Xerox Corporation Download

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Xerox Corporation
Tyler Haynes – [email protected]
Patrick Greene – [email protected]
Fernando Alvarado – [email protected]
Leanne Lazar – [email protected]
Michael Marquart – [email protected]
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Table of Contents
Executive Summary..................................................................................................... 3
Financial Analysis, Forecasting, and Cost of Capital................................... 6
Valuations Analysis.................................................................................................. 7
Business Overview....................................................................................................... 8
Industry Overview ..................................................................................................... 10
The Five Forces Model .............................................................................................. 11
Rivalry Among Existing Firms............................................................................ 12
Threat of New Entrants........................................................................................ 20
Threat of Substitute Products ........................................................................... 24
Bargaining Power of Buyers............................................................................... 26
Bargaining Power of Suppliers.......................................................................... 28
Value Creation Analysis ........................................................................................... 31
Firm Competitive Advantage Analysis................................................................ 34
Formal Accounting Analysis ................................................................................... 37
Key Accounting Policies ....................................................................................... 39
Accounting Flexibility ........................................................................................... 48
Evaluate Accounting Strategy ........................................................................... 52
Qualitative Disclosure .......................................................................................... 56
Other Qualitative Analysis of Quantitative Disclosure............................. 58
Quantitative Accounting Measures and Disclosure................................... 60
Sales Manipulation Diagnostics ........................................................................ 62
Expense Manipulation Diagnostics.................................................................. 71
Potential Red Flags................................................................................................ 80
Undoing Accounting Distortions or Irregularities...................................... 82
Financial Analysis, Forecasting Financials, and.............................................. 83
Financial Analysis................................................................................................... 83
Liquidity Ratio Analysis.................................................................................... 84
Profitability Ratio Analysis ............................................................................. 98
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Capital Structure Analysis............................................................................. 106
Credit Risk............................................................................................................... 111
Financial Statement Forecasting.................................................................... 114
Financial Statement Forecasting.................................................................... 114
Income Statement ........................................................................................... 114
Balance Sheet .................................................................................................... 119
Statement of Cash Flows............................................................................... 123
Cost of Capital Estimation................................................................................. 127
Cost of Equity..................................................................................................... 127
Cost of Debt........................................................................................................ 130
Valuation Analysis.................................................................................................... 132
Method of Comparables..................................................................................... 133
Price to Earnings Trailing .............................................................................. 134
Price to Earnings Forward............................................................................. 135
Price to Book...................................................................................................... 136
Price Earnings Growth (P.E.G.) ................................................................... 137
Price over EBITDA............................................................................................ 138
Price over Free Cash Flows........................................................................... 140
Enterprise Value over EBITDA..................................................................... 141
Intrinsic Valuation Models................................................................................ 143
Discounted Free Cash Flows Model ........................................................... 144
Residual Income Model.................................................................................. 147
Long Run Residual Income Perpetuity .................................................... 149
Abnormal Earnings Growth (AEG) Model ................................................ 151
Appendices.................................................................................................................. 155
References .................................................................................................................. 184
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Executive Summary
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Industry Analysis
Xerox is a document management company utilizing both software and
hardware to accomplish their business objectives. The main competitors for
Xerox are Cannon, Hewlett-Packard, Ricoh, and IKON. These existing firms
compete on economies of scale and scope, superior product quality and variety,
research and development, and investment in brand image which are also their
key success factors. We can see the five forces that drive competition within the
industry in the table below.
Five Forces
Competition Level
Rivalry Among Existing Firms
Threat of New Entrants
Threat of Substitute Products
Bargaining Power of Buyers
Bargaining Power of Suppliers
Overall
Low
Low
Mixed
Mixed
Mixed
Low to Mixed
Most importantly the firms compete on innovation or research and
development. Xerox invested $922 million in 2006 to support the production of
new products in order to continue to hold and possibly gain current market share
within the industry. To support this assumption Xerox claims in their 2006 10-K
that two-thirds of equipment sales are form products launched in the past two
years. Economies of scale help to curb the entry of new firms by placing a
premium on large investments in R&D. Due to this fact, the cost of entering into
this industry would limit the candidates to primarily established companies with
large cash assets who are looking to expand into other market segments.
Furthermore, the investment in brand image and superior product quality and
variety help to distinguish each firm in this low to mixed competitive market.
Due to the high concentration and low competition within the document
management industry, firms are able to market their products based on
differentiation instead of competing on a primarily cost structure. This allows
firms to charge a premium for their products.
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Accounting Analysis
Firms submit a 10-K report to the SEC which has its stated financials and
is the starting point of an analyst’s valuation of the firm. Accounting drives these
numbers and is therefore sometimes used as an aggressive or conservative tool
to affect the perceived value of the firm.
It is valuable to look at how the accounting procedures back up the firm’s
key success factors in order to determine if accounting procedures and proper.
Key accounting policies for Xerox included the proper expensing of R&D as
incurred, the proper recording of capital and operating leases, and the
determination for pension expense. Here we find that the first two items are
being adequately and correctly recorded by the accounting procedures, but we
find that there is less disclosure concerning the employee pension plans. This
doesn’t mean Xerox is misleading us but simply that we don’t have enough
information to determine the accuracy and consistency of the procedures without
making generalizing assumptions.
We then looked at accounting flexibility which is determined by generally
accepted accounting procedures (GAAP). GAAP offers no flexibility to the
recording of R&D. It must simply be expensed as incurred which hinders our
ability to value the firm’s contribution to R&D. For operating/capital leases and
pension plans GAAP allows much more flexibility. Since Xerox does not use
extensive operating leases there is really no affect on the firm’s value from this
aspect; however, GAAP allows firms to estimate their own pension plan discount
rates which if overstated can cause an understated pension expense.
Overall disclosure for Xerox was adequate but not overly impressive. We
feel that we could usually hunt down the information we needed, but Xerox
seemed to bury important information deep in the footnotes of the 10-K which
made us skeptical of their accounting ethics and wondered if they were trying to
hide certain items from investors and analysts.
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Financial Analysis, Forecasting, and Cost of Capital
When valuing a firm it is critical to look at the ratio’s used by common
analysts to understand the inner workings of the company. These ratios consist
of liquidity, profitability, and capital structure. It is also important to forecast the
financial statements out a significant amount of years or 10 years in our case.
This gives us data to use when running regressions for valuations later in the
project. Another item used heavily in the intrinsic valuations is cost of equity,
cost of debt, and weighted average cost of capital.
The liquidity ratios which materially altered our overall decision on valuing
Xerox included the quick asset ratio and accounts receivable days. Xerox quick
asset ratio significantly outperforms its competitors demonstrating the ability to
liquidate the firm within 24-36 hours. On the other hand, the accounts
receivable days was much longer compared to HP, Canon, Ricoh, and Ikon.
Unfortunately this shows inability to collect on outstanding accounts in a timely
manner. When considering profitability ratios, the operating profit margin for
Xerox is much higher then for its competitors which demonstrates its ability to
create profit after all operating expenses have been deducted. As for the capital
structure ratios, Xerox is underperforming in the debt to service margin ratio
which shows their inability to pay short term notes with operating cash flows.
We then forecasted the financial statements for the next ten years in
order to provide statistical data for intrinsic valuations. Major forecasts
performed included net income, CFFO, CFFI, retained earnings, and book value
of equity which were utilized in the valuations. These are considered the future
cash flows for the firms which will then be discounted back in order to find the
present value. We also calculated the cost of debt, cost of equity, and weighted
average cost of capital to be used in the valuations. These figures are then used
as the discount rate to find the present value factors. We used analytical
techniques consisting of weighted averages and linear regressions to find
adequate estimates for valuing the firm’s equity as of November 1, 2007.
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Valuations Analysis
The financial valuations are the most important and significant part of the
equity analysis. Here we take our forecasted financials, knowledge of the
industry, and ability to understand finance in order to assign estimated fair
values to the market price per share of Xerox. The ultimate goal of the
valuations is to build an investment strategy based on whether the firm is
overvalued, undervalued, or fairly valued.
We started with the method of comparables. These are tools based on
financial ratios that value the firm based on 7 different aspects. Using these
methods we found that the value of the firm could not be appropriately
estimated using these ratios. These methods proved inaccurate since they tend
to value mediocrity instead of excellence.
Our other valuations were intrinsic valuations based in theory and derived
through forecasted financial statements. Here we started by assessing the value
of the firm based on free cash flows, but we determined this model was less
effective due to the high sensitivity it has to the estimated growth rate. Never
the less, through sensitivity analysis we found the firm to be a mix of over,
under, and fairly valued using this method with our estimated price in this model
coming out to $13.23 per share which means the current price of $17.44 is
overvalued. The other three methods we used were the residual income, long
run residual income perpetuity, and the abnormal earnings growth model all
consistently showed the firm as overvalued at very similar prices. These models
yielded estimated per share prices of $3.24, $6.60, and $3.29 respectively. In
each case we see that throughout the sensitivity analysis and our estimated price
per shares Xerox is severely overvalued by an average of 75%. The severely
overvalued price per share is why we strongly suggest that this equity has a sell
rating.
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Business Overview
Over the past one hundred years the Xerox Corporation has manufactured
documents through physical and eventually electronic medium. In 1906, The
Haloid Company was founded in Rochester, New York where photographic paper
and equipment were manufactured and sold. Although the company operated
under a different name for a great deal of time, to this day they maintain the
same fundamental values. Over time the company has evolved from only selling
goods to providing both goods and services in a technologically advanced world.
As of 2006, 72% of revenue generated came from leases, maintenance, service,
and financing from past sales (www.xerox.com). This dramatic change was
essential in today’s industry due to the paperless systems integrated in corporate
America.
The printing industry of the early 20th century has completely changed
due to the increasing technological advances. In today’s media intense
corporate environment, companies looking to profit solely off printing electronic
documents are up for a serious test. Companies are now looking towards a
more paperless system which requires software to handle document
management and processing. Xerox spent years of research and development to
not only provide reliable multifunction printers to corporations, but also software
able to scan, store, manage and process the documents needed at any given
time.
Due to Xerox’s unique concentration on one industry, they are able to
spend more time and money working to find the next best technology available.
Xerox is competing on “technology, performance, price, quality, reliability, brand,
distribution, and customer service and support” (www.xerox.com). Xerox’s main
competitors within the document management industry are Canon, Ricoh, IKON,
and Hewlett-Packard. Xerox’s market capitalization in the industry is 15.88
Billion. Although both of its competitors Canon and Hp have significantly higher
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market caps of 69.53 Billion and 129.08 Billion respectively, Xerox continues to
improve and grow as a corporation. In 2006, Xerox spent 761 million dollars on
research and development in order to improve business printing and lower costs
for the end user.
Xerox and its competitors compete on different aspects of the document
managing industry. Both HP and Canon tend to focus more on actual equipment
and printing supplies rather than overall document management (www.hp.com).
Xerox’s revenue stream is definitely sided towards one market over the other
when it comes to managing documents. Seventy two percent of its revenue is
generated from financing and leasing machines to businesses. The other 28% of
the revenue is gathered from manufacturing and selling equipment and supplies
for printing.
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Industry Overview
In the past thirty years, the printing industry has evolved into a more
technologically advanced environment then ever expected. The days of only
needing to print an electronic document are obsolete. In today’s industry
companies require electronic document management. This includes scanning,
managing, organizing, and printing documents quickly and efficiently. Many
companies in the industry have spent a great deal of research and development
to stay ahead of demand and maintain market share. The new industry of
documents focuses more on managing an electronic document and distributing it
quickly and easily over vast areas.
One of the most shocking facts about this industry is the little to no
growth over the past five years. This causes the companies in this industry to
fight to gain market share from each other rather than acquiring new areas of
growth. One area of growth Hewlett-Packard, Canon, and Xerox all agree upon
is in color printing at the office level (www.xerox.com, www.hp.com,
www.canon.com). Each company is working hard to manufacture an efficient
printer to entice executives to allow color printing throughout their offices. This
would be a great increase in market share due to the increase in costs of printing
color pages versus monochrome ones.
The printing industry can be classified into basically two sections. Basic
printing of electronic documents onto paper was the original form of business
and then electronic document management accomplished with software.
Companies feel their expenses could be greatly decreased if software made it
readily available to share documents to a large amount of people safely and
effectively.
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The Five Forces Model
The five forces model is an analysis instrument used to assign value to the
firm’s key success factors in profitability and determine the overall industry and
market structure. The model focuses on five areas. First, it assesses the rivalry
among existing firms; when rivalry among existing firms is high, competition is
high and vice versa. Second, the five forces model determines the threat of new
entrants. If the threat of new entrants is high then there is a likely hood of
increased competition. Next, we assess the threat of substitutes that could be
alternatives to buyers purchasing the firms’ existing products which if high,
would illustrate a competitive market competing on a cost basis. Finally, the
model will assess the bargaining power of buyers and suppliers. If the
bargaining power is higher for buyers the firm is at a disadvantage and will be
forced to compete. If the bargaining power of suppliers is high we will also find
an increase in competition because of the difficulty to secure a value chain.
Ultimately we can determine if it is a high competition industry involving cost
leadership, low competition industry competing on differentiation and
specialization, or mixed competition industry involving a fairly balanced quantity
of both.
Five Forces
Competition Level
Rivalry Among Existing Firms
Threat of New Entrants
Threat of Substitute Products
Bargaining Power of Buyers
Bargaining Power of Suppliers
Low
Low
Mixed
Mixed
Mixed
Overall
Low to Mixed
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Rivalry Among Existing Firms
The overall level of profit and revenue for a company derives primarily
from the rivalry among existing firms within the market segment. We find this to
be the case because these existing firms are the first and foremost threat to
each other’s market share and can determine what environment in which the
firm must compete. In order to be profitable a firm within this industry must
retain its current market share or steal form others within the industry and
continue to push innovation and differentiation as key success factors for each
firm within the industry. Companies work to accomplish this by investing in
research and development to innovate while maintaining an adequate cost
structure.
Industry Growth-Rate
Industry Growth
Percentage Growth
6.000%
4.95%
5.000%
4.000%
3.000%
2.72%
2.82%
2003
2004
2.29%
2.000%
1.000%
-0.03%
0.000%
-1.000%
2002
2005
2006
Year
* Percentages developed by defining comparable sales from each firms sales as listed on
the 10-k statements of Xerox, Canon, IKON, Hewlett-Packard, and Ricoh.
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The industry growth-rate greatly determines a firm’s position in the
market. If a firm participates in an industry where growth is rapid and expansion
is constant, the firm does not have to compete against other existing firms in
order to increase market share; the firm must simply obtain a fraction of the new
customers as they enter the market. On the other hand if the firm competes in a
stagnant or slow growing industry, the firm must fight to retain its existing
market share and in order to grow must obtain market share from the
competition within its existing industry.
Growth in the document management industry is somewhat sporadic, but
nevertheless remains relatively low. This means in order for firms to gain market
share they must steal customer base from their competitors. In this
technologically advanced and service oriented industry, the most successful
companies pursue brand marketing and a dependable, quick, and efficient
industry service reputation to maintain current customers and convince others to
switch. The slow growth in the electronic office equipment industry discourages
new firms from entering the industry due to the extreme difficulty in establishing
and maintaining a new customer base. Looking at the above chart, you can see
how the industry growth rate has varied from year to year but overall remains
low. Using the information in the chart, we can determine that the average
growth rate over the past five years has been 2.55%. This data proves the
industry is experiencing high competition due to a growth rate too minute to
cover the inflation rate during the same period which averaged 2.634%
(http://inflationdata.com).
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Concentration
Percentage of Market Share
Market Share
40.00%
35.00%
30.00%
XRX
25.00%
CAJ
20.00%
IKN
15.00%
HPQ
10.00%
RICOY
5.00%
0.00%
2002
2003
2004
2005
2006
Year
* Percentages developed by defining comparable sales from each firms sales as
listed on the 10-k statements of Xerox, Canon, IKON, Hewlett-Packard, and
Ricoh.
An industry’s concentration is determined by the number and size of the
firms within that industry. The use of concentration as a means of analysis
stems from the idea that the amount of concentration in a given industry directly
affects the extent to which organizations within the industry can control the basis
on which that industry either competes or coordinates. Larger firms in industries
with higher concentration indices have more power to exact their competitive
desires on and throughout the rest of the industry. Industries with lower
concentration are forced to compete on the basis of price which can be
detrimental to the firm’s financial agenda and can hinder innovation and
differentiation. The Herfindahl-Hirschman Index (HHI), which is used by the
Federal Trade Commission, can be used to assess the levels of concentration
within an industry. (Palepu & Healy) By summing the squares of the market
share of Xerox and its key competitors, we can see that the HHI for this industry
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is 2403. It is considered that any value above 1800 represents a highly
concentrated industry or market; this is why firms like Xerox and their
competitors can afford to compete on technology and quality service rather than
just prices. Above we can see a graphical representation the disbursement of
the market share over the past five years within the industry. This shows us that
the concentration of firms within the market segment demonstrates a low level
of competition and illustrates the ability of the industry to compete on
differentiation instead of cost structure.
Differentiation and Switching Costs
Differentiating a firm’s products or services is one way that a company
can help to avoid aggressive competition within their specific market or industry.
Differentiation allows a company to avoid competing in an industry with
substitutes which would cause firms to compete on price. In the document
management industry businesses continually strive to create the next innovative
technology to speed or ease the flow of information within the industries that
they support; however, when such technologies are developed, the industry
quickly copies or imitates the new technology so that the developing firm holds
an advantage for only as long as a patent remains valid or until another firm is
able to reverse-engineer the process.
Switching costs in this sense describes a company’s ability to switch to
producing a different product or service instead of continuing to compete within
the industry. Switching costs in an industry describe a company’s ability to
switch from its current operation to a completely different industry and start a
new business. When switching costs within an industry are high, companies are
forced to continue current production due to the additional cost or hassle
associated with changing businesses. Conversely, low switching costs cause low
competition within an industry allowing companies to easily leave and start
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performing other services. Xerox and the document management industry in
general experience low switching cause due to no government regulations and
little specialized equipment preventing them from changing their business
structure. Therefore the document industry has low competition in regards to
switching costs because companies can pack up and change their business pretty
easily.
Learning Economies of Scale
Learning economies of scale exist when there is an advantage given to
firms with and increased knowledge gained from either previous experience or
more prevalently form research and development. This holds true to the
expected norm that technology based industries must compete on large leaning
economies of scale with high research and development budgets in order to
produce enough innovative products to stay competitive in the market. The
document management industry relies heavily on these advances in R&D in order
to produce a product that will turn a profit in the future markets. We know that
organizations that spend large amounts of capital on R&D are trying to
differentiate themselves in the market and tend to be competing in markets with
low competition.
The best way to determine how successful a company is at utilizing R&D
to protect themselves from other companies and maintain their advantage from
learning economies is to measure how successful the firm is in producing sales
from the R&D that they incur. The table below shows the amount of R&D per
sales dollar spent by each firm since 2002. As you can see, HP which has been
in this segment of the market for a shorter period of time is still investing heavily
in R&D to try and reach the level of knowledge that Xerox and Canon have
already produced. This shows that the learning economies of scale tend to
decrease rivalry among existing firms by always benefitting those who have been
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in the market for longer. The result of this information leads us to conclude that
the overall competition from learning economies of scale is low since there is an
advantage given to firms already in the industry that have invested in these
activities.
R&D Per Sales Dollar
2002
2003
2004
2005
2006
Xerox
$.034
$.033
$.035
$.036
$.035
Canon
$.104
$.112
$.115
$.114
$.114
NR
NR
NR
NR
NR
$.165
$.161
$.147
$.139
$.134
NR
NR
NR
NR
NR
IKON
HP
Ricoh
*NR: Not reported
www.finance.google.com
Excess Capacity and Exit barriers
Excess capacity in an industry for a firm’s product or service entices firms
to cut prices to sell their remaining inventory. Excess capacity for technology
firms in the document management industry is a relatively small problem as
most companies out source their manufacturing. In this case, all a firm must do
is to sell their product at the inventory level which they estimated and demanded
from their manufacturer. This limits the effects of excess capacity on the firms
themselves. If exit barriers are present, this causes competition to skew towards
a highly competitive industry. Exit barriers usually form either from government
regulations or specialized equipment which prevents the firm from being able to
adapt to produce a new product or sell of their existing machines for profit. In
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the document management industry, there are few exit barriers which causes
the level of competition from this aspect to be low.
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Conclusion
The rivalry among existing firms within the industry demonstrates low
competition. New entrants are unlikely to enter the market due to low market
growth. The industry concentration is high showing the ability to coordinate and
compete on differentiation and innovation. Switching costs are low representing
a high degree of differentiation. Economies of scale do exist especially when
considering the amount spent on R&D. Excess capacity is not really a problem
because of utilization of outsourcing. The rivalry among existing firms within the
industry is relatively low due to the level of concentration, switching costs,
learning economies of scale, and exit barriers all promoting low competition and
offsetting the only high competition aspect within the existing firms which was
the lack of industry growth. Combining all these factors we can see that the
rivalry among existing firms is relatively low contributing to a lower overall level
of competition within the market.
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Threat of New Entrants
In industries heavily relying on technology improvements and
advancements, few are able to enter the market for the first time and survive in
an expensive product differentiation based business. Low competition between
Xerox and its main competitors makes it difficult to compete in this industry.
Although HP and Canon focus more of their business on printing equipment and
supplies, individuals looking to enter the market would struggle buying down the
cost of components. Many road blocks are currently in place such as economies
of scale, first mover advantage, channels of distribution and relationships, and
legal barriers.
Economies of Scale
Total Assets
2002
2003
2004
2005
2006
Xerox
$25,550
$24,591
$24,884
$21,953
$21,709
Cannon
$25,744
$27,838
$31,379
$35,367
$39,551
IKON
$3,231
$3,831
$4,518
$6,600
$6,397
HP**
$25,549
$23,135
$23,058
$22,433
$23,958
Ricoh
$16,035
$16,490
$16,209
$17,080
$17,854
*In millions, Yen was converted to US dollar
**HP's total assets were calculated as an equivalent percentage derived from using the revenue percentage of the
Imaging and Printing Group (IPG).
Technology based industries have a tendency to favor large companies
with a great deal of capital backing research and development as well as
production. This idea of economies of scale helps established corporations and
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leaves little market share for smaller companies. Small businesses looking to
enter the industry of document management face struggles in several different
areas. One of these struggles involves deciding how much capital needs to be
initially invested. Too much and a company finds itself short on cash, whereas
too little and they can’t compete on price at all. Although some would say
printing paper is an easy task, when it comes to dealing with businesses that
experience some of their greatest cost from printing, it becomes a challenge.
Even for small companies printing is often one of the most expensive costs they
incur throughout the year. Therefore offices around the world are looking for
alternative solutions to printing. Xerox has seen the potential in this market and
invested a great deal of revenue into innovating new ways to deal with an
electronic sheet of paper (www.xerox.com). For a small company it would be
nearly impossible to compete on this level due to the great deal of research and
experience needed to make efficient large scale copiers and software for the
office environment. Xerox and its competitors also have an advantage in regards
to regulatory requirements both in the United States and abroad.
First Mover Advantage
When operating a worldwide business there are often aspects overlooked
by the average citizen. These include certain embargo requirements and rules
by the U.S. government as to who a company can trade with. America has
certain countries it forbids trading with because of terrorism activity in those
countries. Without prior knowledge of this situation a small company looking to
go worldwide could experience serious legal prosecution if not careful.
Established companies such as Xerox and its competitors have a significant
advantage over anyone looking to enter the industry due to this knowledge.
Another advantage for existing firms is shared information as well as patents.
Each of these companies spends a great deal of money on research and
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development each year. Therefore they acquire incredible amounts of patents
and sometimes even share them with each other in order to stay successful. For
a new firm entering the market, they would be forced to fend for themselves
when it came to technology and patents needed to produce products. Patents or
the access to another firm’s patents are almost required in order to capitalize off
the innovative ideas and designs driving the industry. “More than two-thirds of
our equipment sales are from products launched within the past two years” (10-k
www.xerox.com). This quote shows just how important innovation is within the
document management industry, and solidifies the fact that new companies
entering the market would struggle without access to these resources.
Access to Channels of Distribution and Relationships
Relationships with existing suppliers, distributors, and competitors act as a
significant advantage for any firm working with technology. As mentioned
previously, many companies in the document management industry share
patents and ideas in order to survive and cut costs. Although they are directly
competing, if a product is lacking a critical component, it may be necessary to
pay a competitor to use it. Another relationship area firms continue to focus on
is with their suppliers. In today’s society people feel technology is so advanced,
they should receive it at smaller costs. Consequently, firms require their
suppliers to offer discounts or incentives to buy more components from them.
Legal Barriers
In international business operations government agencies can put
limitations on corporate relationships with other countries. New companies
looking to enter the industry would have difficulties knowing the current policy in
effect. The United States has made it very clear to international businesses
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there disapproval of making transactions with countries supporting terrorism.
This affected Xerox because it continues to do business in the Middle East.
Countries such as Syria and Iran support terrorism in their country causing Xerox
Limited to terminate previous agreements with them (www.xerox.com).
Conclusion
Industries primarily with low competition make it difficult for new
companies to enter the market and be successful. The document management
industry has many barriers preventing such companies from entering such as
economies of scale, first mover advantage, channels of distribution and
relationships, as well as legal barriers. Xerox invests a great deal of revenue into
research and development in order to stay on the cutting edge of technology.
Without their size of production this would not be possible, causing the company
to compete on old technology. Also maintaining an established company for this
long builds relationships with suppliers, lowering their overall bottom line.
Although the document management industry is low competition, these
companies still have to compete on price. Therefore with these relationships
they have a clear advantage of buying down the purchase price of needed
components. Finally, legal barriers can cause serious troubles for companies
when considering international business and the repercussions for disobeying the
United States orders. Overall the odds are in favor of existing firms in the
document industry proving the threat of competition from new entrants is low.
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Threat of Substitute Products
The presence of substitute products is an ongoing threat to virtually any
company in every industry. Cheaper products or services that rely mainly on
cost competition can overrun an industry and plague those firms who choose to
produce higher quality even though cost is the consumer’s main priority. This
threat relies on the customer’s perception of the price and performance of
competing products and their willingness to substitute. Differentiation in the
document industry is the main way to compete and fend off substitutes that
would hinder a firm’s sales, but the document management industry is neither
completely cost based nor is it completely differentiated.
Relative Price and Performance/Willingness to Substitute
The relative price and performance of goods determine whether or not
those goods are going to be forced to compete in the market as cost leaders or
as superior performing differentiated products. Products can be substituted only
if it performs the same function as the original product. Substitutes also fail
when the price is not substantially less than that of the original good.
In the document management industry the personal copier segment of
this industry is rapidly growing, and personal copiers are becoming less
distinguished than medium or high end copiers. This is the result of the
commoditization of the lower level more personal copiers. The personal copier
or document machines have become a product within the industry that competes
mainly on the basis of price. Consumers of this type are ever ready to switch to
a substitute product in order to save money. The higher end machines that do a
plethora of activities covering every aspect of consumer business are especially
different. These machines compete in the business or office segment on service,
quality, differentiation, and branding. This shows that the relative price and
24
performance of products determine how firms compete in each segment of the
document management industry. A large variety of low end substitute products
combined with few high end substitute products creates mixed competition in
terms of substitute products.
25
Bargaining Power of Buyers
Buyers possess power in the market place when certain conditions are
present, which in turn determines the method or technique that firms must use
to compete for their business. There are two dynamic s that together determine
the extent of power held by consumers or buyers within the market. The two
factors, price sensitivity and relative bargaining power, are responsible for
developing a customers’ position within the market and their tendency to behave
in response to that position.
Price Sensitivity
Price sensitivity is best explained by the predisposition of buyers to negotiate or
deal on price. Price sensitivity in markets actually helps the firms within that
industry develop and pursue their specific cost structure. For instance, if the
cost of a product is too high for a firm’s customers a firm may find ways to
develop a cost structure that would help cut costs. If customer experiences high
price sensitivity, then they are also more apt and willing to accept substitute
products that in turn are cheaper. This is further evident when the overall
quality of a product is not particularly important to the consumer. If the
consumer is buying a printer or scanner for the purpose of supporting their
college course work and printing assignments, the printer is just an accessory
item where quality may be sacrificed for a cheaper substitute. In the document
management industry, price sensitivity increases in the market for lower end
personal machines while it decreases as the products become more specialized
and differentiated.
26
Relative bargaining Power
Relative bargaining power acts as a catalyst helping customers greater
utilize the level of price sensitivity that they possess. Simply stated, relative
bargaining power is the cost of not doing business with each other. Firms that
have alternative customers or alternative business segments possess more
bargaining power than the other firms in the same market. This is because they
don’t have to do business with the customer in order to survive as a firm.
Conversely, when buyers can find and purchase their products through different
outlets, they possess the greater bargaining power. In the document
management industry firms and buyers split the relative bargaining power.
Firms tend to hold the bargaining power in the upper end, highly specialized and
differentiated goods while customers possess the majority the bargaining power
when purchasing lower end more highly commoditized personal business
peripherals.
Conclusion
Price sensitivity and relative bargaining power work hand in hand to set
the standards for the bargaining power of buyers within the market. As the
buyers’ bargaining power increases through price sensitivity and relative
bargaining power prices will decrease within the industry forcing firms to find
ways to cut costs. If price sensitivity is lower and the relative bargaining power
of the firm is higher, prices will not be affected, but rather firms will continue to
focus on specialization and differentiation through innovation. Overall the
bargaining power of buyers is moderate in terms of power resulting in mixed
competition.
27
Bargaining Power of Suppliers
The power of suppliers directly affects a firm’s ability to control costs and
profits. Suppliers with high levels of barraging power can exert tremendous
pressures onto retailers for several reasons. Highly leveraged suppliers can limit
a firm’s ability to choose from multiple suppliers because of their secure market
position within the industry. These suppliers can exert higher prices onto firms
and ultimately higher costs. Retailers are forced to comply in order to insure
their supplier relationship continues. The opposite is true for suppliers with low
bargaining power. In these instances, the firm has the higher power in relation
to its ability to implement demands over its suppliers. For example, a firm can
force suppliers to produce and maintain specific inventory levels, as well as,
demand lower prices or face losing business.
Price Sensitivity
The price sensitivity on the supplier side of the document management
industry is somewhat high but often times mixed and relatively moderate. The
price sensitivity is offset by two features. One, firms have an interest to
purchase products that are not important to the overall quality and performance
of their business machines at a discounted price. In this segment of their supply
chain firms within the industry focus on price and experience high levels of price
sensitivity. Secondly however, firms tend to rely on the advancement and
innovation created by their suppliers to help fuel their own innovation and
differentiation within their own products or services. These two factors cancel
each other out leaving the price sensitivity within the industry at a fair median.
28
Relative Bargaining Power
Suppliers in the technology and service industry have little bargaining
power. The majority of the products that suppliers produce are undifferentiated,
that is, there are multiple suppliers in this industry that can produce similar
products. The availability of multiple suppliers allows firms to use more than one
supplier, eliminating any potential power the supplier can have over the firm.
However, this industry is highly competitive and to maintain a competitive
advantage, firms most invest heavily in researching and developing new
technologies. These investments into cutting-edge technologies force firms to
develop highly sensitive relationships with specialized suppliers. The demand and
supply between firms and suppliers is highly susceptible to market fluctuations
and competition within the industry. In these situations, it is in the firm and
suppliers best interest to forgo any bargaining power over each other, rather,
collaborate and maintain market share over industry rivals.
The level of bargaining power suppliers have over Xerox is minimal. Xerox
has unique purchasing agreements with suppliers, as well as, vertically
integrating itself into their supply chain. Xerox is currently outsourcing a
significant portion of their manufacturing process to Flextronics. In the
arrangement, Xerox agreed to purchase Flextronic products, as well as,
repurchase inventory that remains unused for more than 180 days, in exchange;
Flextronics must meet anticipated inventory levels determined by Xerox. By
outsourcing manufacturing, Xerox has buffered itself against suppliers and
developed a relationship with Flextroincs that allows Xerox control over the
amount of goods in inventory.
Xerox has vertically integrated itself into their supply chain by acquiring a
25% interest into Fuji Xerox an unconsolidated affiliate of Fujifilms. Fuji Xerox
currently develops, manufactures and distributes document processing products
in Japan, China, Hong Kong and other areas in the South Pacific, Australia, and
29
New Zealand. In the arrangement Xerox agreed to purchase selected products
from Fujifilms and both Xerox and Fuji Xerox have agreed to share patents as
well as research and development findings.
Conclusion
The forces of price sensitivity and relative bargaining power drive the
overall bargaining power of the suppliers; however, firms within the industries
have learned to cooperate with their suppliers to collaborate and innovate the
document management industry. Through the relinquishment of focus on
relative bargaining power, both firms and suppliers alike are able to enjoy a
mutually conducive environment in which to conduct business. This results in
mixed competition due to the power shared between both sides of the
transaction.
30
Value Creation Analysis
In technologically driven industries creating value can be accomplished in
a number of different ways. Often companies tend to differentiate themselves
when they create value due to different objectives set forth by executive
management. Competitive advantages can be obtained by focusing on a specific
area in an industry. Economies of scale, superior product quality and variety,
research and development, investment in brand image create value and
characterize where an industry falls in creating competitive advantages.
Competitive strategies such as cost leadership and product differentiation are
two ways businesses create value in an industry. In our industry companies
have chosen to focus more on product differentiation, but still keep in mind the
overall price of their product.
Economies of Scale and Scope
Providing a low cost product is all dependent on the corporation’s
relationship with its suppliers. When companies have the ability to drive down
the purchase price of components in their final product they are then able to
pass those benefits onto their customers. In a world full of technology driven
individuals, corporations are searching for the best value they can find. HewlettPackard, Canon, Xerox, Ricoh, and IKON all utilize their relationships with
suppliers in one form or another to drive down input prices of components.
Another way to increase efficiency and drive down the bottom line is to
outsource manufacturing. This allows a company to focus on a competitive
advantage they have and leave the actual production to someone else.
31
Superior Product Quality and Variety
Customers in today’s economy expect quality when purchasing significant
investments for their company. Quality not only depends on the overall
production of the actual product, but also the innovation behind its creation.
Without considering quality, firms must maintain an adequate servicing
department to ensure durable goods hold up to their advertised capabilities.
Although quality is an important aspect of production, variety is equally
important to guarantee market coverage. Providing greater product width allows
companies to match current production with the market demand in a specific
industry. Hewlett-Packard continues to focus on providing variety in the form of
affordable desktop printers to a wide variety of customers to capture market
share. In the past couple of years they have become very successful, due to
lower prices and greater availability (www.hp.com).
Research and Development
In a relatively constant market companies continuously fight over market
share to further their success in the industry. In the document management
industry current competitors feel the only room available for growth is in color
printing. This idea was originated from new technology allowing printer
manufacturers to produce more cost efficient color printers and copiers.
Competitors in the industry make this possible due to their significant size and
ability to invest a majority of their retained earnings in research and
development. Xerox, Hewlett-Packard, and Canon all together invested over $7
Billion in research and development for the 2006 fiscal year. This proves to
survive in a technology driven industry competitors must maintain a high degree
of innovation to sustain market share.
32
Investment in Brand Image
Logo’s, names, and slogans have a significant impact on consumer
spending habits. Often clever advertising along with brand recognition can play
a vital role in influencing in store purchasing decisions. Companies competing in
the document management sector spend a great deal focusing on brand image
to increase sales. Hewlett-Packard used clever advertising with picture frames to
encourage amateur photographers to print pictures at home quickly and easily
(www.hp.com). Other companies such as canon have also encouraged at home
printing with easy digital photography (www.canon.com).
Conclusion
In an industry with a mixed competitive strategy, businesses focus on
innovation, brand image, product quality and variety, as well as economies of
scale. Although product differentiation takes precedence over cost leadership,
companies have to maintain a realistic cost structure to compete effectively.
Companies strive to differentiate themselves from competing firms in order to
retain customer loyalty. The differentiation strategy is unique due to the ability
to create value for a specific innovative product or service in an industry. Firms
competing in this type of industry are able to avoid price competition and earn a
conservative profit.
33
Firm Competitive Advantage Analysis
Individual companies in the document management industry all have
unique advantages over competitors. Xerox has different areas of expertise
allowing it to both compete more efficiently in some areas and differentiate itself
in others. Competitive advantages come in a multitude of forms varying from
physical qualities to intellectual knowledge. Xerox’s competitive advantages
consist of economies of scale and scope, superior product quality and variety,
extensive research and development, and brand recognition.
Economies of Scale and Scope
Operating a business with substantial revenue allows executives to pick
and choose different operating functions to further their profitability. One area
Xerox has a significant advantage in is their relationship with both suppliers and
other competitors. They have the ability to provide scheduled delivery times to
suppliers to help alleviate component storage problems while waiting for
production. Xerox also uses its strategic alliance with other companies to share
patents and licenses to pertinent components needed to produce specific
products. Xerox has also chosen to outsource twenty percent of its current
production to Flextronics to act as a buffer to suppliers and inventory storage
issues. The other eighty percent of production is conducted in house to ensure
an appropriate level of product quality.
Superior Product Quality and Variety
Xerox offers a vast array of printing equipment and supplies, as well as
document outsourcing services. Its office segment (has x amount) types of
34
paper printing equipment, to adequately provide the different varieties
demanded by the current market. Xerox’s production line offers “high-end digital
monochrome and color systems (Xerox 2006 10-k)” for use in large businesses,
especially those with graphic communication needs. When providing high end
printing machines quality is Xerox’s main priority due to the cost of leasing these
machines. Customers expect a high degree of quality and Xerox continues to
maintain a good relationship with its corporate customers. Xerox has started to
make its transition into the paperless digital technologies by providing workflow
analysis services, assisting in identifying “the most efficient, production mix of
office equipment and software” for their customers (Xerox 2006 10-k). Xerox is
continually growing its variety of office and production equipment, but doing so
while making the transition in to the digital side of its business.
Research and Development
Cutting edge technology is essential to any company looking to compete
in the high end digital document market. With a majority of sales coming from
products designed in the past two years, Xerox continues to see the potential in
extensive research and development. Xerox spent over $700 million dollars on
research and development in 2006 to ensure their profitability in the upcoming
years. With this drive towards innovation, Xerox “was awarded nearly 560 U.S.
utility patents in 2006” (www.xerox.com). This maintained their significant
presence in acquiring patents totaling nearly 8,300 at the end of 2006.
Investment in Brand Image
A company’s brand can be one of the most valuable assets due to its
recognition and overall history in the appropriate industry. Xerox started out as
the Haloid Company in 1906 manufacturing photographic paper. Later it came
35
out with the first automatic plain paper copier in 1959 starting the incredible
copying industry we experience each and every day in the business world
(www.xerox.com). This all led to the brand recognition Xerox possesses and
utilizes on a daily basis in the electronic document management industry of the
21st century.
Xerox considers its “brand recognition” an important competitive
advantage in the printing industry.
Conclusion
When competing to gain market share in an industry with little to no
growth, competitive advantages act as a tool to differentiate companies from one
another. Xerox does a tremendous job of utilizing its competitive advantages to
create innovative products directed towards loyal customers in the document
management market. Companies are looking for solutions to a multi- million
dollar problem of continuously printing out documents when there are better
ways of sharing valuable information. Overall it is critical Xerox uses every
resource available, everything from their size to their brand recognition to
compete efficiently in a tight market.
36
Formal Accounting Analysis
Generally Accepted Accounting Principles (GAAP) are the backbone for
company accountants working to disclose their business in financial statements.
These principles help govern and provide consistency across not only the
document management industry, but the U.S. marketplace as a whole. Without
these guidelines, investors looking to value a firm would first be challenged to
even the playing field for different businesses. One of the most important
principles required by GAAP is accrual accounting. This concept is known for
recording events when they occur rather than when cash changes hand. Accrual
accounting allows firms to offer more insight into the company and give a better
representation of the current state of operation. The process of creating
financial statements was once left to the accountants in a specific company and
audited by certified public accountants. Recently the Sarbanes-Oxley Act has
increased delegation to the CEO and CFO of the corporations to increase
responsibility of the entire company.
Formal accounting analysis includes six steps to determine a company’s
overall transparency and accuracy of financial statements. The first step to
identifying key accounting principles is referencing a firm’s competitive
advantages. Competitive advantages are often where companies possess their
most beneficial accounting procedures. The next step is to assess accounting
flexibility in accordance with GAAP. The ability a firm has to choose accounting
principles that coincide with their daily operations is the amount of flexibility a
firm has. The third step in accounting analysis is evaluating accounting
strategies. Firms are often pressured by shareholders to meet quarterly
forecasts therefore overstate revenues or understate expenses to increase net
income. This works short term, but causes significant adjustments at the end of
the year. The next step is to evaluate the quality of disclosure within the
financial statements. Some firms choose to disclose more than others which
37
allows for more transparency. The fifth step in accounting analysis is identifying
red flags within a company’s accounting records. Areas such as goodwill write
off can be manipulated by managers of the firm. The final analysis step is to
undo accounting distortions. This process consists of analyzing how the
documents were manipulated to determine how adjustments can correct these
problems and give investors a better idea about the firm. Overall the accounting
analysis is one of the key areas where manipulation can be corrected and reveal
a great deal of new information about the firm.
38
Key Accounting Policies
The company’s key success factors as previously stated within the Firm
Competitive Advantage Analysis are vital in determining which accounting
policies will and do materially affect the company’s apparent value. A firm can
either clearly disclose the information concerning their key success factors and
key accounting policies, or the firm can provide a less vivid and more clouded
image of these factors inhibiting an individual from discerning the “true and fair”
value of the firm. The key success factors identified within the Firm Competitive
Advantage Analysis involve utilizing economies of scale and scope, superior
product quality and variety, research and development, and investing in brand
image. Each of these dynamics combines to contribute to the overall value or
perceived value of the firm. Accounting policies that affect these key success
factors and can change how they are recorded and disclosed are recording
research and development, the utilization of either capital or operating leases,
and the disclosure and accounting for defined benefit or pension plans. It is the
way in which these activities are disclosed and recorded that directly affect the
latter, the perceived value, and it is GAAP that allows the firm some flexibility in
determining how their information is originated and comes to find its way on the
financial statements. Inversely however, GAAP can also limit the usefulness of a
firm’s financial statements as a means of value which is clearly displayed in the
inability of any firm to capitalize research and development, instead forcing the
firm to expense the activity in full at its inception.
39
Recording Research & Development
According to Generally Accepted Accounting Principles, R&D can not be
capitalized and recorded as an asset. This applies to all American firms that
report to the SEC which has the authority to prescribe GAAP. Since R&D is a
vital part of the overall value of Xerox and any other firm in the document
industry, it is quite unfortunate that R&D must be expensed and cannot be
capitalized. According to Xerox’s 2006 10-K report that they filed with the SEC,
Xerox spent $922 million on research and development; furthermore, Xerox
discloses that “two thirds of (our) equipment sales are from products launched
during the past two years.”(Xerox 2006 10-K) Therefore there could be a valid
argument that in the document industry, R&D would be well served to list as an
asset to the company. Though all firms in the industry are at the same
disadvantage concerning the recording of R&D as an expense, when comparing
the document industry across the market against other firms in less
technologically advanced fields, an analyst must consider the value of R&D to
determine the comparative overall value of the firm against the other investment
options. In this case, even though Xerox is not granted the discretion to decide
on its own how to handle R&D, the accounting policies in affect that are required
by GAAP are key in realizing that one can not value the firm adequately without
determining the future benefit of R&D and conceptually recording it as an asset.
Below is a chart that determines the theoretical asset equivalent of R&D if GAAP
allowed it to be capitalized as an asset.
40
Theoretical Asset Equivalent of R&D
2002
Xerox
Canon
IKON
HP
Ricoh
$917
2003
$868
2004
$914
2005
$943
2006
$922
$2,046 $2,269 $2,410 $2,508 $2,699
NR
NR
NR
NR
NR
$3,368 $3,651 $3,563 $3,490 $3,591
NR
NR
NR
NR
NR
Assumption that GAAP would accept R&D as assets
*In Millions
www.finance.google.com
*NR: Not Reported
2002-2006 SEC 10-K Filings
The theoretical asset equivalent of R&D was determined by just taking the
actual R&D expense for each firm which would account for how much R&D
would support future sales. Recall two thirds of Xerox’s sales come from
products released in the past two years, so we would assume that R&D in the
document industry has a short life span, maybe around only five years. Again,
theoretically we could conceive that an asset with a five year useful life could be
put on the books and depreciated over those five years for each year of R&D
expenditures. If we looked at the depreciation from R&D starting from 2002 to
current, we can see how the compounding usefulness of R&D can make an even
greater affect on the amount of R&D expended or used during each period
because in essence the R&D expended by Xerox and its competitors has a
balance as an asset account for five years. Inserted below is a chart that shows
the effects of capitalizing and depreciating R&D over a five year time span which
is equivalent to the assumed life of the asset. We assume for the sake of
simplicity and demonstration that R&D did not exist before 2002 and therefore
did not have a balance in that asset account. Also notice that by year five, you
are now depreciating and adding the same number of assets. What this means
41
is that each year you add a new depreciation on a new payment and lose an old
depreciation on a previous payment.
Xerox
Theoretical R&D Asset Balance
2002
2003 2004
Beginning Balance
Paid in
1
Total Depreciation:
From '02
From '03
From '04
From '05
From '06
Ending Balance
*$0.00*
$917
2005
2006
$734 $1,246 $1,500 $1,595
$868
$914
$943
$922
($183) ($183) ($183) ($183)
($173) ($173) ($173)
($304) ($304)
($188)
($183)
($173)
($304)
($188)
($184)
$734 $1,246 $1,500 $1,595 $1,485
1
Assume: straight line depreciation, 5 yr life, and depreciation did not exist prior to 2002
* "Paid In" is equal to the R&D expense for each year -- 2002-2006 10-K statements
This would definitely leave us with a better impression as to the value of
the firm. This also adequately and decisively shows how important it is to
consider facts that are presented outside of the required and mandated
accounting policies to determine a firm’s overall value and positioning. To
reiterate the theoretical contribution of R&D to assets, we can look at the value
of Xerox and its competitors using this theory to develop and conclude the
following over-under analysis of the firms within the document industry since
they can’t show R&D as an asset.
ASSETS
U
U: Understated
=
LIABILITIES
N
O: Overstated
+
EQUITY
REVENUES
U
N
N: No Effect
42
-
EXPENSES
O
=
NET
INCOME
U
Capital Leases vs. Operating Leases
A key and major accounting principal, that when existing must be
examined, is the affect of capital leases and operating leases on overall liabilities
of the firm. We know that capital leases take on an ownership of the item;
conversely, operating leases treat the lease as pure rent expense. In a capital
lease for all intents and purposes you purchase the asset and capitalize it over a
period of time to show a long term liability that equals the present value of the
future lease payments. A capital lease actually puts a liability “on the books” and
is recorded by accountants in that manner. Any time a firm utilizes these off
balance sheet transactions, an analyst should examine and scrutinize the
efficiency of recording such leases in their respective manners. Capital leases
and operating leases are often times very difficult to evaluate from financial
statements such as a 10-K, because there is not a vast amount of information
available to the consumer to determine exactly how the firm is reaching the
figures that they have disclosed. In the document industries, most firms do
utilize operating leases to some extent; however, we must calculate the effect of
these accounting policies because this does not always significantly affect the
perceived value of the firm. Below is a visual representation of how recording
capital lease as an expensed operating lease rather than valuing it as an asset on
the books.
ASSETS
U
=
LIABILITIES
U
U: Understated
O: Overstated
+
EQUITY
REVENUES
N
N
-
EXPENSES
N
=
NET
INCOME
N
N: No Effect
In an ideal world with full and complete disclosure, an analysis of the
firm’s capital and operating leases could be determined by finding the present
value of all future cash flows utilizing a disclosed discount rate. However, with
the level of disclosure and transparency ever dwindling, we must assume a
43
discount rate since one has not been previously disclosed to us. In this case we
have determined that we will assume a 10% or .10 discount rate. Also, we don’t
know exactly how long these payments are expected to go on. In this case we
will assume 15 years. When we discounted the future value of expected cash
flows back to the present period via the assumed discount rate, we had to first
determine how much of the post 2011 payments would be allotted to each year.
In our case we can assume that the average of all remaining payments after
2011 can be used to serve this purpose. We then took the present value factor
(1/(1+discount rate) and multiplied it with our yearly payments to calculate the
present value of yearly future cash payments. This process was copied for the
use of both capital and operating leases. Once we had this information we were
able to determine some interesting facts about Xerox’s operating leases.
Operating leases for Xerox account for only 12.39% of capital leases, 3.97% of
total liabilities, and 2.67% of total assets. We can easily conclude that Xerox is
not materially affecting the value of the firm by recording these leases as
operating instead of capital; in fact, it is probably more accurate for them to do
so. We can determine through this accounting analysis of the recoding of
operating and capital leases that despite the low level of disclosure concerning
these items, we conclude that Xerox is appropriately recording these items and is
not engaged in any form of aggressive accounting to make their financial
statements look more appealing to investors.
PV of Future Operating Leases / PV Capital Leases:
Operating Leases / Total Liabilities in 2006:
Operating Leases / Total Assets in 2006:
*Liability and Asset information from 2006 10-K for Xerox
44
0.1239
0.0397
0.0267
12.39%
3.97%
2.67%
Defined Benefit and Pension Plans
Defined benefit plans and pension plans are liabilities to the firm since
they do in fact represent some future debt owed to an individual. This debt is
recorded at the present value of the future expenditures and is therefore subject
to a discount rate much like the discount rate used in the prior section
concerning the capital and operating leases. Xerox and its other competitors do
however disclose this accounting activity much better than they did the operating
and capital leases. Xerox, Canon, HP, IKON, and Ricoh all do a significantly
better job by actually disclosing the discount rate that the firm is using to
determine the present value of the future expected expenditures from estimated
liabilities owed to individuals within the company. An understatement of the
discount rate will cause an overstatement of liabilities; inversely, an overstated
discount rate will understate liabilities. The following graph shows the disclosed
discount rate for all firms competing firms within the industry.
Xerox
Canon
IKON
HP
Ricoh
Pension Plan Discount Rates
2002
2003
2004
2005
6.2%
5.8%
5.6%
5.2%
NA
2.7%
2.7%
2.7%
7.2%
7.2%
6.0%
6.3%
7.0%
6.8%
6.5%
5.7%
NA
NA
NA
NA
2006
5.3%
2.7%
5.3%
5.9%
NA
*Discount rates disclosed in 10-K statements of each company.
NA: Not disclosed
Xerox reaches these assumed discount rates by calculating them based on
“Moody’s Aa Corporate Bond Index and the International Index Company’s iBoxx
45
Sterling Corporate AA Cash Bond Index, respectively in the determination of the
appropriate discount rate assumptions” (Xerox 10-K). From the above data we
can determine that excluding Ricoh who does not disclose its discount rate or its
pension plan, that the average discount rate used by the competitors within the
industry over 2006 was 4.8%. The average inflation rate in the United States for
2007 is at 2.445% (inflationdata.com). It is apparent that most firms are using a
discount rate over inflation since any return would likely grant you that much in
interest alone. The T-bond rate is also currently at 4.51%
(http://money.cnn.com/). Since many consider this to be as close to risk free
rate as one can get, a firm investing to provide for future cash expenditures
should surely be able to surpass this mark as well. The firms Xerox, IKON, and
HP are more conservatively estimating their discount rates, but each firm is
estimating them at a fairly equal rate. According CNN Money, the year-to-date
return on the S&P 500 has been 8.78% (money.cnn.com/data/markets/sandp/?).
This shows that the companies (excluding Canon) are most likely conservatively
overstating liabilities. This could cause us to conclude the following over-under
analysis.
ASSETS
N
U: Understated
=
LIABILITIES
O
O: Overstated
+
EQUITY
REVENUES
U
N
-
EXPENSES
O
=
NET
INCOME
U
N: No Effect
Though this is a correct analysis, the difference between the rate the companies
use to discount and the rate that can be gained in the market could be attributed
to the volatility of the market in which these companies invest. Xerox actually
discloses their expected return on plan assets or assets invested to account for
future cash expenditures required by the expected financial outlays involved with
their pension plans. The expected rate of return on investments over the past
three years has been 8.1%, 8.0%, and 7.8% from 2004 to 2006 respectively
(Xerox 10-K). This would adequately support our comfortable range somewhere
46
between the return on a 10 year T-bond and the return on the S&P 500 as
stated above. By taking a rate above inflation and the 10 year T-Bond, and also
taking a rate below the return on the S&P 500, the firms within the industry are
utilizing a conservative yet fair estimate at what the true present value of the
expected future cash flows from defined benefits and pension expenditures.
47
Accounting Flexibility
Accounting flexibility is the degree to which firms within the industry can
influence the perceived value of the firm by utilizing different means of disclosure
and adding to the man-made factor of financial statements and disclosures.
Some policies such as R&D are tightly constrained and closely monitored by the
Federal Accounting Standards Board (FASB) which has delegated authority from
the SEC who possesses the ultimate legal authority on accounting practices and
statement disclosures. Other policies such as capital leases and operating leases
are less closely scrutinized allowing the firms to use their discretion to practice
accounting policies that best fit their individual activities or are most appropriate
in their sector of American business. The key to the latter policy is that the firms
themselves do hold the power of selecting the accounting policies and
procedures of their firm, so a savvy group of accountants can decisively choose
accounting policies to significantly alter ones view of the company unless he or
she is conducting substantial and extensive accounting analysis such as this one.
Flexibility of R&D
Research and development is a tightly constrained activity with very little
overall flexibility. The firm is required by GAAP to expense these activities as
they are incurred. As we have previously stated, this is quit unfortunate in an
industry as technologically dependant and advanced as the document industry in
which Xerox competes. We have already made the case that R&D does directly
correlate to the revenues created by the firm and therefore is value added and
should be capitalized as an asset and amortized over its expected useful life
which would be somewhere between three and five years. Unfortunately there is
no accounting flexibility to allow such actions. The SEC allows absolutely no
48
flexibility in this practice of accounting and maintains that all resources utilized in
the course of research and development be expensed as they are incurred.
Capital and Operating Leases
There is a much greater degree of flexibility allowed to the firms when it
comes to accounting for leases. There are basically two types of leases each
holding unique characteristics that separate the two and often times cause a firm
to decisively and purposely choose one over the other. Capital leases take direct
ownership of the firm and are used to list the firm’s use of equipment or
buildings as a leased asset with a corresponding leased liability. On the other
hand, operating leases are recognition of a leased asset where the owner of the
asset leases it to the firm for a specified number of years, and expects to receive
it back at the end of that lease with value still left in the asset. The alternative
to receiving the asset back at the end of the lease term is a renewal of the lease
in which the same ultimate conditions would apply until that lease obligation was
fulfilled. These operating lease activities are considered off-balance sheet
activities and can cause the following affects on a firm’s over-under analysis
when operating leases are used where a capital lease better fits the operation.
ASSETS
U
U: Understated
=
LIABILITIES
U
O: Overstated
+
EQUITY
REVENUES
N
N
-
EXPENSES
N
=
NET
INCOME
N
N: No Effect
The industry itself utilizes both capital leases and operating leases. The industry
much like Xerox is fairly conservative in their use of leases, maintaining mostly
capital leases and less operating leases. This could be attributed to the fact that
in the document industry, most of the final consumer physical sales of the
business are done by other retail intermediaries that sell these high tech printers,
copiers, and scanners. If the firms themselves were selling their products
49
directly to the general public, we would probably see more operating leases as
they would probably record their retail outlet stores using operating leases and
treating the leases as rent. With the current marketing situation in the
document industry, the firms within this industry do utilize some operating leases
but use mostly capital leases to account for these financial transactions within
each individual firm.
Pension Plans
Pension plans, defined benefit plans, or any other type of post-retirement
benefit plans are all sources of man-made numbers that can significantly affect
the total liabilities of the firm either in an aggressive or conservative manner.
Through our analysis of pension as a key accounting principal relating to our key
success factors we were able to determine that Xerox was using a fairly
appropriate discount rate and would both adequately account for the future
financial outlays from pension expenses and maintain a fair value that would not
overestimate the value of the liability account. However, accounting flexibility
does enable firms to short these numbers in order to appear more profitable.
These numbers and discount rates are assumed rates that are derived from
expectations created within the company. These figures would be intuitively
based on the average age of employees when they retire, the average life
expectancy of employees, and the number of employees nearing retirement age
currently. If the company is looking to increase the value of the firm, it can use
a higher discount rate to make the estimated future liabilities of the firm appear
lower. In effect, there is an inverse relationship between the discount rate and
the liabilities that result from that activity. This can be explained by the
following over-under analysis.
50
ASSETS
N
U: Understated
=
LIABILITIES
U
O: Overstated
+
EQUITY
REVENUES
O
N
-
EXPENSES
=
NET
INCOME
U
O
N: No Effect
This shows the ability of the firm to affect these man-made numbers based on
man-made expectations to increase the apparent value of the firm. This is
allowed by GAAP and is a perfect example of how flexibility in accounting, while
useful in allowing firms to adequately and better describe the economic
significance of their individual decisions within the firm, can sometimes be used
by corporations to distort the picture presented by the financial statements and
materially alter ones view of the financial position of the company.
51
Evaluate Accounting Strategy
Management manipulation is the main concern with accounting strategies
within firms. Managers have incentives to alter financial statements for
shareholders and other significant readers of a company’s financial reports. One
way in which managers can effectively due so is through adjusting revenues and
expenses in creative ways. Accounting strategies in this industry consist of the
effect research and development, recognition of leases, and pension plans have
on the financial statements and the overall value of the firm. Due to limited
disclosure it is difficult to determine the true effect these strategies have on the
value of Xerox and its competitors. Transparency is a major concern of investors
when considering the value of document management firms due to the lack of
information provided to perform an effective analysis.
Research and Development
In the document management industry, research and development is a
key accounting principle due to inflexible accounting policy. In technology driven
industries, a major operation in a company’s business structure is focused on
innovation. As stated previously in the business analysis, two thirds of Xerox’s
sales come from products released in the past two years. Therefore we can
conclude the average product produced by Xerox has a useful life of roughly five
years. When determining the overall value of a firm it is important to make
adjustments due to accounting flexibility not willing to allow companies to
effectively record day to day operations.
Strict accounting policies limiting management’s ability to record research
and development can influence them to make up for this expense in other ways.
Unfortunately this can further manipulate the financial statements altering their
correct form. Although GAAP requires firms to immediately expense any
52
research and development when recognized, it is safe to assume a mistake has
been made here when valuing the company. A large amount of research and
development should be adjusted to the asset account allowing a firm to utilize
their innovation and receive credit. When adjusting research and development,
it causes expenses to be overstated, therefore causing net income to be
understated. If net income is understated and moves directly into retained
earnings, then owner’s equity is also understated. Balance sheets are in place to
ensure assets are either financed by liabilities or owner’s equity. Therefore if
owner’s equity is understated, then assets are understated too. This theory
works due to research and development needing to be recognized as an asset
rather than an expense causing assets to be understated.
In most industries GAAP appropriately requires companies to record their
research and development as an expense. Unfortunately in an industry requiring
technology innovation each year, GAAP fails to allow firms to accurately value
their company. Xerox and its competitors spend a great deal on research and
development which can dramatically affect the balance sheet after adjustments
have been made. Finally, this lack of flexibility may cause managers to
compensate for large research and development expenses in other ways.
Furthermore this will dramatically affect the financial statement disclosed causing
more trouble to investors then a simple exception to research and development
requirements by the SEC.
Leases
The recording of leases can affect a firm’s overall value by decreasing
liabilities on the books and increasing expenses. Although this does not
significantly affect net income for each year, it does impact the current ratio for
the firm. Xerox and its competitors utilize operating leases to a certain extent,
but the overall effect on the balance sheet is minute.
53
When managing a large amount of leases managers can be influenced to
record these leases as expenses rather than liabilities. This has been a problem
for firms looking to decrease their liabilities to look more valuable to investors.
Where firms run into trouble is when both the lessee and the lesser record the
asset as an operating lease. When considering each lease agreement one of
clients needs to record the asset as a liability and the other as an operating
lease.
Overall the incentive to decrease liabilities can cause managers to
manipulate the financial statements and record leases as expenses. Although
this is the case, Xerox and its competitors consistently record transactions using
capital leases to properly value their firm.
Pensions
A large portion of expenses incurred by businesses with many employees
is the employees themselves. Other than pure compensation for duties
performed, there are also expenses such as health care and retirement.
Retirement in the form of pension plans have to be estimated using different
discount and growth rates. Inevitably these estimates can possess flaws causing
liabilities to be overstated. This is yet another way in which top managers can
manipulate the financial statements to acquire a satisfying current ratio and net
income.
Pension plans are a unique attraction to company employees due to the
security they posses once reaching retirement. This is great for employees, but
costly for both firms as well as investors. Investors looking to evaluate the
liabilities and expenses established by possessing adequate pension planes need
to look at the discount rate used to find the present value of future payments.
In the document management industry companies used a similar discount rate
across the board. Although similar, Xerox’s discount rate was slightly lower than
54
HP and IKON causing investors to wonder why. A lower discount rate in turn
causes the present value of expected cash payments to be higher, therefore
increasing liabilities and expenses. HP and IKON may be estimating this way due
to better knowledge of upcoming events in the economy, or because top
management has incentives to produce a balance sheet with lower liabilities and
higher retained earnings.
When considering the effect managers may have on financial statements
it is important to identify key areas of opportunity for them to manipulate the
numbers. When given the opportunity to make a bad decision people tend to do
so especially when influenced by owners of the company. A company’s main
priority is to provide a return on shareholders’ wealth; therefore owners may not
intend to influence their managers but then inadvertently do.
Conclusion
Accounting strategies can be a valuable asset to a firm in some cases, but
often managers use these strategies to manipulate the overall value. Top
managers in today’s corporate America are under tremendous pressure to
produce a significant return on investment for their shareholders. When overall
operations fall short of expectations some managers feel the need to take
matters into their own hands. When this occurs investors receive a biased
perception of the firm causing them to revaluate their overall interest in the
company. Investors look at misleading activities as a sign of weakness in the
company.
55
Qualitative Disclosure
Qualitative disclosure is the measure of the usefulness of the information
provided by the financial statement, the notes, and the management’s
assessment of the company in the 10-K report filed with the SEC. This
information should be value added and lend to the overall usefulness of the
information provided by the firm. Companies within the same industry
competing among existing firms often times refrain from full disclosure due to
proprietary risks that could give away the competitive strengths of the individual
firm. The better the qualitative disclosure, the more reliability and confidence an
investor can place in his or her conclusions based from analyzing the information
gained form that analysis. When the quality of disclosure is insignificant or
inadequate, investors are likely to be more pessimistic and skeptical about the
value of the firm based on that same analysis.
Research & Development
Research and development is well disclosed by all firms within the
document industry. The reason that R&D would be so well disclosed is that
R&D, as discussed in the key success factors and key accounting principles, is
the fact that R&D directly affects the sales of businesses who bases their
potential profitability on product innovation and quality. Since GAAP does not
allow a company to capitalize R&D as an asset, companies are quick to make
sure that they disclose this information at the highest level to show investors
that they are supporting research and investment activities that would promote
the future profitability of the firm and further the company’s product line with
innovative design and quality. The level of disclosure that Xerox and its
competitors within the industry display is quite well documented and aids in the
overall development of a valuation of the firm.
56
Capital and Operating Leases
The level of disclosure for operating and capital leases does not
significantly explain the use of these leases and their affects on the firm. There
is not a discount rate disclosed by Xerox that would allow us to find the present
value of the future expected liabilities form both capital and operating leases.
Also, the operating leases are not disclosed to an extent to where we can
assume a term over which the company expects these incur these expenses. We
are forced to estimate and guess the amount spent in each period over the
future years. If Xerox would disclose this information to us, we might find that
operating leases are only good through the next 10 years in which we might
conclude that operating leases are renewed more often and held at a higher
owed balance, so it would in fact increase the present value of these future
liabilities and adversely affect the impact operating leases would have on the
company if we capitalized them in a capital lease. With the limited disclosure
provided by Xerox and its competitors concerning this aspect of the analysis, we
have more trouble valuing the firm and are forced to make assumptions that
reduce the relevancy of our conclusions.
Pension
The qualitative disclosure on pension for Xerox is somewhat limited, but
overall compared across the industry, it is quite sufficient to compare to its other
competitors. Ricoh was the only competitor in the industry to have not reported
or disclosed a discount rate used to find the present value of future expected
expenditures for the last five years except for Cannon, who did not disclose this
information in 2002 but has ever since then at a constant rate. What would be
helpful in determining the value of pension expense would be for the companies
to disclose the projected growth rate of future expenditures tied to pensions or
57
other post-retirement benefit plans. This would allow us to project these
expected expenditures over the future periods and determine if the company has
been adequately preparing for future increases in these costs and how they
might affect the profitability of future periods. The information provided by the
disclosure of Xerox is fairly equivalent to that of the industry which could be
higher, but is at a significant level nonetheless.
Other Qualitative Analysis of Quantitative Disclosure
(Financial Statements)
There are numerous other levels of disclosure that adversely affect our
capability to adequately analyze and value the firm as well as inhibit the
relevance of the conclusions we reach. Simplified financial statements along with
a lack of categorized expenses create a gap in disclosure when conveying the
actual business operations to investors. Although we may not fully understand
the technique used to inform investors, the document management industry
chooses to limit disclosure of their numerical date for a specific reason. This
technique causes analysts a great deal of trouble when valuing a firm due to
problems understanding where and when revenue and expenses are received
and incurred.
A major difference in the document management industry is the type of
disclosure in warranty liabilities. This fluctuation of disclosure between
competing companies may be due to retaining proprietary information or could
be used to just hide expenses. Canon does not list warranty costs on the
financial statements, but lists an explanation of warranty liabilities and how much
they amount to each year in the notes. This helps investors do an analysis of
the past couple of years and determine whether the amount of liability is high
enough compared to past estimates. HP mentions their warranty liabilities and
expenses as a percentage of net revenue. Although this is a different way to
58
estimate warranty expenses, it still allows investors to understand an increase or
decrease in the recorded amount.
Xerox and Ricoh on the other hand fail to disclose actual warranty
liabilities. Instead they are combined into the overall sales price of the product
and not specified as an individual numerical amount; Xerox actually includes their
warranty liabilities into their bundled leases which hides the actual effect from a
financial allocation basis. This raises concern when attempting to value the firm
and determine whether estimates are accurate with available information. This
concept of simplifying expenses is performed throughout these company’s
income statements creating limited knowledge of detailed expenses. In this
portion of the disclosure offered by the firms within the industry, we see a bare
minimum of disclosure. They disclose and report what is required and little more
which hurts an analyst’s ability to adequately value the firm while also decreasing
the relevance of the conclusions reached by the analyst.
Conclusion
In broad terms limited disclosure is a battle fought by analysts due to the
challenges it causes in accurately valuing a firm. Without receiving all the
information needed to understand a company’s operation, investors struggle to
determine the value a firm has. When companies provide more information in
their filings they make it easier on investors causing the overall value of the
company to increase if activities are recorded accurately. In Xerox, we see a mix
between quality disclosure, adequate disclosure, and sub-par disclosure. Overall
the level of disclosure hurts an analyst’s ability to analyze a firm’s comprehensive
value from independent operations held within the firm, but not closely
disclosed.
59
Quantitative Accounting Measures and Disclosure
Quantitative disclosure, much like qualitative disclosure, is intended to
determine the effectiveness of the actual financial statements’ numbers, the way
these numbers interact, and how they might aid or deter the valuation of the
firm that is being analyzed. The use of flexibility allowed by GAAP permits an
individual company to, at some extent, determine the way in which information
is disclosed to shareholders and prospective investors and to what extent this
same information is disclosed. The temptation for firms to use such techniques
to alter the apparent value of the firm, can cause analysts to see a skewed and
distorted picture of what the firm’s business activities may actually look like. On
the other hand, sometimes these same diagnostics can allow analysts to almost
look inside the company and better determine the value of the firm.
We look at two separate quantitative measures and indicators to help
determine if the firm is adequately and appropriately accounting for its business
activities with accuracy and dependability. First, we will look at the sales
manipulation diagnostics. These diagnostics, much like the name infers, are
diagnostics based on different factors affects on net sales. In this portion of the
analysis we will be dividing net sales by numerous other line items and derived
figures to determine each item’s overall affect on the ratios provided and in all
actuality determine whether or companies are trying to appear more productive.
We will divide net sales by cash form sales, net accounts receivable, unearned
revenue, warranty liabilities, and inventory. Next we will take a look at the core
expense manipulation Diagnostics. These ratios are much less uniform but
provide information to determine whether or not a company has unexplained
increases or decreases in reported expenses that would in effect show
questionable accounting policies that would need to be looked at to determine
the overall affect these activities might have on the apparent value of the
business. We want to utilize these two measures and diagnostics to make check
60
the integrity of the figures released by the company and check out any red flags
that they present.
61
Sales Manipulation Diagnostics
When we conduct our sales manipulation diagnostics we use the five most
recent years’ information to determine the trends set forth by the company’s
disclosures in each of the diagnostic ratios that we evaluate. By looking at not
only Xerox but its competitors within the industry as well, we can better check to
determine if the irregularities that we see in these diagnostics are industry wide
and acceptable or in fact a potential red flag and risk for the accurate valuation
of the firm.
Net sales/Cash from Sales
Net sales over cash from sales is used to determine if the cash we are
receiving from sales is equal to the amount of sales we had less the expenses
incurred in the selling such as sales returns and allowances and allowance for
bad debts. This ratio intuitively should be close to one (1:1) showing that the
62
amount of cash that we receive over the course of the year is somewhat close to
if not equal to the amount of net sales we had, or the amount of sales that we
actually expected to collect on. As the graph shows, every firm has roughly the
same ratio following the same pattern the past five years. However, IKON’s
information portrays a situation where they would by receiving more cash from
sales than actual sales. This is a ratio that must be taken with a grain of salt.
The reason that IKON’s ratio is so off is that they disclose their net sales only as
a percentage of the previous year’s sales. This complicates the financials and
makes it hard to determine the actual net sales that are received from the
business activities. Its only saving grace and the important thing to focus on is
that the slope and change in the ratio is somewhat equivalent to the change in
the other ratios. If we dissect the graph and look at each line individually they
do mostly mirror each other which would prove that even though the figures are
skewed for IKON, the industry as a whole moved together presenting adequate
support that the market would determine the ability of the firms within the
industry to collect cash from their customers. Overall we can see that with the
net sales over cash from sales ratio being so close to 1:1, that Xerox’s cash from
sales is accurately supported by their actual sales and therefore shows no signs
of accounting or financial distortions. Simply stated, the cash collections cycle
accurately supports the sales cycle legitimating and reinforcing the quality of
their accounting practices.
63
Net Sales/Accounts Receivables
Net sales over accounts receivable shows the ratio of receivables that
support net sales. As we can see by the graph above, the amount of receivables
that support net sales do vary over the industry but once again have moved in
synchronization with each other. What this shows is that the market itself is
determining how much accounts receivables are backing net sales. By taking a
closer look at Canon and Ricoh compared to the rest of the industry, we see that
these two ratios move in opposite synchronization of the rest of the industry.
This might present the idea that Canon and Ricoh are substitute products within
the industry and when they are desired the products of the other firms are not;
however, as we look at the ratios, we can clearly see that the ultimate effect on
these ratios over the past five years has been mostly insignificant and should not
change our valuation of the firm in general, thus allowing us to conclude that
64
Xerox has not significantly tried to alter the perceived value of the firm through
altering net sales or net accounts receivable.
65
Net Sales/Unearned Revenue
We find that Canon and IKON do not report unearned revenues and
therefore do not have a ratio. Xerox itself discloses unearned revenues for the
four years prior to 2006, but then decides to no longer disclose this information.
This presents a specific red flag since anytime a firm changes their disclosure
level or even more so what they disclose, we should take a look at what the
overall affect is on the value of the firm. Ricoh and HP seem to be continuing to
disclose these at a constant and reliable rate which makes them the only two
within the industry to do so. All the unearned revenue disclosure came in the
form of notes and other disclosure outside of the big three financials which are
the balance sheet, income statement, and the statement of cash flows.
Unearned revenue is ultimately a liability, since we have received something
(cash) and not yet paid out for it (service). An under-over-analysis diagram
66
helps us to see the effects of not recording unearned revenues when they do
exist.
ASSETS
=
LIABILITIES
N
U: Understated
+
U
O: Overstated
EQUITY
REVENUES
O
O
N: No Effect
67
-
EXPENSES
N
=
NET
INCOME
O
Net Sales/Inventory
When utilizing the ratio of net sales to inventory, the idea to keep in mind
is that an increase in inventory or a decrease in net sales can cause the ratio to
decrease. Oppositely, an increase in net sales and a decrease in inventory cause
the ratio to increase. As we can see, the industry trend in net sales to inventory
has been for that ratio to increase. Though the companies hold different
amounts of inventory than each other and also have different values of net sales,
the important thing to notice is that the trends are all once again moving in a
synchronized fashion. Referring back to the Rivalry Among Existing Firms, we
see the industry growth-rate rising at a rate of around 3%. This growth was
determined through comparable sales within the industry, which leads us to
conclude that the increase in the ratio of net sales to inventory over the past five
years is due primarily to the overall industry growth-rate.
68
Conclusion
The overall quantitative quality of disclosure as assessed by these sales
manipulation diagnostics shows that Xerox has not tried to significantly alter the
perceived value of the firm. The Net Sales/Cash from Sales was justifiably
correct each supporting the other. The Net Sales/Accounts Receivable shows
that the overall trend in the ratios are fairly steady allowing analyst to conclude
that Xerox has not attempted to boost its appeal by manipulating either the net
sales or the accounts receivable. In 2006 Xerox decided to quit disclosing
unearned revenues which illegitimates the usefulness of Net Sales/Unearned
Revenue. If Xerox is not recording unearned revenues when they do exist, then
the net income would be overstated manipulating analysts’ and investors’
valuation of the firm. The Net Sales/Inventory shows that the levels of inventory
kept have held true to form over the past five years leading us to believe that
Xerox is not manipulating the asset inventory to boost the perceived value of the
firm. Overall we can say that despite discontinuing the recording of unearned
revenue, Xerox has not made any attempts through accounting distortions and
manipulation to try and alter the perceived value of the firm.
69
XEROX
Sales Manipulation Diagnostics
2002
2003
2004
2005
2006
Net Sales/Cash from Sales
1.01
1.01
0.99
0.99
1.01
Net Sales/Net Account Rec
7.65
7.27
7.57
7.71
7.23
Net Sales/Inventory
12.87
13.63
13.76
13.07
13.67
Net Sales/Unearned Revenues
61.66
62.55
64.69
82.20
N/A
Net Sales/Warranty Liabilities
N/A
N/A
N/A
N/A
N/A
Net Sales/Cash from Sales
1.07
1.01
1.02
0.99
1.01
Net Sales/Net Account Rec
6.69
8.19
7.81
8.75
8.43
Net Sales/Inventory
9.76
12.05
11.30
12.61
11.83
Net Sales/Unearned Revenues
17.36
29.27
27.01
22.73
21.27
Net Sales/Warranty Liabilities
N/A
36.7695
N/A
39.9153
40.7731
Net Sales/Cash from Sales
1.02
1.01
1.02
1.02
1.02
Net Sales/Net Account Rec
6.23
6.27
6.06
5.67
5.63
Net Sales/Inventory
6.80
7.19
7.09
7.36
7.71
Net Sales/Unearned Revenues
N/A
N/A
N/A
N/A
N/A
Net Sales/Warranty Liabilities
N/A
N/A
N/A
N/A
N/A
Net Sales/Cash from Sales
1.03
0.99
1.00
1.02
1.00
Net Sales/Net Account Rec
4.68
5.08
5.15
4.79
5.09
Net Sales/Inventory
14.36
17.02
17.78
16.61
18.38
Net Sales/Unearned Revenues
10.36
12.11
13.46
16.21
16.21
Net Sales/Warranty Liabilities
N/A
N/A
N/A
N/A
N/A
Net Sales/Cash from Sales
0.43
0.43
0.44
0.44
0.42
Net Sales/Net Account Rec
3.77
3.55
2.66
2.89
3.13
Net Sales/Inventory
6.73
8.86
8.53
8.13
8.54
Net Sales/Unearned Revenues
N/A
N/A
N/A
N/A
N/A
Net Sales/Warranty Liabilities
N/A
N/A
N/A
N/A
N/A
HP
CANON
RICOH
IKON
70
Expense Manipulation Diagnostics
Much like our sales manipulation diagnostics, we can use expense
manipulation diagnostics for the five most recent years to determine the trends
set forth by the company’s disclosures in each of the diagnostic ratios that we
evaluate. By looking at not only Xerox but its competitors within the industry as
well, we can better check to determine if the irregularities that we see in these
diagnostics are industry wide and acceptable or in fact a potential red flag and
risk for the accurate valuation of the firm.
Asset Turnover
The asset turnover ratio is broken down and derived by dividing sales by
assets. Xerox has maintained a good even average with a small steady growth
rate over the past five years. What this ratio really brings into question is
whether or not Xerox is appropriately writing off or depreciating its assets. If
71
Xerox fails to write off items like goodwill or fails to depreciate long term plant
and equipment assets, we will see this ratio rise abruptly. The ideal curve or
trend line that an analyst would want to see is a fairly stable flatter line. Xerox is
growing its Asset Turnover Ratio at an extremely low and stable rate showing
that the firm is practicing the appropriate accounting principles. Xerox is actually
the only firm in the industry with an extremely stable and standard asset
turnover trend even though it is slightly smaller than the rest of the industry.
The relatively low Asset Turnover for Xerox simply shows that Xerox has
traditionally produced sales at about 70-75% of its assets. The consistency of
this ratio over the past five years shows that Xerox has held steady and stable
accounting policies in place to appropriately disclose the performance of its firm.
72
Changes in Cash Flows from Operations/Operating Income
The CFFO/OI ratio should be as close to one as possible to show that cash
flows from operations match well with operating income. Xerox matches up
fairly well with this theory. From 2004 to 2006 Xerox varies closely around the
value of a 1:1 ratio. However, as we look backward from 2003 and 2002 we see
that there is a huge increase in the ratio. The difference in the cash flows from
operations and the operating income is based in the practice of accrual
accounting. This ratio asks, is the income Xerox reports supported by its cash
flows. In 2002 operating income was extremely low representing that cash flows
were collected from sales accrued in 2001 not from operating income in 2002.
Since 2002, we can see that Xerox has steadied its disclosure to show that they
now collect cash from operations at a steady ratio around 2:1. This move
towards a lower more realistic and steady number shows that the recording of
accruals is no longer a red flag for Xerox and that the industry average would
support this level of activity.
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Changes in CFFO/Net Operating Assets
Net operating assets are fixed assets such as property, plant, and
equipment (PP&E). The ratio of cash flows from operations to net operating
assets shows how much income is derived from the net operating assets such as
PP&E. The higher the ratio, the higher the return on PP&E or net operating
assets. Xerox actually best manages this aspect of the market. Xerox maintains
a low deviation from a 1:1 ratio, but more importantly, it maintains a basically
unaffected overall change from 2002 to 2006. This shows that Xerox has kept
the same accounting mechanisms for recording these activities and reliably
conveys this information to the investor. Other firms in the industry also do
reasonable well with the exception of IKON who seems to have a high variation
and deviation from year to year, showing an inconsistency with the existing
accounting policies to previous ones. Overall, the net operating assets do
appropriately support Xerox’s cash flows from operations. Furthermore, the
consistency of the near 1:1 ratio over the last five years shows that Xerox has
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good accounting policies in place and is not trying to mislead analysts and
investors by manipulating the recording of the day to day accounting.
75
Pension Expense/ SG&A
The pension expense to the selling, general, and administrative expenses
ratio determines the amount percent of pension expense of the operating
expenses. When the ratio is low, there is less capital spent on pension expenses.
In other words companies want this ratio low because it shows how much the
firm is paying its retired workers. If this ratio is high, it would show investors
that the company inadequately managed the retirement plans set forth by the
firm and pays too great of a pension to its retired employees thus effecting net
income. In 2006 we can see that about 30% of the total SG&A expenses were
comprised of pension expenses. In the document industry, the firms seem to be
adequately managing their use of pensions since there is not a single ratio above
a .5. Once again the consistency of Xerox’s pension expense/SG&A expense
ratio shows that Xerox has not in the last five years significantly altered its
recording of pension expenses. If we were seeing a large drop in pension
expense as a percentage of SG&A expenses over the last five years, we might
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find that it is a red flag and that Xerox is understating its pension expense to
overstate its net income; however, since this is not the case, Xerox passes this
test of quantitative accounting measure and disclosure as well.
Conclusion
The expense manipulation diagnostics ratios showed once again that
Xerox does not intentionally or purposefully manipulate its accounting principles
to entice investors to purchase shares or make analysts overvalue the firm. The
asset turnover ratio’s consistency showed that Xerox’s sales have been
appropriately supported by the company’s assets which means that Xerox has
been appropriately writing off and depreciating its assets. We are concerned
about the asset turnover being so much lower than the industry average, but
overall we feel that the steadiness associated with the ratio lessens our
suspicion. The cash flows from operations/operating income ratio shows that
since 2003 Xerox has maintained a steady ratio around the 1:1 mark which is
ideal. Similarly we see that the net operating assets sufficiently support the
operating cash flows as well through the cash flows from operations/net
operating assets ratio. Finally, we have found that the pension expense/SG&A
expense ratio shows that around 30% of the total SG&A expenses are comprised
of pension expenses. The consistency of this ratio at about .25 to .30 over the
past five years shows that there have been no significant changes in accounting
policy that would deteriorate the quality of the accounting practices in place.
Overall we feel that the Xerox does not distort or manipulate accounting policy to
try and appear more profitable or efficient to analysts and investors. There was
very little evidence if any to show that Xerox had significantly redesigned the
way they record their accounting transactions over the past five years. The
consistency Xerox has had legitimates its accounting policy and its financial
statements allowing skeptical analysts such as ourselves to put more faith in the
numbers that Xerox provides to the public.
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XEROX
Expense Manipulation Diagnostics
2002
2003
2004
2005
2006
Asset Turnover
0.62
0.64
0.63
0.72
0.73
CFFO/OI
19.04
4.31
1.81
1.71
2.00
CFFO/NOA
1.13
1.03
0.99
0.87
1.06
Total Accruals/Change in Sales
1.62
9.75
-37.38
28.10
-4.17
Pension Expense/SG&A
0.29
0.25
0.28
0.28
0.33
NA
NA
NA
NA
NA
Asset Turnover
0.80
0.98
1.05
1.12
1.12
CFFO/OI
-5.45
2.09
1.22
2.38
1.73
CFFO/NOA
0.79
0.93
0.77
1.24
1.65
Total Accruals/Change in Sales
-0.58
-0.19
-0.14
-0.69
-0.97
Pension Expense/SG&A
0.23
0.17
0.21
0.21
0.28
NA
NA
NA
NA
NA
Asset Turnover
0.99
1.01
0.97
0.93
0.92
CFFO/OI
1.30
1.02
1.03
1.04
0.98
CFFO/NOA
0.54
0.55
0.58
0.53
0.55
Total Accruals/Change in Sales
-3.15
-0.04
-0.07
-0.08
-0.03
Pension Expense/SG&A
0.15
0.27
0.15
0.08
0.08
NA
NA
NA
NA
NA
Other Employment
Expenses/SG&A
HP
Other Employment
Expenses/SG&A
CANON
Other Employment
Expenses/SG&A
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RICOH
Asset Turnover
0.91
0.92
0.96
0.93
0.94
CFFO/OI
0.81
1.39
1.03
1.00
1.19
CFFO/NOA
0.04
0.75
0.65
0.55
0.66
Total Accruals/Change in Sales
0.00
-0.79
-0.12
0.01
-0.30
Pension Expense/SG&A
0.21
0.34
0.13
0.15
0.15
NA
NA
NA
NA
NA
Asset Turnover
0.76
0.71
1.01
1.14
1.31
CFFO/OI
1.62
1.73
-1.84
-0.02
0.48
CFFO/NOA
2.35
2.47
-2.27
-0.02
0.68
Total Accruals/Change in Sales
-0.08
0.69
126.25
-0.55
-0.70
0.2742
0.37
0.40
0.33
0.47
NA
NA
NA
NA
NA
Other Employment
Expenses/SG&A
IKON
Pension Expense/SG&A
Other Employment
Expenses/SG&A
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Potential Red Flags
Potential red flags are determined by taking the inexplicable changes we
found in the qualitative and quantitative disclosure mechanisms. When there is
apparent unexplained phenomenon that could materially affect the investor’s
view of the company, it is necessary to review this red flag and try to chase
down an answer to solve this problem. An industry or single company with a
high level of disclosure usually has fewer red flags since one can better
coherently link each change to an accounting policy and determine if that policy
is correct and accurately depicts the value of the firm. Overall, we have
concluded that the level of disclosure is sufficient to estimate the value of the
firm, but is not extensive by any stretch. Therefore, it is not surprising that a
few red flags did seem to pop up and stick out as the information disclosed was
analyzed.
Any time there is a change in accounting policy or level of disclosure, we
should check to see if that changes our perception of the firm. If it does, or if it
might, then we have found a red flag that needs to be further interpreted. In
Xerox’s case, we have found that Xerox disclosed unearned revenues from 2002
to 2005, but they stopped reporting this information in their footnotes in 2006.
There are two explanations for why Xerox has discontinued the disclosure of this
accounting mechanism and no longer makes this knowledge available to the
public. The first reason that Xerox would rather you believe, is that unearned
revenues does not materially affect the value of the firm. Xerox might have you
believe that their unearned revenues in the past few years had gotten so low
(hence the increasing trend line in our ratio analysis) that it was no longer
beneficial to disclose this information, because it is an insignificant portion of the
overall net sales. The second and more conspiring theory would be that
unearned revenues boosted and were adversely affecting the value of the firm
by showing an increased liability still outstanding. Though the trend set by the
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ratio analysis would lead you to believe the former rather than the latter,
analysts must ensure that they be skeptical of any information given to them and
evaluate all the possible sources that could cause a company to arrive at those
numbers.
Another red flag that could be interpreted a number of ways is the fact
that Xerox’s asset turnover ratio is lower than the other competitors within the
industry. When we looked at the graphical representation of this, the effect on
the slope of Xerox’s ratios were always steadily increasing at a slow but steady
rate. In fact while some of the other industry leaders such as Canon and Ricoh
began to see their ratios decrease is when we actually saw the largest increase
for Xerox. The fact that Xerox’s ratio is so low worries us we see this as it might
be taking too long for assets to be benefiting sales, but since the ratio seems
steady and is increasing we will not worry too much about this particular red
flag.
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Undoing Accounting Distortions or Irregularities
There is no need to go back in and try to fix any of the accounting policies
or numbers that have been reported in the financial statements. The reason for
this is that Xerox does a good job at accurately disclosing the numbers that they
have in the financial statements and in the footnotes as well. We have seen that
there are only a couple of red flags that present themselves, of which neither
need to be or can be fixed without inside information concerning the day-to-day
workings of the firm. Without inside and confidential information that is not
disclosed for Xerox, we can’t really determine the effect of not disclosing
unearned revenue in 2006. In essence, from the inferences we can make from
the net sales to unearned revenue ratio, which shows that unearned revenues
were decreasing to increase the ratio, we can assume that recording unearned
revenues would affect the value of the firm very little and therefore does not
need to be estimated based on previous years’ information. The other red flag,
the asset turnover ratio, is what it is. We cannot better the numbers to change
that information and in fact can embrace those figures and that ratio since it is
obvious that Xerox did not try and change the numbers to beneficially and
positively affect the value of the firm. Also as discussed in accounting flexibility,
we need not reallocate the costs of operating leases since they are not a
significant portion of the overall liabilities as posted on the balance sheet. If the
ratio would have been higher, we would have had to estimate at an industry
average, the period in which those payments are expected to be made and what
discount rate would be most fitting in the industry; however, since they were
not, no manipulation of the disclosed amounts was needed to better value that
portion of the Xerox’s business strategy.
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Financial Analysis, Forecasting Financials, and
Cost of Capital Estimation
In this section we will use ratio analysis, forecasting financials, and cost of
capital estimation to add valuable insight into the financial positioning of Xerox.
We will use financial ratios to determine the firm’s liquidity, profitability, and
capital structure as well as determine the credit risk that these ratios give Xerox.
We will then forecast financial statements based on the ratio analysis we perform
to determine where we visualize Xerox going and how we see it growing. Finally
we will determine the cost of capital estimation for Xerox and thus create a
model for how much it costs Xerox to raise capital for use in its business
operations.
Financial Analysis
Financial ratio analysis is used in to analyze the firm in direct comparison
to its industry competition. The analysis is based on at least 16 different ratios
that are designed to represent three specific areas of business activities. These
three activities are categorized into ratios to determine liquidity, profitability, and
capital structure. By utilizing ratios, we can ultimately common-size the industry.
This allows us the ability to look past the sizes of the numbers such as sales and
expenses and look into how the numbers relate to each other across the
industry. In essence the usefulness of financial ratio analysis stems from the
idea that 1/2 = 5/10, or no matter how large the numbers, it is the proportions or
how the numbers relate that matters. By utilizing this technique we can more
easily decipher which companies are industry leaders, which companies are
lagging behind, and how Xerox matches up to the competition.
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Liquidity Ratio Analysis
Liquidity ratios are “a class of financial metrics that is used to determine a
company's ability to pay off its short-terms debts obligations”
(www.investopedia.com). These are often used to determine the amount of
credit risk that a company possesses and can be used by lenders to enforce debt
covenants that require firms to maintain a certain level of leverage and liquidity.
The most useful and common ratios included in the liquidity ratio analysis include
the Current Ratio, Quick Asset Ratio, Accounts Receivable Turnover, Days in
Accounts Receivable, Inventory Turnover, Days in Inventory, Working Capital
Turnover, and the Cash-to-Cash Cycle. While all of these ratios are categorized
as liquidity ratios, we can subcategorize Accounts Receivables Turnover and Days
in A/R, Inventory Turnover and Days in Inventory, and the Cash-to-Cash Cycle
are operating efficiency measures within the liquidity analysis.
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Current Ratio
The current ratio portrays how well current assets cover the firm’s current
liabilities. This shows the ability of a firm to pay back its current debt by
liquidating its most current assets. In this case the higher the ratio, the greater
the ability of the firm to make this happen. This shows investors, creditors, and
lenders the ability of the firm to make payments on short term debt should there
be some unexpected financial loss of cash. In the document industry, we can
see that since 2004 Xerox has held a firm advantage over the majority of the
industry beating the industry average each of the past three years.
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Quick Asset Ratio
The quick asset ratio, or acid test as it is often referred to, determines the
firm’s ability to pay off debt using the most liquid of all assets: cash and cash
equivalents, securities, and accounts receivable. These are items that can be
most quickly converted to cash often times, if necessary, within a matter of 24 to
36 hours. Anything less than 1 is undesirable, equal to one is adequate, but
greater than one is desired and shows particular strength in terms of financial
liquidity. Xerox has done significantly better than the average since 2003. Since
2003 the Industry average has been 1.16 while the average for Xerox over the
same period has been 1.33. In order for a change to be significant, it must be +
or - .1 from the previous value. In this case, we see that over the past four
years Xerox has averaged .17 above the industry average. This shows that
Xerox has outperformed the industry in terms of adequately providing quick
liquidity to support its current liabilities.
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Working Capital Turnover
Working capital turnover simply measures the sales generated from
working capital. Working capital itself is current assets minus current liabilities.
If working capital turnover is high, then the firm is efficiently producing sales
from its investments in working capital. Once again bigger is better when it
comes to the working capital turnover ratio. The industry-wide working capital
turnover has seen a similar trend apart from HP which we can determine is an
industry outlier in this case. We can see that overall the working capital turnover
ratio has decreased over the last five years. One way for the working capital
turnover to decrease is for working capital to increase. This can come from
either an increase in current assets or a decrease in current liabilities. Xerox has
actually decreased both its current assets and its current liabilities; however, its
liabilities have decreased at a greater rate than its assets. For Xerox over the
past five years we see the following relationship (in the graph below) between
current assets and current liabilities as a percentage of total assets and total
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liabilities & owner’s equity, which are intuitively equal. As we can see the
comparative difference in terms of current liabilities directly mirrors the trend line
for Xerox’s working capital turnover. We can see that in 2003, the working
capital would decrease as current liabilities increased by 5% comparative to the
current assets. This would cause the working capital turnover (sales/WC) to
increase thus the spike in the trend line above. The opposite can be seen for
2004. In 2004 Xerox’s current liabilities decreased comparative to current assets
by 24%. This would decrease the working capital by that same percentage and
thus cause a drastic drop in the working capital turnover ratio. Overall we can
explain the changes in the trend line for working capital turnover, and we can
attribute most of this action to market cyclicality since most every firm within the
industry has experienced similar results.
2002
Change in Current Assets
Change in Current Liabilities
Comparative Difference in
Terms of Current Liabilities
2003
2004
2005
2006
-7%
-2%
5%
-9%
0%
-17%
3%
-19%
-20%
10%
-10%
5%
-24%
-11%
**Percentages Derived from common-sized balance sheet
computed from Xerox 2001-2006 10-K's**
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10%
Account Receivable Turnover
Accounts receivable turnover is used to measure the number of times that
accounts receivable actually turns over in the course of one year by dividing
sales over accounts receivable. In this case, you would want the highest number
possible. This infers that the company is being more efficient with its accounts
receivable. Xerox is obviously underperforming in this area of the liquidity
analysis. Xerox’s average accounts receivable turnover for the past five years is
2.96 while the industry average is 2.24 higher at 5.20. This intuitively states that
it is taking Xerox longer to collect from its debtors than other companies in the
industry thus making them less efficient and effective in creating value from its
receivable offerings. The time value of money principal would also lead an
investor to believe that the length at which it is taking Xerox to collect on its
receivables is effectively and comparatively costing the firm money when
measured against the industry.
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Days in Accounts Receivable
Days in accounts receivable is exactly what it says; it is the days that it
takes for each firm to collect on its accounts receivables. These trend lines
inversely match those in the accounts receivable turnover ratios since they are
taken by dividing the number of days in a year by the actual receivables turnover
ratio (365/Accts Rec T/O). This is quite possibly the most intuitively simple ratio
of them all ranked right there with the days in inventory which we will discuss
shortly hereafter. We can see that it is taking Xerox a considerably larger
number of days to collect on its accounts receivable. The industry average for
the number of days that it takes to collect on accounts receivables is roughly 75
days while it is taking Xerox almost 124 days to collect on the same accounts.
This re-explains the same information above as number of days instead of
number of turns; the only difference is that it gives information consumers who
are not market savvy and don’t understand ratios a more logical explanation of
the information listed above, but no matter how you disclose this liquidity theory
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still tells investors that Xerox is less efficient in collecting money from sales which
are on extended credit.
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Inventory Turnover
Inventory turnover, similar to accounts receivable turnover, explains the
number of times inventory turns over in one year. This is accomplished by
dividing cost of goods sold over inventory. Simply put, this tells you how many
times the company has to re-order or re-stock their inventory. The more times
the company is forced to re-stock, the more sales it will produce which is a good
thing. Also a larger inventory turnover means that you hold the less in
inventory. This shows the liquidity in this ratio. By holding fewer inventories,
you can hold more cash which makes you more liquid. We can see that Xerox
finds itself right in the middle of the industry. It is above Canon and Ikon and
below HP and Ricoh. Also it beats the industry average which is determined
independently of Xerox’s ratios. This in theory could be better than leading the
industry in inventory turnover. If inventory is turning over at too high of a rate,
the company can have trouble keeping up with its orders and can grow outside it
current economies of scale essentially straining its supply chain until it breaks
and leaves the firm without a product to sale. If the wheel spins too fast, it will
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eventually fall off. Using this ideology, we can assume that Xerox’s ability to
position itself conservatively within this aspect of operating efficiency and
liquidity shows that it will not suffer from strain on its supply chain and the
adverse effects that can cause for a company. This would actually add perceived
value showing that Xerox is well developed and holds a steady control and
command of its inventory turnover.
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Days in Inventory
Days in inventory is much like the days in accounts receivable except it
shows the number of days it takes for money to go into inventory and come out
as a sold product.. It is simply the number of days in a year divided by the
inventory turnover ratio which is the cost of goods sold divided by the inventory.
Once again it should surprise us to see Xerox hovered in the middle of the pack
again. On average over the past five years Xerox is effectively beating the
industry average by 12.5 days. Just like the days in accounts receivable, this
number allows an amateur investor who doesn’t deal with ratios very often to
see that it is simply taking the industry on average longer to make sales on its
inventory. This is a positive sign of productivity and makes Xerox attractive to
future investors.
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Cash-To-Cash Cycle
The cash-to-cash cycle shows investors how long it takes Xerox to pump
cash out the business. It is how long it takes for the companies inputs into
inventory and labor to come out as cash after collecting on receivables. The
cash-to-cash cycle is the number of days in accounts receivable plus the number
of days in inventory ultimately accounting for the total number of days that it
takes to complete one cash cycle. Xerox is definitely taking a longer time to
receive cash from its investments into its operations, but it is becoming more
efficient along with everyone else in the industry. The usefulness of the cash-tocash cycle is especially evident when we look at a company like Xerox. Xerox
had one of the worst or longest days accounts receivable while it had a better
days in inventory figure. What the cash-to-cash cycle does is make sure that our
judgment is not clouded by the single positive. If we looked at days in accounts
receivable and the days in turnover separately we might find that we are
tempted to forget the unfavorable days in receivables and put more weight into
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the more favorable days in inventory. The cash-to-cash cycle graphic and
figures show us the effect of both days’ ratios on overall operating efficiency.
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Conclusion
From the graphic below, we can see how Xerox faired compared to the
overall market or industry. We see that Xerox basically matched the industry
average in the current ratio showing its uniformity in its ability to pay back its
current debt by liquidating its most current assets. It out-performed the industry
in terms of the quick asset ratio by possessing the power to liquidate an
adequate level of its most liquid current assets in anywhere between 24-36
hours. It averaged well with the working capital turnover which was decided to
be a selling point of the firm since this shows that Xerox has a substantial
command and control on it growth. The accounts receivable turnover ratio along
with the days in accounts receivable both under-performed in the industry. It
takes Xerox substantially longer to collect on its credit sales than it does others
within the industry. Inversely, inventory turnover outperformed the industry
average. Xerox effectively turns inventory inputs into sales outputs in terms of
cost of goods sold. Combining the effects of the days in receivables and the
days in inventory we calculated the cash-to-cash cycle and found that the
adverse effect of the unfavorable days in accounts receivable out-weighed the
favorable days in inventory thus producing an under-performing result for Xerox
in term of the cash-to-cash cycle. Overall by averaging the performance of the
liquidity ratios, we can determine that Xerox is maintaining an average level of
liquidity.
Ratio
Performance
Current Ratio
Quick Asset Ratio
Working Capital T/O
Accounts Receivable T/O
Inventory T/O
Cash-to-Cash Cycle
Overall
Average
Out-performed
Average
Under-performed
Out-performed
Under-performed
Average
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Profitability Ratio Analysis
Profitability analysis is used to determine the efficiency of a firm in turning
out a profit. All items in the profitability ratios are divided by sales which allow a
common and direct link to the performance of the company which is driven by
sales. The more efficient the firm is in turning a profit, the more profitable they
ultimately are compared to less efficient industries within the firm. There are six
measures of profitability ratios that can be used to determine and compare
company’s profits which include the Gross Profit Margin, Operating Expense
Ratio, Net Profit Margin, Asset Turnover, Rate of Return on Assets, and Return
on Equity.
Gross Profit Margin
The gross profit margin is gross profit divided by sales, or broken down it
is sales minus cost of goods sold all over sales. The gross profit margin shows
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the ability of the firm to cover its inventory costs or any other cost that are
included in the cost of goods sold. This gross profit is the basis for which all
other profits are made throughout the business. If a company does not turn a
good profit, it is highly unlikely that the company will be able to field a net
income rather than a net loss. The higher the gross profit margin, the better the
company is at covering its costs and therefore should in theory have a better
shot at producing a higher net income. Xerox is running at about the average
within the industry in terms of a comparable gross profit margin. When you
factor out the two industry outliers, Ikon and HP, the rest of the industry is
matched up well with one another at around a 45% gross profit margin.
Operating Expense Ratio
The operating expense ratio shows selling and administration expenses
(SG&A) as a percentage of overall sales. This shows the percent of SG&A
expense that will take up or eliminate gross profit. When using this ratio as a
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tool of comparison, we can see which companies are spending more or less on
selling and administration expenses. By looking at the above graphic, we can
see that as a percent of sales Xerox has directly mirrored the industry average
since 2004 with an average operating expense ratio during this period of 26%.
It is important to remember that this ratio possesses an inverse sign of efficiency
and profitability. In other words the smaller the ratio, the better the ratio. For
all intents and purposes, we can see that Xerox has held one of the lowest
operating expense ratios in the industry excluding the ever outlying HP.
Operating Profit Margin
The operating profit margin shows the operating income as a percentage
of sales. This ultimately shows the percent of profit to sales after operating
expenses have been incurred and accounted for. The higher the operating profit
margin, the more efficient the company is being in terms of creating a profit
after all operating expenses has been deducted. Notice that Xerox holds the
highest operating profit margin in the industry at an average for the past five
100
years of 33%. Notice that Ikon has been left off the above graphic due to its
extreme variations and inconsistency that produced noise in the industry;
therefore, the operating profit margin of Ikon was not included in the industry
average.
Net Profit Margin
Net profit margin is the most common profitability ratio and shows the net
income as a percentage of sales. The net profit margin shows the bottom line
profitability of a business therefore bigger is better. This figure feeds the profits
of the business and determines for investors how much of each sales dollar will
be available for retained earnings, paying dividends, or reinvesting in the assets
or property of a business. This makes it easy to see why this ratio can be
considered as one of the most important ratios to produce and analyze when
looking to invest funds profits into a business. Xerox has out-performed the
industry since 2004 and has been increasing each year over the past five years.
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This would lead us to believe (and eventually show in our forecasts) that Xerox is
establishing higher levels of net income that will continue to grow at a moderate
rate in the foreseeable future.
Asset Turnover
The asset turnover ratio shows how many times assets produce
sales in a given fiscal year. Xerox for instance has an average asset turnover for
the past five years of .667 which means that for every $1 in assets we receive
only $.667 in sales. This ratio is not good for Xerox and shows lack productivity
and profitability spun off from our total assets in terms of sales dollars. The
industry has performed on a similar trend but at a higher level over the past five
years. As an investor looking to value a company for prospective analysis of
investment profitability, we must look to see how much Xerox is investing in
assets since Xerox doesn’t seem to be getting a good return on those assets in
terms of sales. When we look at Xerox’s investment in total assets over the past
six years and look at the rate of growth in those assets, we are seeing a constant
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and steady decline in the book value of assets the business holds. This allows us
to conclude that Xerox is not needlessly and fruitlessly investing its funds into
assets that are providing minimal return and in some effect slightly alleviates the
problem with such a low asset turnover.
Rate of Return on Assets
The rate of return on assets is a combination of the net income and the
total assets. It is figured by dividing the current year’s net income by the
previous year’s assets. This makes intuitive sense since it would be the assets
that you hold during the course of the year not the assets you purchased that
should add value and eventually profitability to the firm. The overall rate of
return on assets for the industry has been clustered together very near the
average for each of the past five years. The five year industry average for the
return on assets has been 4.9% while Xerox’s average over the same period has
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been 3%. In the grand scheme of things Xerox is doing sufficiently well
compared to the industry.
Rate Return on Equity
The return on equity is much like the return on assets and is calculated by
dividing net income by owner’s equity. Once again we take the current period’s
net income divided by the previous period’s owner’s equity. We see that Xerox
has had a particularly good rate of return on equity during the recent past. Over
the past five years Xerox has earned an average return on equity of 13.6%
compared to the industry average over the same period which has been only
10.4%. This shows that Xerox is earning more on their raised equity than most
of the others in the industry.
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Conclusion
By looking at the culmination of these profitability ratios, we can
determine the efficiency of profitability that the Xerox has compared to that of
the industry. Xerox has maintained an average performance comparable to the
industry in its gross profit margin, operating expense ratio, net profit margin, and
return on assets. Xerox has underperformed in their asset turnover but has
been steadily cutting the investment in assets which will in time deteriorate the
effectiveness of this ratio by making its effect on the company minimal. Xerox
has outperformed or done just above average in both the operating profit margin
and the return on equity respectfully. All in all, Xerox show a slightly above
average positioning of efficient profitability within the document industry.
Ratio
Performance
Gross Profit Margin
Operating Exp Ratio
Operating Profit Margin
Net Profit Margin
Asset Turnover
Return on Assets
Return on Equity
Overall
Average
Average
Out-performed
Average
Under-performed
Average
Out-performed/Average
Slightly Above Average
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Capital Structure Analysis
The capital structure of a business is designed to obtain equity with which
to purchase acquire assets. A company can be financed two ways, either by
debt or by equity. Debt financing is in its simplest terms borrowing money from
the bank. Equity financing is selling shares of the company as stock. The capital
structure analysis allows us to see how efficient and productive each of these
different strategies are within a business.
Debt to Equity
The debt to equity ratio tells us how much of the company is financed by
debt compared to overall equity. If a firm has a debt to equity ratio of 1.5, it
means that the company has $1.50 of debt for each $1.00 of equity. Xerox has
shown a drastic decrease in its debt to equity ratio over the past five years
showing their move from financing activities mainly from debt to financing less of
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their assets from debt and more of the company’s equitable value from stocks.
However, over the past two years we are seeing the debt to equity increasing
from 2.05 to 2.07 which is totally insignificant and shows basically zero change.
This would lead us to believe that Xerox is satisfied with its current capital
structure and debt to equity ratio. By lowering this ratio, Xerox has decreased its
credit and bankruptcy risk drastically which looks good to both lenders and
investors who might have previously been skeptical of Xerox’s capabilities to
support its former capital structure. Overall this move towards a lower debt to
equity has stabilized the capital structure of the firm and will provide for more
favorable market conditions which could cause a future increase in its market or
stock price.
Times Interest Earned
Times interest earned explains how many days you work to pay the
interest you incur over a given period, most often a fiscal year. Times interest
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earned can be a volatile ratio because so often in the market a company’s
interest rate and therefore interest expense will change. Since times interest
earned is calculated by dividing income from operations over interest expense, a
change in the interest expense will directly affect the ratio. While much of the
industry has experienced dramatic jumps and changes in the times interest
earned, Xerox has maintained a fairly level ratio which would imply that Xerox
has established itself as a mature company and no longer suffers from drastic
changes in interest rates, or Xerox at least has a good handle on controlling that
rate. By looking at the overall industry, despite the sudden changes due to the
volatility of interest in the credit market we can see that the industry average
looks very similar to the interest rate yield curve. This lets us know that even
though different companies are forced to borrow at different rates and may be
borrowing more or less than others, the overall times interest earned has been
reacting parallel to the expected and assumed yield curve.
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Debt Service Margin
The debt service margin shows how well a company can pay for its debt
through cash flows from operations. This is another instance where we take the
current cash flows from operations and divide it by the previous year’s notes long
term notes payable current. By taking the previous year’s notes payable current
we are actually taking the current installment due on long term debt that will be
paid in the current year. If we took this year’s notes payable current, we would
be calculating the ratio using debt that wouldn’t come due until next year. We
see a lot of volatility in these ratios but once again Xerox holds fairly firm in its
position. In a ratio where bigger is better, it appears that Xerox is underperforming in this aspect of its comparative capital structure, but in reality with
these ratios so volatile and inconsistent it would be tough to comfortably assume
that until we omit any outliers. When we throw out the two biggest outliers,
Canon and Ikon which were all over the place, we see that the rest of the
industry hovers at a rate of 2.2 while Xerox itself holds a five year average of
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only .6 which is quite a bit lower. This confirms our initial suspicion that Xerox
cannot satisfactorily provide cash from its operations to pay for its debt.
Conclusion
The capital structure ratios provide insight and information into the
efficiency and effectiveness of the present and past capital structure of the firm
which we assume will be indicative of its future performance in those same
areas. The debt to equity ratio was extremely high but was moving towards a
more moderate number. This is ideal in that it would assume that more of
Xerox’s financing is coming from its own retained earnings. Xerox’s times
interest earned is low compared to most of the industry and does beat the
industry average which tells us that Xerox works fewer days out of the year to
pay for its interest. Debt service margin for Xerox was undesirable and low
showing that Xerox is not making enough in cash flows from operations to cover
its current portion of notes payable. Overall Xerox is holding at about the
industry average. They are better in some areas and worse in others, but overall
we find Xerox’s capital structure to support the industry average.
Ratio
Performance
Debt to Equity
Times Interest Earned
Debt Service Margin
Overall
Average
Out-performed
Under-performed
Average
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Credit Risk
We have utilized the Altman’s Z-Score in determining the bankruptcy risk
for Xerox and its competitors. The Z-score is used as a financial measurement
for predicting a company’s insolvency risk as well as their financial health
(http://www.bizwiz.ca/). A company is predicted to be bankrupt when the score
is less than 1.81, and is predicted to have low credit and bankruptcy risk when
the score is above a 2.67 (Palepu).
The Altman’s Z-Score is calculated by combining the five ratios below:
Z-Score= 1.2(Working Capital/Total Assets) + 1.4(Retained Earnings/Total
Assets) + 3.3(Earnings Before Interest and Taxes/Total Assets) + .6(Market
Value of Equity/Book Value of Liabilities) + 1.0(Sales/Total Assets)
Xerox
HP
Canon
Ikon
Ricoh
Altman's Z-Score
2002
2003
2004
0.7534 0.9807
1.335
2.496 3.2515 3.0269
4.207 4.8289 6.2979
1.2523
1.21 1.8536
1.8917
1.979
1.918
2005
1.5333
3.3163
7.0019
2.0862
2.1536
2006
1.7023
3.7448
6.6777
1.8379
2.2789
The Z-Score for Xerox in the past 5 years has been relatively low
compared to its competitors, but has been gradually increasing every year.
Xerox’s earnings as well as the market value of equity have significantly
increased which is causing the final Z-Score to also increase. One of the main
reasons why Xerox’s Z-Score is lower than all of its competitors is because their
sales/total assets ratio is a fourth of what the industry’s is. This low ratio is a
result of their total assets inadequately providing revenue. Also, Xerox’s asset
turnover ratio is low which is causing retained earnings/total assets to be low.
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SGR/IGR
SGR/IGR
20.00%
15.00%
Trends
IGR
10.00%
Industry
IGR
SGR
5.00%
Industry
SGR
0.00%
-5.00%
2002
2003
2004
2005
2006
Year
IGR
The internal growth rate or the IGR shows analysts how big a particular
firm can be in the long run. It is based on the principal that if we re-invest
without external financing, we take the net income right into the assets for the
next year. The IGR is calculated by taking the return on assets and multiplying it
by one minus the dividend payout ratio. The dividend payout ratio is the
dividends paid divided by the net income. This shows how much of the net
income will be depleted prior to the company converting left over funds from the
net income into retained earnings. The average internal growth rate for Xerox
over the past five years has been 2.93% compared to the industry average of
4.77%. This would assume that Xerox can’t grow as fast as the industry average
because Xerox is not re-investing enough of its own resources back into the
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business or is just not making enough in net income to afford to do so and
therefore cannot grow at a higher rate due to a lack of internal funding.
SGR
Sustainable growth rate is the growth rate that can be achieved by
growing the IGR and holding the same debt leverage. This ratio is calculated by
multiplying the IGR by one plus the debt to equity ratio. This allows Xerox to
estimate what the sustainable growth rate should be when they not only reinvest
their own left over net income into retained earnings, but it allows for an
estimation of how much they can grow by adding borrowings in as well holding
their current ratio of debt leverage. By looking at this we can see that the
Sustainable growth rate for Xerox on average over the past five years is 10.39%
while the industry average has been only 9.46%. This implies that while Xerox
can only support a 2.93% growth rate by itself, it can support an additional
7.46% growth by borrowing from outside sources.
2002
2003
2004
2005
2006
AVG
Internal Growth Rate
0.33%
1.41%
3.49%
3.93%
5.51%
2.93%
Industry Internal Growth Rate
2.38%
4.63%
5.35%
4.87%
6.64%
4.77%
Sustainable Growth Rate
3.50%
7.41% 12.19% 11.97% 16.90% 10.39%
Industry Sustainable Growth
Rate
6.28% 10.03% 10.07%
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8.81% 12.12%
9.46%
Financial Statement Forecasting
Forecasting financial statements can add value to a firm by providing an
estimate of the future cash flows. The financial statements are found within the
10-K report which outlines the overall operation of the firm. These statements
are the foundation to forecasting the future expected performance of the
company. To forecast a financial statement it is first necessary to common size
the statement over a common factor. This allows us to analyze Xerox and its
competitors on a level playing field rather than trying to compare large numbers
to small numbers. After leveling the playing field for the different firms within
the document management industry we looked to find a comfortable number of
years to forecast. Ten years of forecasted financial statements is a number we
feel comfortable and confident about. To forecast the financial statements we
utilized different growth rates, averages, as well as liquidity and profitability
ratios. These allowed us to forecast a strong number in assets or sales and work
off of it to determine other future performance based figures.
Income Statement
The income statement is the most influential tool utilized to predict future
cash flows within the organization. Investors analyze the income statement to
understand where revenues are earned and expenses incurred. By
understanding the past we can then forecast the future sales, cost of goods sold,
gross profit, and net income. When looking to forecast the income statement we
first computed a common sized statement to allow comparison between different
firms within the industry. This was done by calculating every value within the
statement as a percentage of total revenues.
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The first item we looked to forecast was total revenues for the company
which included sales, service, and finance income. We debated finding the
overall growth for each section and performing a weighted average for the three
to determine an overall growth rate to forecast, but in the end we determined it
was less accurate than simply forecasting the total sales for Xerox. Therefore we
immediately looked at the overall growth rate for total sales over the past six
years and compared it to the overall growth for each of the competitors within
the industry. We found total revenue growth for Xerox to fluctuate from year to
year with an increase in some and a decrease in others. This left us little
confidence in the current method we were using to forecast the next 10 years of
sales for Xerox. Therefore, we determined an average growth rate of 2.5% or
the expected inflation found on www.inflationdata.com would yield the best
results in the long run. We felt comfortable with this estimate due to the limited
change in the overall market share over the past couple of years along with the
limited room for growth within the industry. This estimate is more so based on
the inflation of costs and prices than anything else.
The next item we looked to forecast was cost of goods sold. Once again
we utilized our common sized income statement to get a better understanding of
the past 6 years of changes in cost of goods sold. After reviewing the gathered
information we determined it necessary to throw out 2001’s record of costs of
goods sold due to the extreme outlier it became in our results. This was most
likely due to the 9/11 incident causing an increase in overall cost of goods sold
for many industries in America. Finally, we determined a percentage of total
revenue as our cost of goods sold as well as our gross profit by averaging the
past five years and eliminating 2001 statistics. The cost of goods sold was found
to be 56.11% of total revenue and gross profit was found to be 43.89% of total
revenue. These values must always add up to equal one because gross profit is
simply the difference between total revenue and cost of goods sold.
The next figures we forecasted for the next ten years were research and
development as well as net income. Research and development showed a
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definite trend over the past six years of roughly 5% of total revenue. Therefore
we averaged the past six year’s percentage of total revenue and found it to be
5.9%. We then used this number as a percentage of our forecasted total
revenues to forecast research and development for the next ten years. We also
analyzed the net income as a percentage of total revenues over the past six
years. We found a few outliers in the first 3 years causing us to only average
the past three years to find the expected percentage of total revenue for the
forecasted future. We found this percentage of sales to be 6.44%. As a result
we used this figure in our forecast which caused net income to grow slowly over
the next ten years.
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Balance Sheet
The balance sheet is nothing more than the total assets for a company
and how they are financed. The way they are financed can often be gathered
from the income statement due to net income flowing directly into retained
earnings in owner’s equity. This was one way in which we forecasted Xerox for
the next ten years in the balance sheet. Although we were able to use net
income to forecast retained earnings, we had to use our common sized balance
sheet to determine the other forecasts such as total assets. After preparing the
common sized statement we looked at the growth between years and compared
it to the industry. The different financial statistics we forecasted were current
and total assets, current and total liabilities, retained earnings, total equity and
total liabilities and owner’s equity.
The first financial figure we forecasted was total assets by utilizing the
common sized balance sheet. We analyzed the change in total assets over the
past six years to determine an adequate depletion rate. After further examining
the percentage of change in each year we decided to throw out two outliers,
which were in the year 2002 and 2005. These two years demonstrated
significantly higher decreases in total assets which could materially effect are
overall average decrease. Therefore we took the average change in assets in
years 2003, 2004, and 2006 to find a declining rate of 1.22%. We then took
100% less this declining rate and multiplied it by our total assets in 2006 to
determine total assets in 2007. This decrease in total assets is due to
outsourcing production to Flextronics. After determining the forecasted total
assets for the next 10 years we examined the current assets percentage of total
assets for the past six years. While looking at the data we chose to eliminate the
first four years of percentages because they were outside the acceptable
parameters. Therefore we averaged the last two years and determined current
assets should be forecasted at 40% of total assets.
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The next area of the balance sheet we looked to forecast was retained
earnings. Retained earnings was computed using year one’s retained earnings
and adding year two’s net income found in the income statement. After
analyzing and determining a comfortable estimate for net income in the next ten
years we were then able to use this to forecast retained earnings for the next ten
years. Owner’s Equity was then found by mirroring retained earnings in the
amount of growth from one year to the next. Therefore both retained earnings
and owner’s equity grow by the amount of net income generated in the current
year. Unfortunately there is a flaw in this assumption due to the fact a company
would not allow their retained earnings to grow to such a large amount over
time. At some point they would begin to start paying a dividend to their
shareholders to encourage reinvestment.
We then used owner’s equity and total assets to find total liabilities by
taking total assets less total equity. Overall as mentioned before Xerox’s total
assets will continue to decrease by a small amount due to outsourcing
production. This requires total liabilities and owner’s equity to match it because
balance sheets have to balance. Unfortunately with our current assumptions we
have owner’s equity increasing despite the decrease in total assets over the next
ten years. This requires our total liabilities to decrease in order for our balance
sheet to balance. This may be a flaw in our forecast, but one could assume an
increase in total assets due to an increase in assets financed through the total
liabilities. To calculate current liabilities we used the current ratio by finding the
average current ratio over the past three years. We removed the first three
years from the average because they were too far away from the mean. We
then took current assets in year 2007 and divided it by the current ratio. This
calculated current liabilities for the forecasted years with better confidence then
a proportion of total liabilities.
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121
122
Statement of Cash Flows
The statement of cash flows is an important component of the financial
statements. This statement provides a better understanding of the flow of cash
from operating, financing, or investing activities. To forecast the operating cash
flows we analyzed the Cash Flows from Operations/ Sales, Cash Flows from
Operations/ Net Income, and Cash Flows from Operations/ Operating Income.
We looked for a trend in these ratio’s and determined CFFO/Sales was our best
estimate for forecasting cash flows from operations. We took the calculations
performed for CFFO/ Sales and averaged the past six years to find an average
ratio of 10.56%. We then took sales from 2007 and multiplied them by this ratio
to find cash flow from operations in 2007. This trend was continued for the next
9 years to forecast cash flows from operations. We then used the change in long
term assets to forecast cash flows from investing activities. This method can be
used because as long term assets increase, cash is being used to purchase these
items. As these assets decrease cash is being received from the sale of these
assets therefore leading to positive cash inflow from investing activity.
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124
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Conclusion
Overall the forecasting of Xerox’s financial statements proved to be helpful
in understanding the long term effect of their current activities. The choice to
outsource production of printers has led to a decrease in assets causing liabilities
to decrease over time as well. However, owner’s equity has continued to
increase slowly due to continued expectations of a positive net income. Although
we have projected a steady small growth in net income, we have also forecasted
in an increase in spending on research and development. This can be offset by
expectations of an increase in total revenue for the next 10 years.
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Cost of Capital Estimation
Cost of Equity
The cost of equity for a firm is the interest rate they pay to investors who
invest in their company by purchasing equity. These investors require a higher
rate of return on their investment due to the risk they incur. If the company
goes bankrupt they are the last individuals to be paid leading to a greater risk of
loss on investment. The cost of equity is measured using the CAPM method.
This formula uses the risk free rate (treasury interest rate), beta (measure of risk
for the firm), and the market risk premium (the market risk less the risk free
rate) to find the cost of equity.
We gathered information from Xerox’s market close for the past seven
years to run a regression with the market risk premium for the same period of
time. To find the market risk premium we gathered information from the St.
Louis Federal Reserve to determine the Treasury rate for the past seven years.
We used several different versions of the treasury yield including the 3 month, 1
year, 2 year, 5 year, 7 year, and 10 year. This enabled us to get a better
average of the treasury yield in order to run a more accurate regression. Each
treasury yield served a specific purpose due to an investor’s intension to hold a
company’s stock for a different amount of time. Riskier stocks are often bought
and sold quickly utilizing a short term risk free rate to determine the cost of
equity. We also gathered the S & P 500 return for the past 7 years to find the
market return. We performed a different regression for each of the treasury
yields along different time periods of 24, 36, 48, 60, and 72 months in order to
test beta variance. Longer term regressions yielded a higher beta due to the
riskiness of holding an equity long term. We selected our beta used to compute
CAPM model by analyzing the explanatory factor within the performed
regressions. The higher explanatory factor shows us that the regressions
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analysis can account for more of the volatility in the beta than the same
regressions with lower explanatory power. To find the market risk premium we
had to take the market risk less the treasury yield for the last 7 years and run
the regression.
After running 30 regressions we compiled a database of Beta’s to compute
our cost of equity. To find the best beta we analyzed the Adjusted R^2 value
which explains the percentage of beta explained by Xerox’s return and the
market risk premium. The highest Adjusted R^2 was found using the 1 year
treasury yield for 72 months which provided a 44% explanatory factor. This
statistical explanatory percentage gave us confidence when selecting the beta of
2.00 to use to compute our cost of equity. Although we had a good amount of
evidence pointing to a Beta gathered from the 1 year treasury yield at 72
months, the other treasury yields at the same point along the yield curve
provided similar Beta’s of roughly 2.00. We then used this combined with our
risk free rate and the size adjusted market risk premium of 4.76% to find our
cost of equity. We chose a market risk premium of 6.8% from Business Analysis
& Valuation Using Financial Statements which stated this was the average return
on the S & P 500 less the Treasury bond yield from 1926-2005. We then
multiplied it by “.7” to compensate for the size of Xerox in the market during
2005 to find Xerox’s size adjusted market risk premium. These calculations were
then input into the CAPM formula leading to a cost of equity equal to 13.67%.
Regression Analysis
Months
72
60
48
36
24
Beta
2.01
1.55
1.44
1.22
1.08
3 Month Rate
Risk Free Rate
Adjusted R Squared
3.99%
0.43
3.99%
0.34
3.99%
0.30
3.99%
0.29
3.99%
0.26
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Cost of Equity
13.54%
11.37%
10.83%
9.78%
9.12%
Months
72
60
48
36
24
Months
72
60
48
36
24
Months
72
60
48
36
24
Months
72
60
48
36
24
Months
72
60
48
36
24
Beta
2.00
1.55
1.43
1.22
1.08
1 Year Rate
Risk Free Rate
Adjusted R Squared
4.14%
0.44
4.14%
0.34
4.14%
0.30
4.14%
0.29
4.14%
0.26
Cost of Equity
13.67%
11.51%
10.97%
9.94%
9.27%
Beta
2.00
1.55
1.43
1.22
1.08
2 Year Rate
Risk Free Rate
Adjusted R Squared
4.01%
0.43
4.01%
0.34
4.01%
0.30
4.01%
0.29
4.01%
0.26
Cost of Equity
13.52%
11.37%
10.82%
9.82%
9.14%
Beta
1.99
1.54
1.42
1.22
1.08
5 Year Rate
Risk Free Rate
Adjusted R Squared
4.20%
0.43
4.20%
0.34
4.20%
0.29
4.20%
0.29
4.20%
0.26
Cost of Equity
13.67%
11.54%
10.96%
10.02%
9.34%
Beta
1.99
1.54
1.42
1.22
1.08
7 Year Rate
Risk Free Rate
Adjusted R Squared
4.33%
0.43
4.33%
0.34
4.33%
0.29
4.33%
0.29
4.33%
0.26
Cost of Equity
13.79%
11.66%
11.08%
11.16%
9.47%
Beta
1.99
1.54
1.41
1.23
1.08
10 Year Rate
Risk Free Rate
Adjusted R Squared
4.52%
0.43
4.52%
0.33
4.52%
0.29
4.52%
0.29
4.52%
0.26
Cost of Equity
13.97%
11.84%
11.25%
10.35%
9.66%
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Cost of Debt
The cost of debt for a company is the interest rate they pay to lenders
they borrow from. This rate is significantly lower than the cost of equity due to
the limited risk experienced by the lenders. In the case of bankruptcy debt
holders are the first to be satisfied by remaining assets within the company. This
gives them a sense of collateral when considering a lending agreement. In turn
they can charge a lower interest rate due to less risk. The cost of debt is
computed using a weighted average formula in order to find an effective interest
rate for all debt held by the company. Xerox has a number of liabilities which all
have a different interest rate. The liabilities for Xerox total just over $14.5 billion
which is roughly double the amount of equity held. This large amount of debt
has interest’s rates ranging from 5.3% to 8%. These interest rates were found
in the notes preceding the financial statements. A table below displays the
interest rate and amount of debt for each category. After using the weighted
average method we found Xerox’s cost of debt to be 6.49%.
Cost of Debt
Liabilities and Equity
Debt
Interest Rate
Short Term Debt and Current Long term debt
1485
0.062
Accounts Payable
1133
0.062
Accrued Compensation and Benefit Costs
663
0.053
Other Current Liabilities
1417
0.080
Long-term debt
5660
0.070
Liabilities to subsidiary trusts issuing
preferred securities
624
0.080
Pension and other benefit Liabilities
1336
0.053
Post Retirement Medical benefits
1490
0.053
Other Long-term liabilities
821
0.053
TOTAL LIABILITIES
14629
* Data gathered from Xerox 10-K
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Weight
0.10
0.08
0.05
0.10
0.39
WACD
0.63%
0.48%
0.24%
0.77%
2.69%
0.04
0.09
0.10
0.06
0.34%
0.48%
0.54%
0.30%
6.49%
Weighted Average Cost of Capital
The weighted average cost of capital is the average interest rate a
company is required to pay on its financed assets. This formula weighs both the
cost of debt and the cost of equity using the percent of each in comparison to
the overall financed assets. This allows the company to find a better average for
the overall interests rates paid for financing. There are two different types of
WACC which calculate the average before and after tax. After computing the
data we found the WACC before tax to be 8.88% and the WACC after tax to be
7.34%. The WACC after tax is lower due to the tax breaks received on financing
assets through debt. Generally Accepted Accounting Principles only allow
companies to write off the interest expense paid on debt, not the dividends paid
to investors. This is one way in which companies are encouraged to finance
their assets through debt, but are still judged on the liquidity ratio they posses.
This is one area where there is a distinct tradeoff between the two choices.
Cost of
Debt
WACC
BT
WACC
AT
6.49
6.49
Weighted Average Cost of Capital
Tax
Cost of
L/ L + E
Rate
Equity
14629/2107
9
0
13.67
14629/2107
9
0.34
13.67
131
E/ E + L
7080/2107
9
7080/2107
9
WACC
0.08828
3
0.07342
5
Valuation Analysis
When valuing a company or firm, it is necessary to compute and utilize all
valuation tools. There are however two levels of quality that are used in equity
valuations: the method of comparables and the intrinsic valuation models. The
method of comparables values the firm based on its relativity and comparability
to its industry leading competitors. These models are not supported by any
theory. The intrinsic valuation models are based primarily on theory and allow
the analysts to provide their own assessments and estimates to what effect the
future activities of the company should have on its share price. We feel that the
method of comparables provides a weak basis on which to value the firm and will
put much more weight and trust into the estimated share prices that we
determine through the intrinsic valuation models.
132
Method of Comparables
Some analysts use what we call the method of comparables. These
valuation models are based on a firm relative to the industry or market. These
valuations provide no room for adding value to the analysis; they are basically
plug and chug numbers to see if the firm is matching up well with the market.
Here we derive a share price based on industry averages and compare them to
the observed share price for Xerox as of November 1, 2007. The glaring
problem with the method of comparables is that it values mediocrity. If a
company does exceptionally well at one or two things that add tremendous value
to the firm, you don’t get the opportunity to account for them in the models.
Below are the overall results of our findings from completing the method of
comparables valuations followed by each valuation ratio singularly and in detail.
Our basis for deciding whether a firm is fairly valued is based on the models
adhering to 15% margin of error. In other words a firm is fairly valued if it is
within plus or minus 15% of the observed share price which in Xerox’s case
would be a range from $14.82 to $20.56
Model
P/E Trailing
P/E Forward
P/B
P.E.G.
P/EBITDA
P/FCF
EV/EBITDA
Observed Share Price
Nov. 1 - Valuation Date
Suggested
Price
$
$
$
$
$
$
$
18.24
10.72
17.88
4.37
10.04
35.50
5.81
$17.44
133
Compared to
Actual Price
Fairly Valued
Overvalued
Fairly Valued
Overvalued
Overvalued
Undervalued
Overvalued
Price to Earnings Trailing
Company
Xerox
HP
Canon
Ricoh
IKON
PPS
17.44
48.16
50.61
89.7
12.4
P/E Trailing
EPS
P/E Trailing
1.25
13.95
2.47
19.50
3.34
15.15
6.39
14.04
0.85
14.59
Industry Avg. P/E
14.59
throw out
Comparable
XRX PPS
$18.24
The price to earnings trailing (P/E trailing) ratios that we computed for
Xerox is based off of Xerox’s 2006 10-K earnings per share (EPS) and the price
per share (PPS) as published by Yahoo Finance on November 1, 2007 which is
our valuation date. For the industry we took both the PPS and EPS from Yahoo
Finance. The slight differences that might occur due to taking those numbers
from a third party is minimal since Yahoo Finance is such an established and well
known source. By taking the PPS/EPS we derived the P/E trailing ratio. We then
averaged the industry’s P/E trailing ratios excluding any outliers, which in this
case was HP due to the above average P/E ratio. (NOTE: all the industry
averages do not include Xerox because it would add unwanted weight to the
averages) We then tool the industry average P/E trailing and multiplied it by
Xerox’s EPS to give us an estimated and comparable PPS for Xerox. Here we see
that using this method Xerox would be fairly valued at an estimated $18.24 and
an actual $17.44 using our 15% error tolerance. Using only this formula we can
see that compared to the firm, Xerox is trading for a price commensurate to its
performance and would be fairly valued, but other ratios must be used in order
to see if these results are just a fluke or justifiable.
134
Price to Earnings Forward
Company
Xerox
HP
Canon
Ricoh
IKON
PPS
17.44
48.16
50.61
89.7
12.4
P/E Forward
EPS 1yr Out
P/E Forecast
0.86
20.28
3.79
12.71
3.89
13.01
6.98
12.86
1.10
11.27
Industry Avg. P/E
12.46
Comparable
XRX PPS
$10.72
Next we looked at the forward price to earnings ratio and compared it to
the industry. The only difference in the information we used for this method was
in the EPS, which in a forward P/E ratio are next year’s earnings per share. Here
we used our one year forecasted earnings for Xerox and divided them by Xerox’s
number of shares outstanding as of the last fiscal year end which allows us to be
more consistent with our numbers. Also the number of shares outstanding for
Xerox should not differ much in ten months since they had roughly 946 million
shares to begin with. Once again we took the industry average P/E forward and
multiplied it by the EPS one year out to derive the estimated share price which
we calculated to be $10.72. Here we see that the share price would be
overvalued against its current price which counters the P/E trailing that we had
just computed. Part of the drawback to this ratio, apart from the fact it values
mediocrity, is that this model is extremely sensitive to the forecasted earnings for
Xerox. If we were too conservative in our forecasted earnings, we should expect
to see an overvalued firm; however, we feel that in Xerox’s case we
appropriately estimated the earnings growth rate. Another drawback to this
method is that it only values firms in the short run. If expected earnings growth
was too expand drastically in the second year, we would have no way to account
for that in the estimated share price.
135
Price to Book
Company
Xerox
HP
Canon
Ricoh
IKON
PPS
17.44
48.16
50.61
89.7
12.4
P/B
BPS
7.48
14.55
20.24
65.96
14.25
P/B
2.33
3.31
2.50
1.36
0.87
Industry Avg. P/B
2.39
Comparables
XRX PPS
$17.88
throw out
The price to book ratio (P/B) attempts to determine that a company’s value is
supported by its book value of equity. The P/B ratio is calculated simply by
taking the price per share (PPS) and dividing it by the book value per share
(BPS). Once again we took and industry average of the P/B ratios excluding
IKON which we determined to be an outlier due to its extremely low price to
book ratio. When we go the industry average P/B ratio, we multiplied it by the
book value per share to derive Xerox’s estimated PPS using book value as a
comparative basis. The final estimated and comparable PPS that we calculated
for Xerox was $17.88. This number shows a pretty fairly valued and an
accurately suggested PPS since it is only off by $0.44.
136
Price Earnings Growth (P.E.G.)
Comparable
P.E.G
Company
Xerox
HP
Canon
Ricoh
IKON
PE
13.95
19.50
15.15
14.04
14.59
EGRt+1
2.58
18.39
9.90
12.65
8.48
P.E.G
5.41
1.06
1.53
1.11
1.72
Industry Avg.
1.36
XRX PPS
$4.37
**EGRt+1: Earnings Growth Rate next year
In the price to earning growth model (P.E.G.) we take the price to
earnings ratio trailing and divide it by the estimated earnings growth rate for the
individual firms. For the industry we used information from analysts for Yahoo
Finance to calculate the P.E.G. ratios. Since we are doing a valuation solely for
Xerox and not its competitors, we did not evaluate and estimate our own
earnings growth rate for each competitor, but instead utilized the work of other
analysts to make our efforts more productive and efficient. Once we have found
the customary industry average to the P.E.G., we multiply it by the forecasted
earnings growth rate for Xerox to derive our comparable and estimated PPS
using the P.E.G. model. When we calculated this out we found that based on
this model the PPS for Xerox would be $4.37 which would mean that compared
to the observed share price of $17.44 Xerox would be severely overvalued. This
is a case where as an analyst you must ask yourself, is the firm doing something
that much better or worse than the industry, or is the valuation an outlier in
itself? Looking at Xerox we see that the reason this estimated PPS is so low is
that it is calculated using and industry averaged P.E.G. which is based on
earnings growth rates that are much higher than that of Xerox. We have
concluded that Xerox will not in the foreseeable future converge on the earnings
growth rate average of the other firms in the industry which means that this
method of comparability is not in fact comparable.
137
Price over EBITDA
Company
Xerox
HP
Canon
Ricoh
IKON
Mkt Cap ($Bill)
16.50
128.57
64.36
13.36
1.27
P/EBITDA
EBITDA ($Bill)
1.749
11.48
9.88
2.2
0.274
P/EBITDA
9.44
11.20
6.51
6.07
4.64
Industry Avg.
5.74
throw out
Comparable
XRX PPS
$10.04
To understand what this model actually is valuing, first we must
understand the usefulness and purpose of the P/EBITDA formula. This formula
takes the market capitalization (P), or the amount of investor equity put into the
firm through the purchase of shares, and divides it by our simplest form of cash
flows from operations (EBITDA). For an answer of 9.44, this means that shares
are selling at 9.44 times cash flows, so the basis for this valuation is anchored in
valuing the flow of cash in business. The lower the number, the better the
apparent value of the firm by showing that its market capitalization, or share
price, is supported by the cash flows from operations.
The P/EBITDA translates out to mean the price divided by the earnings
before interest, taxes, depreciation, and amortization (EBITDA). To calculate the
price in this sense means to use the market capitalization which is the observed
share price times the number of shares outstanding. In Xerox’s case this
calculated out to $16.5 billion. The EBITDA can be figured from the most recent
financials. To find this number we took the income from continuing operations
before income tax (accounts for the EBT), added back financing interest
(accounts for I), and finally added back depreciation and amortization (accounts
for DA) to get EBITDA. This is shown in the chart on the following page.
138
XRX
In $Millions
Income from Continuing Operations before Income Tax
808
(plus) Equip Fin Interest
305
(plus) Depreciation and Amortization
636
EBITDA (In $Millions)
1749
All information was taken off Xerox's 2006 10-K
Once again for the simplicity’s sake we used the EBITDA as calculated by
the analysts for Yahoo Finance. Next, we took the market capitalization (P) and
divided it by the EBITDA to get our P/EBITDA ratio. We then took and industry
average throwing out HP as an outlier since its ratio is significantly higher than
other competitors in the industry. After finding our industry average we
multiplied it by the EBITDA to get a comparable share price for Xerox which in
this case turned out to be $10.04 and overvalued.
139
Price over Free Cash Flows
Company
Xerox
HP
Canon
Ricoh
IKON
Mkt Cap ($Bill)
16.5
128.57
64.36
13.36
1.27
P/FCF
FCF ($Bill)
1.474
2.98
3.12
0.485
-37.91
P/FCF
11.19
43.14
20.63
27.55
-0.03
Industry Avg.
24.09
throw out
Comparable
XRX PPS
$35.50
throw out
The price over free cash flows or P/FCF valuation starts with determining
the free cash flows (FCF) of the firm. The free cash flows are the cash flows
from operations plus or minus the cash flows from investing (CFFI) depending on
whether CFFI is negative or positive. In Xerox’s case the CFFI showed a positive
inflow of cash so we added the CFFI. We then calculated the P/FCF by using the
market capitalization that we used in the previous method and divided it by the
calculated FCF. Then, like the rest of the models, we determined the industry
average P/FCF throwing out the two outliers HP and IKON. Once we had an
industry average, we multiplied it by the free cash flows to get an estimated and
comparable price per share for Xerox based on the P/FCF ratio. The value we
got for the price per share was $35.50 shows the firm extremely undervalued.
140
Enterprise Value over EBITDA
Enterprise Value/EBITDA
Company
EV ($Bill)
EBITDA ($Bill) EV/EBITDA Industry Avg.
Xerox
29.59
1.749
16.921
10.63
HP
123.5
11.48
10.758
Canon
58.01
9.88
5.871 throw out
Ricoh
23.12
2.2
10.509
IKON
1.97
0.274
7.190 throw out
**EV=MktCap + BV of liabilities - short term investments-cash
Comparable
XRX PPS
$5.81
The enterprise value (EV) over EBITDA ratio is often used to value firms
within their respective industries. To calculate this we must first calculate the
enterprise value. The EV is the market capitalization (PPS*Shares Outstanding)
plus the book value of liabilities minus short term investments and cash. This
calculates out as the following equation listed in billions of dollars:
EV=(PPS(.946205))+14.629-(.137+1.399)
We then divide the calculated EV by the established EBITDA value and
find the industry average of the EV/EBITDA formula. In our case above we can
see that we threw out Canon and IKON since their ratios were once again
significantly lower than the established median within the market. Once we
derived the industry average, we then plugged that figure into the equation
below and solved and derived algebraically for the variable PPS. By doing this
we found the comparable and estimated price per share to be $5.81 which
compared to the observed share price is extremely overvalued.
10.63
=
(PPS(.946205))+14.629-(.137+1.399)
1.749
141
Conclusion
After looking at the method of comparables we can see that they do not
in fact represent a cohesive picture of the value of the firm. Looking back on the
ratios that we computed, we can see a total lack of methodological sequence in
the estimated and comparable PPS for Xerox based on the method of
comparables. The fact that these ratios are not based in theory and allow the
analysts no room to add value to the valuation or offer additional professional
insight making the method of comparables only mildly useful as a screening tool
and useless for consistently specific and accurate firm valuation.
142
Intrinsic Valuation Models
The other more accurate and theory based models are what we call the
intrinsic valuations. Like the name suggests, we feel that the intrinsic value
models reflect the very nature of the firm and allows us to see how the firm is
valued based on its operations. The intrinsic models include the Discounted
Dividends Model (this model is not applicable since Xerox does not pay a
dividend), Free Cash Flows Model, Residual Income Model, Long-Run Residual
Income Perpetuity Model, and the Abnormal Earnings Growth Model. By looking
at these models individually, we can see where the firm originates its value and
whether or not those values are substantiated by our findings. We will also look
at sensitivity analysis. Since these models are based on the future activities of
the firm and therefore utilize forecasts, the sensitivity analysis allows us to see
how the margin of error would change if we incorrectly estimated growth rates
and earnings, or if the WACCBT or Ke changed significantly over the next few
years. Overall we feel that we can better derive the true and fair value of the
firm by utilizing these intrinsic valuation models.
143
Discounted Free Cash Flows Model
The discounted free cash flows model is our first attempt at utilizing an
intrinsic valuation to determine the fair value for Xerox. This is a better model
than the method of comparables because we forecasted out the cash flows from
operations and the cash flows from investing activities which yields free cash
flows allowing us to discount them back using the weighted average cost of
capital before tax. We use the before tax figure so that we do not mistakenly
account for taxes twice since cash flows from operations already accounts for
taxes via the first line item, net income. We used a year by year future cash
flows forecast and terminal value perpetuity to derive the value of the firm or the
value of the firm’s assets. This however allows us to study the value derived
from both the present value of the forecasted cash flows and the present value
of the terminal value perpetuity. When we look at this based on what
percentage of the firm’s value is derived from the next ten year’s versus the
continuing perpetuity we find that the usefulness of this model is slightly
diminished. Since roughly 55% of the firm’s value is based on future activities,
that 55% is extremely sensitive and subjective to the estimated growth rate.
The free cash flows model requires that we forecast cash flows from
operations and cash flows from investing which we had done and disclosed
previously in the report. It also requires that we have the book value of liabilities
at the most recent fiscal year end and the weighted average cost of capital
before tax (WACCBT) which we had also previously disclosed. We also must
estimate the growth rate of the perpetuity which we determined to be best
estimated by using the previous year’s growth rate in free cash flows because it
was on the average of the past years excluding some yearly growth outliers.
The free cash flows as previously discussed is the cash flows from
operations plus or minus cash flows from investments depending on whether the
CFFI is an inflow or outflow. One the free cash flows are calculated for the next
144
ten years we must discount them back to year zero dollars which is the fiscal
year end for Xerox December 31, 2007. We calculated the present value factor
to bring these forecasted free cash flows back to year zero dollars by using the
following formula.
PV Factor =
1
(1+WACCBT)t
By multiplying each year’s free cash flow by its present value factor and
taking the summation of the product, we can find the present value of the firm’s
free cash flows for the next ten years. We then added the present value of the
perpetuity which starts in year eleven and is stated in year ten dollars (thus we
use the year ten present value factor for discounting) to the present value of the
ten year forecast giving us the estimated value of the firm of $26,299 million.
The equation for the perpetuity is as follows:
FCF2017
Perpetuity2016 =
(WACCBT-Growth)
By referring to the appendices you can see these calculations in depth.
We then subtract the book value of liabilities of $14,629 million which gives us
the estimated market value of the firm’s equity of $11,670 million. Dividing the
estimated market value of the firm’s equity by the share outstanding of 946.205
million shares, we get the estimated share price as of January 1, 2007 to be
$12.33 per share. To find a time consistent share price as of November 1, 2007,
we took the future value of the estimated share price raised to (10/12) to
account for the ten months from the fiscal year end to the valuation date as seen
below. This number would give a time consistent price per share of $13.23 as of
November 1, 2007.
Future Value =
(Estimated PPS)(1+WACCBT)(10/12)
145
W
A
C
C
(BT)
6.00%
7.00%
8.00%
8.83%
10.00%
11.00%
Overvalued < $14.82
Discounted Free Cash Flow Sensitivity Analysis
Growth Rates
0.00%
2.85%
6.00%
9.00%
$
19.69
$
39.13
N/A
N/A
$
13.61
$
26.00
$ 115.77
N/A
$
9.76
$
17.92
$
51.13
N/A
$
7.77
$
13.23
$
32.08
N/A
$
4.78
$
8.43
$
18.54
$
87.38
$
2.70
$
5.39
$
11.92
$
37.26
* N/A represents irrelevant negative share prices
$14.82 < Fairly Valued > $20.06
12.00%
N/A
N/A
N/A
N/A
N/A
N/A
Undervalued > $20.06
The above chart shows the sensitivity analysis of the discounted free cash
flow model. We started off with a growth rate of 2.58% and a WACCBT of 8.83%
which gave us our initial valuation of $13.23 per share. As you can see, this
model is extremely sensitive to growth. What this means is that if the growth
rate is altered or if our estimation of the growth rate is off, the free cash flow
based valuation derived from this model will be easily skewed. We can also see
that the model is somewhat sensitive to the WACCBT . However, with the use of
forecasting, this model is still more accurate than any of the method of
comparables.
Looking at the estimated share price derived from this model of $13.23
compared to the November 1, 2007 observed share price of $17.44, we can see
that this model shows that the firm is overvalued at our initial estimate. The
chart also shows that in order to be fairly valued, the higher the WACCBT
becomes, the higher the growth rate must be in order to prevent further
overvaluing the firm. Feeling that our growth rate and our WACCBT are
appropriately estimated, we find that the derived share price using the
discounted free cash flow model is overvalued; however, with the extreme
sensitivity we will limit the weight of influence this model has on our valuation of
Xerox.
146
Residual Income Model
The residual income valuation model is often referred to as one of the
most accurate and dependable valuation tools available to analysts. This model
is often more empirically sound than other models reaching R2 (explanatory
power) of up to 90%. Unlike the free cash flows model which is more current to
backward looking, the residual income model is a forward looking since it is
based on accrual accounting. This matches much better with a market price that
is also based on forward looking data.
The residual income is the value created or destroyed by the firm. To
calculate the residual income, we started by finding the benchmark or normal
earnings. These were calculated by multiplying last year’s actual earnings by the
cost of equity. The residual income is the difference between the actual earnings
and the benchmark earnings we calculated. Xerox has negative residual income
in each year from 2008 forward. This means that each year the firm is
destroying its value and the value of the company to its investors. Then we take
the present value factor which is as follows:
1
PV Factor =
(1+Ke)t
By summing the present values found by multiplying the present value
factor by the residual income, we get the present value of annual residual
income which equals $-1838 million. Next we calculated the value of the
continuing perpetuity as follows, and then discounted it back using the present
value factor in year ten (2016) which calculates out to be $-2484 million when
using Xerox’s calculated cost of equity at 13.67% and a 0% growth rate .
RI2017
Perpetuity2016 =
(Ke-Growth)
147
The summation of the present value of the annual residual income, the
present value of the perpetuity, and the initial book value of equity equals the
market value of equity for Xerox as of January 1, 2007. When we divided by the
number of shares outstanding, we got the estimated price per share at that
same time. We then found the future value of this number ten months later to
find the time consistent price per share as of November 1, 2007 of $3.24 by
using the following calculation.
Future Value =
Cost
of
Equity
(Estimated PPS)(1+Ke)(10/12)
Residual Income Sensitivity Analysis
Growth Rates
0.0%
-10.0%
-20.0%
10.00% $
2.93
$
5.63
$
6.53
11.00% $
3.15
$
5.30
$
6.06
12.00% $
3.25
$
4.98
$
5.63
13.67% $
3.24
$
4.48
$
4.98
15.00% $
3.15
$
4.11
$
4.52
16.00% $
3.05
$
3.84
$
4.20
Overvalued < $14.82
$14.82 < Fairly Valued > $20.06
$
$
$
$
$
$
-30.0%
6.98
6.45
5.97
5.25
4.74
4.40
$
$
$
$
$
$
-40.0%
7.25
6.69
6.18
5.42
4.89
4.53
Undervalued > $20.06
Looking at this sensitivity analysis of the calculations we can see that
when applying these costs of equity and the above growth rates Xerox was
constantly overvalued. We used negative growth rates in the sensitivity analysis
because theoretically speaking, the residual income should converge on zero
since the benchmark earnings and the earnings per share should equal each
other in the long run. Having said that, this model is not nearly as sensitive to
growth rates or the cost of equity. To get any value that would show that Xerox
has a fairly valued share price, they would have to have a growth rate of -40%,
to speed the convergence of the residual income to zero, and a ridiculously low
cost of equity around 1.25%. This leads us to conclude that based on the
residual income model, Xerox is consistently overvalued.
148
Long Run Residual Income Perpetuity
This model is based on the residual income model, the long run return on
equity, and the growth in the return on equity which relates back to the balance
sheet making this valuation thoroughly embedded in the forecasted financials
done in previous sections. This helps to drive out the intrinsic value of the firm
by adding value to the analysis we have already completed.
The model starts by finding our long run return on equity. To do this we
took the net income over the previous year’s book value of equity that we
forecasted. We estimated that the return on equity in the long run would
average out to be about around 10%. Since it is long run number that will
fluctuate over time, we did not suggest that we could accurately forecast the
return on equity down to the decimal, thus the round number. This is shown
below by taking the average return on equity that we forecasted for the next ten
years.
Next we need to find the growth in the return on equity. To do this we
took the recent growth in the return on equity and estimated it to be 4%, once
again the round number is based on the fact that we will not be able to
accurately estimate a growth rate down to the one thousandths decimal place.
After calculating the long run return on equity and the long run growth,
we now have enough information to run the long run residual income model
which is written in the following equation:
(
Estimated Mkt Cap = BVE
1+
(
ROE-Ke
Ke-growth
))
By taking the estimated market cap that we calculated in the previous equation
and dividing it by Xerox’s 946.205 million shares we get the estimated price per
share using the long run residual income perpetuity model of $6.60 per share.
149
Long Run Residual Income Sensitivity Analysis
Growth Rates
-40.00%
-30.00%
-20.00%
-10.00%
-4.00%
10.00%
$
7.76
$
7.63
$
7.42
$
7.03
$
6.60
Return
11.00%
$
7.91
$
7.82
$
7.67
$
7.39
$
7.07
on
12.00%
$
8.07
$
8.01
$
7.91
$
7.74
$
7.54
Equity
13.00%
$
8.22
$
8.20
$
8.16
$
8.09
$
8.01
14.00%
$
8.38
$
8.39
$
8.41
$
8.44
$
8.48
15.00%
$
8.53
$
8.58
$
8.65
$
8.79
$
8.95
**Cost of Equity is held Constant at 13.67%
Overvalued < $14.82
$14.82 < Fairly Valued > $20.06
Undervalued > $20.06
Long Run Residual Income Sensitivity Analysis
Cost of Equity
11.00%
12.00%
13.67%
15.00%
16.00%
10.00%
$
7.62
$
7.20
$
6.60
$
6.19
$
5.93
Return
11.00%
$
8.16
$
7.71
$
7.07
$
6.64
$
6.35
on
12.00%
$
8.71
$
8.22
$
7.54
$
7.08
$
6.77
Equity
13.00%
$
9.25
$
8.74
$
8.01
$
7.52
$
7.20
14.00%
$
9.79
$
9.25
$
8.48
$
7.96
$
7.62
15.00%
$ 10.34
$
9.77
$
8.98
$
8.41
$
8.04
**Growth Rate is held Constant at 4%
Overvalued < $14.82
$14.82 < Fairly Valued > $20.06
Undervalued > $20.06
Long Run Residual Income Sensitivity Analysis
Growth Rates
-40.00%
-30.00%
-20.00%
-10.00%
-4.00%
10.00%
$
8.10
$
8.10
$
8.10
$
8.10
$
8.10
Cost
11.00%
$
8.00
$
7.96
$
7.90
$
7.77
$
7.62
of
12.00%
$
7.91
$
7.83
$
7.71
$
7.48
$
7.20
Equity
13.67%
$
7.76
$
7.63
$
7.42
$
7.03
$
6.60
15.00%
$
7.64
$
7.47
$
7.21
$
6.73
$
6.19
16.00%
$
7.56
$
7.36
$
7.06
$
6.51
$
5.93
**Return on Equity is held Constant at 10%
Overvalued < $14.82
$14.82 < Fairly Valued > $20.06
Undervalued > $20.06
For this model we use three levels of sensitivity analysis to adjust for
three variables that go into this model: cost of equity, growth rates, and return
on equity. Like the residual income model that we had previously computed and
worked, we find that this firm is not as sensitive as the free cash flows model.
By allowing each variable to adjust, we can see the array of values that the firm
150
could possibly have; however, by looking we can see that the firm is consistently
overvalued in each aspect of the sensitivity analysis leading us to firmly believe
in the presented facts that Xerox has an overvalued price per share based on this
model.
Abnormal Earnings Growth (AEG) Model
The abnormal earnings growth model revolves around the abnormal
earnings of a firm and is based in the theory of a forward price to earnings ratio.
Abnormal earnings are the forecasted earnings, plus reinvested dividend
earnings, minus normal earnings. For Xerox who does not pay a dividend, it is
simply the forecasted earnings minus the normal or benchmark earnings.
Theoretically and practically speaking this in no way hinders us from valuing the
firm based on this model. When a firm pays dividends the share holder will
reinvest those dividends at the cost of equity. When a firm doesn’t pay
dividends it has those funds to itself to reinvest in the company. So either way
the abnormal earnings will get reinvested back into the company making this
model viable for both dividend and non-dividend paying firms.
Before calculating the abnormal earnings growth we must understand that
there is a lag structure built in to the model which causes our valuation to be
based on fiscal year end in 2007. So that we maintain consistency in our
intrinsic valuation models, we will discount it back to the fiscal year end
December 31, 2006 and then find the future value of the price per share ten
months from that time to get us to the valuation date of November 1, 2007. To
calculate the abnormal earnings we used the forecasted net income that we had
done in previous section of this analysis. We then calculated the benchmark
earnings by taking the previous year’s earnings and multiplying it by one plus the
cost of equity. We then subtracted the benchmark earnings from the forecasted
earnings to get the abnormal earnings.
151
Benchmark Earnings =
NIt-1 * Ke
Abnormal Earnings = Forecasted NI - Benchmark Earnings
*for a non-dividend paying firm
Here we can utilize a good check figure to make sure that we are on the
right track and have performed the model properly up to this point. The
abnormal earnings for each of the forecasted periods should equal the change in
residual income for the same period that we calculated in the residual income
model. In this case they do equal validating our model and are shown as
follows:
Abnormal Earnings
$(116)
$(119)
$(122)
$(126)
$(129)
$(132)
$(136)
$(138)
$(143)
Change in RI Check Figure
$(116)
$(119)
$(122)
$(126)
$(129)
$(132)
$(136)
$(138)
$(143)
Next we took the present value of the abnormal earnings by calculating a
present value factor like we had before, and found the summation of those
which gives us the present value of the annual abnormal earnings. We then
forecasted abnormal earnings for 2017 which we used to find our terminal value
of abnormal earnings in year 2016. By using the present value factor for year
2016 we are able to find the present value of the terminal value.
Terminal Value 2016 =
Abnormal Earnings 2017
(Ke-Growth)
When we added the present value of the annual abnormal earnings with
the present value of the terminal value, we got the total present value of the
abnormal earnings on December 31, 2007 of $-828 million. By adding the total
present value of abnormal earnings with the core earnings that we forecasted for
2007, we get the total average earnings perpetuity for December 31, 2007 of
152
$382 million. To get this back to a December 31, 2006 number we must divide it
by the capitalization rate of the perpetuity which is equal to the estimated cost of
equity at 13.67%. This gives us the estimated intrinsic value of the firm at
December 31, 2007 of $2,795 million.
Intrinsic Value 2006 =
Total Earnings Perp 2007
(Ke)
Finally we divide the intrinsic value of the firm in 2006 by the number of
shares outstanding to get the share price at the end of 2006. We then do as we
have before and take the future value of this price forward ten months to get the
time consistent price per share at the time of valuation of $3.29 per share.
Cost
of
Equity
Abnormal Earnings Growth Sensitivity Analysis
Growth Rates
-10.0%
-20.0%
-30.0%
-40.0%
10.00% $
5.87
$
6.66
$
7.06
$
7.29
11.00% $
4.84
$
5.53
$
5.89
$
6.10
12.00% $
4.19
$
4.81
$
5.13
$
5.33
13.67% $
3.29
$
3.79
$
4.06
$
4.23
15.00% $
2.77
$
3.19
$
3.42
$
3.57
16.00% $
2.46
$
2.83
$
3.04
$
3.18
Overvalued < $14.82
$14.82 < Fairly Valued > $20.06
$
$
$
$
$
$
-50.0%
7.45
6.25
5.46
4.34
3.68
3.27
Undervalued > $20.06
When we look at the sensitivity analysis of the abnormal earnings growth
model we can see that this model is less sensitive to error. Once again we use
negative growth rates to account for the theory that abnormal earnings should
and will converge towards zero as the benchmark earnings and the actual or
core earnings converge towards each other. We already know that it is liked to
the residual income model (remember our check figures) so we would expect to
see similar prices. At our initial cost of equity of 13.67% and a -10% growth
rate we find our share price to be $3.29 which for all intents and purposes
mirrors the $3.24 per share that we came up with in our valuation of Xerox using
153
the residual income model. This sensitivity analysis also paints a unanimously
overvalued picture of the firm which holds true to the estimates of the other
intrinsic valuations that we have done.
Conclusion
Looking at the overall effect of the intrinsic valuation models we can see
that Xerox is unanimously overvalued in the market. The free cash flows model
which we put the least trust into because of its extreme sensitivity to growth is
the only model that allowed Xerox to reach a fairly valued firm. The residual
income model, long run residual income perpetuity model, and the abnormal
earnings growth model all found the firm to be unanimously overvalued. When
we tried to accommodate a reason that a firm could hold such an overvalued
share price we came up with a few conclusions. First of all we could have been
too conservative with our growth rates that we allotted to the firm; however, we
worked very methodically to find growth rates that made sense and were
reflected and supported by recent data that the company had released in its 10K reports, so we don’t feel that this would be the case. The only other
explanation that we could think of is that with the globalization of financial
markets and the added liquidity that this gives, firms are trading at inflated
prices due to the high demand investors have to hold equities. For example if
100 people want to purchase 10 stocks that would normally cost $1, supply and
demand would inflate the value of the stocks until 90 people are forced out of
the market. The problem with this is that when the markets become volatile and
everyone starts dumping shares, they will be forced to dump them at the
intrinsic value which will be well below the price they paid. For this reason we
do suggest that investors sell Xerox cutting their losses and moving on since we
feel that the firm is extremely overvalued in the current market.
154
Appendices
Liquidity Ratio’s
155
Probability Ratio’s
Capital Structure
156
Sales Diagnostics
Expense Diagnostics
157
Credit Risk
The Altman’s Z-Score is calculated by combining the five ratios below:
Z-Score= 1.2(Working Capital/Total Assets) + 1.4(Retained Earnings/Total
Assets) + 3.3(Earnings Before Interest and Taxes/Total Assets) + .6(Market
Value of Equity/Book Value of Liabilities) + 1.0(Sales/Total Assets)
Xerox
HP
Canon
Ikon
Ricoh
Altman's Z-Score
2002
2003
2004
0.7534 0.9807
1.335
2.496 3.2515 3.0269
4.207 4.8289 6.2979
1.2523
1.21 1.8536
1.8917
1.979
1.918
158
2005
1.5333
3.3163
7.0019
2.0862
2.1536
2006
1.7023
3.7448
6.6777
1.8379
2.2789
Weighted Average Cost of Debt
Cost of Debt
Liabilities and Equity
Debt
Interest
Rate
Weight
WACD
short Term debt and current portion of long term debt
1485
0.062
0.10
0.63%
Accounts Payable
1133
0.062
0.08
0.48%
Accrued Compensation and Benefit Costs
663
0.053
0.05
0.24%
Other Current Liabilities
1417
0.080
0.10
0.77%
TOTAL CURRENT LIABILITIES
4698
Long-term debt
5660
0.070
0.39
2.69%
Liabilities to subsidiary trusts issuing preferred securities
624
0.080
0.04
0.34%
Pension and other benefit Liabilities
1336
0.053
0.09
0.48%
Post Retirement Medical benefits
1490
0.053
0.10
0.54%
Other Long-term liabilities
821
0.053
0.06
0.30%
TOTAL LIABILITIES
6.49%
14629
Weighted Average Cost of Capital
Weighted Average Cost of Capital
WACC
BT
WACC
AT
Cost of
Debt
L/ L + E
Tax
Rate
Cost of
Equity
6.49
14629/21079
0
13.67
7080/21079 0.088283
6.49
14629/21079
0.34
13.67
7080/21079 0.073425
159
E/ E + L
WACC
Weighted Average Cost of Equity
3 Month Treasury
SUMMARY OUTPUT 72 MONTHS
Regression Statistics
Multiple R
R Square
Adjusted R Square
Standard Error
Observations
0.66550398
0.442895548
0.434936913
0.078766026
72
ANOVA
df
SS
Regression
Residual
Total
1
70
71
Coefficients
Intercept
X Variable 1
0.01103409
2.00567994
0.34525549
0.434286078
0.779541568
Standard Error
0.009333539
0.268862522
MS
0.34525549
0.006204087
t Stat
1.182197764
7.459871776
F
55.64968691
P-value
0.241127522
1.79962E-10
Significance F
1.79962E-10
Lower 95%
-0.007581068
1.469450555
Upper 95%
0.029649247
2.541909325
Lower 95.0%
-0.007581068
1.469450555
Upper 95.0%
0.029649247
2.541909325
SUMMARY OUTPUT 60 MONTHS
Regression Statistics
Multiple R
R Square
Adjusted R Square
Standard Error
Observations
0.592973731
0.351617846
0.340438843
0.055626728
60
ANOVA
df
Regression
Residual
Total
SS
1
58
59
Coefficients
Intercept
X Variable 1
0.007153404
1.550293404
0.097327347
0.179471308
0.276798655
Standard Error
0.007456914
0.276426691
MS
0.097327347
0.003094333
t Stat
0.959298082
5.608334712
F
31.45341824
P-value
0.341390638
5.96954E-07
160
Significance F
5.96954E-07
Lower 95%
-0.007773232
0.996965269
Upper 95%
0.02208004
2.103621539
Lower 95.0%
-0.007773232
0.996965269
Upper 95.0%
0.02208004
2.103621539
SUMMARY OUTPUT 48 MONTHS
Regression Statistics
Multiple R
R Square
Adjusted R Square
Standard Error
Observations
0.56058347
0.314253827
0.299346301
0.04584736
48
ANOVA
df
SS
Regression
Residual
Total
1
46
47
Coefficients
Intercept
X Variable 1
0.004153937
1.436119798
0.044310196
0.096691098
0.141001294
Standard Error
0.006841115
0.312790218
MS
0.044310196
0.00210198
t Stat
0.60720174
4.59131941
F
Significance F
21.08021393
P-value
0.54670278
3.41481E-05
3.41481E-05
Lower 95%
Upper 95%
Lower 95.0%
-0.009616513
0.806505755
0.017924386
2.065733841
-0.009616513
0.806505755
Upper 95.0%
0.017924386
2.065733841
SUMMARY OUTPUT 36 MONTHS
Regression Statistics
Multiple R
R Square
Adjusted R Square
Standard Error
Observations
0.554551429
0.307527288
0.287160443
0.040083229
36
ANOVA
df
Regression
Residual
Total
SS
1
34
35
Coefficients
Intercept
X Variable 1
-0.001026286
1.216681618
0.024259694
0.054626619
0.078886312
Standard Error
0.006907093
0.313110038
MS
0.024259694
0.001606665
t Stat
-0.14858435
3.88579563
F
Significance F
15.09940768
P-value
0.882759396
0.000448664
161
0.000448664
Lower 95%
Upper 95%
Lower 95.0%
-0.015063187
0.580365466
0.013010616
1.85299777
-0.015063187
0.580365466
Upper 95.0%
0.013010616
1.85299777
SUMMARY OUTPUT 24 MONTHS
Regression Statistics
Multiple R
R Square
Adjusted R Square
Standard Error
Observations
0.536151933
0.287458896
0.255070664
0.035509457
24
ANOVA
df
Regression
Residual
Total
SS
1
22
23
Coefficients
Intercept
X Variable 1
0.004222036
1.07795871
0.011191198
0.027740273
0.038931471
Standard Error
0.007639101
0.361832748
MS
0.011191198
0.001260922
t Stat
0.552687475
2.979162931
F
8.875411768
P-value
0.586049833
0.006920565
162
Significance F
0.006920565
Lower 95%
-0.011620491
0.327563522
Upper 95%
0.020064562
1.828353898
Lower 95.0%
-0.011620491
0.327563522
Upper 95.0%
0.020064562
1.828353898
1 Year Treasury
SUMMARY OUTPUT 72 MONTHS
Regression Statistics
Multiple R
R Square
Adjusted R Square
Standard Error
Observations
0.665649166
0.443088812
0.435132938
0.078752362
72
ANOVA
df
Regression
Residual
Total
SS
1
70
71
Coefficients
Intercept
X Variable 1
0.345406147
0.434135421
0.779541568
Standard Error
0.011502926
2.00310287
0.009325559
0.268411929
MS
0.345406147
0.006201935
t Stat
1.233483821
7.462793777
F
Significance F
55.69329096
P-value
0.221521168
1.77753E-10
1.77753E-10
Lower 95%
Upper 95%
-0.00709631
1.467772165
0.030102166
2.538433575
Lower 95.0%
Upper 95.0%
-0.00709631
1.467772165
0.030102166
2.538433575
SUMMARY OUTPUT 60 MONTH
Regression Statistics
Multiple R
R Square
Adjusted R Square
Standard Error
Observations
0.593318055
0.352026315
0.340854355
0.055609204
60
ANOVA
df
Regression
Residual
Total
SS
1
58
59
Coefficients
Intercept
X Variable 1
0.007483672
1.549321342
0.097440411
0.179358245
0.276798655
Standard Error
0.00743863
0.276006066
MS
0.097440411
0.003092384
t Stat
1.006055116
5.613359759
F
31.50980778
P-value
0.318567937
5.85832E-07
163
Significance F
5.85832E-07
Lower 95%
Upper 95%
Lower 95.0%
-0.007406364
0.996835179
0.022373707
2.101807505
-0.007406364
0.996835179
Upper 95.0%
0.022373707
2.101807505
SUMMARY OUTPUT 48 MONTHS
Regression Statistics
Multiple R
R Square
Adjusted R Square
Standard Error
Observations
0.56064432
0.31432206
0.29941601
0.04584508
48
ANOVA
df
SS
Regression
Residual
Total
1
46
47
Coefficients
Intercept
X Variable 1
0.00448677
1.43462309
0.04431982
0.09668148
0.14100129
Standard Error
0.00682271
0.31241477
MS
0.04431982
0.00210177
t Stat
0.65762322
4.59204626
F
21.0868889
P-value
0.51405775
3.4067E-05
Significance F
3.4067E-05
Lower 95%
-0.0092466
0.80576478
Upper 95%
0.01822017
2.0634814
Lower 95.0%
Upper 95.0%
-0.0092466
0.80576478
0.01822017
2.0634814
Lower 95.0%
Upper 95.0%
-0.0148237
0.58322436
0.01316583
1.85327805
SUMMARY OUTPUT 36 MONTHS
Regression Statistics
Multiple R
R Square
Adjusted R Square
Standard Error
Observations
0.55582555
0.30894204
0.2886168
0.04004226
36
ANOVA
df
Regression
Residual
Total
SS
1
34
35
Coefficients
Intercept
X Variable 1
-0.00082894
1.21825121
0.0243713
0.05451501
0.07888631
Standard Error
0.00688636
0.31247561
MS
0.0243713
0.00160338
t Stat
-0.12037383
3.89870813
F
15.1999251
P-value
0.90489556
0.00043248
164
Significance F
0.00043248
Lower 95%
-0.0148237
0.58322436
Upper 95%
0.01316583
1.85327805
SUMMARY OUTPUT 24 MONTHS
Regression Statistics
Multiple R
R Square
Adjusted R Square
Standard Error
Observations
0.536698476
0.288045254
0.255683675
0.035494843
24
ANOVA
df
Regression
Residual
Total
SS
1
22
23
Coefficients
Intercept
X Variable 1
0.004306609
1.078188594
0.011214025
0.027717446
0.038931471
Standard Error
0.007626288
0.361392575
MS
0.011214025
0.001259884
F
8.900840437
t Stat
0.564705738
2.983427632
P-value
0.577987089
0.00685262
165
Significance F
0.00685262
Lower 95%
Upper 95%
Lower 95.0%
-0.011509345
0.328706269
0.020122562
1.827670918
-0.011509345
0.328706269
Upper 95.0%
0.020122562
1.827670918
2 Year Treasury
SUMMARY OUTPUT 72 MONTHS
Regression Statistics
Multiple R
0.66493356
R Square
0.44213663
Adjusted R Square
0.43416716
Standard Error
0.07881966
Observations
72
ANOVA
df
SS
Regression
MS
F
1
0.34466388
0.34466388
Residual
70
0.43487768
0.00621254
Total
71
0.77954157
Coefficients
Standard Error
t Stat
Significance F
55.4787538
P-value
1.889E-10
Lower 95%
Upper 95%
Lower 95.0%
Upper 95.0%
Intercept
0.01199011
0.00932746
1.28546338
0.20286701
-0.00661292
0.03059314
-0.00661292
0.03059314
X Variable 1
1.99697948
0.2681083
7.44840613
1.889E-10
1.46225435
2.53170461
1.46225435
2.53170461
SUMMARY OUTPUT 60 MONTHS
Regression Statistics
Multiple R
0.592652176
R Square
0.351236602
Adjusted R Square
0.340051026
Standard Error
0.05564308
Observations
60
ANOVA
df
Regression
SS
MS
1
0.097221819
0.097221819
Residual
58
0.179576836
0.003096152
Total
59
0.276798655
Coefficients
Standard Error
t Stat
F
31.40085118
P-value
Significance F
6.0752E-07
Lower 95%
Upper 95%
Lower 95.0%
Upper 95.0%
Intercept
0.007753621
0.007431254
1.043379874
0.301101833
-0.00712165
0.022628891
-0.00712165
0.022628891
X Variable 1
1.546839544
0.276041612
5.603646239
6.0752E-07
0.994282226
2.099396861
0.994282226
2.099396861
166
SUMMARY OUTPUT 48 MONHTS
Regression Statistics
Multiple R
0.559636603
R Square
0.313193127
Adjusted R Square
0.298262543
Standard Error
0.045882804
Observations
48
ANOVA
df
Regression
SS
MS
F
1
0.044160636
0.044160636
Residual
46
0.096840658
0.002105232
Total
47
0.141001294
Coefficients
Standard Error
t Stat
Significance F
20.9766157
P-value
3.54371E-05
Lower 95%
Upper 95%
Lower 95.0%
Upper 95.0%
Intercept
0.004693203
0.006818195
0.688335089
0.494698678
-0.009031111
0.018417517
-0.009031111
0.018417517
X Variable 1
1.430601173
0.312356729
4.580023548
3.54371E-05
0.801859698
2.059342647
0.801859698
2.059342647
SUMMARY OUTPUT 36 MONTHS
Regression Statistics
Multiple R
0.55746475
R Square
0.310766948
Adjusted R Square
0.290495387
Standard Error
0.039989357
Observations
36
ANOVA
df
Regression
SS
MS
1
0.024515258
0.024515258
Residual
34
0.054371054
0.001599149
Total
35
0.078886312
Coefficients
Intercept
X Variable 1
Standard Error
F
15.33019374
t Stat
P-value
Significance F
0.000412427
Lower 95%
Upper 95%
Lower 95.0%
Upper 95.0%
-0.000814282
0.006875112
-0.118439118
0.906416723
-0.01478619
0.013157626
-0.01478619
0.013157626
1.220128055
0.311624498
3.915379131
0.000412427
0.586830884
1.853425226
0.586830884
1.853425226
167
SUMMARY OUTPUT 24 MONTHS
Regression Statistics
Multiple R
0.537262297
R Square
0.288650776
Adjusted R Square
Standard Error
0.25631672
0.035479746
Observations
24
ANOVA
df
Regression
SS
MS
1
0.011237599
0.011237599
Residual
22
0.027693872
0.001258812
Total
23
0.038931471
Coefficients
Standard Error
t Stat
F
8.927144163
P-value
Significance F
0.006783112
Lower 95%
Upper 95%
Lower 95.0%
Upper 95.0%
Intercept
0.004209464
0.007632466
0.551520802
0.586835487
-0.011619301
0.020038228
-0.011619301
0.020038228
X Variable 1
1.077487461
0.3606251
2.987832687
0.006783112
0.329596782
1.825378139
0.329596782
1.825378139
168
5 Year Treasury
SUMMARY OUTPUT 72 MONTHS
Regression Statistics
Multiple R
0.663168281
R Square
0.439792169
Adjusted R Square
0.4317892
Standard Error
0.078985106
Observations
72
ANOVA
df
Regression
SS
MS
1
0.342836277
0.342836277
Residual
70
0.436705291
0.006238647
Total
71
0.779541568
Coefficients
Standard Error
F
54.95362627
Significance F
2.1931E-10
t Stat
P-value
Intercept
0.013107643
0.009334738
1.40417904
0.164686972
Lower 95%
-0.005509904
Upper 95%
0.031725191
Lower 95.0%
-0.005509904
Upper 95.0%
0.031725191
X Variable 1
1.989792352
0.268416729
7.413071312
2.1931E-10
1.454452073
2.52513263
1.454452073
2.52513263
SUMMARY OUTPUT 60 MONTHS
Regression Statistics
Multiple R
0.589980362
R Square
0.348076828
Adjusted R Square
0.336836773
Standard Error
0.055778419
Observations
60
ANOVA
df
Regression
SS
MS
1
0.096347198
0.096347198
Residual
58
0.180451458
0.003111232
Total
59
0.276798655
Coefficients
Intercept
X Variable 1
Standard Error
t Stat
F
30.96753862
P-value
Significance F
7.02346E-07
Lower 95%
Upper 95%
Lower 95.0%
Upper 95.0%
0.008495472
0.007418383
1.145191824
0.256833268
-0.00635404
0.023344979
-0.00635404
0.023344979
1.54209572
0.277113694
5.564848481
7.02346E-07
0.987392398
2.096799042
0.987392398
2.096799042
169
SUMMARY OUTPUT 48 MONTHS
Regression Statistics
Multiple R
0.555813985
R Square
0.308929186
Adjusted R Square
0.293905908
Standard Error
0.046025012
Observations
48
ANOVA
df
SS
Regression
MS
1
0.043559415
0.043559415
Residual
46
0.097441879
0.002118302
Total
47
0.141001294
Coefficients
Standard Error
F
Significance F
20.56336673
4.1108E-05
t Stat
P-value
Intercept
0.005191202
0.006816545
0.76155905
0.450210133
Lower 95%
-0.008529792
Upper 95%
0.018912195
Lower 95.0%
-0.008529792
Upper 95.0%
0.018912195
X Variable 1
1.420816982
0.3133221
4.534684854
4.1108E-05
0.790132316
2.051501649
0.790132316
2.051501649
SUMMARY OUTPUT 36 MONTHS
Regression Statistics
Multiple R
0.55875177
R Square
0.31220354
Adjusted R Square
0.29197424
Standard Error
0.03994766
Observations
36
ANOVA
df
Regression
SS
MS
1
0.02462859
0.02462859
Residual
34
0.05425773
0.00159582
Total
35
0.07888631
Coefficients
Intercept
X Variable 1
Standard Error
t Stat
F
Significance F
15.4332295
P-value
0.00039727
Lower 95%
Upper 95%
Lower 95.0%
Upper 95.0%
-0.00073476
0.00686206
-0.10707534
0.91535855
-0.01468015
0.01321063
-0.01468015
0.01321063
1.22332762
0.31139696
3.92851492
0.00039727
0.59049285
1.85616239
0.59049285
1.85616239
170
SUMMARY OUTPUT 24 MONTHS
Regression Statistics
Multiple R
0.537965768
R Square
0.289407168
Adjusted R Square
0.257107494
Standard Error
0.035460877
Observations
24
ANOVA
df
Regression
SS
MS
1
0.011267047
0.011267047
Residual
22
0.027664424
0.001257474
Total
23
0.038931471
Coefficients
Intercept
X Variable 1
Standard Error
t Stat
F
8.960064615
P-value
Significance F
0.006697213
Lower 95%
Upper 95%
Lower 95.0%
Upper 95.0%
0.00416732
0.007631864
0.546042223
0.590531803
-0.011660197
0.019994837
-0.011660197
0.019994837
1.078861378
0.36042099
2.993336703
0.006697213
0.331393997
1.826328759
0.331393997
1.826328759
171
7 Year Treasury
SUMMARY OUTPUT 72 MONTHS
Regression Statistics
Multiple R
0.662346072
R Square
0.43870232
Adjusted R Square
0.430683781
Standard Error
0.079061899
Observations
72
ANOVA
df
Regression
SS
MS
1
0.341986694
0.341986694
Residual
70
0.437554874
0.006250784
Total
71
0.779541568
Coefficients
Standard Error
t Stat
F
54.71100889
P-value
Significance F
2.35022E-10
Lower 95%
Upper 95%
Lower 95.0%
Upper 95.0%
Intercept
0.013594963
0.009339166
1.455693475
0.149947801
-0.005031416
0.032221342
-0.005031416
0.032221342
X Variable 1
1.986966229
0.268629141
7.396689049
2.35022E-10
1.451202307
2.522730151
1.451202307
2.522730151
SUMMARY OUTPUT 60 MONTHS
Regression Statistics
Multiple R
0.588559055
R Square
0.346401761
Adjusted R Square
0.335132826
Standard Error
0.055850032
Observations
60
ANOVA
df
Regression
SS
MS
1
0.095883542
0.095883542
Residual
58
0.180915114
0.003119226
Total
59
0.276798655
Coefficients
Standard Error
t Stat
F
30.73952917
P-value
Significance F
7.5828E-07
Lower 95%
Upper 95%
Lower 95.0%
Upper 95.0%
Intercept
0.008844436
0.007414036
1.192931342
0.23775356
-0.005996369
0.02368524
-0.005996369
0.02368524
X Variable 1
1.539226816
0.277622087
5.54432405
7.5828E-07
0.983505834
2.094947798
0.983505834
2.094947798
172
SUMMARY OUTPUT 48 MONTHS
Regression Statistics
Multiple R
0.554334162
R Square
0.307286363
Adjusted R Square
0.292227371
Standard Error
0.046079685
Observations
48
ANOVA
df
Regression
SS
MS
F
1
0.043327775
0.043327775
Residual
46
0.097673519
0.002123337
Total
47
0.141001294
Coefficients
Standard Error
t Stat
Significance F
20.40550659
P-value
4.35182E-05
Lower 95%
Upper 95%
Lower 95.0%
Upper 95.0%
Intercept
0.005421447
0.006814287
0.795599991
0.430351054
-0.008295
0.019137895
-0.008295
0.019137895
X Variable 1
1.417141801
0.31371813
4.517245464
4.35182E-05
0.785659967
2.048623635
0.785659967
2.048623635
SUMMARY OUTPUT 36 MONTHS
Regression Statistics
Multiple R
0.559024992
R Square
0.312508942
Adjusted R Square
0.292288616
Standard Error
0.039938789
Observations
36
ANOVA
df
Regression
SS
MS
1
0.024652678
0.024652678
Residual
34
0.054233634
0.001595107
Total
35
0.078886312
Coefficients
Intercept
X Variable 1
Standard Error
t Stat
F
15.45518868
P-value
Significance F
0.000394113
Lower 95%
Upper 95%
Lower 95.0%
Upper 95.0%
-0.000659672
0.006855746
-0.096221702
0.92390943
-0.014592223
0.01327288
-0.014592223
0.01327288
1.224340394
0.311433282
3.931308774
0.000394113
0.59143182
1.857248968
0.59143182
1.857248968
173
SUMMARY OUTPUT 24 MONTHS
Regression Statistics
Multiple R
0.538009494
R Square
0.289454216
Adjusted R Square
Standard Error
0.25715668
0.035459703
Observations
24
ANOVA
df
Regression
SS
MS
1
0.011268878
0.011268878
Residual
22
0.027662593
0.001257391
Total
23
0.038931471
Coefficients
Intercept
X Variable 1
Standard Error
t Stat
F
8.962114592
P-value
Significance F
0.006691904
Lower 95%
Upper 95%
Lower 95.0%
Upper 95.0%
0.004187376
0.007629428
0.548845346
0.588639146
-0.01163509
0.020009842
-0.01163509
0.020009842
1.07916708
0.360481883
2.993679106
0.006691904
0.331573416
1.826760745
0.331573416
1.826760745
174
10 Year Treasury
SUMMARY OUTPUT 72 MONTHS
Regression Statistics
Multiple R
0.661950644
R Square
0.438178656
Adjusted R Square
0.430152636
Standard Error
0.079098771
Observations
72
ANOVA
df
Regression
SS
MS
1
0.341578476
0.341578476
Residual
70
0.437963092
0.006256616
Total
71
0.779541568
Coefficients
Standard Error
F
Significance F
54.59476787
t Stat
P-value
2.42956E-10
Lower 95%
Upper 95%
Lower 95.0%
Upper 95.0%
Intercept
0.014009159
0.009339899
1.499926103
0.138130523
-0.004618683
0.032637
-0.004618683
0.032637
X Variable 1
1.986213262
0.26881306
7.388827232
2.42956E-10
1.450082525
2.522343999
1.450082525
2.522343999
SUMMARY OUTPUT 60 MONTHS
Regression Statistics
Multiple R
0.587723934
R Square
0.345419423
Adjusted R Square
0.334133551
Standard Error
0.055891987
Observations
60
ANOVA
df
Regression
SS
MS
F
1
0.095611632
0.095611632
Residual
58
0.181187024
0.003123914
Total
59
0.276798655
Coefficients
Standard Error
t Stat
30.60635656
P-value
Significance F
7.93066E-07
Lower 95%
Upper 95%
Lower 95.0%
Upper 95.0%
Intercept
0.009167438
0.007406781
1.237708829
0.220811177
-0.005658844
0.02399372
-0.005658844
0.02399372
X Variable 1
1.537950742
0.27799476
5.532301199
7.93066E-07
0.981483776
2.094417709
0.981483776
2.094417709
175
SUMMARY OUTPUT 48 MONTHS
Regression Statistics
Multiple R
0.553042774
R Square
0.30585631
Adjusted R Square
0.29076623
Standard Error
0.046127225
Observations
48
ANOVA
df
SS
Regression
MS
F
1
0.043126136
0.043126136
Residual
46
0.097875159
0.002127721
Total
47
0.141001294
Coefficients
Intercept
Standard Error
Significance F
20.26870006
t Stat
P-value
4.57267E-05
Lower 95%
Upper 95%
Lower 95.0%
Upper 95.0%
0.005661119
0.006810661
0.831214331
0.410146521
-0.008048031
0.01937027
-0.008048031
0.01937027
1.41390154
0.314055367
4.502077305
4.57267E-05
0.781740884
2.046062197
0.781740884
2.046062197
X Variable 1
SUMMARY OUTPUT 36 MONTHS
Regression Statistics
Multiple R
0.559267582
R Square
0.312780229
Adjusted R Square
0.292567882
Standard Error
0.039930909
Observations
36
ANOVA
df
Regression
SS
MS
1
0.024674079
0.024674079
Residual
34
0.054212233
0.001594477
Total
35
0.078886312
Coefficients
Standard Error
t Stat
F
15.47471161
P-value
Significance F
0.000391331
Lower 95%
Upper 95%
Lower 95.0%
Upper 95.0%
Intercept
-0.00055906
0.006848149
-0.081636646
0.935414354
-0.014476172
0.013358052
-0.014476172
0.013358052
X Variable 1
1.225269919
0.31147306
3.933790998
0.000391331
0.592280507
1.858259331
0.592280507
1.858259331
176
SUMMARY OUTPUT 24 MONTHS
Regression Statistics
Multiple R
0.538043887
R Square
0.289491224
Adjusted R Square
0.257195371
Standard Error
0.03545878
Observations
24
ANOVA
df
Regression
SS
MS
F
1
0.011270319
0.011270319
Residual
22
0.027661152
0.001257325
Total
23
0.038931471
Coefficients
Standard Error
t Stat
8.963727339
P-value
Significance F
0.006687731
Lower 95%
Upper 95%
Lower 95.0%
Upper 95.0%
Intercept
0.004232861
0.007624392
0.555173602
0.584377383
-0.01157916
0.020044883
-0.01157916
0.020044883
X Variable 1
1.079652732
0.360611664
2.993948453
0.006687731
0.331789919
1.827515546
0.331789919
1.827515546
177
Method of Comparables
Company
Xerox
HP
Canon
Ricoh
IKON
Company
Xerox
HP
Canon
Ricoh
IKON
Company
Xerox
HP
Canon
Ricoh
IKON
PPS
17.44
48.16
50.61
89.7
12.4
PPS
17.44
48.16
50.61
89.7
12.4
P/E Trailing
EPS
P/E Trailing
1.25
13.95
2.47
19.50
3.34
15.15
6.39
14.04
0.85
14.59
Industry Avg. P/E
14.59
throw out
P/E Forward
EPS 1yr Out
P/E Forecast
0.86
20.28
3.79
12.71
3.89
13.01
6.98
12.86
1.10
11.27
PPS
17.44
48.16
50.61
89.7
12.4
P/B
BPS
7.48
14.55
20.24
65.96
14.25
P/B
2.33
3.31
2.50
1.36
0.87
Industry Avg. P/E
12.46
Industry Avg. P/B
2.39
PE
13.95
19.50
15.15
14.04
14.59
EGRt+1
2.58
18.39
9.90
12.65
8.48
Comparable
XRX PPS
$10.72
Comparables
XRX PPS
$17.88
throw out
Comparable
P.E.G
Company
Xerox
HP
Canon
Ricoh
IKON
Comparable
XRX PPS
$18.24
P.E.G
5.41
1.06
1.53
1.11
1.72
**EGRt+1: Earnings Growth Rate next year
178
Industry Avg.
1.36
XRX PPS
$4.37
Company
Xerox
HP
Canon
Ricoh
IKON
Company
Xerox
HP
Canon
Ricoh
IKON
Mkt Cap ($Bill)
16.50
128.57
64.36
13.36
1.27
P/EBITDA
EBITDA ($Bill)
1.749
11.48
9.88
2.2
0.274
Mkt Cap ($Bill)
16.5
128.57
64.36
13.36
1.27
P/FCF
FCF ($Bill)
1.474
2.98
3.12
0.485
-37.91
P/EBITDA
9.44
11.20
6.51
6.07
4.64
P/FCF
11.19
43.14
20.63
27.55
-0.03
Industry Avg.
5.74
throw out
Industry Avg.
24.09
throw out
Comparable
XRX PPS
$35.50
throw out
Enterprise Value/EBITDA
Company
EV ($Bill)
EBITDA ($Bill) EV/EBITDA Industry Avg.
Xerox
29.59
1.749
16.921
10.63
HP
123.5
11.48
10.758
Canon
58.01
9.88
5.871 throw out
Ricoh
23.12
2.2
10.509
IKON
1.97
0.274
7.190 throw out
**EV=MktCap + BV of liabilities - short term investments-cash
179
Comparable
XRX PPS
$10.04
Comparable
XRX PPS
$5.81
Discounted Free Cash Flows Model
180
Residual Income Model
181
Long Run Return on Equity Model
182
Abnormal Earnings Growth Model
183
References
1. BizWiz Website: http://www.bizwiz.ca
2. Canon’s Website: www.canon.com
2006 20-F
3. CNN Money: www.money.cnn.com
4. Hewlett-Packard’s Website: www.hp.com
2006 10-k
5. Inflation Data’s Website: www.inflationdata.com
6. Investopedia Website: www.investopedia.com
7. Palepu & Healy. Business Analysis & Valuation. Chapter 2
8. SEC’s Website: www.sec.gov
9. Xerox’s Website: www.xerox.com
2002 10-k to 2006 10-k
10. Yahoo Finance’s Website: finance.yahoo.com
184
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