10-year Treasury bill with a 72 month regression. The
Beta was 1.016 with an adjusted R^2 of .139 after adjusting our cost of equity for
Wyeth’s market cap we concluded their Ke (cost of equity) to be 13.1%.
126
Finally, after calculating Wyeth’s cost of equity using the CAPM formula we chose to try
an alternative method to be completely confident in our results. This formula also has
three individual elements; the price to book ratio, return on equity, and the growth rate
of net income. The price to book ratio was taken from Wyeth’s key statistics of
yahoo.com. The return on equity was calculated by taking the forecasted Net income
divided by the previous years total equity. After calculating ten years worth of
forecasted ROE we used the average for this particular equation. Finally the growth rate
was found by finding the average growth change for the same forecasted Net Income
we used to find ROE. Once we had all of the information we plugged the particular
elements into the following equation: Ke= (ROE + ((P/B)-1) * g) / (P/B)). Wyeth’s
alternative cost of equity was 10.9%, which we were pleased to discover was very close
to there original CAPM cost of equity. Now that we are confident with Wyeth’s cost of
equity it will enable us to perform specific valuation models such as, AEG, Discount
Dividends Approach, Residual Income, and Long Run Residual Income Approach.
Cost of Debt
Firms borrow money in order to finance their assets and sustain their capital structure.
Debt holders are the first to be compensated in the event of total liquidation of a firm.
We know that different levels of risk should expect relative levels of return. The rate of
return at which these debt holders earn money on the funds they lend out, are different
for each type of liability account. In order to accurately estimate the cost of debt for
Wyeth, we first had to find the most appropriate rates for each item of total liabilities.
Since Wyeth has current and long-term notes payable, we found the stated rates for
these notes in their 10K, published 2008.
The rates for all current liabilities, except current portion of long-term debt, were the
most reasonable interest rates applicable to the risk and type of current liability. Trade
accounts payable and accrued expenses use the 90-day non-financial commercial paper
monthly interest rate. We took the rate of 3.25% at January 1, 2008 from the Federal
127
Reserve Bank of St. Louis’ website for Economic Research
(http://research.stlouisfed.org/fred2/data/CPN3M.txt). For accrued taxes, we found the
10-year Treasury Bond Rate, which is also the risk-free rate we used to calculate our
cost of equity, to be the most relevant rate. Wyeth states the rate used for each portion
of long-term debt in their 10K. To find the total rate of long-term debt, we found the
weighted rate for each note and calculated the total rate of long-term debt. Included in
long-term debt is a liability amount attributable to interest rate swaps. Wyeth uses the
LIBOR rate +/- varying percentages based on the loss or gain on the swap. We took a
weighted average of the losses and gains in order to find the rate for the liability
attributable to rate swaps as a portion of long-term debt. Pensions and other
postretirement benefits had explicit rates stated in the 10K. The table below shows the
calculation of weighted rates we used to find a cost of debt to be 5.19%.
Liabilities: Rate Weight Weighted Rate 2007Current Portion of LTD 4.13% 0.013 0.05% 311,586Trade accounts payable 3.25% 0.053 0.17% 1,268,600Accrued expenses 3.25% 0.222 0.72% 5,333,528Accrued taxes 3.98% 0.017 0.07% 410,565Total Current Liabilities 7,324,279
Long-term debt 5.81% 0.479 2.78% 11,492,881Accrued postretirement benefit obligations 6.45% 0.070 0.45% 1,676,126Other noncurrent liabilities 6.45% 0.146 0.94% 3,511,621Total Liabilities 5.19% 24,004,907
Weighted Average Cost of Capital
Weighted average cost of capital is the total of both the cost of debt and the cost of
equity. The weights are derived from the value of debt or equity over the value of the
firm (D+E) multiplied by its respective cost we previously calculated. There are two
types of WACC, before and after tax, where the tax implications are on the weighted
cost of debt only. Using our cost of debt we found, 5.19%, and the cost of equity,
13.08%, we derived from our regression analysis and CAPM, we found WACC before
128
tax to be 11% and after tax, 10%. The following charts show the original or current
WACC for Wyeth in comparison to the restated WACC.
Cost of Debt Weight of Debt Tax Rate Cost of Equity Weight of Equity WACCBefore Tax 5.19% 0.28 0% 13.08% 0.72 0.11After Tax 5.19% 0.28 34% 13.08% 0.72 0.10
Cost of Debt Weight of Debt Tax Rate Cost of Equity Weight of Equity WACCBefore Tax 5.19% 0.40 0% 13.08% 0.60 0.10After Tax 5.19% 0.40 34% 13.08% 0.60 0.09
Weighted Average Cost of Capital
Restated Weighted Average Cost of Capital
Valuation Analysis
Method of Comparables
The method of comparables is a simplistic manner by which to value a company. The
underlying process that all of these methods use is finding the industry average of the
specific ratio being used, leaving Wyeth’s ratio out of the average, and comparing it to
the denominator to find the price of Wyeth. These comparables can be performed
quickly because all of the information used is listed in financials found in periodicals and
websites and few calculations are used. The downside to these methods is that they
are too simple to provide a reliable approximation of a firm’s value. The share price
used in these measurements is the listed price of $44.13 as of June 2nd 2008. The
margin of safety observed is 15%.
129
Price-to-Earnings Trailing
Trailing P/E
Firm PPS EPS P/E Trailing
Comparables Price
Wyeth 44.13 3.48 12.68 54.94
Wyeth Restated 44.13 4.82 9.15 76.10
Industry Avg 15.78
Abbott 53.75 3.23 16.64
Pfizer 17.69 1.10 16.08
Eli Lilly 46.94 3.21 14.62
Trailing price to earnings ratio is a comparable method that uses current price per share
and current earnings per share. The figures used in this evaluation were found in
finance.yahoo.com. The trailing price to earnings ratio is calculated by dividing the
earnings per share by the price per share. This is done for everyone except Wyeth in
order to obtain an industry average. Afterwards, Wyeth’s earnings per share is found
and multiplied by the industry average price to earnings ratio. This ultimately gives one
an approximation of the price per share of Wyeth as compared to its industry.
After using past data for this method, Wyeth’s price per share was $54.94. This is
above the listed price of $44.13, making the share price undervalued. After restating
Wyeth’s statements the share price rose to $76.10, making the listed price appear
undervalued as well. There is a fundamental flaw with using this method in that one
is observing past data rather than future figures. The final price found using this
method should not be seriously considered because of this problem.
130
Price-to-Earnings Forward
Forward P/E
Firm PPS EPS P/E Forward
Comparables Price
Wyeth 44.13 3.73 11.84 47.04
Wyeth Restated 44.13 5.19 8.50 65.58
Industry Avg 12.63
Abbott 53.75 3.69 14.57
Pfizer 17.69 outlier outlier
Eli Lilly 46.94 4.40 10.68
The forward price to earnings ratio is a step in the right direction regarding accuracy in
comparable methods. Instead of using past figures one uses the earnings of one year
ahead. The forecasted earnings found in the forecasted income statement were used
in this equation. Similar to the trailing price to earnings ratio, the industry average
price to earnings ratio is measured, leaving Wyeth out of the equation. The new
forecasted earnings is multiplied by this figure to calculate the price per share. The
forward price to earnings method is a little more reliable compared to the trailing price
to earnings method but it is still a very crude calculation.
When using Wyeth’s stated figures in this measurement, the comparables price is
$47.04. This is higher than the listed price of $44.13 but not higher than the margin of
safety making the listed price fairly valued. The restated amounts give a comparables
price of $65.58, which is above the margin of safety. The restated amount makes the
listed price appear undervalued.
131
Price-to-Book
Price/Book
Firm PPS BPS P/B Comparables Price
Wyeth 44.13 13.73 3.21 56.26
Wyeth Restated 44.13 27.69 1.59 113.41
Industry Avg 4.10
Abbott 53.75 11.65 4.61
Pfizer 17.69 outlier outlier
Eli Lilly 46.94 13.11 3.58
Price-to-book ratio is a comparable valuation ratio where market price is driven by book
value of equity per share. We found the price per share for each of Wyeth’s identified
competitors and their respective book value of equity divided by shares outstanding.
Then we computed the price-to-book ratio by dividing price per share by book value per
share, then took an average to calculate the industry price-to-book. We did not include
Pfizer in the industry average as we decided that its values were an outlier of the
industry and would adversely affect the average. To find Wyeth’s comparable price, we
multiplied the industry price-to-book by Wyeth’s book value per share. Our analysis
based on the price-to-book ratio shows that the market price for Wyeth is
undervalued.
132
Price Earnings Growth
Firm P/E Trailing EGR PEG Comparables PriceWyeth 13.54 12.65 1.07 15.88Wyeth Restated 9.77 9.07 1.08 11.39Industry Avg 1.26Abbott 16.64 14.57 1.14Pfizer 16.08 outlier outlierEli Lilly 14.62 10.68 1.37
PEG
The price earnings growth model or PEG ratio is based on a price-to-earnings ratio and
our forecasted analysis. First we used the trailing price-to-earnings ratio, as previously
calculated, and divide it by the forecasted earnings growth per share. This earnings
growth is calculated based on the one year projected growth of our forecasted earnings
divided by the number of shares outstanding. Once again, we found Pfizer to be an
outlier that would inaccurately affect the industry average so we threw it out. By
multiplying the industry average by the earnings growth rate of Wyeth and Wyeth
Restated, we found the market price to be very undervalued. The results of the PEG
ratio are so far overvalued that although, the numbers are calculated correctly, we do
not find it to be a fair comparable ratio for valuation. We do not consider the PEG ratio
to be a reliable valuation tool to be used without any other comparable analysis to back
up these results.
133
Price-to-EBITDA
Firm Market Cap(billons) EBITDA P/EBITDA Comparables PriceWyeth 61.36 4.58 13.39 47.42Wyeth Restated 61.36 7.04 8.72 72.84Industry Avg - - 10.35Abbott 81.71 6.78 12.05Pfizer 117.44 outlier outlierEli Lilly 52.15 6.03 8.65
Price/EBITDA
The price over EBITDA model is a little more refined than the previous comparable
models in that it focuses on specific items that help value a firm in a more reliable
manner. The price factor for this measurement is the market cap. This number is
calculated by multiplying the price of shares by the number of shares. EBITDA stands
for earnings before interest, taxes, depreciation and amortization. This figure gives one
a clearer picture of cash flow into the firm without other variables affecting the amount.
Pfizer is not included in the industry average because the ratio would skew the figure
too much. The industry average price over EBITDA is calculated and multiplied by the
EBITDA of Wyeth to measure the market cap of Wyeth. The comparables price listed
above is a market cap measurement. Dividing this figure by the total amount of shares
will provide one with the price per share comparable. The market cap found using this
method is $47.42. This ratio demonstrates that Wyeth’s Market cap is fairly valued
considering the listed market cap of $61.36. When using restated figures, the market
cap is undervalued.
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Price-to-Free Cash Flows
Price/Free Cash Flows
Firm Market Cap(billons) FCF(billons) P/FCF
Comparables Price
Wyeth 61.36 3.27 18.75 49.48
Industry Avg - - 20.11
Abbott 81.71 4.05 20.19
Pfizer 117.44 Outlier outlier
Eli Lilly 52.15 Outlier outlier
The price to free cash flows comparable is calculated by dividing the free cash flows of
the company from the market cap. The market cap takes the place of price in this
ratio. As stated before, the market cap is calculated by multiplying the share price by
the total amount of shares. Free cash flow is measured by subtracting cash flow from
investing from cash flow from operations. This comparable ratio takes into effect how
cash flows maintain the value of equity. Pfizer and Eli Lilly are not used in the industry
average due to the fact that their ratios will skew the industry average too much to be
able to calculate a reasonable average. The industry average is calculated and
multiplied by the free cash flow figure that is measured from Wyeth’s statements. The
listed comparables price is the market cap. Dividing this figure by the number of shares
will provide one with the price of shares compared to other companies in the industry
through the price to free cash flows ratio. The listed market cap is higher tan the
comparables price, making the listed price overvalued.
135
Enterprise Value-to-EBITDA
Enterprise Value/EBITDA
Firm EV EBITDA EV/EBITDA Comparables Price
Wyeth 74.91 4.58 16.36 42.33
Industry Avg - - 9.24
Abbott 91.92 6.78 13.56
Pfizer 105.75 19.44 5.44
Eli Lilly 52.65 6.03 8.73
The enterprise value is the amount of money it would take to completely buy a firm.
This figure includes the market cap plus the book value of liabilities, because when
obtaining a company one will also inherit the liabilities associated with the company.
Finally, cash and cash equivalents are subtracted from this amount because this money
is sitting in the bank and can be pocketed immediately. The EBITDA is divided from the
enterprise value to obtain the ratio. This ratio is performed for all of Wyeth’s
competitors excluding Wyeth and an average is found. This average, multiplied by the
EBITDA of Wyeth, gives one the enterprise value of Wyeth compared to its competitors.
This price is much lower than the listed enterprise value, making the price overvalued.
136
Conclusion
All of these methods can be used to help derive a value for the firm being analyzed.
Unfortunately they are extremely fickle and should not be completely relied upon to
provide an accurate portrayal of the company. As can be seen by the above methods
of comparables, some show Wyeth’s share price as being overvalued, others show an
undervalued amount while other provide fairly valued prices. It is proof that the
method of comparables should not be used by themselves as a means to value a
company. They are fast and easy to calculate and might provide an extremely general
description of the value of the firm but should be used along with more in depth
valuation procedures that take into effect more than the industry averages.
137
Discount Dividends Approach
The discount dividends approach attempts to measure the value of a firm by calculating
an estimated share price mainly based on dividends per share and the company’s cost
of equity. This approach believes that an investor would continuously hold onto a
companies stock based on the amount of dividends received. This is highly unrealistic
because an investor does not plan on holding onto stock forever and considers more
then just dividends when purchasing shares of a company. Since this approach does not
have a high explanatory power it has very low reliability when valuing a company. We
are choosing to include it in our analysis anyways Wyeth does pay dividends and the
analysis is possible to run.
In order to value the current share price based on dividends approach we must first
forecast dividends per share. When looking at Wyeth’s historical dividend payments we
noticed a trend. Wyeth pays four dividends per year, the last payment in November is
steadily increase by two cents. Therefore we forecasted our dividends using the same
approach and increased the last payment. This did not give us a consistent rate of
growth. For the growth rate that is required for the discount dividends approach we
found the average dividend growth rate for the ten forecasted years, which was 5.65%.
After finding Wyeth’s forecasted dividends we assumed the time of the perpetuity to be
2018 and the dividend per share was found the same was as mentioned earlier. We
found the present value factor for each year by using the formula: 1/((1+ke)^t). After
having each years PV factor we multiplied that by the corresponding years dividends
per share. The sum of the present value year-by-year dividends per share was $8.179.
Next, we had to calculate the present value of the perpetuity we took the time 11
dividend per share and divided it by the cost of equity minus the growth rate. This
process gave us the terminal value of the perpetuity we then discounted it back by
using year 10’s present value factor giving us $7.604. Adding this with the year-by-year
sum we found the 12/31/2007 price to be $15.78. Since we are valuing the company at
138
June 1, 2007 we had to find the future value (by five months) of the share price.
Wyeth’s final observed price using the discount dividends approach was $16.61.
The next step was to perform the sensitivity analysis. Based on what we know about
the discount dividends approach the sensitivity analysis is expected to show Wyeth as
being extremely overvalued. We used a 15% interval based on the confidence in our
forecasting. With the June 1, 2008 observed price being $44.13 we concluded our price
judgments to be as followed:
50.76 or >= undervalued
37.51-50.75= fair valued
50.76 or < = overvalued
*legend for sensitivity analysis
For our cost of equity we started with our 13.1% and then using our higher and lower
beta intervals we found two more cost of equity points to examine. Our original growth
rate is the 5.65% and we used other reasonable growth rates for the range.
Sensitivity Analysis
0 0.02 0.04 0.0565 0.06 0.08 0.1(GR)0.102 17.31 19.14 22.15 26.62 28.02 44.57 392.220.110 15.94 17.38 19.65 22.79 23.73 33.24 80.810.119 14.63 15.75 17.44 19.64 20.27 26.01 43.840.131 13.16 13.98 15.16 16.61 17.01 20.3 27.840.139 12.33 13.00 13.95 15.08 15.37 17.77 22.610.148 11.50 12.05 12.80 13.66 13.89 15.61 18.780.160 10.55 10.97 11.53 12.15 12.31 13.48 15.43(Ke)
139
Like we expected the dividend discount approach shows Wyeth to be overvalued.
However, when concluding the overall value of Wyeth the dividend discount approach
will have the least effect.
140
Discounted Free Cash Flows Model
The discounted free cash flows model is a valuation method used to determine the
value of a firm through the present value of future cash flows. The main components
of this model include cash flow from operations and investing activities, book value of
debt and preferred stock, before tax weighted average cost of capital, and a perpetuity
growth rate. The CFFOs and CFFIs in this model are both stated in after tax terms, so
we used a before tax WACC of 11% in our calculations.
To determine the value of a firm based on the discounted free cash flows model, you
must begin by subtracting CFFI from CFFO for each period which gives the free cash
flows of the firm. The next step is to adjust the time value of these cash flows by
multiplying each by their respective present value factor using the WACC as the
discount rate. The sum of these periods gives you the present value year by year free
cash flows. From there, the market value of assets is derived by adding the year by
year cash flows to the terminal value perpetuity. The terminal value of perpetuity is
found by taking the forecasted estimate in year 11 and discounting it back 10 years to
get the present value. At that point, you subtract the market value of assets from the
book value of debt and preferred stock which gives you the book value of equity. Using
this amount, you divide by the number of shares outstanding to get a model price and
then adjust it to the time consistent price for the date of interest.
There are a few disadvantages in drawing conclusions from this model. This model
uses information and inputs that are not only difficult to estimate, but also can be
manipulated to portray a false picture of the firm’s value. This method is one of the
least predictive among the valuation models due to its high sensitivity to the terminal
value growth rates.
141
A sensitivity analysis of the discounted free cash flows models was used to estimate the
intrinsic value of Wyeth at various WACC and growth rates. The following chart shows
the results of this analysis.
Discounted Free Cash Flows Sensitivity Analysis Growth Rates
WACC
0.0 1.0 2.0 3.0 4.0 5.0
9.00% 22.75 19.70 19.84 19.88 19.91 19.92
9.60% 22.63 19.74 19.88 19.93 19.95 19.97
10.14% 22.54 19.77 19.92 19.97 19.99 20.00
11.00% 22.42 19.84 19.99 20.04 20.06 20.07
11.28% 22.38 19.86 20.01 20.06 20.08 20.09
11.85% 22.32 19.90 20.06 20.10 20.12 20.14
13.00% 22.23 19.98 20.14 20.18 20.21 20.22
Overvalued < $37.51 $37.51 < Fairly Valued > $50.75 Undervalued >
$50.76
The observed share price on June 1, 2008 was $44.13. The time consistent price
estimated through this model was $22.42. The results of the discounted free cash
flows model show that Wyeth is highly overvalued. Due to the low predictability and
high sensitivity of this model, it is necessary to use additional valuation methods in
determining the value of this firm.
142
Residual Income Model
The residual income model is a predictive valuation model used in estimating the
intrinsic value of a firm. The primary components of this model include forecasted net
income, forecasted total dividends, book value of equity, cost of equity, and a
perpetuity growth rate. This model provides a more accurate valuation of the firm as
compared to the free cash flow and discount dividends model because it is not as
sensitive to terminal value growth rates.
In computing this model we used the major components listed above based on Wyeth’s
10-K and our forecasted financials, which includes the restated financials to account for
the impairment of goodwill and the classification of R&D as an asset. The cost of equity
used in this valuation is 13.1%.
In order to determine the value of a firm based on this model, you must begin by
calculating the book value of equity. This amount is found by taking the previous year’s
book value of equity, adding the current year’s net income, and subtracting the current
year’s total dividends. From there you compute the residual income by taking the
current year’s net income less the normal benchmark income. The benchmark income
is found by taking the previous year’s book value of equity and multiplying it by the cost
of equity. The next step is to take the present value residual income of each year and
add it to the terminal value perpetuity. Using this amount, you divide by the number of
shares outstanding to get a model price and then adjust it to the time consistent price
for the date of interest.
A sensitivity analysis of this model was used to determine the intrinsic value of Wyeth
at various costs of equity and growth rates. The results of this analysis can be seen on
the following two charts.
143
Residual Income Sensitivity Analysis Growth Rates
Cost of E
quity
0% ‐0.1% ‐0.2% ‐0.3% ‐0.4% ‐0.5%10.2% 42.50 36.86 34.95 34.00 33.42 33.0411.0% 37.92 33.83 32.38 31.64 31.18 30.8811.9% 33.62 30.82 29.77 29.22 28.89 28.6613.1% 28.94 27.33 26.70 26.36 26.15 26.0013.9% 26.35 25.31 24.88 24.65 24.50 24.4014.8% 23.83 23.27 23.02 22.89 22.80 22.7516.0% 21.01 20.88 20.83 20.79 20.77 20.76
Overvalued < $37.50 $37.51 < Fairly Valued > $50.75 Undervalued >
$50.76
Restated Residual Income Sensitivity Analysis Growth Rates
Cost of E
quity
0% ‐0.1% ‐0.2% ‐0.3% ‐0.4% ‐0.5%
10.2% 19.15 18.89 18.80 18.76 18.73 18.71
11.0% 17.54 17.61 17.63 17.64 17.65 17.66
11.9% 16.01 16.32 16.44 16.50 16.54 16.56
13.1% 14.30 14.82 15.02 15.13 15.20 15.25
13.9% 13.34 13.93 14.18 14.31 14.39 14.45
14.8% 12.39 13.03 13.31 13.46 13.56 13.62
16.0% 11.30 11.97 12.27 12.44 12.54 12.62
Overvalued < $37.50 $37.51 < Fairly Valued > $50.75 Undervalued > $50.76
The observed share price for Wyeth on June 2, 2008 was $44.13. The initial time
consistent price found using this model was $28.94, and $14.30 using the restated
financial statements. Based on the results of the residual income model, we conclude
that Wyeth is extremely overvalued. Because this model provides a more accurate
valuation than other methods, we feel that this is a valid estimation of the firm’s
intrinsic value.
144
Abnormal Earnings Growth Model
The abnormal earnings growth model is another valuation model used in estimating the
value of a firm. According to Palepu and Healy, this approach “expresses the value of a
firm’s equity as book value plus discounted expectations of future abnormal earnings”.
Abnormal earnings are simply the total earnings minus normal earnings. For this model
we used our original and restated forecasted financial statements with a cost of equity
of 13.1%.
The estimation of a firm’s value using this model starts with the calculation of drip
income. Drip income is found by taking the previous year’s dividends and multiplying
them by the cost of equity. The drip income is then added to the current year’s
earnings to arrive at the cumulative dividend earnings. The annual AEG is then
calculated by subtracting the normal (benchmark) income from the cumulative dividend
earnings. The benchmark income is derived by taking the previous year’s net income
multiplied by 1 plus the cost of equity.
As with previous models, each annual value must then be multiplied by its present
value factor in order to adjust all values to the same time period. The sum of these
adjustments is added to the net income of the period and the terminal value perpetuity
to arrive at the total adjusted earnings perpetuity. The market value of equity is then
found by taking this adjusted perpetuity and dividing it by the cost of equity. Using this
amount, you divide by the number of shares outstanding to get a model price and then
adjust it to the time consistent price for the date of interest.
Similar to the residual income method, we conduct a sensitivity analysis of the AEG
model using costs of equity and growth rates in estimated the intrinsic value of this
firm. The following two charts show the results of this analysis based on the original
and restated financial statements.
145
Abnormal Earnings Growth Sensitivity Analysis Growth Rates
Cost of E
quity
0% ‐0.1% ‐0.2% ‐0.3% ‐0.4% ‐0.5%
10.2% 35.90 34.54 34.08 33.85 33.71 33.61
11.0% 33.30 32.71 32.50 32.39 32.32 32.28
11.9% 30.60 30.70 30.73 30.75 30.76 30.77
13.1% 27.29 28.09 28.40 28.57 28.68 28.75
13.9% 25.22 26.39 26.87 27.13 27.29 27.41
14.8% 22.99 24.51 25.15 25.50 25.73 25.89
16.0% 20.17 22.04 22.87 23.34 23.64 23.85
Overvalued < $37.50 $37.51 < Fairly Valued > $50.75 Undervalued > $50.76
Restated Abnormal Earnings Growth Sensitivity Analysis Growth Rates
Cost of E
quity
0% ‐0.1% ‐0.2% ‐0.3% ‐0.4% ‐0.5%
10.2% 21.92 19.59 18.80 18.40 18.16 18.01
11.0% 21.08 19.05 18.33 17.96 17.74 17.59
11.9% 20.20 18.46 17.81 17.47 17.26 17.11
13.1% 19.12 17.68 17.11 16.80 16.61 16.48
13.9% 18.44 17.16 16.64 16.36 16.18 16.05
14.8% 17.70 16.59 16.12 15.85 15.69 15.57
16.0% 16.77 15.83 15.42 15.18 15.03 14.93
Overvalued < $37.50 $37.51 < Fairly Valued > $50.75 Undervalued > $50.76
The observed share price on June 1, 2008 was $44.13. The initial time consistent price
estimated through this model was $27.29, and $19.12 using the restated financial
statements. The results of the abnormal earnings growth model are in agreement with
the previous method findings that Wyeth is overvalued.
146
Long Run Residual Income Model
The long run residual income perpetuity model is used by analysts to calculate the
equity value of a firm. The difference between this model and the residual income
model is that return on equity is used instead of net income multiplied by the cost of
equity. The first step in calculating this model is determining the long run estimate of
return on equity. After subtracting the cost of equity, this figure will portray the long
run rate that will outperform investor’s required rate of returns. The present day effect
on this outperformance in the future is found by dividing by the cost of equity minus
the growth rate of equity. Finally, multiplying this figure by the present day book value
of equity will establish the surplus book value of equity. Dividing this last number by
the total shares outstanding will give the book value of equity in a per share basis and
the approximate value of the shares according to one’s research.
The return on equity used in this equation was found by calculating the average of the
forecasted return on equity figures based off of forecasted statements. The 12% equity
growth rate that was used in the long run residual income model was determined by
observing the forecasted equity growth rate and taking into effect the trend that was
taking place.
Sensitivity was analyzed three different times with changing variables. The different
variables used include return on equity, equity growth rates and cost of equity. The
share price was fairly valued when the growth rate decreased and the return on equity
increased. The majority of the prices were overvalued. When using restated net
income and stockholders equity there was a substantial increase in fairly valued prices.
The long run residual model states that Wyeth is undervalued.
147
Long Run Residual Income Sensitivity
ROEKe 0.10 0.12 0.14 0.16 0.18 0.20 0.22
0.102 15.26 ‐ (15.26) (29.77) (45.78) (61.03) (76.29) 0.11 27.47 ‐ (27.47) (53.59) (82.40) (109.86) (137.33) 0.119 274.66 ‐ (274.66) (535.88) (823.97) (1,098.63) (1,373.29) 0.131 (24.97) ‐ 24.97 48.72 74.91 99.88 124.84 0.139 (14.46) ‐ 14.46 28.20 43.37 57.82 72.28 0.148 (9.81) ‐ 9.81 19.14 29.43 39.24 49.05 0.16 (6.87) ‐ 6.87 13.40 20.60 27.47 34.33
GrowthKe 0.09 0.1 0.11 0.12 0.13 0.14 0.15
0.102 78.99 405.27 (84.15) (29.77) (14.23) (6.87) (2.58) 0.11 47.39 81.05 ‐ (53.59) (19.93) (8.71) (3.10) 0.119 32.69 42.66 74.80 (535.88) (36.23) (12.44) (4.00) 0.131 23.12 26.15 32.06 48.72 398.56 (29.03) (6.52) 0.139 19.34 20.78 23.21 28.20 44.28 (261.23) (11.26) 0.148 16.34 16.89 17.72 19.14 22.14 32.65 (61.95) 0.16 13.54 13.51 13.46 13.40 13.29 13.06 12.39
GrowthROE 0.09 0.1 0.11 0.12 0.13 0.14 0.15
0.1 3.35 ‐ (6.54) (24.97) (411.99) 61.03 36.14 0.12 10.05 8.86 6.54 ‐ (137.33) 30.52 21.68 0.14 16.75 17.72 19.62 24.97 137.33 ‐ 7.23 0.16 23.45 26.58 32.70 49.94 411.99 (30.52) (7.23) 0.18 30.15 35.44 45.78 74.91 686.64 (61.03) (21.68) 0.2 36.84 44.30 58.86 99.88 961.30 (91.55) (36.14) 0.22 43.54 53.16 71.93 124.84 1,235.96 (122.07) (50.59)
undervalued > $50.75fairly valued $37.50 ‐ $50.74overvalued < $48.739
148
Restated Long Run Residual Income Sensitivity
ROEKe 0.10 0.12 0.14 0.16 0.18 0.20 0.22
0.102 30.76 ‐ (30.76) (60.02) (92.28) (123.04) (153.81) 0.11 55.37 ‐ (55.37) (108.03) (166.11) (221.48) (276.85) 0.119 553.70 ‐ (553.70) (1,080.33) (1,661.11) (2,214.81) (2,768.51) 0.131 (50.34) ‐ 50.34 98.21 151.01 201.35 251.68 0.139 (29.14) ‐ 29.14 56.86 87.43 116.57 145.71 0.148 (19.78) ‐ 19.78 38.58 59.33 79.10 98.88 0.16 (13.84) ‐ 13.84 27.01 41.53 55.37 69.21
GrowthKe 0.09 0.1 0.11 0.12 0.13 0.14 0.15
0.102 159.24 817.02 (169.65) (60.02) (28.70) (13.86) (5.20) 0.11 95.54 163.40 ‐ (108.03) (40.17) (17.55) (6.24) 0.119 65.89 86.00 150.80 (1,080.33) (73.04) (25.08) (8.06) 0.131 46.61 52.71 64.63 98.21 803.48 (58.51) (13.15) 0.139 39.00 41.90 46.80 56.86 89.28 (526.63) (22.71) 0.148 32.95 34.04 35.72 38.58 44.64 65.83 (124.89) 0.16 27.30 27.23 27.14 27.01 26.78 26.33 24.98
GrowthROE 0.09 0.1 0.11 0.12 0.13 0.14 0.15
0.1 6.75 ‐ (13.18) (50.34) (830.55) 123.04 72.86 0.12 20.26 17.86 13.18 ‐ (276.85) 61.52 43.71 0.14 33.76 35.72 39.55 50.34 276.85 ‐ 14.57 0.16 47.27 53.58 65.92 100.67 830.55 (61.52) (14.57) 0.18 60.77 71.45 92.28 151.01 1,384.26 (123.04) (43.71) 0.2 74.28 89.31 118.65 201.35 1,937.96 (184.57) (72.86) 0.22 87.78 107.17 145.02 251.68 2,491.66 (246.09) (102.00)
undervalued > $50.75fairly valued within $6.62overvalued < $37.51