Online Tutorial #9: How Do You Perform a Price-Implied Expectations (PIE) Analysis?

In the previous eight online tutorials, we defined and explained how to calculate and project various Operating Value Drivers and Other Value Determinants:

 Operating Value Drivers Topic Covered in Tutorial #: 1. Sales Growth Rate Tutorial #2 (Sales Growth Rate) 2. Operating Profit Margin Tutorial #3 (Margins) and Tutorial #6 (Employee Stock Options) 3. Incremental Investment Rate Tutorial #4 (Working Capital) and Tutorial #5 (Fixed Capital) Other Value Determinants Topic Covered in Tutorial #: 1. Cash Tax Rate Tutorial #7 (Cash Tax Rate) 2. Cost of Capital Tutorial #8 (Cost of Capital) 3. Forecast Period Tutorial #9 (below)

This session puts it all together and uses those value drivers and determinants to explain the mechanics of the PIE analysis. We perform this analysis in four steps:

1. Calculate Free Cash Flow
2. Value Non-Operating Assets
3. Calculate Market Value of Equity
4. Determine the Market-Implied Forecast Period

As with the previous tutorials, we will use Gateway, Inc. (as of April 21, 2000) as a case study. Readers who want to perform the PIE calculations may wish to download the accompanying spreadsheet.

In the calculations to follow, we will use the Operating Value Drivers and Other Value Determinants that we have projected previously.

 Sales Growth Rate (%) 20% Operating Profit Margin (%) 9.0% Cash Tax Rate (%) 35.0% Incremental Working Capital Rate (%) (5.0)% Incremental Fixed Capital Rate (%) 11.0%

Step 1: Calculate Free Cash Flow

All three Operating Value Drivers and one Other Value Determinant--the Cash Tax Rate--affect Free Cash Flow:

We calculate Free Cash Flow for any given year by performing the following five steps:

A. Calculate Sales
B. Calculate Operating Profit
C. Calculate and Subtract Cash Taxes
D. Calculate and Subtract Incremental Investment
E. Calculate Free Cash Flow

A. Calculate Sales. For historical data, we use actual Sales figures as a starting point. For projected data, we apply the Sales Growth Rate (%) to historical Sales figures to project future Sales. For example, Gateway's 1999 historical Sales amounted to \$8.6 billion. With a 20% projected Sales Growth Rate, this would translate into \$10.4 billion in Sales in 2000 and \$12.5 billion in 2001.

 1999 2000 2001 Sales (in billions) \$8.6 \$10.4 \$12.5 Sales Growth Rate (%) 20.0% 20.0%

B. Calculate Operating Profit. We multiply Sales by the Operating Profit Margin (%) to obtain pre-tax Operating Profit. The historical Operating Profit Margin in 1999 equaled 6.9%. So, pre-tax Operating Profit in 1999 amounts to 6.9% times \$8.6 billion in Sales, or \$596 million. Using our projected Operating Profit Margin of 9.0%, projected Operating Profit in 2000 amounts to 9.0% times \$10.4 billion in Sales, or \$934 million. Operating Profit in 2001 amounts to 9.0% times \$12.5 billion in Sales, or \$1.1 billion.

 1999 2000 2001 Sales (in billions) \$8.6 \$10.4 \$12.5 Operating Profit Margin  (%) 6.9% 9.0% 9.0% Pre-Tax Operating Profit (in millions) \$596 \$934 \$1,120

C. Calculate and Subtract Cash Taxes. We then take the company's pre-tax Operating Profit and multiply it by the Cash Tax Rate (%). We subtract the amount of Cash Taxes from pre-tax Operating Profit to obtain Net Operating Taxes After Taxes (NOPAT). In 1999, Gateway had a Cash Tax Rate of 35.1%, meaning Gateway paid cash taxes equal to 35.1% times its pre-tax Operating Profit of \$596 million, or \$209 million. This equates to \$387 million in NOPAT. Applying our projected 35% cash tax rate to our 2000 and 2001 pre-tax Operating Profit estimates results in NOPAT of \$607 million and \$728 million, respectively.

 1999 2000 2001 Pre-Tax Operating Profit (in millions) \$596 \$934 \$1,120 Cash Tax Rate (%) 35.1% 35.0% 35.0% Cash Taxes (in millions) \$209 \$327 \$392 Net Operating Profit After Taxes (in millions) \$387 \$607 \$728

D. Calculate and Subtract Incremental Investments. To calculate incremental investments for any given year, we multiply the projected increase in sales by the Incremental Working Capital Rate and add this to the projected increase in sales times the Incremental Fixed Capital Rate. For example, in 1999, Gateway invested \$98 million in Incremental Working Capital--equal to the Incremental Working Capital Rate of 8.3% times the projected increase in sales of \$1.2 billion--and \$206 million in Incremental Fixed Capital--equal to the Incremental Fixed Capital Rate of 17.4% times the projected increase in sales of \$1.2 billion. This amounts to \$304 million in Total Incremental Capital in 1999.

Applying our projected Operating Value Drivers into the future yields an estimate of \$104 million and \$124 million in Total Incremental Capital for 2000 and 2001.

 1999 2000 2001 Sales (in billions) \$8.6 \$10.4 \$12.5 Incremental Sales (in millions) \$1,178 \$1,729 \$2,075 Incremental Working Capital Rate (%) 8.3% (5.0)% (5.0)% Incremental Working Capital (in millions) \$98 \$(86) \$(104) Incremental Fixed Capital Rate (%) 17.4% 11.0% 11.0% Incremental Fixed Capital (in millions) \$206 \$190 \$228 Total Incremental Capital \$304 \$104 \$124

E. Calculate Free Cash Flow. We are now ready to calculate Free Cash Flow, which is simply Net Operating Profits After Taxes minus Total Incremental Capital:

 1999 2000 2001 add Net Operating Profit After Taxes (in millions) \$387 \$607 \$728 minus Total Incremental Capital (in millions) \$304 \$104 \$124 Free Cash Flow (in millions) \$83 \$503 \$604

Step 2: Value Non-Operating Assets

Once we have calculated projected Free Cash Flows into the future, we need to calculate the value of Gateway's Non-Operating Assets and Economic Liabilities. We do this using the following three steps:

A. Calculate Value of Non-Operating Assets. Excess cash and marketable securities largely account for the value of non-operating assets. As of April 21, 2000, Gateway had approximately \$1.336 billion in total cash and marketable securities, or approximately \$4.00 per share.

B. Calculate Value of Economic Liabilities. To calculate the total value of economic liabilities, we add the following:

• Debt. Gateway had an immaterial amount of debt on April 21, 2000.
• Value of Outstanding Employee Stock Options. Economic liabilities from outstanding Employee Stock Options amounted to \$713 million.
• Capitalized Operating Leases. Operating Leases are a form of off-balance sheet financing. If you have capitalized the value of future Operating Lease payments, add this amount to total economic liabilities. (The impact of this negative adjustment will be partially offset by a reduction in operating expenses equal to the pre-cost of debt times capitalized operating leases in a given year.)

Gateway's economic liabilities total roughly \$715 million, or \$2.25 per share.

C. Calculate Net Value of Non-Operating Assets and Economic Liabilities. To do this, we add the value of Gateway's Excess Cash of \$1.336 billion and subtract the value of Gateway's Economic Liabilities of \$715 million. This gives us a Net Value of Non-Operating Assets and Economic Liabilities of \$620 million.

Step 3: Calculate Market Value of Equity

To calculate the market value of equity, we multiply the share price by the number of outstanding shares:

 As Of April 21, 2000 Share Price (\$, per share) \$52.00 Outstanding Shares (in millions) 321.0 Market Value of Equity (\$, in billions) \$16.7

Step 4: Calculate Market-Implied Forecast Period

We are now ready to calculate the Market-Implied Forecast Period. To do this, we determine the present value of Gateway's Free Cash Flows (calculated in Step 1), using the company's Weighted Average Cost of Capital of 10% (calculated in Online Tutorial #8). We then extend the Forecast Period as far as necessary to match the current stock price. Our residual value is a perpetuity with inflation and assumes a 2 percent inflation rate.

We estimate Gateway's value at the end of 2000 to be \$25.26 per share, and it increases each year until it reaches its \$52 stock price in 2006, the seventh year (see spreadsheet). The market-implied forecast period is therefore seven years. The spreadsheet also automatically calculates the Market-Implied Forecast Period in cell C31 of worksheet "Price Implied Expectations."

This concludes our Tutorial on calculating Price-Implied Expectations.

Please note that you can this same spreadsheet to perform sensitivity analyses to see the valuation impact of scenarios with various Operating Value Drivers and Other Value Determinants--as explained in Chapter 6 and 7. 