1 APPLYING THE MCKINSEY MODEL General Dynamics 2008 10-K
Overview 2 This is a fully documented example for General Dynamics the model is in the following workbook: generaldynamics.xls This note addresses: Setting Up the Model Entering Historical Data Entering Forecasts Assessing Outputs
Setting Up the Model 3 Consists of four worksheets Historical Data Forecast Drivers Results Valuation Summary Switch to the Forecast Drivers worksheet Enter the relevant data in the range D8:D15
Historical Data Income Statement 4 Switch to the Historical Data worksheet Unprotect the worksheet 2 years data sufficient but the more the better Begin with the income statement You will have to make judgements as to how best to tie up the valuation model inputs and the income statements for your company You may find it convenient to set up a new worksheet that documents the assumptions that you are making. Be careful that you correctly deal with pre vs. post tax items (i.e. That you are not adding pre-tax and post tax dollars You should only enter items in yellow cells. If you wish something to be negative, you must put a minus in front of it (i.e. the subtotals A detailed explanation of how each number was linked to the income statement is available in the GDIncome worksheet
Historical Data Balance Sheet 5 Again, some care is necessary since the captions in the valuation model will not match the captions on the balance sheet for your company A useful technique is to create a new worksheet to document how you computed the items Judgement is required when you try to relate items and will depend upon the company that you are examining Note that the balance sheet check should be zero if you have a balance sheet that balances. If your balance sheet does not balance, you must detect the error at this stage. A detailed explanation of how each number was linked to the balance sheet is available in the GD Bsheet worksheet
Historical Data Owners Equity 6 Once you have completed the income statement and the balance sheet, some of the detail will be available for owners equity The first trick is to insert the Owners Equity at the beginning of 2007 in cell M36. Note that this is about the only example where you should enter data in a white cell! Also, make sure that you understand what is happening in the other adjustments to equity if it is a large number. This is likely to include gains and losses on a pension plan, gains and losses on derivatives etc. A detailed explanation of how each number was linked to the balance sheet is available in the GD Owneq worksheet
Historical Data Off Balance Sheet 7 Items You only need to worry about off balance sheet data for the most recent period Tax rate quick estimate is income taxes/earnings before taxes Capital Expenditure available from the statement of cash flows under investing activities Market value of common equity obtain from finance.yahoo.com (make sure it is in same units e.g. $million) Non operating component of pension expense ignore Weighted average cost of capital use 10.05% -you can adjust it later on after the lecture on the cost of capital 10 year t-bond assume that it is 3.5% Operating leases and interest rate on leases see worksheet GD Oplease Interest rate on long term operating provision ignore Per share amounts 000. Refer to footnote on Earnings per Share this will contain shares used for basic average shares outstanding and the effect of dilution Shares outstanding at year end is available in the stockholders equity footnote. Make sure that shares outstanding excludes treasury stock At this stage you should: Make sure that the error check in Cell A2 is OK. If not you should check your work Save the worksheet and make a backup copy
Forecast Drivers Income and 8 Working Capital Unprotect the Forecast Drivers worksheet Enter the 52 week high and low stock prices from finance.yahoo.com in cells D18 and D19 The key assumptions that will drive your valuation are growth in operating revenues and gross margins. A simplified forecast of these amounts is contained in the GD Segments Worksheet You should think carefully about the sales and margins for your company are likely to be affected by the downturn in economic activity A starting point for all of the other items is to assume that the percentages will be unchanged from the percentages that were calculated for 2007-8
Forecast Drivers(Assets) Row68 ff 9 In cell D68, you can choose the method for calculating Capex. You can choose: Net PPE % of revenues you must fill in 069:S69 and select 1 in D68 CAPEX % of Revenues you must fill in O70:S70 and select 2 in D68 A $ amount of expenditure fill in O71:S71 and select 3 in D68 The easiest way is to use option 1 (the default) and assume that it will be the same as 2008 Subsequently, you can modify your assumptions to reflect the impact of your sales and gross margin forecasts For example, the CAP EX numbers in the GD worksheet are completely incorrect (O72:S72) if you choose option 1 (a huge Cap Ex drop in 2009!) They are incorrect because I have assumed sales will contract as a result one ends up with CAPEX numbers that are completely incorrect An alternative is to use a $ forecast and this will result in a more sensible projection For Depreciation assume that the 2008 rate will persist you can subsequently modify this assumption to reflect your analysis of the company. Do not enter any amounts for goodwill in 082:S83 Assume that historic amortization of intangibles will continue in subsequent years (O90:S90) Ignore all of forecasts in rows O94:S124 unless you have a good idea Operating leases assume that 2008 data will be repeated in future (rows 128 and 130) Ignore all subsequent items down to row 188 (you can play with them later!)
10 Phase 2, Continuing Value (291-323) and the valuation Phase 2 is years 5-14 Long term sales assumption (T292: AD292) will depend on whether industry is in decline etc. A good starting point is 3-4%(long term growth of economy) EBITA Margin will depend on long term competition in industry etc. The Sales growth assumption and the EBITA margin assumption are the principal value drivers Easiest thing is to assume that cash taxes, PPE as % of revenue, Other invested capital as % of revenue and cumulative goodwill continue at rates observed in 2013 (you can modify it later) Continuing Value Essentially, you have three choices in D314 enter a value in D316 (option 1), assume that it will equal ROIC in last year of Phase 2 (option 2) or assume that it is equal to the WACC (option 3). The most conservative choice is Option 3. Assume a growth rate for NOPLAT (D322) 4% is a good starting point
11 WACC, Interest Rates and taxes (Rows 190-286) The minimal data you need are assumptions about the rate at which the company can borrow and lend money. The following are a reasonable starting point: Excess Cash 0.5% Debt 5% (adjust following the lecture on WACC) WACC 10.05% Fill in this data in O192:S196 and O223:AD223 If the company pays dividends, enter % dividend payments O240:S240 and O261:s261 (latter should be negative) Enter tax rates in o278:s279 easiest way is to begin with tax rates in 2008 Enter taxes paid in 0273:s273 easiest way is to assume that these amounts are equal to amounts in 272. Note that you should ensure that there is a minus sign in front of this amount Potential modifications you could consider Allow interest rates to vary Develop a detailed model of WACC A model of taxes that includes deferred tax positions and more granular detail on the tax rates
Results and Valuation 12 Results Worksheet Detailed financials for next 5 years Do they make sense is the 2013 EBITA reasonable? Do the cash balances make sense in 2013 why/why not? How about return on invested capital why is it increasing? Does this mean that CAP EX has been underestimated? Valuation Summary Worksheet Implies that the firm is substantially undervalued (i.e. Value per share of 64 compares with market price of $38)
Refining the Valuation 13 Basic challenge we want to understand why our model says the market is wrong Our review of the 10-K suggests that there are two key things Growth in DefenseSpending The Executive Jet Business First step, what is the value of the firm in the absence of the Exec Jet Business Create a new scenario No Jets (workbook is GD Nojets) Alter GD Segments so that sales in 2011 decline by 100% (cell g7) 40 Value per Share Drops to 54.54 Therefore we can conclude that the value per share of the Executive Jet Business is $9.03 We can push it even further and assume that Executive Jets dries up completely in 2009 (insert -100% in cell E7) and Value per share drops to 52.29 (i.e. There is 2.25 of value in the current order book). Next, try and examine sensitivity of the defence rump to changes in Defence Spending. Using a base case of $54.54 per share, the weighted average growth rate in defence spending is 4.75%. Create a new scenario based on No Jets (workbook is GD Defence) Set up the GD Segments worksheet so that defence spending becomes the driver of revenue growth Create a new worksheet Sensitivity to examine impact of rate of growth in defence spending Use Data Table and Chart tools to produce the graph on the right Conclude Using a worst case scenario of no growth in defence spending and no income from executive jets, General Dynamics is worth $44 per share. Share Price 60 55 50 45 35 0.0% 2.0% 4.0% 6.0% Growth in Defence Spending