General Electric
April 1, 2005
Benjamin Stokes: [email protected] April Harris: [email protected] Chase Kochwelp: [email protected] Will Whitsitt: [email protected]
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TABLE OF CONTENTS Executive Summary...... 4
Business & Industry Analysis...... 6
Industry Overview ...... 6
Five Forces Model...... 8
Industry Analysis ...... 14
Key Success Factor………………...... 15
Accounting Analysis ...... 19
Accounting Analysis Steps ...... …..19
Screening Ratios ...... 28
Ratio Analysis & Forecast Financials...... ….31
Financial Ratio Analysis...... …..... 31
Cross Sectional (Benchmark) Analysis ...... ……..... 32
Financial Statement Forecasting Methodology……....….... 51
Valuations Analysis...... 52
Method of Comparables...... 53
Calculation of WAAC and Cost of Equity……………………….56
Altman’s Z-score……………………………………………………….57
Discounted Dividends...... …………………………………. 58
Abnormal Growth Earnings...... 59
Discounted Free Cash Flow...... 60
Residual Income Valuation Model...... 62
Long Run Average Residual Income Perpetuity…………..63
Appendices...... …...... …....44
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General Electric Investment Recommendation: HOLD April 1, 2005
EPS Forecast GE/ NYSE Current Price…...$35.63 FYE 2004(A) 2005E 2006E 2007E 52 week price range $29.55-37.75 EPS $1.57 1.69 1.83 1.97 Revenue (2004) $152,363B Market Capitalization $377.78B Valuation Ratio Comparison GE Industry Avr. Trailing P/E 22.53 17.21 Shares Outstanding 10.6B Forward P/E 17.47 23.99 Forward PEG 1.99 1.48 Dividend Yield 2.44% M/B 3.40 1.84 3-month Avg Daily Trading Volume 16,653,772 Percent Institutional Ownership 54.83% Valuation Estimates
Book Value Per Share (mrq) $10.42 Actual Current Price (1 April 2005) $35.47 ROE 17.43% ROA 2.40% Ratio Based Valuations Est. 5 year EPS Growth Rate 10% P/E Trailing $27.20 P/E Forward $37.23 2 Cost of Capital Estimates Beta r Ke Dividend Yield $45.75 Ke Estimated .0649 21.2 M/B $19.17 5-year Beta 1.095 32.3 .0642 Ford Epic $52.66 3-year Beta .8914 23.48 .0588 Intrinsic Valuations 2-year Beta .8084 31.27 .0563 Discounted Dividends $32.48 Published Beta .895 .0589 Free Cash Flows $23.64 Residual Income $37.43 Kd 3.95% Abnormal Earnings Growth $33.64 WACC (bt) 4.36% Long Run ROE Perpetuity $28.96
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Executive Summary
Recommendation
General Electric Co. (GE) is a well-diversified conglomerate that provides electrical related products and services. Operating as one of the largest companies in the world, General Electric’s array of business segments, products, and services create an extremely large and expansive customer base. We feel that because of GE’s diversification and past trends, it will continue to grow at a steady rate, and in the near future, GE’s stock price should stay between $32.50 and $37.40. Given this information, we feel that General Electric should be currently rated HOLD.
Industry Analysis
The Diversified Industrials Industry consists of many large companies that operate in a number of diversified fields. Those competing in this industry are constantly looking for new acquisitions that will be profitable in the long run. Companies in this industry are generally large in scale and have overlapping segments with each other. GE, which accounts for over one-third of the entire market capitalization in the industry, is the largest. Overall, the Diversified Industrials industry has steady growth potential.
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Accounting Strategy
GE is often the considered the benchmark in accounting policies in its industry because of its size and market capitalization. Many policies utilized by
GE demonstrate accounting conservatism. The degree and quality of disclosure beyond GAAP requirements is an important aspect of measuring a firm’s transparency. General Electric has acknowledged and shown the importance of this through its extensive amount of disclosure. With GE’s conservative accounting policies, we can assume that GE has disclosed all vital information to the public which allows us to get an accurate assessment of the company.
Valuation and Forecasts
The valuation models have given us several estimations of the share price within dollars and cents of its actual market trading value. With the exception of the free cash flows model, we feel that GE is fairly valued. If you already own GE, you should keep it; if not, you should buy it. GE can provide a long term, low risk positive investment choice. The values calculated in our models show us that GE’s market price per share is very close to its intrinsic value and at this point, if anything, GE is only slightly overvalued.
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Business & Industry Analysis
Company Overview
General Electric Co. (GE) is a well-diversified conglomerate that provides electrical related products and services. Operating as one of the largest companies in the world, GE’s broad range of business activities can be divided into 11 segments: Advanced Materials, Commercial Finance, Consumer Finance,
Consumer and Industrial, Energy, Healthcare, Infrastructure, Equipment and
Other Services, Insurance, NBC Universal, and Transportation. GE is a market and industry leader in the development of a wide range of products including aircraft engines and major appliances. GE also offers product, financial, and information services.
Industry Overview
The Diversified Industrials Industry consists of many large companies that operate in a number of diversified fields. Many companies competing in this industry are constantly looking for new acquisitions that will be profitable in the long run. Synergy is important to many competitors in deciding which additions to the company will be the most beneficial. Today's successful companies focus on their own strengths and tend to have very focused, capable management
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teams that are knowledgeable in distributing available cash throughout the organization.
Companies in this industry are generally large in scale and have overlapping segments with each other. GE, which accounts for over one-third of the entire market capitalization in the industry, is the largest. On average, the
Diversified Industrials industry has experienced steady growth since early 2003.
Five-year price performance of stock, its DJ Industry group and the DJ
U.S. Total Market Index, re-indexed to zero.
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Performance General Electric DJ Diversified DJ U.S. Total
During Past: Company Industrials Market Index
3 Months 3.01% 3.39% 1.23%
6 Months 10.25% 9.57% 8.07%
Year-to-Date -0.68% -0.37% -3.29%
12 Months 9.25% 13.27% 5.14%
2 Years 57.27% 62.18% 41.75%
5 Years -23.18% -5.81% -16.57%
Five Forces Model
• Current Competitors
General electric is one of the world's largest and most diversified
companies. With eleven different segments of the company, ranging from
Advanced Materials to NBC Universal, General electric has a strong hold on many separate markets. As a whole, General Electrics' main competitor on a conglomerate level consists of Siemens.
Siemens AG (SI) is a leading diversified company offering products and
services in information and communications, automation and control, power,
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transportation, medical, water and wastewater treatment, lighting, financing, real estate, and home appliances. Siemens' is one of the largest markets in the world, with thirteen worldwide businesses and annual sales of $97 billion. Siemens companies in the U.S. employ approximately 70,000 people and 430,000 people globally. Siemens’ most closely mirrors General Electric’s size and structure, making it their largest competitor.
Breaking GE down into individual segments reveals a more accurate depiction of the company’s competition. Each separate venture of GE has its own degree of competition. While all eleven segments of the company are important, the largest and most profitable areas of business are GE’s finance, media, and technology businesses.
GE’s Consumer Finance and Commercial Finance are GE’s most lucrative businesses producing 39 billion dollars in revenue for 2004. These financial institutes offer a wide array of services and products such as commercial loans, home loans, bank cards, auto loans, leasing and financing inventory, debt consolidation loans, and home equity loans. Citigroup, a GE competitor, provides financial services for more than 200 million people in over
100 countries with revenues of over 66 billion. Citigroup competes with General
Electric’s financial service business segment with their four business groups in the financial services. These segments consist of Global Consumer Group, Global
Corporate & Investment Banking Group, Global Investment Management, and
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Global Wealth Management. The competition in this area is high between GE
and Citigroup.
GE NBC Universal is one of the worlds leading media and entertainment
companies owning a television network, world-renowned theme parks, motion
picture company and other various media outlets. While GE NBC produces a
lower revenue than its competitors, such as Disney and Time Warner Inc., GE
maintains a relatively competitive profit.
Another large competitor GE faces is Koninklijke Philips Electronics competing on more of a technological battlefield. Phillips is a global company
that generates more than 39 billion in sales and employees 161,000 people in over 60 countries. Phillips is one of General Electric’s smaller competitors though
Philips Medical Systems is increasingly creating more competition in that business segment of General Electric.
General electrics main advantage is the fact that they are so diversified.
The competition is steep in each of their individual companies, but there are few
companies that can compete with General Electric as a whole.
• New Entrants
The threat of new entrants for General Electric is small due to the vast
size of the company. Many of GE's companies require a great deal of brand
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recognition to stay successful. The scale of economy that GE operates in places a
hardship on new entrants to any of the three major segments of GE.
The financial services industry would require an extremely large amount
of start up cost and capital making it difficult for small companies to compete.
The finance industry also hinges on an established and trusted name for success.
The threat of new entrants to the finance industry competing on the scale that
GE competes in is very small.
GE NBC also has little threat of new entrants imposing competition. In
the world of broadcast and entertainment there is also a great deal of monetary
value that must be expended in order to even have hopes of competing with such networks as NBC. New entrants must also face the legal barriers licensing regulations created by the government to limit entry into the broadcast industry.
Not only must new entrants have a mass amount of capital and legal issues but
they must also compete with the NBC name.
Technology is yet another industry that requires large capital and
expense. It would be difficult for new entrants to obtain the cash and
development that is essential in this industry. Also, new companies must take
into realized the channels of distribution for the production of technologies are difficult to achieve without an already established relationship.
The threat of new entrants in all aspects of GE is low due to the repeating trends of the market requirements that GE employs. People already
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have a solid relationship with the brand name GE, and it would be very
expensive for a new company to try and compete with it. It would require a
great deal of capital in advertising to get a new companies brand name out to
the public. All of GE's companies are in very large-scale economies, which are
difficult to break into.
• Threat of Substitute Products
Every company has to worry about the threat of new products being
created which would make their product obsolete. GE is no exception. Just about
every product that General Electric creates has the threat of substitute products.
The financial segment of GE is not as susceptible to a threat of
substitutes as other units of GE. A consumer is not as likely to switch their
financial provider, as they are their light bulb brand.
GE NBC is one segment that could be prone to substitutes. Substitution
for GE NBC is as easy as viewers switching a channel and advertisers switching
networks. This creates a high level of competition that promotes companies to
continually have the edge over their competitors.
The technology industry is also an at-risk industry to threats of substitutions. From their consumer products to their healthcare technologies, everything has the ability to be taken over by a newer technology or a more efficient product.
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General electrics advantage in this field is their strength of brand name.
With new products coming out all of the time, consumers may be reluctant to switch due to their loyalty to the GE brand name.
• Bargaining Power of Buyers
Due to the size of General electric, they have considerable bargaining power for most of their products. For many of their companies, the switching cost for buyer is extremely high. This is true with the financial, broadcasting and technology industry. For many companies, such as GE Healthcare, the volume per buyer is very large in both quantity of goods and cost of goods. This makes the switching cost for buyers high, giving GE yet another advantage over their buyers. This is true for most of their companies, but not all. Some of General
Electric’s companies, such as GE Consumer and Industrial, the switching cost of buying a different product is minimal. In these few scenarios, GE must stay competitive in the price wars with their competition.
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• Bargaining Power of Suppliers
The bargaining power of suppliers is relatively low for General Electrics
many industries. Due to the shear volume of goods that GE buys from their
suppliers, the suppliers have no ability to bargain with GE. Most of GE's suppliers
could not survive if they lost GE's business. General Electric is also very flexible in who they choose to be their suppliers. This gives them the advantage of having suppliers fight for their business.
Classification of Industry
From jet engines to power generation, financial services to plastics, and
medical imaging to news and information, GE people worldwide are dedicated to
turning ideas into products and services. Although General Electric employs
many industries, GE is classified as a conglomerate, with its market capitalization
of 358 billion. The 11 different areas of GE are as follows: Advanced Materials,
Commercial Finance, Consumer Finance, Consumer and Industrial, Energy,
Healthcare, Infrastructure, Equipment and Other Services, Insurance, NBC
Universal, and Transportation.
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Key Success Factors
Competitive Advantage
Maintaining a competitive advantage in the market means to have a
strong hold of your Key Success Factors. There are several factors that enable
GE to have its advantage, of the many, General Electric’s service quality and
their ability to maintain customer satisfaction has given them a constant edge over the rest.
Quality of service is essential to GE, and it invests in multiple programs to insure that this quality is maintained. ‘GE has devoted a large part of it efforts in operating the highest reliability facilities from Nuclear Power Stations to Data
Centers for over fifty years.’ Simplified maintenance costs, reduced financial risk,
shared focus on minimizing downtime, and reduced internal administration are
just a few changes to their structure that eliminate inefficiencies and reduce a
complex process to a simplified one.
One of the most unique processes that GE utilizes is their Six Sigma
approach, which reduces downtime at the customer's site. Six Sigma is basically
a statistical term that measures how a certain process deviates from perfection.
This process is highly disciplined, and helps focus on developing and delivering
near-perfect products and services. The main goal with Six Sigma is to measure
how many flaws or defects are in the process being used, then by focusing on
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these problems you can make the needed changes to eliminate them and get as
close to zero defects as possible. Having their ideas behind this approach is one
of the many reasons GE has been maintaining quality in and around the
workplace.
Customer support and satisfaction has been a stronghold for GE.
Support programs, such as Remedy's Customer Service Solutions, strengthen
customer relationships by automating customer support, engineering it, and
creating quality assurance processes across your organization. As a result, you
gain a significant competitive advantage through increased customer satisfaction, higher productivity, and lower costs. Remedy Customer Support is one of the functions of this program. It automates your support processes and provides closed-loop resolution to customer problems. Another advantage this brings is that it also enables you to deliver the superior service it takes to raise customer satisfaction and build customer loyalty for increased revenues. Remedy Quality
Management is another function that automates the process of managing product defects and new feature requests. Having the capability to track defects and new request features increase the effectiveness of GE’s development and quality assurance processes, responsiveness to customers, and shorten time to market. Remedy Web Self Service is a quick-to-install and easy-to-adapt Web- based customer interface to the Remedy Customer Support application. It offers the fastest path to improved service quality and customer satisfaction by
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removing friction from the way your customers gain access to the critical
information they need.
KSF: Degree of Attainment & Continuation
Key success factors facilitate the goals and accomplishments of a company but
can only do so in the environment with a highly efficient and effective infrastructure accompanied by a strong customer base, developed management team, and facilities of a high caliber.
Customers
General Electric’s array of business segments, products, and services
create an extremely large and expansive customer base. From light bulbs to jet
engines, financial services to plastics, and medical imaging to news and
information customer diversity is endless and unclassifiable. All of the 11
divisions of GE businesses supply products and services to both individual
consumers of all ages and creed and industries of all shapes and sizes. This
enormous span of customers helps to create and sustain the company’s success.
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Management
Extraordinary management is not only imperative for a company of this
dimension and diversity but it is also the catalyst by which this position was
achieved. General Electric’s management has been a continuance of ingenuity and character.
Thomas Edison founded General Electric in 1892. Many great leaders
succeeded him for the next 113 years. Arguably one of the greatest leaders of
his time, Jack Welch, was one of them. Chairman and CEO from 1981 – 2001,
Welch changed the beliefs and ideas of this company, implementing a now widely known management strategy the six sigma. Jack Welch retired as
Chairman and CEO of General Electric in September 2001. Jeffery R. Immelt is the current Chairman and CEO and continuing to exercise the management implemented by Welch.
Facilities
General Electric is a highly globalized company that has a stake in every
continent in the world. Operations are held in 100 different countries employing
more than 300,000. General Electric utilizes several different areas across the
world for the corporate headquarters of each of the 11 segments of its business.
Connecticut is home to the CEO and other officers in the corporation.
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Aside from the operations and corporate facilities, there are several leadership
and training facilities throughout Europe, Asia, Latin America and other parts of
the world. Among these is the 46 million dollar John F. Welch Leadership Center
at Crotonville, which provides leadership training to all levels of employees.
Accounting Analysis
In this section we discuss methods to evaluate the quality of General
Electrics accounting policies. A six step qualitative method was used to evaluate
the quality of accounting procedures. These steps include: key accounting
policies, potential accounting flexibility, actual accounting strategy, quality of disclosure, potential red flags, and undo accounting distortions. Quantitative
measures where also used to measure sales manipulation diagnostics and core
expense manipulation diagnostics.
Key Accounting Policies
General Electric's key success factors lie in both their product quality and
Innovation. GE's consolidated financial statement consists of all companies that
they have control of and in which they have a majority voting interest. All of
General Electrics accounting policies adhere to the Generally Accepted
Accounting Principals (GAAP).
To maintain the level at which GE is in the industry it must continue to grow
and develop. It may do this by Research and development and continually
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expanding its current product lines. By focusing on these areas, GE will continue to be the top performers in their industry.
Below are summaries of some of GE's significant accounting policies:
• SALES- Sales are recorded on the accrual basis. This is a conservative
method that does not allow the recording of a sale or asset until it is
reasonably assured.
• DEPRICIATION AND AMORTIZATION- GE depreciates property,
plant, and equipment over its estimated life. U.S. assets use the sum-
of-years- digits formula, while non-U.S. assets use the strait-line basis.
These are also conservative accounting strategies.
• INVENTORIES- GE uses last-in, first-out (LIFO) for almost all of their
U.S. inventories, First-in, first-out is used for the remainder GE's
inventories. All of GE's inventories are stated at the lower of cost or
realizable value.
• NEW ACCOUNTING STANDARDS- On July 1, 2004, GE adopted
FASB modifies FIN 46R, which added approximately $2.5 Billion to
their total assets and liabilities.
Many of General Electrics accounting policies differ slightly throughout their 11 different companies, but the above categories stay relatively steady.
Some of the most important accounting policies throughout the company are sales, depreciation, cash, inventories, and looses on receivables. Inventories are
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the most important account due to General Electric consisting of many different
manufacturing companies.
Potential Accounting Flexibility
General Electric has taken several actions in the recent past that has helped keep their balance sheet strong and their triple-A ratings consistent. GE’s key accounting policies are largely influenced by incorporating a large amount of flexibility in to them. One of the methods GE has used to improve their financial flexibility is reducing “parent-supported debt”. In the past, GE Capital had a capital structure that included about $8 of debt for each $1 of equity. In order to measure segment profit, this 8:1 leverage ratio was then used to assign debt and interest cost to each of GE’s financial services businesses. At the beginning of 2003 GE changed that accounting policy by using the flexibility allowed by the
SEC. The leverage ratio was then changed in to a business-specific, market- based leverage that is currently used to measure performance. “As a result, at
January 1, 2003, debt of $12.5 billion previously allocated to the business segments was allocated to the Equipment & Other Services segment”. This debt of 12.5 billion is referred to as parent supported debt. GE then reduced this debt by the following actions: reducing the dividends payable from GECS to GE down to 10% of operating income (1.7 billion), strategic dispositions to the FDIC, US
Auto, and Home Assets (1.7 billion), rationalization of insurance activities including mortgages (.7 billion), and their continuing strategy to optimize fleet
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mix, age and size at Equipment & Other Services ($0.5 billion). As a result of
these actions, a total of $4.6 billion of such debt was eliminated, reducing the
total to $7.9 billion at year-end. Furthermore, GE plans to have this debt
eliminated by 2005 by using the proceeds from further strategic dispositions.
Another way GE uses accounting flexibility is by changing the way it
classifies Goodwill and Other Intangible Assets. “In 2002, we (GE) adopted SFAS
142, Goodwill and Other Intangible Assets, under which goodwill is no longer
amortized but is tested for impairment using a fair value methodology”. GE
tested all of their goodwill for impairment as of January 1, 2002, and 1.204 billion dollars that all related to equipment and other services was recorded as a non-cash charge. Several factors that contributed to the impairment charge include; a difficult economic environment in the information technology sector, and high price competition in the auto insurance industry. The change from the previous goodwill impairment policy that was based on undiscounted cash flows to the new policy for goodwill that is based on a fair value is a clear example of
GE’s accounting flexibility.
ACCOUNTING STRATEGY
According to the amount of flexibility that is present, a company may
choose to report financial information either aggressively or conservatively.
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Conservative accounting tends to give customers a more accurate description of true value. GE uses a conservative strategy to retain trust in their company and
to promote their customer focused growth agenda. Because of GE’s size and
market capitalization, it is often the benchmark in accounting policies in the
conglomerate industry. Many policies utilized by GE demonstrate accounting
conservatism.
GE records sales of goods when a firm sales agreement is in place,
delivery has occurred, and collectibility of the fixed or determinable sales price is
reasonably assured. If customer acceptance of products is not assured, sales are
recorded only upon formal customer acceptance.1 Sales could easily be manipulated by recording them before it was certain that they would be carried out. Recording sales only after being accepted by customers shows a conservative strategy.
The interest method is used to recognize income on all loans. GE
recognizes interest income on non-earning loans either as cash or on a cost-
recovery basis as conditions warrant.1 Accruing interest is conservatively used on
loans only when the loans meet current payment requirements or if future
payments are “reasonably assured.”
1 GENERAL ELECTRIC CO 10-K 2003-12-31
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GE depreciates its non-U.S. assets over the estimated economic life
using the straight line depreciation method. However, unlike the industry norm,
all U.S. assets are depreciated using an accelerated method based on a sum-of-
the-years digits formula.1 By using this more conservative method, GE is
assuming that an asset loses a majority of its value in the first several years of use.
Allowance for losses on financing receivables is represented by a best
estimate strategy of probable losses inherent in the portfolio. The method of calculating estimated losses depends on the size, type and risk characteristics of
the related receivables.1 Although GE cannot accurately predict the actual
amount of receivables that will be paid, they use previous experience as well as
other highly developed methods to convey a reasonable estimate on the financial
statements.
GE has also applied changes to several of their discount rates. The
pension discount rate has been lowered from 6.75% to 6.00% due to historical
and expected returns on various categories of plan assets.1 According to the
company, the new rate reduces the underlying variability in assets. Although this
reduction caused a significant increase in pension expense, the expected return
on assets was lowered by .75% to offset the increase in expenses.
1 GENERAL ELECTRIC CO 10-K 2003-12-31
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Debt rating agencies frequently evaluate the debt of GE, to ensure to
lenders that GE will be able to repay their debt. GE often receives the highest
debt ratings of AAA, which shows that they are more than likely going to be able to pay back their debt. Maintaining these high ratings is extremely important to
GE because it lowers the cost of borrowing and allows a greater variety of
lending sources.
One recent accounting change involved GE adopting FASB Interpretation
No. 46, Consolidation of Variable Interest Entities, which did not result in any
significant gains or losses.
Quality of Disclosure
The degree and quality disclosure beyond GAAP requirements is a vital facet of measuring a firm’s accounting quality and transparency. General Electric
has acknowledged and demonstrated the importance of this through its
extensive amount of disclosure found in the company’s footnotes, letter to the
Shareholders, Management Discussion and Analysis, and in many other dimensions in company statements.
General Electric’s letter to the Stakeholders in their annual report clearly and adequately provides information regarding the company’s business model and the economic environment and consequences otherwise not presented in the financial statements. The letter also clearly describes its competitive position
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and its future plans and estimates. General Electric provides a realistic view of the company’s financial performance and environment in order for investors and the public to assess an accurate view of the company*.
General Electric also utilizes footnotes to explain key accounting policies and assumptions throughout their financial statements. Accounting changes, revenue and expense recognition, retiree health and life benefits, pensions, fair value of assets and plant asset allocation are just a few of the many areas that are elaborately explained in the footnotes.
The Management Discussion and Analysis creates a facet for investors and the public to evaluate and understand changes in the firm’s performance.
General Electric’s Management Discussion and Analysis presents an overview of the company’s earnings for the past three years as well as an overview for the reasons of fluctuation in performance. The analysis also describes the segments of each business and its performance, allowing a more vivid and accurate analysis for each individual division. It also analyzes the performance and changes in financial resources and liquidity.
General Electric provides the public with valuable information outside the narrow scope of GAAP regulation that enables an easier assessment of their accounting quality. By providing realistic and extensive information General
Electric has increased its reliability and investor trust.
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Potential “Red Flags”
Though General Electric has changes in its accounting policies and other
questionable items, General Electric has fully explained these discrepancies through its disclosure. For example;
LIFO revaluations increased $26 million in 2003, compared with decreases of $70 million in 2002 and $169 million in 2001. Included in the 2003 change was an increase of $3 million that resulted from higher LIFO inventory levels. Included in the 2002 and 2001 changes were decreases of $21 million and $8 million, respectively, which resulted from lower LIFO inventory levels. Net costs increased in 2003 and decreased in 2002 and 2001. As of December 31, 2003, we are obligated to acquire certain raw materials at market prices through the year 2023 under various take-or-pay or similar arrangements. Annual minimum commitments under these arrangements are insignificant.
From this excerpt of the General Electric footnote, it is clearly explains all
items that could be construed questionable or dubious.
General Electric has not only followed GAAP but also gone above and
beyond expectations regarding disclosure, giving detail and explanation to
anything that could raise questions.
Undo Accounting Distortions
After reviewing all of General Electrics consolidated financial statements,
we have concluded that the reports had no misleading activity. GE’s annual
reports tend to explain every change made in full detail in the notes. The
flexibility of accounting methods was apparent in the financial statements of GE,
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but they did not use flexibility to manipulate their numbers. Therefore since all
changes were clearly explained in the footnotes, there was no need to make any
major adjustments or corrections to the financial statements
Quantitative Measures and Indicators
To analyze the past performance of General Electric, quantitative
measures and indicators must be researched. The sales manipulations diagnostics shows the behavior of sales relative to cash from sales, accounts
receivable, and inventory. The core expense manipulation diagnostics shows
earnings relative to expenses.
Sales Manipulation Diagnostics:
1999 2000 2001 2002 2003
Net Sales/Cash 1.00 1.00 1.00 1.00 1.00 from Sales Net Sales/Net Account 7.51 7.68 7.46 7.14 6.74 Receivables Net Sales/ 9.14 9.34 8.34 8.24 8.27 Inventory
These ratios show that net sales to cash from sales remained the same. Net
sales to accounts receivables increased at small doses from 1999 to 2000, then
started to decrease. Which means sales increased more than accounts
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receivables in the first two years and then accounts receivables were greater than sales in the years 2001, 2002, and 2003. The net sales to inventory increased slightly from 1999 to 2000 which means the company is holding more inventories. Then in 2001 it dropped a whole point, then came to a some what steady number.
Core Expense Manipulation Diagnostics:
1999 2000 2001 2002 2003
Sales/Assets 0.158 0.167 0.144 0.133 0.112
CFFO/OI 2.29 1.78 2.35 2.13 2.02
Sales to assets increased from 1999 to 2000, but ended in 2003 in a decrease.
Cash flows from operations to operating income dropped from 1999 to 2000, but then increased in 2001. In 2002 started to decrease into year 2003, and ended in a decrease. This reflects the decrease in cash flows from operations.
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% Changes in Measures:
2000 2001 2002 2003
Net Sales/Cash No Change No Change No Change No Change from Sales Net Sales/Net Account 2.21% -2.95% -4.48% -5.93% Receivables Net 2.14% -11.99% -1.21% 0.362% Sales/Inventory
Sales/Assets 5.39% -15.97% -8.27% -18.75%
CFFO/OI -28.65% 24.26% -10.33% -5.45%
*www.ge.com
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Financial Statement Ratio Analysis
The forecasting analysis is an evaluation of a firm’s financial statements in
order to show the current position a firm holds in a market, and its prospect for
future growth. Financial forecasting can be valuable to any body with an interest
in the future value of a firm. By analyzing the liquidity, profitability, and capital
structure ratios, we can forecast the probability of future growth. By doing the
same ratio analysis for the top industry competitors, we can compare each
company side-by-side, and observe how our company stands up to the Industry
average. By analyzing GE’s current and past year ratios, we will be able to find
trends in different sections of the company, and forecast those trends into future
years. Buy using these trends and any current or new information available
about the company or its industry; we can better understand in what direction a company is traveling in the near future.
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Liquidity Analysis:
2000 2001 2002 2003 2004 Current Ratio 1.89 1.71 2.14 2.24 2.39 (CA/CL)
Quick Asset Ratio 0.69 0.60 0.75 0.77 0.80 (QA/CL)
Accounts Receivable 0.41 0.32 0.30 0.24 0.25 Turnover (SALES/AR) Days Supply Of 883.57 1135.11 1214.34 1492.84 1435.70 Receivables days days days days days (365/AR TO) Inventory Turnover 5.03 4.17 4.19 4.25 4.36 (COGS/INV)
Days Supply Of Inventory 72.53 87.62 86.91 85.89 83.69 (365/INV TO) Working Capital Turnover 0.54 0.44 1.06 1.45 1.61 (SALES/WC)
These liquidity ratios show the cash equivalence of General Electric’s assets
and their ability to maintain sufficient near-cash resources to meet their
obligations in a timely manner.
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Profitability Analysis:
2000 2001 2002 2003 2004
Gross Profit Margin N/A 31.24% 30.67% 29.23% 27.09% (GP/SALES)
Operating Expense Ratio 87.10% 84.26% 82.73% 85.73% 86.97% (OP EXP/SALES)
Net Profit Margin 17.46% 19.17% 18.52% 20.73% 19.59% (NI/SALES)
Asset Turnover 0.17 0.14 0.13 0.11 0.11 (SALES/TA)
Return On Assets 2.91% 2.76% 2.45% 2.32% 2.21% (NI/TA)
Return On Equity 25.22% 24.96% 22.16% 18.95% 15.05% (NI/EQUITY)
These profitability ratios show four critical factors related to profits:
1) operating efficiency; 2) asset productivity; 3) rate of return; and 4) rate of return on equity.
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Capital Structure Analysis:
2000 2001 2002 2003 2004
Debt To Equity Ratio 7.56 7.93 7.94 7.10 5.66 (TL/OE)
Times Interest Earned 1.57 1.78 1.85 1.84 1.69 (NIDIT/INT. EXP) Debt Service Margin 1.14 1.3 1.52 1.47 1.48 (OPP. CASH FLOW/NP)
These capital structure ratios show the sources of financing used to acquire assets. There are two primary concerns when analyzing capital structure: the amount of debt relative to the owners’ equity, the ability to service the principal and the interest requirements on debt.
Sustainable Growth Rate (SGR):
The sustainable growth rate is way to evaluate GE’s ratios in a comprehensive manner. The dividend payout ratio is subtracted because dividends are paid out to shareholders, which diminishes the money that can be
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put back into the company. The sustainable growth rate for GE is on the higher end because of all of the activities that allow assets to sustain growth. Since interest rates are on an upward turn in our economy, we expect this growth to decline over the next ten years.
SGR = ROE * (1 – DIVIDEND PAYOUT RATIO)
Sustainable Growth Rate
2000 2001 2002 2003 2004 AVERAGE
ROE 25.22% 24.96% 22.16% 18.95% 15.05% 21.27%
DPR 42.41% 46.46% 50.69% 50.95% 49.88% 48.08%
SGR 14.52% 13.36% 10.93% 9.29% 7.54% 11.13%
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Cross Sectional Analysis
Liquidity
By using liquidity ratios we were able to analyze GE's ability to repay its
current liabilities. These are very important ratios because without the cash to pay back short-term debts, any company can take a downfall. Even the chance to invest in new business opportunities will have to be overlooked if the cash is not there. The first three of the four liquidity ratios compare a firm's liabilities with its short-term assets. GE is benchmarked and compared to its competitors,
ITT Corp., United Technologies Corp., Federal Signal Corp., and the industrial
average. Current Ratios
1999 2000 2001 2002 2003 Ind. Avg. 2.5 2 ITT 1.5 UTC 1 FSC 0.5 0 GE 1999 2000 2001 2002 2003
Ind. Avg. 0.84 0.82 0.89 0.98 0.91 ITT 0.59 0.54 0.58 0.72 0.82 UTC 1.15 1.14 1.35 1.52 1.19 FSC 0.78 0.79 0.76 0.7 0.72 GE 1.69 1.89 1.71 2.13 2.24
The current ratio is a key index for a firm's short-term liquidity. It
measures the current receivables compared to the current liabilities. GE's current
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ratio is substantially better than its competitors. A ratio equal to less than 1
means the company does not have enough short-term assets to cover its liability.
This is not a good sign for either the company or its investors. GE on the other
hand, has constantly held its current ratio above 1, and in the past two years has
twice the amount of current assets to cover its current liabilities. This is a great
sign for GE.
Firms often have trouble with their short-term liquidity if some of its
currents assets are not easy to liquidate. To measure a firm's ability to pay of debt "quickly", the Quick Asset ratio is used. This ratio takes into account most liquid assets like cash and marketable securities.
Quick Asset Ratios
1.00 Ind. Avg. 0.80 0.60 ITT 0.40 UTC 0.20 FSC 0.00 GE 1999 2000 2001 2002 2003
1999 2000 2001 2002 2003 Ind. Avg. 0.44 0.43 0.47 0.53 0.51 ITT 0.37 0.33 0.36 0.44 0.54 UTC 0.57 0.56 0.68 0.82 0.62 FSC 0.38 0.41 0.39 0.34 0.37 GE 0.61 0.7 0.6 0.75 0.76
As the chart shows, a ratio of 1 is sought after but not yet reached for GE.
Although, as it is compared to it's competitors and the industry average, GE is
sustaining a larger ratio than the others and is headed for a possible increase in
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market share with it's dominating ability to pay its short-term liabilities.
The Accounts Receivable Turnover ratio and the Days Supply of receivables are directly related. This ratio is one of the ways a firm can examine the productivity of it working capital. With a company's sales being larger than their accounts receivable, their ratio will be larger and more appealing to investors.
Accounts Rec. Turnover
8.00 6.00 Industry Avg. ITT 4.00 FSC 2.00 GE 0.00 1999 2000 2001 2002 2003
1999 2000 2001 2002 2003 Ind. Avg. 4.11 4.31 4.37 3.95 4.06 ITT 5.55 5.93 6.04 5.74 5.77 UTC 5563.06 5980.43 6515.78 6.6 5.98 FSC 6.39 6.59 6.74 5.81 6.15 GE 0.4 0.41 0.34 0.31 0.25
UTC is exempt from this comparison because it is a fairly new company with abnormal ratios for its first couple of years. An industry average is better computed with out the company and GE can be compared against realistic statistics. GE's accounts receivable turnover is substantially lower than its competitor's. This is largely due to the high amount of financing receivables. As the chart shows, as GE's A/R turnover ratio continues to decrease, the duration
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of days it takes to collect receivables goes up. The days supply of receivables is increasing which indicates an inability to collect receivables in a short amount of time, which is a bad indicator for GE.
Inventory turnover is the cost of goods sold divided by inventory. This ratio computes the amount of times a firm can empty and refill its inventory. GE has been able to turnover its inventory about 4-5 times a year. GE's inventory turnover is good but not great. Their turnover is decreasing over time which might suggest that they are having trouble pushing inventory out. Along with their decreasing ability to liquidate their assets, this is a bad sign for GE.
Inventory Turnover
7.00 6.00 Ind. Avg. 5.00 ITT 4.00 FSC 3.00 GE 2.00 1.00 0.00 1999 2000 2001 2002 2003
1999 2000 2001 2002 2003 Ind. Avg. 5.05 5.31 5.09 4.71 5.18 ITT 5.98 6.01 6.13 5.81 6.37 UTC 5189.78 5050.59 5055.88 5.3 5.09 FSC 4.23 4.88 4.97 4.13 4.94 GE 4.93 5.03 4.16 4.19 4.24
The Days Supply of Inventory computes the amount of inventory being
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held as in days. GE is in between ITT and FSC near the year 2000, but is on a
steady incline above its competitors the following years. It is ideal for a company to have a low inventory turnover to keep inventory from being overstocked.
Having that been said, GE leads us to believe that it is not managing its inventories very well and needs to make changes.
The Working Capital Turnover ratio is determined by dividing sales by
working capital (current assets - current liabilities). GE is on top of its
competitors with a positive ratio. This is a positive thing for GE because it means
that its current assets are greater than its current liabilities. ITT and FSC both
have negative working capital turnovers. They are worst off than GE because a
negative ratio might mean an inability to pay of debt since their current assets
are less than their current liabilities. ITT, FSC, and GE could all improve their
ratio by focusing on their overall liquidity.
Working Capital Turnover
5.00
0.00 Ind. Avg. 1999 2000 2001 2002 2003 ITT -5.00 FSC GE -10.00 -15.00
1999 2000 2001 2002 2003 Ind. Avg. -4.84 -5.04 -4.58 -4.12 -6.24 ITT -4.17 -3.81 -4.48 -7.31 -12.55 UTC 17087.11 20169.2 9646.27 6.97 15 FSC -10.69 -11.86 -9.71 -6.12 -7.62 GE 0.34 0.55- 41 - 0.44 1.06 1.46
Profitability
The Gross Profit Margin is a percentage that measures a firm’s profitability by dividing its gross profit by its sales. GE is right along the industrial average with a relatively stable ratio. ITT leads its competitors by about 5% at the end of year 2003 which suggest it is prone to increased profits. A steady increase in sales is attributable to a good profit margin.
Gross Profit Margin
40.00% 35.00% Ind. Avg. ITT 30.00% UTC 25.00% FSC 20.00% GE 15.00% 12345
1999 2000 2001 2002 2003 Ind. Avg. 28.30% 30.99% 30.67% 30.80% 29.37% ITT 29.50% 33.84% 34.89% 35.57% 34.53% UTC 24.63% 28.64% 28.00% 28.54% 27.47% FSC 30.76% 30.50% 29.12% 28.28% 26.11% GE 28.27% 28.96% 31.24% 30.67% 29.23%
The Operating Expense ratio is a firm’s operating expenses, such as selling and administrative expenses, divided by its sales. A high operating expense ratio suggest, that a company is not on the right track towards profitability, and that sales are not covering the incurred expenses. This is exactly the case for GE since its ratio is far above any of its competitors. GE's
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lack of generating profit for money spent to earn profit is a problem. Although
GE's ratio is on the decline, if it doesn't change closer to competitors it could spell trouble for GE and its ability to compete.
Operating Expense Ratio
100.00% Ind. Avg. 80.00% ITT 60.00% UTC 40.00% FSC 20.00% GE 0.00% 12345
1999 2000 2001 2002 2003 Ind. Avg. 15.92% 15.55% 15.60% 15.44% 15.69% ITT 14.38% 14.78% 14.36% 14.45% 14.66% UTC 12.99% 11.93% 11.91% 11.35% 11.77% FSC 20.39% 19.95% 20.54% 20.53% 20.64% GE 87.10% 87.10% 84.26% 82.73% 85.73%
GE's net profit margin is well above the industry average and a majority of
its competitors. This ratio is a good indication of GE’s efficient operating
management. Not only is GE an industry leader in net profit margin, but it
sustained its leadership position by maintaining a steady growth rate. A high net
profit margin also shows GE's ability to manage the firm's expenses effectively.
- 43 - N ET PROFIT MARGIN
25.00% 20.00% ITT 15.00% UNITED 10.00% 5.00% FEDERAL
PERCENTAGE 0.00% INDUSTRY 2000 2001 2002 2003 2004 GE YEAR
NET PROFIT MARGIN 5.03% 5.48% 5.92% 7.62% 7.18% ITT 6.35% 6.80% 6.95% 7.93% 7.61% UNITED
5.89% 5.20% 4.44% 3.61% 3.09% FEDERAL 5.75% 5.83% 5.77% 6.39% 5.96% INDUSTRY 17.46% 19.17% 18.52% 20.73% 19.59% GE
Asset turnover is critical to overall profitability. GE consistently has an
asset turnover slightly over 1. Although they are below the industry average, GE still manages their assets well. The low ratio is due to its large number of receivables generated from their financing activities.
ASSET TURNOVER 1.50
1.00 ITT 0.50 FEDERA L TOTAL 0.00 INDUSTRY 2000 2001 2002 2003 2004 GE YEA R
ASSET TURNOVER 1.05 1.04 0.92 0.95 ITT 990.19 1048.06 1034.41 0.97 0.88 UNITED 1.03 1.12 1.04 0.90 1.02 FEDERAL 1.03 1.08 1.04 0.93 0.95 INDUSTRY
0.17 0.14 0.13 0.11 0.11 GE Return on assets shows how much profit a company can generate for
each dollar of assets invested. As with asset turnover, GE falls below the industry
average due to its receivables from financing activities. United Tech is not
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incorporated into this graph because its percentages in 1999-2001 are unrepresentative of the industry.
RETURN ON ASSETS
E 8. 00% 6. 00% ITT 4. 00% FEDERA L 2. 00% INDUSTRY
PERCENTAG 0. 00% 2000 2001 2002 2003 2004 GE YEAR
RETURN ON ASSETS 5.14% 5.74% 6.14% 7.05% 6.80% ITT 6283.35% 7128.21% 7186.03% 7.66% 6.69% UNITED 6.07% 5.81% 4.63% 3.27% 3.14% FEDERAL 5.60% 5.77% 5.39% 5.99% 5.55% INDUSTRY 2.91% 2.76% 2.45% 2.32% 2.21% GE
GE has experienced a falling return on equity over the past five years but still remains close to the industry average. This ratio represents a firm's ability to profitably employ its assets, as well as the size of the firm's asset base relative to shareholder's investment.
RETURN ON EQUITY
E 40.00% 30.00% ITT 20.00% FEDE RAL 10.00% INDU STR Y
PERCENTAG 0.00% 2000 2001 2002 2003 2004 GE YEAR
ITT 21.19% 21.84% 20.11% 33.40% 21.86% 21511.87 23596.97 UNITED % % 23156.89% 26.76% 20.17% FEDERAL 16.25% 16.10% 13.24% 9.60% 8.83% INDUSTRY 18.72% 18.97% 16.67% 23.25% 16.95% GE 25.22% 24.96% 22.16% 18.95% 15.05%
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Debt to equity ratio is a company's total long-term debt expressed as a percentage of shareholders' equity. Because GE is above the industry average, it may hurt the firm's ability to borrow. However, GE has been experiencing a drop in this number over the past few years.
DEBT TO EQUITY RATIO
10.00 8. 00 ITT 6. 00 UNITED 4. 00 TOTAL 2. 00 FEDERAL 0. 00 INDUSTRY 2000 2001 2002 2003 2004 GE YEAR
DEBT TO EQUITY RATIO 3.12 2.81 2.28 3.74 2.21 ITT 2.42 2.31 2.22 2.49 2.01 UNITED 1.68 1.77 1.86 1.94 1.81 FEDERAL 2.41 2.30 2.12 2.72 2.01 INDUSTRY 7.56 7.93 7.94 7.10 5.66 GE
GE has maintained a non-volatile times interest earned ratio, but it has remained below the industry average. Times interest earned indicates the extent of which earnings are available to meet interest payments. A lower times interest earned ratio means that the company is more vulnerable to increases in interest rates.
- 46 - TIMES INTEREST EARNED
15.00 ITT 10.00 FEDERAL 5.00 TOTAL INDUSTRY 0.00 GE 2000 2001 2002 2003 2004 UNITED YEA R
TIMES INTEREST EARNED 8.87 6.56 6.40 16.59 N/A ITT N/A N/A N/A 9.60 10.25 UNITED 4.34 3.71 3.49 4.08 3.34 FEDERAL 6.61 5.14 4.94 10.09 6.80 INDUSTRY 1.57 1.78 1.85 1.84 1.69 GE
GE's debt service margin is slightly above the industry average. This ratio compares operating cash flow relative to current notes payable. Any number greater than one indicates that the firm has generated enough cash flow to service their borrowings, in the short term.
DEBT SERVICE MARGIN
2.00 1.50 ITT 1.00 FEDE RAL TOTAL 0.50 0.00 INDU STR Y 2000 2001 2002 2003 2004 GE YEAR
DEBT SERVICE MARGIN 0.90 1.07 1.19 1.23 0.91 ITT 1180.38 1107.03 1380.33 1.36 1.10 UNITED 0.84 1.06 1.78 1.16 0.91 FEDERAL 0.87 1.07 1.49 1.25 0.97 INDUSTRY 1.14 1.30 1.52 1.47 1.48 GE
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Method of Comparables
We performed all the ratios for General Electric’s competitors, and evaluated an industry average for all ratios for each year.
ITT Industries 1999 2000 2001 2002 2003 Liquididty current ratio 0.59 0.54 0.58 0.72 0.82
quick asset ratio 0.37 0.33 0.36 0.44 0.54
accounts recievable turnover 5.55 5.93 6.04 5.74 5.77
days supply of recievables 65.77 61.59 60.44 63.57 63.22
inventory t/o 5.98 6.01 6.13 5.81 6.37
days sup of inven 61.00 60.69 59.50 62.83 57.32
wrking cap t/o -4.17 -3.81 -4.48 -7.31 -12.55
Profitibility gross profit margin 29.50% 33.84% 34.89% 35.57% 34.53%
operating expense ratio 14.38% 14.78% 14.36% 14.45% 14.66%
net profit margin 5.03% 5.48% 5.92% 7.62% 7.18%
asset t/o 1.02 1.05 1.04 0.92 0.95
return on assets 5.14% 5.74% 6.14% 7.05% 6.80%
return on equity 21.19% 21.84% 20.11% 33.40% 21.86%
Capital Structure Debt to equity 3.12 2.81 2.28 3.74 2.21
times int earned 8.87 6.56 6.40 16.59 N/A
debt service margin 0.90 1.07 1.19 1.23 0.91
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United Technologies Corp. 1999 2000 2001 2002 2003 Liquidity current ratio 1.15 1.14 1.35 1.52 1.19 quick asset ratio 0.57 0.56 0.68 0.82 0.62 accounts receivable turnover 5563.06 5980.43 6815.78 6.60 5.98 days supply of receivables 0.07 0.06 0.05 55.33 61.01 inventory t/o 5189.78 5050.59 5055.88 5.30 5.09 days sup of inven 0.07 0.07 0.07 68.85 71.68 working cap t/o 17087.11 20169.20 9646.27 6.97 15.00
Profitability gross profit margin 24.63% 28.64% 28.00% 28.54% 27.47% operating exp ratio 12.99% 11.93% 11.91% 11.35% 11.77% net profit margin 6.35% 6.80% 6.95% 7.93% 7.61% asset t/o 990.19 1048.06 1034.41 0.97 0.88 return on assets 6283.35% 7128.21% 7186.03% 7.66% 6.69% return on equity 21511.87% 23596.97% 23156.89% 26.76% 20.17%
Capital Structure Debt to equity 2.42 2.31 2.22 2.49 2.01 times int earned N/A N/A N/A 9.60 10.25 debt service margin 1180.38 1107.03 1380.33 1.36 1.10
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Federal signal Corp. 1999 2000 2001 2002 2003 Liquidity current ratio 0.78 0.79 0.76 0.70 0.72 quick asset ratio 0.38 0.41 0.39 0.34 0.37 accounts receivable turnover 6.39 6.59 6.74 5.81 6.15 days supply of receivables 57.13 55.42 54.13 62.78 59.39 inventory t/o 4.23 4.88 4.97 4.13 4.94 days sup of inven 86.30 74.83 73.41 88.48 73.96 working cap t/o -10.69 -11.86 -9.71 -6.12 -7.62
Profitability gross profit margin 30.76% 30.50% 29.12% 28.28% 26.11% operating expense ratio 20.39% 19.95% 20.54% 20.53% 20.64% net profit margin 5.89% 5.20% 4.44% 3.61% 3.09% asset t/o 1.03 1.12 1.04 0.90 1.02 return on assets 6.07% 5.81% 4.63% 3.27% 3.14% return on equity 16.25% 16.10% 13.24% 9.60% 8.83%
Capital Structure Debt to equity 1.68 1.77 1.86 1.94 1.81 times int earned 4.34 3.71 3.49 4.08 3.34 debt service margin 0.84 1.06 1.78 1.16 0.91
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Industry Averages:
1999 2000 2001 2002 2003 Liquidity current ratio 0.84 0.82 0.89 0.98 0.91
quick asset ratio 0.44 0.43 0.47 0.53 0.51
accounts receivable turnover 1858.33 1997.65 2276.19 6.05 5.97
days supply of receivables 40.99 39.02 38.21 60.56 61.21
inventory t/o 1733.33 1687.16 1688.99 5.08 5.46
days sup of inven 49.12 45.20 44.33 73.39 67.65
working cap t/o 5690.75 6717.84 3210.69 -2.16 -1.72
Profitability gross profit margin 28.30% 30.99% 30.67% 30.80% 29.37%
operating expense ratio 15.92% 15.55% 15.60% 15.44% 15.69%
net profit margin 5.75% 5.83% 5.77% 6.39% 5.96%
asset t/o 330.75 350.07 345.50 0.93 0.95
return on assets 2098.18% 2379.92% 2398.93% 5.99% 5.55%
return on equity 7183.10% 7878.30% 7730.08% 23.25% 16.95%
Capital Structure Debt to equity 2.41 2.30 2.12 2.72 2.01
times int earned 6.61 5.14 4.94 10.09 6.80
debt service margin 394.04 369.72 461.10 1.25 0.97
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Forecasting
We began our forecasting by first calculating the liquidity, profitability, and capital structure ratios for GE and three of it main competitors. We then used the data from the last year of operations and computed the last quarter in order to forecast ten years from now. We did this by averaging the quarters together and using that data to forecast. GE is a diverse an well spread out corporation so we assumed no huge accounting changes or economic difficulties would take place.
Regarding the income statement, we used the past financial statements of
GE, and then we computed the percentage change of each line, and averaged
the numbers to come up with our future forecasting ratio. This percentage of
revenues was then multiplied by the actual amounts to come up with the next
future year. This process was repeated until the year 2014. The cost of sales was
calculated by taking the past 4 years of data about the cost of goods sold and
revenue information. This data was then averaged and used to forecast the future periods.
The most reasonable way to calculate the other data on the income
statement was to use a moving average approach. We first calculated the
weighted moving average of the data and applied that average to the actual data
to come up with the forecasted figures.
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Valuation Analysis
Valuation of a firm is the conversion of forecasts into an estimation of the value
of the firm. This is a necessary step in almost every business decision.
Valuations can help us estimate a firm’s equity, stock price
(overvalued/undervalued), and many other important calculations that can show
us where the company stands in their industry.
Valuations
We will concentrate on six valuation models that will help us estimate the share price, equity and current standing of the company. These valuations are:
(1) Method of Comparables- measuring comparable firm’s performance and
value to that of your own firm
(2) Discounted Dividends- the value of the firms equity, as the present value
of forecasted future dividends
(3) Discounted Free Cash Flows- forecasts of future cash flows, discounted
at the firms estimated cost of capital, to arrive at an estimated present value
(4) Abnormal Earnings Growth- equity of a firm expressed as the sum of its book value and discounted forecasts of abnormal earning
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(5) Discounted Residual Income Model- a stream of residual income values, including terminal value, over the next ten years, discounted back to present time
(6) Long Run Average Residual Income Perpetuity - perpetuity that converges to the residual income model
Method of Comparables
Price/Earnings (Forward) PPS EPS P/E Forward Valuation General Electric 35.47 2.04 17.40 37.23 PHG 26.76 1.85 14.45 Tyco 33.45 2.31 14.47 Citigroup 44.62 4.61 9.67 Sony 39.33 1.14 34.48 AVG 18.27
Price/Earnings (Trailing) PPS EPS P/E Trailing Valuation General Electric 35.47 1.58 22.44 27.20 PHG 26.76 2.90 9.22 Tyco 33.45 1.43 23.36 Citigroup 44.62 3.22 13.85 Sony 39.33 1.75 22.42 AVG 17.21
Price/Book PPS BPS P/B Valuation General Electric 35.47 10.42 3.40 19.38 PHG 26.76 15.06 1.78 Tyco 33.45 15.93 2.10 Citigroup 44.62 20.82 2.14 Sony 39.33 27.35 1.44 AVG 1.86
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Dividend Yield PPS DPS Dividend Yield Valuation General Electric 35.47 0.88 0.0248 45.75 PHG 26.76 0.52 0.0194 Tyco 33.45 0.40 0.0120 Citigroup 44.62 1.76 0.0394 Sony 39.33 0.24 0.0061 AVG 0.0192
PEG Ratio Ford Epic
General Electric 1.81 52.66 PHG N/A 45.91 Tyco 1.03 39.55 Citigroup 0.96 109.16 Sony 1.16 33.22 Avg 1.05 39.56
The method of comparables is a popular tool used by analysts to value a company. This method is a quick and easy way of estimating a firm’s value. Measures of performance, such as earnings or dividend yield, are selected as the basis of the calculations. By averaging the overall performance of the major competitors, the value of the firm being analyzed can be easily estimated. General Electric’s major competitors used in the method of comparables are Koninklijke Philips Electronics, Tyco, Sony, and
Citigroup. The ratios that best illustrated the industry averages were price to earnings
(forward and trailing), price to book, and dividend yield.
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The price to earnings (forward) ratio measures a company's share price compared to its per-share earnings taken from the estimates of earnings expected in the next four quarters. This ratio produced a valuation of $37.24 compared to an actual share price of
$35.47. The average P/E forward ratio was $18.27.
The price to earnings (trailing) ratio also measures share price compared to per share earnings. This “trailing” ratio, however, uses earnings per share taken from the last four quarters. This ratio shows a valuation of $27.21.
The price to book ratio compares a stock's market value to its book value. GE’s initial price to book ratio indicates a higher return on assets than its competitors. Many of the competitors used have much higher book values per share. Because these are so much higher, the valuation produces a price per share of $19.38.
The final ratio in the method of comparables is the dividend yield. This is calculated by dividing dividend per share by the price per share. The average dividend yield for GE’s competitors is .0192. This ratio presents a valuation of $45.75 compared to an actual share price of $35.47.
General Electric sustains a PEG ratio higher than its main competitors and well above the industry average. The PEG ratio relates price earnings to expected growth of the company. This high ratio shows the GE may experience less growth in the near future then they have now.
The ratio that comes closest to General Electric’s actual share price is the price to earnings (forward) ratio. This method’s valuation was $37.24 as compared to an actual share price of $35.47. Overall, the method of comparables constructed a fairly accurate
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valuation of our firm. The four ratios indicated share prices both above and below the actual share price. These calculations, although representing a quick and easy comparable tool, provide relevant information for the valuation of GE.
Calculation of WACC and Cost of Equity
The following equation was used to calculate the weighted average cost of capital:
V V WACC = d rT()1−+e r ()d e VVde+ VVde+
Values:
Vd =213.161 Billion
Ve =110.284 Billion rd =.0395 T =.1747 re =.06493
The value of equity and debt were extracted from General Electric’s financial statement. To determine the cost of debt (rd), the weighted average cost of long term debt was calculated multiplying the interest rates of the debt by their percentage of total debt. The average tax rate (including exemptions) stated in the financial statements was 17.47 percent. The cost of equity, which
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was determined using the capital asset pricing model, was calculated to be approximately 6.5 percent.
The capital asset pricing model (CAPM) is as follows:
re = Rf + β( Km - Rf )
To calculate an estimation of beta (β), the slope of the linear regression relationship between the firm’s return and the market risk premium was used. The estimated beta was 1.095. The average risk free rate was determined by taking the average of the monthly yield risk free rate and then multiplying by 12. By using these numbers in the capital asset pricing model, a cost of equity of .06493 is revealed. Once the cost of equity is determined, the weighted average cost of capital can be computed in the above formula. The cost of equity and WACC determined using these two equations give reasonable values that will be used in the discounted valuation models.
Altman’s Z-Score
General Electric 1.081 PHG 2.82 Tyco 1.8228 Sony 1.1785
General Electric’s Z-score is consistent with many of its competitors.
Because the value is below 1.2, GE may be classified as a high-risk investment.
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However, we feel that this low Z-score is not representative of GE’s true
riskiness. The low Z-score may be due to their large amount of total assets in
relation to its sales and EBIT.
Intrinsic Valuation Methods
• Discounted Dividends Model
Sensitivity Analysis Growth Rate 0.03 0.04 0.05 0.06 0.07 Ke 0.05 43.77 80.84 0.06 29.09 40.44 74.47 0.07 21.76 26.97 37.39 68.67 0.08 17.36 20.23 25.03 34.62 63.38 0.09 14.43 16.19 18.84 23.25 32.08
The discounted dividends model determines the equity value of a firm by
calculating the present value of expected future dividends. Based on recent trends of dividend payout as well as a ten-year forecast, a 4 percent growth rate
will be used for this model. By assuming this 4 percent growth of dividends, this
model gives a share price of $32.48. Compared to the actual share price of
$35.47, it can be determined that the growth rate and cost of equity are
reasonable estimates.
The sensitivity analysis of this model shows the correlation of several different costs of equity and growth rates. Only several of the estimations result
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in values that are within 5 dollars of General Electric’s share price. When the growth rate is 6 percent and the cost of equity is 8 percent, the estimated share price is closest to the actual price. The discounted dividends model shows the least volatility in the sensitivity analysis; so it is reasonable that most of the share prices are within 10 to 20 dollars of the actual share price. According to this model, it can be determined that General Electric is slightly overvalued if not fairly valued.
• Abnormal Earnings Growth Model
Sensitivity Analysis Growth 0 0.01 0.02 0.03 0.05 $46.49 $86.62 $100.53 $128.35
Ke 0.06 $37.13 $58.39 $63.97 $73.27 0.07 $30.55 $42.28 $44.77 $48.50 0.08 $25.71 $32.22 $33.39 $35.01 0.09 $22.01 $25.52 $26.06 $26.78 The abnormal earnings growth model determines the equity value of a firm by adding the book value of equity to the present value of the expected future abnormal earnings. It also shows the relationship between dividends and earnings. Abnormal earnings are calculated by subtracting normal earnings from cumulative dividend earnings. Assuming no growth, this model gives a share price of $33.64. When compared to the actual price of $35.47 it can be
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determined that no growth is a reasonable assumption for General Electric’s
abnormal earnings.
The sensitivity analysis gives several variations between growth rate and
cost of equity that will produce a share price within 5 dollars of the actual price.
A cost of equity of 8 percent along with a growth rate of 3 percent gives the
closest valuation. The abnormal earnings growth model sensitivity analysis,
although producing several accurate share prices, shows considerable volatility.
According to this model, it can be assumed that General Electric is slightly
overvalued if not fairly valued.
• Discounted Free Cash Flow
Sensitivity Analysis Growth Rate 0 0.01 0.02 0.03 0.04 0.04 26.69 38.89 63.57 137.33
0.08 8.23 10.87 14.38 19.30 26.67 WACC 0.1 4.54 6.18 8.23 10.86 14.37
0.12 2.07 3.19 4.53 6.17 8.22 0.14 0.31 1.12 2.06 3.18 4.52
This valuation was constructed by using forecasted cash flows that were
based on the past 5 years of GE’s cash flow statements. The predicted cash flow
from operations is subtracted from the cash used for investing activities to derive the free cash flow to the firm. Each future cash flow was the discounted back to
the present in order to estimate the value of the firm. The difference of the book
value of GE’s debt, taken from the balance sheet, and the value of the firm
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shows the value of equity. This value of equity is then divided by the number of shares outstanding to show the firms value per share.
A WACC of 4.36% was used in computing the free cash flows and the value per share. The result of the valuations using a growth rate of 0 was a share price equal to $23.64. After further research, we have concluded that the reason for this low share price is due to the large amount of financing cash flows of GECS. GECS is basically a bank that produces financing cash outflows with financing cash inflows, which can be thought of as investing and operating cash flows, respectively. By adding the financing cash flows to the operating cash flows, we derive a new operating cash flow. Taking this into consideration, we then performed a sensitivity analysis on the share price using different WACC and growth rate values. Keeping the WACC the same, we increased the growth rate values to 1 and 2%. These modifications changed the per share amounts to
38.89 and 63.57, respectively. This 1% change in the growth rate gave us a value closest to the actual share price.
In conclusion, the Discounted Free Cash Flow Model does not seem to be a valuation that should be taken too seriously for GE. A large part of GE’s cash flows from financing activities come from GECS, and this model bases its estimates from cash flows. An error in estimating the future cash flow to the firm produces more errors in estimating the firm’s value and value per share.
Therefore, it seems evident that though this model shows a low share price for
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GE, we feel that this model is not a good representation of General Electric’s true value.
• Residual Income Valuation Model
Sensitivity Analysis Growth Rate 0 0.01 0.02 0.03 0.04 0.04 65.07 78.97 106.76 190.15 Ke 0.05 50.60 57.79 69.77 93.72 165.58 0.06 41.04 45.15 51.32 61.61 82.18 0.07 34.27 36.78 40.30 45.58 54.38 0.08 29.24 30.84 32.98 35.98 40.48
The Residual Income Model determines a company’s value per share by calculating the present value of future residual income. To determine the book value of equity in 2004, the forecasted earnings per share is added to the forecasted book value per share and then the dividend per share value is subtracted. This value is the ending book value per share in 2004. Residual income is calculated by subtracting normal income from earnings per share.
Once the present value of residual income is calculated, the estimated value per share price can be determined.
This model gives us a valuation of $37.43, compared to an actual share price of $35.47. No growth was assumed for this model. With the estimated share price from this model, we can assume that our cost of equity and growth rate assumptions are reasonable. The sensitivity analysis of this model gives us
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several values that are within a few dollars of our share price. With a cost of equity of .07, a growth rate of either 0 or .1 determines share prices of $34.27 and $36.78, respectively. When the cost of equity is increased another
Sensitivity Analysis
Growth 0.03 0.04 0.05 0.06 0.07 0.05 50.53 90.65 Ke 0.06 33.69 45.32 80.23 0.07 25.26 30.218 40.11 69.81 0.08 20.21 22.66 26.74 34.91 59.39 0.09 16.85 18.13 20.05 23.27 29.70 percentage point, this shows values that are also close to General Electric’s actual share price. Overall, this model reveals that GE is slightly undervalued, if not fairly priced.
• Long Run Average Residual Income Perpetuity
The Long Run Average Residual Income Perpetuity based on the P/B ratio analysis is a perpetuity that converges to the residual income model. By taking
General Electric’s price to book ratio and comparing it to a long-run perpetuity of the discounted residual income, a share value can be derived. GE’s book value of equity per share and ROE are $10.42 and .127, respectively. With a cost of equity of .0649 as well as a net income growth rate of 3 percent, we compute a value of $28.96.
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The sensitivity analysis of this model shows the correlation of several different costs of equity and growth rates. Only several of the estimations result
in values that are within 5 dollars of General Electric’s share price. When the
growth rate is 6 percent and the cost of equity is 8 percent, the estimated share
price is closest to the actual price. The Long-Run Average Residual Income
Perpetuity model shows a fair amount of volatility in the sensitivity analysis, so it
is reasonable that only a few of the share prices are close to the actual value.
According to this model, it can be determined that General Electric is slightly
overvalued.
Conclusion
The above valuations have almost all given us an estimation of the share
price within dollars and cents of its actual market trading value, with the
exception of the method of comparables model and the free cash flows model.
Discounted dividends and abnormal earnings models rated the stock just under
its current market price of $35.47 with prices of $32.48 and $33.64, respectively.
On the other hand the residual income model valued the company just above the
current market price with a price of $37.43. These numbers show us that GE
market price per share is very close to its intrinsic value and at this point, if
anything, GE is only slightly overvalued.
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We feel that GE will continue to grow at a steady rate as they have over the last few years, but in the near future, GE’s stock price should stay between
$32.50 and $37.40. Given this information, we feel that General Electric should be currently rated HOLD.
Sources
• Yahoo Finance – http://finance.yahoo.com
• MSN Money - http://moneycentral.msn.com/home.asp
• General Electric Homepage - http://www.ge.com
• Edgarscan - http://edgarscan.pwcglobal.com/servlets/edgarscan
• Business Analysis and Valuation Using Financial Statements. Palepu, Healy, Bernard.
• CNN Money - http://money.cnn.com/
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