MWV - Mark E. Moore

MEADWESTVACO
Christa Manley
Jacob Freeman
Eli Hernandez
David Hughes
Table of Contents
Executive Summary………………………………………………
9
Business and Industry Analysis………………………………
16
Company Overview………………………………………………..
16
Industry Overview……………………………………………......
17
Paper Industry ……………………………………………………………………….
18
Packaging Industry………………………………………………………………….
19
Five Forces Model………………………………………………....
Rivalry Among Existing Firms…………………………………..
20
22
Industry Growth………………………………………………………………………
23
Concentration of Competitors…………………………………………………..
24
Level of Differentiation…………………………………………………………….
26
Switching Costs……………………………………………………………………….
26
Learning Economies………………………………………………………………..
27
Economies of Scale…………………………………………………………………
28
Fixed and Variable Costs………………………………………………………….
29
Excess Capacity………………………………………………………………………
29
Exit Barrier………………………………………………………………………………
30
Conclusion………………………………………………………………………………
30
Threat of New Entrants………………………………………......
30
Economies of Scale…………………………………………………………………
31
First Mover Advantage…………………………………………………………….
32
Distribution Access and Relationships……………………………………….
32
Legal Barriers………………………………………………………………………….
33
Threat of Substitute Products………………………………..…
34
2 | P a g e Relative Price and Performance…………………………………..…….
34
Customers Willingness to Switch……………………………………...
34
Conclusion………………………………………………………………………
35
Bargaining Power of Suppliers……………………………..…..
35
Price Sensitivity…………………………………………………………
37
Relative Bargaining Power………………………………………….
37
Paper Products Industry……………………………………………………
38
Switching Costs…………………………………….……………………………
38
Differentiation……………………………………………………..……………..
39
Importance of Pulpwood to the Cost and Quality…………………
39
Number of Pulpwood Supplier within Industry…………….………..
40
Volume of Pulpwood Obtained from Suppliers…………………..…
40
Conclusion…………………………………………………………..………….
41
Packaging Industry………………………………………………………….
41
Bargaining Power of Customers……………………..…..……
42
Price Sensitivity………………………………………………………
43
Relative Bargaining Power……………………………………....
44
Paper Products Industry……………………………………………………
44
Switching Costs………………………………………….……..……………….
45
Differentiation…………………………………….………………..…………….
45
Importance of Cost and Quality to the Customer…………..……..
45
Number of Customers in the Market…………….………………….…..
46
Volume of Paper purchased per Customer……………………..……
46
Conclusion………………………………………………………………..…….
47
Packaging Industry………………………………………………………….
47
Switching Costs……………………………………………………….………..
48
3 | P a g e Product Differentiation………………………………………………………
48
Importance of Packaging to Cost and Quality…………………………..
49
Number of Customers in the Market………………………………………..
49
Volume per Customer…………………………………………………………….
49
Conclusion……………………………………………………………….…..…….
Key Success Factors…………………………………….………
Cost Leadership – Paper Industry…………………………………….……
50
51
51
Tight Cost Control System………………………………………………….…..
52
Economies of Scale……………………………………………….……………….
52
Efficient Production Processes and Lower Input Costs………………..
53
Low Cost Distribution…………………………………………………………….
53
Cost Leadership – Packaging Industry……………………………...…..
54
Economies of Scope……………………………………………………………….
Differentiation – Packaging Industry……………………………………..
54
55
Creativity and Innovation……………………...……………………………....
55
Research and Development…………………………………………………….
56
Product Quality………………………………………………………………………
56
Differentiation – Paper Industry…………………………………………….
57
Customer Service and Product Assurance…………………………………
57
Conclusion………………………………………………………………………….
57
Competitive Advantage Analysis…………….…………………………..…
58
Early Innovations……………………………………………………………..……
58
Modern Innovations………………………………………………………………..
59
Firm Implementation of Value Creation Strategies…….……………..
59
Cost Leadership………………………………………………………………..
59
Economies of Scale and Scope……………………………………….…..
59
Efficient Production Process and Low Cost Inputs…………….…..
60
4 | P a g e Low Cost Distribution…………………………………………………………..
Differentiation……………………………………………………………………..
60
61
Research and Development …………………………………………………
61
Product Quality………………………………………..………………………….
62
Variety………………………………………………………………………….…..
62
Customer Service………………………………………………………….……
62
Conclusion…………………………………………………………………………
Formal Accounting Analysis…...………………………………..
63
64
Key Accounting Policies……………..……..……………………………….
65
As applies to Key Success Factors………………………….…….............
65
Pension Plans…………………………………………………….….………………
66
Derivative Risk Management…………………………………..................
67
Operating and Capital Leases……………………………….………………..
70
Goodwill………………………………………………..…………….…..............
73
Accounting Flexibility…………………………………..…….…………….
77
Pension Plans……………………………………………………………………….
77
Derivative Risk Management……………………………….…………………
80
Operating and Capital Leases…………………………………..……........
80
Goodwill………………………………………………………………..……........
81
Evaluate Accounting Strategy……………..………………….............
82
Pension Plans……………………………………………………………..….…..
83
Derivative Risk Management………………………………………..………
86
Operating and Capital Leases…………………………………….…….…..
88
Goodwill……………………………………………………………………..….....
91
Quality of Disclosure…………………………………………………..
93
Pension Plans………………………………………………………….……….…
93
Derivative Risk Management………………………………………………..
94
5 | P a g e Operating and Capital Leases………………………………….…………
95
Goodwill…………………………………………………………………………..
96
Quantitative Analysis……………………………………….……….
96
Sales Manipulation Ratios…………………………………………………..
98
Net Sales/Cash from Sales……………………………………………..
99
Net Sales/ Net Accounts Receivables………………………………
100
Net Sales/Inventory……………………………………………...........
103
Conclusion……………………………………………………………………
106
Expense Manipulation Ratios……………….……………………………...
107
Asset Turnover……………………………………………………………..
107
CFFO/OI………………………………………..…………………………….
109
CFFO/NOA…………………………………….……………………………..
112
Total Accruals/Sales…………….………………………………………..
114
Conclusion…………………………………………………………………….
115
Red Flags…………………………………………………………….….
116
Pension Plans…………………………………………………………….………
116
Undoing Accounting Distortions………………………………..…
116
Goodwill…………………………………………………..…………………….….
117
Financial Analysis, Forecasting Financials
and Cost of Capital Estimation………………………………….…
121
Financial Analysis………………………………………………………
121
Liquidity Ratio Analysis…………………………………………………….……
122 Current Ratio…………………………………………………..……………..…….…..
122
Quick Asset Ratio………………………………………………………………………
123
Working Capital Turnover……………………………………………………….….
124
Accounts Receivables Turnover………………………………………………..…
125
Days Sales Outstanding…………………………………………………….…….…
128
Inventory Turnover………………………………………………………………..….
129
6 | P a g e Days Supply Inventory………………………………………………………………..
130
Cash to Cash Cycle………………..……….………………………………………….
132
Conclusion…………………………….…………………………………………………..
133
Profitability Analysis ………………………………………………………………………………………… 133 Gross Profit Margin..……………………………………………………………………
134
Operating Expense Ratio……………………………………………………..………
135
Operating Profit Margin……………………………………………………………….
136
Net Profit Margin………………………………………………………..………………
136
Asset Turnover……………………………………………………………..…………..
138
Return on Assets………………………………………………….…………………….
139
Return on Equity………………………………………………………..................
140
Conclusion…………………………………………………………………………………
141
Capital Structure Analysis………..………………………………………….……
141
Debt to Equity……………….……………………………………………………………
142
Times Interest Earned…………………………………………………………………
143
Debt Service Margin………………………………………………………….………..
145
Z-score……………………………………………………………………………………..
147
Growth Rate Analysis………………………………………………………………
148
Internal Growth Rate…………………………………………………………..….…
148
Sustainable Growth Rate…………………………………………………………
149
Estimating Cost of Capital…………………………………………..
150
Cost of Equity………………………………………………………………….…
150
Alternative Cost of Equity…………………………………………….………
152
Cost of Debt…………………………………………………….…………….....
153
Weighted Average Cost of Capital…………………………………………
156
Conclusion………………………………………………………………………….
157
Financial Statement Forecasting………………………………….
158
Income Statement………………………………………………………….…..
158
Income Statement (Revised) …………………………………………..….
163
7 | P a g e Balance Sheet…………………………………………………………………......
166
Balance Sheet (Revised)…………………………………………………….....
170
Statement of Cash Flows……………………………………………………….
173
Valuation Analysis………………………………………………….
Method of Comparables………………………………………………
179
179
Price/Earnings Trailing……………………………………………………..…
179
Price/Earnings Forecasted……………………………………………………
180
Price/Book………………………………………………………………………….
181
Price Earnings Growth (P.E.G)………………………………………………
182
Price/EBITDA………………………………………………………………………
183
Enterprise Value/EBITDA………………………………………………………
184
Price/Free Cash Flows…………………………………………………………..
185
Dividends/Price…………………………………………………………………….
186
Conclusion……………………………………………………………………………
186
Intrinsic Valuation Models……………………………………………..
187
Discounted Dividends Model…………………………………………………..
187
Discounted Free Cash Flows Model…………………………………………
189
Residual Income Model………………………………………………………….
191
Abnormal Earnings Growth Model (A.E.G.)……………………………….
194
Long Run Residual Income Model……………………………………………
196
Analyst Recommendations………………………………………….
199
Appendices………………………………………………………………
201
References……………………………………………………………….
224
8 | P a g e Executive Summary
Investment Recommendation: Undervalued Buy
As of November 03, 2008
NYSE (11/03/08)
$14.71
52 Week Range:
Altman Z-scores
$9.44 - $34.61
Revenue:
$6.906 Billion
Market Capitalization:
$1.80 Billion
Shares Outstanding:
170,812,000
2003
2004
2005
2006 2007
Initial Scores:
1.29
1.33
1.58
1.45
1.49
Revised Scores:
1.26
1.29
1.56
1.42
1.50
Current Market Share Price (11-03-08)
Book Value Per Share:
Initial
Revised
$ 47.39
$ 21.33
Financial Based Valuations
Initial
Restated
Return on Equity:
6.26 %
6.36 %
Trailing P/E:
$ 13.62
$ 10.04
Return on Assets:
3.00 %
3.20 %
Forward P/E:
$ 6.83
$ 6.83
Dividends to Price:
$ 3.35
$ 3.35
Price to Book:
$ 51.11
$ 23.02
P.E.G Ratio:
$ 11.38
$ 7.93
Cost of Capital
Estimated
R-Squared
Beta
Ke
2-Year
.056
-.018
3.871 %
Price to EBITDA:
$ 16.79
$ 16.79
3-Year
.032
-.013
3.909 %
Enterprise Value/EBITDA:
$ 36.87
$ 32.21
4-Year
.017
-.012
3.922 %
Price to Free Cash Flows:
$ 17.04
$ 17.04
5-Year
-.014
-.002
3.998 %
6-Year
-.012
.001
4.035 %
Intrinsic Valuations
Initial
Back Door Ke:
7.52 %
Published Beta:
1.59
Cost of Debt:
5.89 %
WACC (BT):
6.78 %
WACC (AT):
5.30 %
Discounted Dividends:
$ 16.22
Free Cash Flows:
$ 19.61
$ 17.17
Residual Income:
$ 18.90
$ 18.66
Long Run Residual Income:
$ 18.21
$ 21.67
Abnormal Earnings Growth:
$ 25.23
$ 23.80
9 | P a g e Restated
-
MWV 1 Year Stock Price
40
30
20
10
0
M…
Industry 1 Year Prices
40
MW
V
20
0
IP
Industry Summary
Mead Paper Corporation was founded in 1846 and focused mainly on the
production and distribution of pulp paper. More than a century later, in 1966, Mead
Paper Corp. acquired West Virginia Pulp and Paper Co. and abbreviated the name to
Westvaco. Finally, in 2002 Westvaco completed the merger with the Mead Co. to form
MeadWestvaco. In the past, Mead Corporation was primarily focused on pulp paper
production. Over a century of mainly paper production, the company acquired a variety
of different firms in order to adapt to the changing marketplace. In 2005
MeadWestvaco reallocated their operations to “boxing rather than shuffling paper.” The
packaging operations ultimately accounted for about ¾’s of the company’s sales.
MeadWestvaco holds a 7% profit growth rate and currently rakes in sales of
$6.906 billion. There are over 150 products created among their assembly lines with
over ninety five international operations. MeadWestvaco operates in five different
industries, including: paper production, packaging solutions, school supplies, consumer
10 | P a g e office products, and specialty chemicals. The two most productive segments are the
paper and packaging industries. The three main competitors in these industries include
Smurfit-Stone (SSCC), International Paper (IP), and Packaging Corporation of America
(PKG). These firms have also diversified into other market segments and industries, as
MeadWestvaco has done. All of these firms produce similar products, resulting in a
higher level of competition. These firms focus mainly on utilizing cost leadership
strategies, which entails tight cost control and efficient production processes. The
packaging industry dips into product differentiation, but must still be cautious about
costs because of the high level of competition within the industry. The packaging
segment relies more on research and development in order to employ their
differentiation strategies.
The paper/packaging industries both have a high rivalry among existing firms
because all the competitors produce a commodity. In other words, the firms operating
in these industries produce vast amounts of similar products. This industry is
characterized by a low threat of new entrants due to the domination of large companies
within these industries. A huge majority of the market share in the paper/packaging
industries are comprised of large firms, making it difficult for small companies to break
into the industry. Threat of substitute products and bargaining power of suppliers is
also low. The low supplier bargaining power in the paper industry is due to the fact of
price sensitive pulpwood contractors. The following Five Forces analysis table defines
the competitive landscape within the paper and packaging industries.
11 | P a g e Packaging/Paper Industry
FIVE FORCES
COMPETITION
LEVEL
Rivalry Among Firms
High
Threat of New Entrants
Mixed
Threat of Substitute
Low
Products
Bargaining Power of
Mixed
Customers
Bargaining Power of
High
Suppliers
Overall
High
The paper and packaging industries key success factors include cost leadership
and differentiation. Since variations between competing firms within the two industries
are small, they must compete heavily on these two factors. By keeping costs to a
minimum and creating new innovative packaging products, firms within these industries
are able to gain a competitive advantage relative to their rival firms.
Accounting Analysis
The accounting analysis section’s primary purpose is to identify MeadWestvaco’s
key accounting policies and determine how precise the policies are in depicting the firm.
In order to evaluate how precise the firm is portrayed by its key accounting policies,
one must asses the level of accounting disclosure the firm make available in its financial
statements. A high level of disclosure enables shareholders and analysts to have an
accurate outlook of the firm. Many firms, however, provide a low level of disclosure, in
12 | P a g e which they disclose only the necessary minimum that is required by the SEC. In
disclosing the bare minimum, the firm has the potential to alter or distort its financial
statements in order to hide or “puff” up their stated financials.
The key accounting policies for the firms in the paper and packaging industry
include the following: pension plans, derivative risk management, operating leases,
capital leases and goodwill. In regards to such policies, MeadWestvaco has levels of
disclosures that vary throughout each accounting policy but remain relatively high in
comparison to the industry trends and averages. MeadWestvaco has high quality levels
of disclosure in providing information on derivative risk management, operating and
capital leases, and good will. The firm provides a moderate level of disclosure on
pension plans that is relative constant with the industry trends.
Quality of
Pension
Derivative risk
Operating
Capital
Goodwill
Disclosure
Plans
management
Leases
Leases
MeadWestvaco
Moderate High
High
High
High
Paper and
Moderate Moderate
Low
Low
Moderate
Goodwill
Packaging
Industry
Competitors in Paper and Packaging Industry: IP, SSCC, PKG
Quality of
Pension
Derivative risk
Operating
Capital
Disclosure
Plans
management
Leases
Leases
MeadWestvaco
Moderate High
High
High
High
Paper and
Moderate Moderate
Low
Low
Moderate
Packaging
Industry
Competitors in Paper and Packaging Industry: IP, SSCC, PKG
13 | P a g e Financial Analysis, Cost of Capital Estimation, and
Forecasting
The financial ratio analysis is calculated and compared to competitors within the
industry in order to benchmark the company’s performance with the industry average.
The financial analysis also allows analysts to identify developing industry trends in order
to grasp a better understanding of a company’s future financial position within an
industry. Liquidity ratios were calculated for MeadWestvaco and main competitors to
illustrate how well a company generates cash flows to cover their liabilities. After
comparing MeadWestvaco’s liquidity ratios to those of competitors it was concluded that
MWV was on par with their competitors and remained close to the industry averages.
The profitability ratios reflect a firm’s ability to generate revenues and also give insight
about how well a company is able to manage costs associated with operations. The
profitability analysis showed that MeadWestvaco is not as profitable as the other
companies within the industry performing under the industry average in most of the
profitability ratios. The capital structure ratios measured the financial leverage of a firm
and provide information on a firm’s ability to meet their financial obligations.
MeadWestvaco again tended to have lower than industry average capital structure
ratios. They were able to slightly cover their financial obligations, but did not much
have much leeway after these liabilities were paid. MeadWestvaco’s internal and
sustainable growth rates both underperformed relative to their competition within the
paper/packaging industry. These low growth rates could indicate low future growth for
the company. In conclusion, MeadWestvaco is currently financially sound but lag
behind their main competitors within the industry. With tighter cost controls, in order
to increase profitability and maintaining capital structure stability MeadWestvaco can
indeed pull alongside their competition
Our first step in calculating MWV’s cost of capital according to the capital asset
pricing model was to perform a regression analysis over 2 year, 3 year, 5 year, 7 year,
and 10 year time horizons in order to observe an initial cost of equity. Our two year
regression displayed the highest adjusted r-squared value and an initial Ke of 3.87%,
which we increased by 1.5% for size adjustment. Weighted average cost of debt was
calculated for MeadWestvaco to be 5.89%. Clearly, for MWV, size adjusted Ke of 5.37%
was not a reasonable figure since, by definition, Ke must be greater than Kd.
Consequently, a back door or alternative cost of equity was calculated using the formula
M/B = 1 + (ROE – ke)/(ke – g) to arrive at a 7.52% cost of equity. In every subsequent
calculation involving Ke, including WACC calculations, 7.52% was assumed as our most
accurate Ke. Weighted average cost of capital for MeadWestvaco was calculated using the
formula WACC = (VL/VA)*Kd + (Ve/VA)*ke as follows assuming a 35% tax rate:
14 | P a g e WACCbt =
6.78%
WACCat =
5.30%
Forecasting is a key factor in determining logical estimations of future
performance based on expected future market conditions. This could not hold truer
than in the current recessionary period being experienced. The capstone forecasting
figure is that of expected future sales growth, as all other forecasting is linked to this
number in one way or another. MeadWestVaco will experience some slowdown in
demand in the United States due to current market conditions thus limiting expected
sales. However, MWV has been aggressively expanding into China and has had great
success that should counter the decrease of revenue in the U.S. market. Based on these
evaluations we have assumed a sales growth rate of 2% for 2008 and 2009, followed
by 4% growth thereafter. Another key factor forecasted pertaining to gross income is a
decrease in COGS. In 2003, MWV spun off a business section that has made the
company much more efficient and has caused a continual decrease in COGS. Based on
this decrease and the benefits of economies of scale as the business in China is further
expanded, we foresee this trend to continue. MWV’s dividend increases have been
consistent and timely with a 5% increase every 5 years. Therefore, MWV’s dividend
payout is expected to remain at 170 million until 2013, when it will increase to 178.5
million. Overall, MWV is expected to suffer little overall effect in the current recession
and continue to benefit from a business spinoff and expansions into China. As stated
earlier all of the forecasting done on the financial sheets can be derived from these
assumptions
Valuations
The culmination of all previously overviewed topics is the formation of an educated
estimate of the value of MWV. There are many models that can be used to formulate
the final values used for price evaluation with differing levels of accuracy. The outputs
of these models are then compared to MWV’s $14.71 share price at 11/3/08 and
15 | P a g e interpreted to be undervalued or overvalued based on a degree of acceptability. This
acceptability is a reflection of an analyst’s personal aggressive or conservative views. As
analysts, we are conservative with a 15% margin in share price that was observed on
11/3/08. With this margin we allow a share price of $12.5 to $16.92 for MWV to be
fairly priced.
The models can be separated into methods of comparables and intrinsic models. The
method of comparables uses ratios to compare a company to their industry and
calculate a share price based on the industry average. Averages are computed by
calculating competitor’s ratios and excluding any firm who is an outlier to produce the
most consistent average for the industry. This average is then plugged in and a share
price is computed. These valuations are inaccurate and not based on solid finance
theory and should be used with perspective. Intrinsic models are far more effective
than methods of comparables due to a solid foundation in financial theory with the use
forecasting to discount back expected values of the company. Naturally, the assumed
discount rates need to have space for flexibility due to forecasting error and unforeseen
future market conditions. This is accomplished through in depth sensitivity analysis to
observe the effect of manipulation of variables in the models.
Business and Industry Analysis
Company Overview
MeadWestvaco was founded in 1846 as the Mead Paper Company. Through the
acquisition of Brazil’s Rigesa, Westab Incorporated, Westvaco, DZN, and Calmar, the company
has adapted to the changing marketplace. MeadWestvaco’s evolution has transformed from
paper production, to the cardboard six-pack bottle carrier, to the spiral notebook, and finally the
expansion of the packaging portion of the company. “MeadWestvaco is involved in packaging
resources, consumer solutions, consumer and office products, and the specialty chemicals
businesses (MeadWestvaco.com).”
16 | P a g e MeadWestvaco is comprised of many separate industries. The main industries are
packaging and consumer solutions, and paper manufacturing. MeadWestvaco is also involved
in: the specialty chemicals industry, and the timber and real estate industry. Most of the
competing firms have also diversified into these fields (MeadWestvaco.com).
MeadWestvaco Corporation has operations in Asia, Europe, Latin America, Mexico,
Canada, and the United States. The company has had seven percent growth of profits from
primary business segments from 2006-2007. Half of all packaging sales are outside of North
America. Their center for packaging innovation is more than 65,000 square feet. They also
have more than four thousand granted patents worldwide. There are more than twenty five
states in the U.S. with MeadWestvaco locations. The company’s products are marketed in over
a hundred nations. There are over a hundred and fifty different product lines and ninety five
different international operations. Their sustainable business practices include 1.8 million acres
of forestland under sustainable management and five consecutive years on the Dow Jones
Sustainability World Index (www.WallStreetJournal.com).
*in millions
2003
2004
2005
2006
2007
Total Assets*
12,487
11,646
8,908
9,285
9,837
Net Sales*
7,553
6,060
6,170
6,530
6,906
Sales Growth
4.3%
-19.8%
1.8%
5.8%
5.8%
Industry Overview
MWV is in two main industries, the paper manufacturing industry and the
packaging and consumer solutions industry. MeadWestvaco has over 24,000
employees worldwide. Their current market cap is 4,683.63 million. MWV’s primary
competitors include Graphic Packaging Company (GPK), Smurfit-Stone Container
Corporation (SSCC), International Paper Company (IP), Bemis Company Incorporated
(BMS), and Temple Inland Incorporated (TIN). (www.ibisworld.com)
17 | P a g e Paper Manufacturing Industry:
About sixteen percent of MeadWestvaco’s sales are in the paper manufacturing
industry (meadwestvaco.com). The paper mill industry participates in the
manufacturing of paper from pulp. The companies can either manufacture or purchase
pulp. Additionally, the businesses may convert the paper they make into other products.
The process of making paper categorizes a business into this industry despite the
output. The paper (including newsprint) is sold in reams and rolls to producers of paper
products like stationery, printing and writing paper, paper bag and coated/treated
paper manufacturers, newspaper publishers, and paper wholesalers
(www.ibisworld.com).
MeadWestvaco is not the largest company in this industry. MeadWestvaco
competes very closely with the opposition. According to the data, MeadWestvaco is
third to International Paper Company and Bemis Company Incorporated in total assets.
The company’s net sales are finally increasing after their downward spin in 2004.
Total Assets (In Millions)
2003
2004
2005
2006
2007
MWV
12,487
11,646
8,908
9,285
9,837
BMS
751.9
873.7
987.8
1,093.7
1,136.9
SSCC
10,102
9,583
9,114
7,777
7,387
IP
35,525
32,217
28,771
24,034
24,159
18 | P a g e Net Sales (In Millions)
2003
2004
2005
2006
2007
MWV
7,553
6,060
6,170
6,530
6,906
BMS
2,635
2,834
3,473
3,639
3,649
SSCC
7,722
6,716
6,812
7,157
7,420
IP
22,138
20,721
21,700
21,995
21,890
Packaging and Consumer Solutions Industry:
Seventy four percent of MeadWestvaco’s sales are in the packaging industry
(meadwestvaco.com). This business encompasses establishments largely engaged in
changing paperboard into containers without manufacturing paperboard. The industry
acquires paper, paperboard and old corrugated containers from mills and converts them
into paperboard containers, which are used to house a range of consumer
manufactured goods, from food and beverage to car engines and footwear. The
containers are bulk-produced and sold to producers of such consumer and industrial
goods. The containers produced range from corrugated and solid fiber boxes to folding
paperboard boxes, non-folding sanitary food containers and other comparable
paperboard packaging. Other products made by these companies include corrugated
sheets, pads, pallets, paper dishes, and fiber drums and reels (www.ibisworld.com).
MeadWestvaco is currently second to International Paper Company in total
assets. There has been a steady decrease in assets across this industry. Net sales for
MWV have taken an upward curl recently.
19 | P a g e Total Assets (In Millions)
2003
2004
2005
2006
2007
MWV
12,487
11,646
8,908
9,285
9,837
GPK
538
538.3
557.9
564.3
586.3
TIN
21,331
20,144
21,630
20,474
5,942
IP
35,525
32,217
28,771
24,034
24,159
Net Sales (In Millions)
2003
2004
2005
2006
2007
MWV
7,553
6,060
6,170
6,530
6,906
GPK
1,683
2,386
2,294
2,321
2,421
TIN
3,501
3,860
3,843
4,185
3,926
IP
22,138
20,721
21,700
21,995
21,890
THE FIVE FORCES MODEL
The five forces model is a tool that can be used to better understand the
competitive landscape of an industry in which a business operates. The model is a
framework composed of five different forces that influence an industry. The model is
broken down into two separate groups which are the degree of actual and potential
competition and the bargaining power in input and output markets. The degree of
actual and potential competition can be further divided into three separate subgroups:
rivalry among existing firms, threat of new entrants, and threat of substitute products.
20 | P a g e These three forces take an in-depth look at a firm’s competitive position and value the
firm’s future profitability in their industry. Bargaining power in input and output
markets can are separated into two more specific categories which include bargaining
power of buyers and bargaining power of suppliers. These two groups focus on the
relationships of both suppliers and customers and their ability to impact the overall
profitability of the firm. By analyzing these five forces a company will be able to
identify the structure of the industry and be able to capitalize on particular
characteristics of their industry.
In a perfect world a firm would compete in only one industry, but this is not the
case for many firms. Due to MeadWestvaco’s diverse and wide production processes
and product mix, the firm operates in several different industries. These include the
paper products manufacturing and packaging/consumer solutions industries. The
following charts are a compilation of the five forces in both the paper and packaging
industries.
Paper Industry
FIVE FORCES
COMPETITION
LEVEL
Rivalry Among Firms
High
Threat of New Entrants
Low
Threat of Substitute Products
Low
Bargaining Power of Customers
Mixed
Bargaining Power of Suppliers
Low
Overall
Mixed
21 | P a g e Packaging Industry
FIVE FORCES
COMPETITION
LEVEL
Rivalry Among Firms
High
Threat of New Entrants
High
Threat of Substitute Products
Low
Bargaining Power of Customers
Mixed
Bargaining Power of Suppliers
High
Overall
High
Rivalry Among Existing Firms: Paper Products
Most firms gauge their profitability by the degree of competition among existing
firms within their specific industry. When an industry is highly competitive, firms are
competing on price. They must sacrifice higher prices in order to be a threat to
competitors. When a firm is forced to lower the price of their product, the profitability
of the firm and the industry will suffer. Other firms, who do not compete on price,
must create a competitive advantage position in their industry by focusing their
business on product differentiation, product development, and cost control systems.
The eight fundamentals used to determine rivalry among existing firms within an
industry are as follows: Industry growth rate, concentration, differentiation, switching
costs, economies of scale, learning economies, fixed and variable costs, excess
capacity, and exit barriers. The objective of analyzing current competition within an
industry is to better understand and act upon possible opportunities or threats created
by a firm’s existing competitors.
22 | P a g e Industry Growth Rate
Measuring a firm’s growth rate is ineffective when analyzing competition, until
it is compared to the industry as a whole. Comparing industry growth rates between
companies give an individual firm an idea of how they rank among their competitors.
When an industry is growing rapidly, the demand for the product outweighs the supply
of the product; therefore, the industry does not struggle with price pressures. In the
absence of price wars, firms are able to focus on expansion rather than having to
attract customers with low prices. Likewise, if an industry’s growth begins to decline,
firms actively fight for market share by lowering prices in an attempt to steal customers
away from competitors. Two helpful tools used to measure industry growth rates are
industry sales and production volume.
Percentage Change in Sales: Paper Industry
2002
2003
2004
2005
2006
2007
MWV
-16.2%
1.2%
2.3%
4.8%
-10.6%
6.4%
IP
-2.9%
9.4%
2.5%
0.4%
7.4%
11.9%
SSCC
-4.7%
4.7%
9.9%
7.6%
5.1%
3.7%
BMS
4%
12.4%
7.1%
26.9%
5.1%
0.1%
INDUSTRY
-4.9%
6.9%
5.4%
9.9%
1.7%
5.5%
The table and chart above illustrate the paper products manufacturing industry growth
rate over a six year span. The industry as a whole has been profitable over the past six
years averaging a growth rate of 4.08% a year. Over the last several years production
volume has risen from 47.99 million tons in 2003 to 51.23 million tons in 2007
(www.ibisworld.com). With these statistics it is logical assumption that the paperboard
industry will continue to see rising sales of industry products as long as demand for
nondurable manufactured products and consumption remain at high levels.
23 | P a g e Percentage Change in Sales: Packaging Industry
2002
2003
2004
2005
2006
2007
MWV
3.2%
8.4%
19%
1.5%
5.5%
6.4%
IP
-2.9%
9.4%
2.5%
3.2%
7.8%
8.5%
PKG
3.8%
3.4%
36.1%
0.3%
0.9%
Merged
TIN
2.2%
4.4%
1.3%
3.3%
5.4%
3.6%
INDUSRTY
1.5%
6.1%
5.9%
2.8%
6.1%
6.1%
AVG
The packaging industry has also steadily grown over the past six years averaging
a growth rate of 4.75%. The industry usually grows along with domestic production of
consumer and industrial goods, as producers require paperboard containers to
transport their final goods to wholesale and retail markets (www.firstresearch.com).
Population growth and increased consumption are key factors to growth in this
industry; therefore stable economic conditions will allow the industry to continue to
expand.
Concentration and Balance of Competitors
To determine the concentration of an industry it is important to look at the
number and size of firms competing in a market and the distribution of the market
share they control. When only a few firms hold a high percentage of the market share,
the industry is said to be highly concentrated. Firms competing in an industry that is
highly concentrated usually set a price that all competitors are willing to adhere to,
therefore avoiding destructive price wars between competitors. Conversely, when there
are many of about the same size firms, organizations are competing in a low
concentrated industry. In this case, firms aggressively battle over low pricing policies
because they are fighting for the same customers and supply of resources. Both the
paper and packaging industries have over 1,500 firms operating in the U.S.
(www.meadwestvaco.com), but only a hand full have obtained a high percentage of the
24 | P a g e market share, consequently these two industries possess a low level of concentration.
About 36.2% of the total market share in the paper industry is owned by four major
operators, while 25.7% of revenues in the packaging industry were generated by the
top four firms (www.ibisworld.com). Concentration has seemed to increase over the
last several years due to several mergers between top operators in both industries. For
example, International Paper’s acquisition of Weyerhaeuser’s packaging segment in
2008 increased International Paper’s, already high, market share
(www.weyerhaeuser.com). The trend of large producers increasing their market share
through acquisitions is one reason for the increased level of concentration in the paper
industry, therefore increasing the level of competition within the industry.
Market Share as a Percentage of Total Industry Sales
2003
2004
2005
2006
2007
MWV
19.3%
16.1%
17.8%
18.3%
19.4%
IP
56.5%
61.9%
62.6%
61.6%
60.4%
SSCC
19.7%
22%
19.6%
20.1%
20.5%
PKG
.003%
.005%
.006%
.006%
.006%
Industry
35,427
37,711
34,684
35,684
36,218
Sales
25 | P a g e Market Segment Share
Publishers
Paper Bag Manufacturers
Stationary Product Manufacturers
Paper Wholesalers
Export
Other
Differentiated Products
A firm’s ability to produce differentiated products allow the firm to defend their
prices and become more profitable. When businesses produce identical commodities or
offer similar services it becomes difficult to retain customers unless they are offered at
the lowest price. Firms that lack differentiation tend to compete solely on price. It is
difficult to differentiate products in the paper manufacturing industry because most of
the firms sell similar products making this industry highly price competitive. The
packaging and container industry have more creative freedom in their production
process. Product differentiation is still difficult to attain in this industry resulting in a
low amount of differentiation and a more intense rivalry. Firms in the packaging
industry also compete heavily on price.
Switching Cost
Switching costs are costs related to a firm’s decision to end existing operations
and using their resources to try and produce a different good. High switching costs
usually involves firms with expensive equipment that performs highly specialized
functions. Large and expensive plant equipment usually cannot be converted for other
26 | P a g e uses making it difficult to sell assets and recover losses. Low switching costs decrease
competition because the business can do something else with their assets at a
reasonably low cost. Switching costs are high in both the paper and packaging
industries because of the expensive and customized equipment used in the production
process. The high switching costs in these two industries bind the firm in the industry
and increase competition because it would be too costly to take on other operations.
Learning Economies
Businesses where knowledge and learning are the crucial factors to be successful
are characterized as learning economies. Firms with high learning economies are more
likely to be profitable and gain market share. Patents, high technological equipment,
and degreed employees’ are just a few examples of factors used to measure the level of
learning economies. For example, Smurfit Stone Container Corp. invested $384 million
in 2007 and expects to invest an additional $400 million in 2008 to modernize their
facilities’ equipment (http://library.corporate-ir.net). MeadWestvaco opened up new
facilities in the Chicago and Los Angeles areas and also made large investments to
upgrade or buy operating equipment (MeadWestvaco’s 2008 10-K). The paper and
packaging industries are both capital intensive. They have invested in new
technological machinery enabling them to flexibly meet customer’s changing needs and
cut the production process time in half (www.ibisworld.com). MeadWestvaco has a
moderate learning economy in both the paper and consumer packaging industry. The
firms competing in these two industries mainly focus on quality and price; but in order
to stay afloat in a growing industry they also have to make technological advances in
order to remain competitive. They must make technological developments in order to
maintain speedy production times, produce mass volumes of their product, and to
maintain their competitiveness. Both the paper and packaging industries also use their
proprietary trademarks and patents, technology, and product design in order to uphold
a competitive position in the industry.
27 | P a g e Economies of Scale
In many industries, the size of the company is crucial to the firm’s ability to
succeed and be profitable. High economies of scale tend to occur in industries with
high capital costs because the initial investment can be spread out over a larger number
of production units driving the cost per unit down.
Total Assets in Millions: Paper Industry
2003
2004
2005
2006
2007
MWV
12,470
11,646
8,908
9,285
9,837
IP
35,525
34,217
28,771
24,034
24,159
SSCC
9,956
9,583
9,114
7,777
9,956
WY
28,599
21,411
22,046
21,896
21,381
Total Assets in Millions: Packaging Industry
2003
2004
2005
2006
2007
MWV
12,470
11,646
8,908
9,285
9,837
IP
35,525
34,217
28,771
24,034
24,159
GPK
3,200
3,111
3,356
3,233
2,777
TIN
10,102
10,805
9,114
7,777
7,387
As shown in the tables above, firms in both industries have large investments in
their assets. For firms to compete on a high level in these industries the firms must be
large and dominant to maintain a presence. Investment in plant and equipment in the
paper industry has been substantial in the five years to December 2008 (averaging
4.3% of revenue), and is expected to increase at an average annual rate of 2.2% to
approximately $930 million in 2008. The packaging industry has also substantially
increased investment in production machinery over the last five years to December
2008; the value of new industry capital invested is expected to rise at an average
28 | P a g e annual rate of 15%, to about $2.82 billion (www.firstresearch.com). Due to the
growth in capital investment the previous two industries do exhibit large economies of
scale which causes the industry to be highly competitive on price.
Fixed and Variable Costs
The level of competition in an industry is also influence by a firm’s fixed and
variable costs. The firms within both the paper and packaging industry have high fixed
costs, so to maintain the highest level of profitability they must constantly attempt to
reduce these costs. In order for a firm to thrive it must be able to effectively manage
its costs. The firms within both the paper and packaging industry have high fixed costs,
so to maintain the highest level of profitability they must constantly attempt to reduce
these costs. For instance, International Paper’s fixed costs accounted for 27% of their
total sales. Organizations with high fixed costs must produce at capacity in order to
cover the hefty expenses. The paper and packaging industry both have high fixed costs
due to their plant equipment which leads to increased competition because competitors
engage in price wars in order to attract customers and sell large volumes of inventory.
Excess Capacity:
Excess capacity also plays a role in determining prices in an industry. High
excess capacity reflects a low demand for the firm’s product in a market. The presence
of excess capacity in an industry forces firms to decrease prices in order to relieve the
firm of the surplus capacity on hand. The demand for products in both the paper and
packaging industries has experience growth over the last several years. The intensity
of the rivalry increases when plant capacity exceeds demand. An addition of capacity
creates high competition between firms. With the high level of demand for the products
in the paper manufacturing and packaging industry most firms do not suffer from
overcapacity, thus decreasing the level of rivalry.
29 | P a g e Exit Barriers
Barriers to exit a market significantly limit a firm’s ability leave an unprofitable or
unsuccessful market. Firms may be forced to continue operations even when earning
low or even negative returns. Companies that have highly customized production
equipment struggle to find an alternative use for their assets, therefore face significant
costs when exiting a market or abandoning a product. Firms who are able to leave an
industry and recover their losses are said to have low levels of exit barriers and face
lower levels of competition. Both the paper and packaging industries have highly
specialized production assets creating an exit barrier and increasing competition among
firms.
Conclusion
The paper manufacturing and packaging industries both have the same
characteristics. The packaging segment is a bi-product of the paper manufacturing;
therefore the two industries are very similar competitively. The paper and packaging
industry both have high industry growth, high economies of scale, undifferentiated
products, large amount of fixed costs, and high switching costs. All of these factors
contribute to the intense rivalry between firms in this industry. Despite the industries
high concentration the firms are still very competitive. Since competition is excessive in
these two industries, firms focus on cost control and other pricing strategies in order to
offer prices lower than their competitors.
Threat of New Entrants
The threat of new entrants pertains to the ease and probability of new
companies entering the industry. When a new company enters an industry it increases
competition and reduces available market share. When industries become too
competitive, price wars may begin causing a significant drop in profitability for all
companies involved. Threats of new entrants are a cyclical process. First, a company
30 | P a g e creates a new industry or market using a Blue Ocean Strategy. Other businesses soon
see the potential for high profits and start to shift into the industry. At this point the
threat of new entrants is extremely high due to a large untapped market, high profits,
and most likely low regulation. New entrants continue to move into the industry making
it progressively more competitive. Soon, the top companies emerge as majority market
holders and it becomes a Red Ocean industry. Now, the industry is highly competitive
and there are many barriers to entry. Throughout this cycle there are many factors that
determine the difficulty of a company to enter the industry. These include economies of
scale, first mover advantage, distribution access, relationships, and legal barriers.
Economies of Scale
Economies of scale pertain to how the size of an industry’s companies can be a
barrier to entry for new entrants. Large established companies can produce in very
large quantities, making the profit needed from each unit of production less. They also
have had time to establish significant research and development. A new entrant would
have to invest heavily initially to even compete against these kinds of companies. In the
paper and paper products industry companies tend to be very large with a significant
amount of established assets. This would be a large hurdle for a new company to try to
overcome and compete.
As you can see in the chart above the average company size is extremely large
and a small company would have a lot of difficulty breaking into the industry. Small to
medium companies can find small market niches. One instance is in the newly
expanding China market. The Wall Street Journal reported that, “…the companies have
lost a major market in China, which, having ramped up its own paper production, has
become a net exporter of paper itself.” When the industry first started entering China,
China was not capable of supporting their paper demand. But, because of China’s
recent economic development they can not only compete within their country but start
exporting. However, this is an exception to the rule and smaller companies rarely can
compete with the larger companies on a global scale.
31 | P a g e On the other hand, in the packaging industry very little capital is needed to start
a competitive business. Only a few large companies are in the market and this leaves
plenty of space for small to medium sized companies to compete. The packaging
industry consists of about 85% of smaller companies with only 15% of market share
belonging to a handful of companies (www.ibisworld.com). The packaging industry is
still a crowded industry with intense competition for contracts, but with the right market
niche companies are able to break into the industry relatively easily and begin to
compete on a large scale.
First Mover Advantage
As I mentioned earlier, the first entrants into a Blue Ocean industry have an
advantage of an untapped market and no price competition. This is referred to as
having a first mover advantage. These companies can keep other companies from
entering the industry in several different ways. One way is that first movers have had
time to establish business ties with the cheapest suppliers. They also have the
advantage of an unregulated industry environment. Governments take time pass
regulations and even realize there is a need for new legislation. First movers also are
able to have already had experience in the industry by the time competitors begin to
enter; this means that all new entrants will have to experience an expensive learning
curve. In both the paper and paper product manufacturing industry and the packaging
industry, the option of being a first mover is almost non-existent. The industry is
crowded and highly competitive, and because there is very little research into
developing new technologies there is little possibility of becoming a first mover based
on a technology development.
Distribution Access and Relationships
Another barrier to entry is the limited access to distributers by new entrants. In
larger industries the only distributers capable of distributing your product may already
be doing business with an established industry company. Even if a company decided to
be its own distributer, there would be a very high initial investment in assets to start.
32 | P a g e Other companies in the industry have also had time to set up relationships with
customers, governments, and companies that your industry does business with. This
can make it difficult for entrant companies to establish business and customer ties. In
the paper and paper production industry distributers play an important role, especially
in the international markets. In order to compete in this industries today you must be
global. International distributers and contacts are very valuable. A new company in the
paper and paper products industry will have a difficult time finding new distributers
overseas to do business with.
In the packaging industry only 15% of the industry is large companies. This
leads to easier access into the market by competing on a local level and expanding.
There are many distributers working with the industry capable of handling small to
midsized distribution loads. This allows new companies to be able to break in and find a
company to distribute their products with relative ease.
Legal Barriers
Legal barriers come in the form of existing patents and copyrights that existing
companies have already developed. This is very common in industries such as
pharmaceuticals where there is intense competition and a very high investment in
research and development. Legal barriers can also come in the form of limited permits
granted by government entities. In the paper and paper production industry there are
many legal barriers due to environmental regulations. In 1998 regulators passed the
Pulp and Paper NESHAP laws. (www.pinellascounty.org) These laws put stricter
specifications on air and water pollution created by the paper industry. A new company
would have to spend even more money making their infrastructure meet these
standards which would increase start up costs. In the packaging industry there is light
regulation and few copyrights and patents that make a significant impact on the
industry. Therefore, a new entrant can easily enter the industry without acquiring hard
to get permits.
33 | P a g e Threat of Substitute Products
Substitute products are any product that could be used in place of the good that
an industry is producing for a similar price. In some industries, research into substitute
products can play a substantial role in how well a company performs. In fact,
companies can lose significant market share if a competing company patents a
significant new technology that they cannot duplicate.
Relative Price and Performance
In other industries there are few to no products to replace the original. These
types of goods are often called commodities. The paper industry is one such industry
where there is a very low threat of substitute products. The companies in the paper
industry still do research but not as much for advancing a product than to develop
technologies to improve production capabilities. In fact, in MeadWestvaco Corp’s 10k it
states, “While, in the aggregate, intellectual property rights are material to our
business, the loss of any one or any related group of such rights would not have a
material adverse effect on our business…” This shows from the company’s lack of
concern for the loss of patents and trademarks that every player in the industry has
mostly the same technology.
Customer Willingness to Switch
Since paper is a commodity product, there are few threats to the industry of a
new product emerging and changing competition in the industry over a large scale. In
recent years the only two products to cause any concern was the increased use of
plastic bags in place of paper and the internet. The Wall Street Journal reported that
“The cyclical downturn comes as production costs rise and ever-greater Internet use
curbs the need for paper.” The increased use of the internet for email and documents
has decreased the demand for plain paper. Plastic bags have become more and more
popular since the early 90’s, which decreased demand for paper. But, because of
34 | P a g e increased environmental awareness, we are seeing an increase in paper bags being
used again (www.ibisworld.com).
Conclusion
In the packaging industry there has been is little significant advancement in
technology since the invention of the assembly line. The only developments in this
industry have not been in new packaging products but in production processes to
increase productivity. There is no foreseen product or technology that will replace
current packaging methods.
Bargaining Power of Suppliers
Generally speaking, the ability of a firm to remain competitive and profitable in
any industry is largely affected by the firm’s relationship with its supplier of raw
materials. The total bargaining power of firms supplying input materials to an industry
can be decomposed into two categories, price sensitivity and relative bargaining power.
Inherent industry conditions determine the relative level of bargaining power and the
sensitivity to changes in price on the part of the firms supplying raw materials to an
industry. The balance of bargaining power between producing firms and suppliers of
raw materials is primarily dictated by the level of switching costs associated with the
next best alternative for the respective parties, the level of product differentiation, the
importance of the input product to the overall cost and quality of the output product,
the number of firms supplying input materials to the industry, and the volume of raw
materials supplied by each firm.
More specifically, within the paper and paper products industry, many large
firms, such as MeadWestvaco, International Paper Company, Smurfit–Stone Container
Corporation, and Temple-Inland Incorporated, manufacture paper from timber, or
“pulpwood”, and also convert their manufactured paper into packaging and containers
for a wide range of consumer products.(www.ibisworld.com) Evidence of paper
35 | P a g e manufacturers increased willingness to vertically integrate into the packaging industry is
found in International Paper Company’s recent acquisition of Weyerhaeuser’s packaging
business for $6 billion in cash.(Wall Street Journal, March 17,2008) With the exception
of a small amount of polymers and bleaching chemicals, pulpwood is the only raw
material necessary for the modern mass production of bulk paper
(www.paperonweb.com). Although most of the larger firms in the paper industry now
hold large assets in pulp-wood forestland which are often managed internally by the
paper producers themselves. Pulpwood contracts through small independent
contractors such as West Frasier Timber Co. Ltd., Longview Fibre Company., and
Allegheny Wood Products Inc. are still very common in today’s paper industry due to
the time lag associated with growing pulpwood.
In addition to the paper/paper products industry and the packaging industry,
many companies like MeadWestvaco also compete, to a much smaller extent, within
periphery industries, the specialty chemicals industry for example, to extract additional
revenue from otherwise useless byproducts of the paper making process. Although the
smaller periphery industries, such as the specialty chemicals industry, where many
paper producing firms operate are value added in the sense that they extract additional
revenue for the paper producers from paper making byproducts, the size and scope of
operations within these industries is miniscule compared to the two primary industries
in which paper firms compete. Consequently, the following analysis of the bargaining
power of suppliers will be strictly limited to the paper/paper products industry and the
packaging industry since these are the two primary value driving industries for most
paper producing firms.
36 | P a g e Price Sensitivity
The degree to which firms care to bargain on the basis of price, collectively
known as price sensitivity, depends primarily upon the level product differentiation, the
importance of the product to the consumer’s own cost structure, and the importance of
the input product in relation to the overall cost and quality of the output product. In
relation to the paper and packaging industries, switching cost for a paper producing
firm is essentially the cost associated with switching pulpwood suppliers, or from the
pulpwood supplier’s perspective, the cost associated with selling pulpwood to the next
paper producing firm in line. In industries with low switching costs and many suppliers
selling very similar commodities, or undifferentiated raw materials, producing firms are
more likely to become very sensitive to changes in the price of these input materials.
Conversely, if the industry supports only a small number of suppliers, or if the
producing firms require very specialized or scarce input materials, producing firms may
tolerate high input prices. Much of the theory behind the price sensitivity analysis of an
industry directly corresponds to basic economic models relating the levels of supply and
demand through price. The idea of price sensitivity is essentially the same notion as
price elasticity in this context.
Relative Bargaining Power
The relative bargaining power of specific firms within an industry depends
primarily upon how many suppliers there are in the market, how similar the suppliers’
products are relative to other suppliers, the importance of the suppliers’ product to the
overall quality of the producers’ end product, and how easily producers can switch
between suppliers. As discussed above, a thorough understanding of the price
sensitivity of both suppliers and producers in an industry is an essential step in making
an accurate conclusion regarding the overall bargaining power of both parties. Within
the paper and packaging industries, a complete analysis of the relative bargaining
power of both pulpwood suppliers and paper producers can be combined with the price
37 | P a g e sensitivity analysis as described above to formulate an accurate conclusion as to which
market participant, either pulpwood suppliers or paper producing firms, holds the
majority of total bargaining power within the industry.
Paper Products Manufacturing Industry
Within the paper and paper products manufacturing industry (paper industry),
the total bargaining power held by pulpwood contractors can be decomposed into the
price sensitivity of pulpwood contractors and the bargaining power of pulpwood
contractors relative to paper producing firms. In general, the paper industry of today is
characterized by relatively strong bargaining power and moderately high price
sensitivity on the part of the producing firms. The five factors that will be addressed
within the industry to help make an informed decision regarding the total bargaining
power of pulpwood contractors in the paper industry are as follows: the level of
switching costs to pulpwood suppliers and to paper producing firms, the level of product
differentiation between individual pulpwood contractors, the importance of pulpwood to
the overall cost and quality of paper, the number of pulpwood contractors in the
market, and the volume of pulpwood supplied by each contractor throughout the
industry.
Switching Costs
By definition, switching costs are the costs resulting from a switch from one
supplier or marketplace to the next.(www.investorwords.com) Within the paper
industry, switching costs remain lower for paper producers than for pulpwood
contractors. Paper producers can easily switch between small pulpwood contractors
with little to no economic penalties since the pulpwood contractors are often
responsible for delivery of the pulpwood to the paper producing firms. Pulpwood
contractors, on the other hand, may face much higher switching costs in the form of
38 | P a g e transportation costs if their pulpwood is delivered to a different paper producer. The
existence of substantial switching costs on the part of the pulpwood contractors within
the paper industry gives rise to increasing bargaining power on the part of the paper
producers, and greatly diminishes the relative bargaining power of the pulpwood
contractors.
Differentiation
Pulpwood is largely regarded by paper producers as an undifferentiated
commodity. The inability of pulpwood contractors to distinguish their product on a
quality basis has contributed to significantly lower switching costs and significantly
higher price sensitivity on the part of paper producing firms. In fact, the
undifferentiated nature of pulpwood has let pulpwood contractors to engage more and
more in low price competition since low switching costs have allowed paper producing
firms to move freely from supplier to supplier to obtain raw materials.
Importance of Pulpwood to the Cost and Quality of Paper Products
As the most important and the most capital intensive resource to the
manufacture of paper, it is essential for industry competitive paper producers to search
out and exploit the lowest possible price for their pulpwood contracts. Generally
speaking, the higher the cost of the input material relative to the output product, the
more time and effort firms can usually afford to spend searching out lower cost
alternatives. This line of thinking strongly supports higher price sensitivity on the part of
the paper producing firms.
39 | P a g e Number of Pulpwood Suppliers in the Paper Industry
The domestic logging industry, in which pulpwood suppliers operate, is made up
of approximately 11,400 independent companies with no one company comprising more
than 4.5% of market share.(www.ibisworld.com) The sheer number of pulpwood
contractors operating upstream from the paper industry increases the relative
bargaining power of paper producers significantly by providing more alternative sources
from which paper producers can potentially obtain pulpwood. Most of the large
companies in the paper industry including MeadWestvaco and International Paper state
in their 10-K annual reports that they obtain input materials, namely pulpwood,
simultaneously from multiple suppliers around the world. Low switching costs, the
undifferentiated nature of pulpwood, and the industry practice of obtaining pulpwood
from multiple suppliers has largely diminished any relative bargaining power once held
by pulpwood contractors in the paper industry.
Volume of Pulpwood Obtained From Each Supplier
Most of the larger firms in the paper industry now hold large assets in pulpwood forestland which are often managed internally by the paper producers
themselves, a detail that increasingly leads to a stronger bargaining position for the
paper producers since less pulpwood has to be obtained from independent pulpwood
contractors. The volume of timber purchased from each supplier continues to be
relatively low across the industry due to the tendency of many paper producers,
MeadWestvaco and Smurfit-Stone Container Corporation included, to sign long term
contracts with several pulpwood contractors in several different regions in an attempt to
hedge the risk of resource destruction by natural disasters.(www.ibisworld.com) As a
result, the relative bargaining power of pulpwood contractors relative to the paper
producing firms in the industry is very much weakened.
40 | P a g e Conclusion
In short, the paper industry is characterized by highly price sensitive paper
producers holding the majority of the relative bargaining power over moderately price
sensitive pulpwood contractors. The existence of many alternative pulpwood suppliers
available to paper producers, low switching costs on the part of paper producers, and
the undifferentiated nature of pulpwood have all contributed to diminished bargaining
power on the part of the pulpwood contractors and increased price sensitivity on the
part of the paper producers. Although pulpwood contractors recognize the importance
of pulpwood to the manufacture of paper, efforts to exert bargaining power over the
paper producing firms have been largely unsuccessful due to the heightened price
sensitivity on the part of the paper producing firms.
Bargaining Power of Suppliers – Paper Industry
Price Sensitivity of Pulpwood Suppliers
Moderate
Relative Bargaining Power of Pulpwood Suppliers
Low
Overall Bargaining power of Pulpwood Suppliers
Low
Packaging Industry
Most of the major firms that compete within the paper and paper products
industry, including MeadWestvaco, International Paper Company, Smurfit–Stone
Container Corporation, and Temple-Inland Incorporated, also compete within the
packaging industry. Significant economies of scale can be achieved when large paper
producing companies vertically integrate and use their own paper to package consumer
products in the packaging industry. Although the capital requirement needed to build a
top quality packaging facility is quite high, input costs can be as low the marginal cost
of producing paper when firms find it economically feasible to participate in both
41 | P a g e industries. Since almost all major packaging firms are vertically integrated with their
own paper producing business segments, bargaining power with suppliers is not an
issue.
Bargaining Power of Customers
Not surprisingly, the following analysis of the bargaining power of customers
closely resembles our previous study of the bargaining power of suppliers. The graph
below (Graph 1) was taken from www.ibisworld.com, and paints a clear picture of the
market for paper products.
Market Segment Share
Publishers ‐ 25.6%
Paper Bag Manufacturers ‐
18.7%
Stationary Product Manufacturers ‐ 18.2%
Paper Wholesalers ‐ 18%
Export ‐ 15%
Other ‐ 4.5%
As the graph above points out, the customer base in the paper and paper products
industry is primarily comprised of publishers, paper bag manufacturers, stationary
product manufacturers, and paper wholesalers. As for the packaging industry,
customers include a wide array of firms mostly within the consumer products
manufacturing industry. In order to draw an accurate conclusion regarding the overall
bargaining power of customers within each industry we will closely examine the
42 | P a g e industry conditions that shape the relationship between firms engaged in the paper
industry and the packaging industry and the customers they serve by focusing on price
sensitivity and relative bargaining power. Ideally, paper and packaging firms would like
to enjoy bargaining power over both pulpwood suppliers and customers of their
product. In reality, however, many product related details including product
differentiation, and customers’ perceived quality of the product, as well as many
industry related conditions including customers’ switching costs, number of customers
in the market, and the volume purchased per customer play a major role in determining
how sensitive customers are to price changes and how much relative bargaining power
customers have within the industry.
Price Sensitivity
Price sensitivity in the context of paper producing firms and paper consumers is
affected primarily by the level of product differentiation, level of switching cost to
consumers, and the importance of the paper product to the consumer’s cost
structure.(Palepu & Healy) Since paper is largely regarded by consumers as an
undifferentiated commodity, paper consumers have become much more price sensitive
as they rely more strongly on price than quality as a determinant for consumption. As a
result, paper producing firms have adopted a low cost structure to more enable them to
compete effectively on a low price basis, a reality which greatly contributes to the price
sensitivity of customers and detracts from the relative bargaining power of paper
producing firms, especially if the industry supports low switching costs. In this context,
switching costs are derived from the cost to paper and packaging consumers of buying
products and services from another firm. Intuitively, the greater the proportion of
resources relative to the consumer’s cost structure spent on a product, the more time
and effort the consumer is likely to spend searching out lower cost alternatives,
especially if the product is largely undifferentiated.
43 | P a g e Relative Bargaining Power
Ultimately, the relative bargaining power of consumers relative to producers
depends on the number of buyers and producers in the market, the number of
alternative products available to the consumer, the volume purchased by each
consumer, and the costs to each party of forgoing the transaction.(Palepu & Healy)
When many alternative products are readily available to the consumer, the cost of
forgoing the purchase of a specific product is significantly reduced, and the relative
bargaining power of the producer is eroded. Conversely, when there are few producing
firms and many potential buyers in the marketplace, the producing firms hold the great
majority of the relative bargaining power. Finally, in order for firms to sell their product
to high volume buyers on a regular basis, the producers very often must relinquish a
portion of their bargaining power relative to the buyers. In effect, lower prices often
result from buyers using high volume contracts as leverage to increase their relative
bargaining power over producers.
Paper Products Manufacturing Industry
The paper products manufacturing industry of today is largely characterized by
highly price sensitive customers holding the majority of bargaining power over the
paper producing firms. This should come as no real surprise considering the
undifferentiated nature of the product, the low switching cost to customers, low cost
and uniform quality of the product across the industry, and the large number of
suppliers in the industry.
44 | P a g e Switching Costs
High levels of competition within the paper industry have led to high industry
standards for quality. As a result, paper is now largely considered a commodity product
sold on the basis of rolls, reams, tons, or square feet. Although customers are justifiably
interested in the quality of the paper products they are buying, modern quality control
technology on the part of the paper producing firms has largely put the quality of paper
products on a level playing field across the industry. For this reason, switching costs to
consumers are very low. The existence of many alternative paper producers capable of
manufacturing essentially the same product has greatly diminished the relative
bargaining power of paper producers, greatly enhanced the price sensitivity of
consumers, and all but eliminated switching costs to consumers within the market for
paper products.
Differentiation
Both MeadWestvaco and Smurfit-Stone Container Corporation explicitly state in
their most recent annual 10-K reports that their competitive strategy for marketing their
paper products is based solidly in cost leadership. The major paper manufacturing firms
including International Paper, MeadWestvaco, and Smurfit-Stone Container Corporation
do not attempt to distinguish their bulk paper products through differentiation.
Together with the existence of low switching costs, the lack of product differentiation
only adds to a greater sensitivity to price on the part of the paper consumers, and again
detracts from the relative bargaining power of paper manufacturing firms in the market.
Importance of Cost and Quality to the Customer
Relative to their own cost structure, paper consumers, including publishers,
paper bag manufacturers, and stationary product manufacturers, expend a large
45 | P a g e portion of their operating income on bulk paper resources.(www.paperonweb.com) As a
result, consumers are willing to spend more time and effort searching out cheaper
alternatives, a condition that leads to more price sensitive consumers and more
competition between paper producing firms. This increased price sensitivity on the part
of the consumers is supported, in part, by the existence of low switching costs to
consumers in the market for paper products. Although quality is extremely important to
some consumers including book publishers and stationary product manufacturers,
enhanced technology such as computer aided manufacturing has significantly improved
the average quality of paper across the industry, another factor that contributes to
increasing paper consumer price sensitivity.(www.ibisworld.com)
Number of Customers in the Market for Paper
The publishing firms, paper bag manufacturers, stationary product
manufacturers, and paper wholesalers together create a strong demand for paper, but
not one that the paper producing firms cannot meet or exceed. Together with low
switching costs, the existence of many buyers and many sellers in the paper products
industry prevents any individual paper producing firm from raising the price of their
product without losing customers to the next paper producing firm in line. Within this
context, neither paper producers nor paper consumers can exert relative bargaining
power over the other party because the number of consumers relative to the number of
paper producers in the market is not large enough.
Volume of Paper Purchased Per Customer
The market for paper products is sufficiently diversified across several consumer
segments to prevent any one consumer from exerting much relative bargaining power
over the paper producing firms.
46 | P a g e Conclusion
Within the paper industry, the undifferentiated nature of paper products across
the industry and the low switching costs to paper consumers have led to increased price
sensitivity on the part of the paper consumers. Despite gains in relative bargaining
power of paper producers over consumers due to the importance of high quality low
cost paper to consumers in the publishing and stationary product manufacturing
industries, the flat technology curve across the industry and the existence of many
paper producers competing strictly on a low price basis more than offsets such a gain.
Bargaining Power of Customers – Paper Industry
Price Sensitivity of Major Paper Consumers
High
Relative Bargaining Power of Paper Consumers
Moderate
Overall Bargaining Power of Paper Consumers
Mixed
Packaging Industry
The customer base in the packaging industry is composed of a wide range of
consumer product manufacturing firms in a number of different industries from
pharmaceuticals to cosmetics. Many of the firms creating the demand side of the
packaging industry face a packaging cost greater than the cost of manufacturing their
product, a detail that forces packaging companies to compete increasingly on low cost
in addition to product differentiation.(ibisworld.com) These consumer product
manufacturing firms look to packaging firms as a one stop shop for packaging,
packaging design, and packaging printing. There are many customers in the packaging
industry and only limited number of quality packaging firms.(www.ibisworld.com)
Within the packaging industry, the consumer product manufacturing firms, the
47 | P a g e customers, are only moderately price sensitive, and largely lack relative bargaining
power over packaging firms.
As previously noted, the importance of the consumers cost structure relative to
the price of the producers’ product plays a vital role in shaping the price sensitivity of
the buyers in the market. As for the packaging industry, the downward pressures from
buyers to lower packaging costs have increased the price sensitivity of consumers, but
not enough to offset the drop in price sensitivity stemming from the differentiated
nature of the product, and the importance of packaging to the ultimate success of the
buyers’ product.
Switching Costs
The extremely differentiated nature of product packaging has contributed to high
switching costs for customers. Consumer product manufacturing firms, the customer
base in the packaging industry, realize that no two consumer products are packaged
and printed in the exact same way, and expect to spend large amounts of capital
resources on the design and development of a quality packaging medium for their
product. Furthermore, consumers in the packaging industry are rightfully reluctant to
switch packaging firms and expose themselves to additional design and development
expenses. Packaging firms gain significant relative bargaining power over buyers
because of the existence of high switching costs.
Product Differentiation
Compared to the paper and paper products industry, the packaging industry
markets a much more differentiated product specialized to the needs of individual
consumer clients. As a result, consumer product manufacturing firms tend to focus on
48 | P a g e the quality and price of the product relative to their own cost structure, and tend to be
less sensitive to changes in price.
Importance of Packaging to the Overall Cost and Quality of Consumer Goods
Consumer product manufacturing firms have realized the importance of
presentation to the overall success of their product and often distinguish between
packaging firms on the basis of quality. Packaging, more than paper production,
depends to no small degree upon human imagination and a thorough understanding of
the product market to achieve a top quality presentation.(www.paperonweb.com) As a
result, the packaging industry contains an uneven distribution of creative talent, and not
all packaging firms produce the same quality of product packaging. Packaging firms
gain relative bargaining power over their customers due to the importance of packaging
to the overall quality of the consumer products.
Number of Customers in the Market
Much like the paper industry, the high volume of buyers and sellers in the
packaging industry prevents, to some extent, either party from exercising relative
bargaining power over the other.
Volume per Customer
The high volume per customer ratio in the packaging industry is evidence of the
high switching costs, and low price sensitivity on the part of the consumer products
manufacturing firms, but contributes slightly to their increased relative bargaining
power. Consumer products manufacturing firms Packaging costs to consumer product
manufacturing firms are high relative to their own cost structure, adding to their
49 | P a g e incentive to build rapport and remain loyal to a single packaging firm despite the
existence of many packaging firms present within the industry.(www.ibisworld.com)
Conclusion
Price sensitivity in the packaging industry is almost a tossup with many factors
influencing consumer products manufacturing firms in both directions. Understandably,
the consumers in the packaging industry have recognized the importance of packaging
to the ultimate success of their product, and the importance of quality has lowered the
price sensitivity of the consumer product manufacturing firms greatly as they more
reluctant to cut corners on packaging expense. The relative bargaining power of
customers in the packaging industry is low due to high switching costs, but not as low
as it would be if there weren’t large numbers of buyers and sellers in the market and a
high volume per buyer ratio. Switching costs remain high due to the extremely
differentiated nature of product packaging. In addition, high switching costs have
contributed to very favorable buyer retention for the packaging firms, contributing to
increased relative bargaining power for packaging firms.
Bargaining Power of Customers – Packaging Industry
Price Sensitivity of Consumer Products Mfg. Firms
Low
Relative Bargaining Power of Consumer Mfg. Firms
Low
Overall Bargaining Power of Consumer Mfg. Firms
Low
50 | P a g e Key Success Factors
In order for an individual firm to be successful in a particular industry, it must
choose a competitive strategy that allows the firm to create a competitive advantage in
the industry. Building a competitive advantage in the industry will in turn create value
throughout the firm. “The profitability of a firm is influenced not only by its industry
structure but also by the strategic choices it makes in positioning itself in the
industry.”(Palepu & Healy-Business Analysis & Valuation: Using Financial Statements, pg
2-8) Primarily there are two competitive strategies that allow a firm to build a
competitive advantage in an industry: The Cost Leadership Strategy and The
Differentiation Strategy. With the Paper/Paper Products Industry being a highly
competitive industry with a low concentration it concentrates largely on Cost
Leadership, while the highly competitive, highly concentrated Packaging Industry
concentrates more on Differentiation. Although, both industries target a certain
strategy, they must not completely ignore the other area that they are not primarily
focused on; the industries must achieve an adequate level in each area.
Cost Leadership (paper/paper products industry)
The markets, in which the paper/paper products industry sells its products is
highly competitive. “Our products are in competition with similar products that are
produced by other forest product companies, therefore there are many factors that
influence a firm’s competitive advantage position, which include: price, cost, product
quality and services.”(International Paper Company. 10K) The Paper/Paper products
industry is mainly a commodity business, in which products are sold mainly based on
price. So the most important strategy it targets in order to build a competitive
advantage is the Cost Leadership strategy. “The Cost Leadership strategy allows the
firm to provide the same product or service at a lower cost than its competitors in the
industry.” (Palepu & Healy-Business Analysis & Valuation: Using Financial Statements,
51 | P a g e pg 2-8 & 2-9) The Paper/Paper product industry can achieve a competitive advantage
by focusing its efforts to maximize value by using the cost leadership strategy. The
industry can achieve cost leadership through a tight cost control system, economies of
scale, efficient production process, lower input costs, and low-cost distribution
Tight cost control system
The Paper/Paper products industry uses a tight cost control system, which
enables firms in the industry to lower costs and position themselves at a competitive
advantage. The way firms in this particular industry are obtaining a tight cost control
system is by improving competitiveness by having vertically integrated operations,
investing in minimum research and development that is focused more on greater
production efficiency rather than new products, and utilizing modern technology and
equipment to improve efficiency.
Economies of Scale
Economies of scale are “the decrease in unit cost of a product or service
resulting from large scale operations, as in mass production.”(dictionary.com) Firms in
this particular industry typically have vertically integrated operations, meaning that they
own their own forest, cut down their own trees and make their own pulp. Being
vertically integrated enables the firms in the industry to produce mass quantities of its
products, which in turn decreases the unit cost of the product. For example, firms in
this particular industry utilize the forest they own to provide the basic raw materials
needed to produce its products; this enables them to operate in large scale, mass
production operations, resulting in the decrease in unit cost of its products. This
enables firms to achieve cost competitiveness with foreign and domestic producers in
the industry.
52 | P a g e Efficient Production Process and Lower Input Costs
In order for a firm to effectively achieve a competitive advantage in cost
leadership, it must have an efficient production process, and it must effectively drive
down the costs involved in the production of its paper and paper products. In other
words the industry must have lower input costs, sufficient technology, and labor
systems to achieve an efficient production process. The paper/paper products industry
achieves lower input costs by having vertically integrated operations. This enables the
firm to reduce the cost of purchasing raw materials such as pulp, which is the industry’s
most significant cost.
Firms in this particular industry also achieve an efficient production process by
utilizing modern technology and new equipment to minimize costs. “The adoption of
new technologies in paperboard manufacturing is significant and dynamic. The
companies involved in paperboard milling have invested in new machines that
corrugate, fold, cut and glue paperboard to manufacture a product to exact
specifications. These investments have allowed the industry to respond better to
changing client packaging needs as their products also evolve over time. They have also
reduced labor intensity and raised the overall mechanization, accuracy and productivity
across the industry.”(ibisworld.com)
Low-Cost Distribution
In order to effectively position them at a competitive advantage, firms in the
Paper/Paper Products industry must efficiently achieve a low-cost distribution in an
effort to create value through cost leadership. Low-cost distribution allows the firm to
deliver its products to customers in an economically efficient way. A firm’s proximity to
its raw material and its customers play a crucial role in obtaining a low-cost distribution.
For example the Paper/Paper products industry establishments are located principally in
53 | P a g e the nation’s east, but chiefly in the South East region, in which it holds 37.5% of the
nation’s total. This region is popular due to the fact that it has close proximity to raw
materials and customers, enabling firms to reduce its transportation costs. Efficient
supply chains and logistic procedures are also crucial in the distribution process. For
example, firms such as International Paper Company leverages its distribution by selling
paper/paper products “directly to end users and converters, as well as, through agents,
resellers and paper distributors”(International Paper Company 10K) “By having efficient
supply chain and proper logistical procedures firms can cut costs and increase
efficiency”(investopedia.com)
COST LEADERSHIP (packing industry)
Although the Packaging Industry targets the differentiation strategy, it must also
achieve an adequate level of cost leadership in order to successfully compete in the
industry. The Packaging industry positions itself at a competitive advantage through
cost leadership in order to effectively create value throughout the firm. Focusing its
efforts to maximize value, the industry can achieve cost leadership through economies
of scope.
Economies of Scope
Economies of scope is “An economic theory stating that the average total cost of
production decreases as a result of increasing the number of different goods
produced.”(dictionary.com) This particular industry has “a diverse range of
manufactured products produced at competitive costs, which maximize a firm’s ability
to seize market power.”(ibisworld.com) For example, Packaging Corp. of America
produces corrugated and solid fiber boxes, folding paperboard boxes, non folding
sanitary food containers, setup paperboard boxes, as well as fiber cans, tubes, and
54 | P a g e drums. By producing this largely diverse range of products, the Packaging Industry is
able to effectively position itself at a competitive advantage through cost leadership.
DIFFERENTIATION (Packing Industry)
In the highly competitive packaging industry, there are only a small number of
large competitors that hold a large portion of the packaging industry; this causes the
industry to have a high concentration. With the concentration level in this particular
industry being high, firms within the industry mainly compete on price and product
innovation. Therefore the industry primarily targets the competitive advantage strategy
of differentiation to create value throughout the firm. The Differentiation strategy
“involves providing a product or service that is distinct in some important aspect valued
by the customer.”(Palepu and Healy, Business Analysis and Evaluation: Using Financial
Statements, pg 2-9). The Packaging industry can achieve a competitive advantage by
focusing its efforts on maximizing value by using the differentiation strategy. The
industry can achieve differentiation through a control system that focuses on creativity
and innovation, investing in research and development, and providing superior product
quality, matchless product variety, and unsurpassed customer service.
Creativity and Innovation
The Packaging Industry uses a control system that fosters creativity and
innovation. This enables the firms in the industry to provide products at a lower cost in
order to achieve a competitive advantage position. The way firms in this particular
industry are obtaining creativity and innovation control systems is by improving
competitiveness through investing in research and development that is focused more on
the innovation and creation of new products, utilizing modern technology and
equipment to provide superior product quality, variety, and customer service.
55 | P a g e Research and Development
The industry involved in the business of Packaging invests money and time in
o
research and development that concentrates more on the engineering of new and
innovative products. Although research and development costs can typically be very
high, they are well worth it, in gaining a competitive advantage position when a new
and innovative product is produced to meet specific customer needs and requirements.
For example, “at Packaging Corp. of America, the story of how they create the world’s
most innovative packages begins and ends with understanding the customer. They turn
market insights into new designs that enhance product value, strengthen brands and
inspire lasting connections between products and people.”( www.packagingcorp.com)
Product Quality, Variety, and Customer Service
The Packaging Industry must provide superior product quality, matchless product
variety, and unsurpassed customer service to create a competitive advantage in the
industry. Producing products with such superiority play a vital role in establishing and
increasing customer loyalty, and also establishing a positive image for a particular firm
in the industry. The industry positions itself at a competitive advantage by achieving
superior product quality, variety and customer service by utilizing modern technology
and equipment. For example, large companies involved in this particular industry have
purchased new machines that enable them to manufacture a product to meet exact
customer expectations, and they have also implemented new technologies which enable
the industry to better respond to customers packaging needs, as they evolve over time.
56 | P a g e DIFFERENTIATION (paper/paper products industry)
Even though the Paper/Paper products industry primarily focuses on cost
leadership in order to gain a competitive advantage, it must also achieve an adequate
level of differentiation to effectively and successfully compete in the particular industry.
The paper/paper products industry can effectively and successfully build a competitive
advantage by differentiating it self through superior product customer service.
Customer Service and Product Assurance
Unsurpassed customer service and product assurance involves the
understanding of customer attitudes, needs and expectations toward a certain product
produced in a particular industry. In an effort to achieve unsurpassed customer service,
the Paper/Paper products industry has greatly improved its abilities in communicating
product benefits to customers and potential customers. As a result the majorities of its
customers remains loyal and, therefore, keep purchasing products in that particular
industry. By creating customer loyalty through unsurpassed customer service and
product assurance the paper/paper products industry has achieved an adequate level of
differentiation, a benefit which allows it to effectively position itself at a competitive
advantage.
Conclusion
Within the Paper/Paper Products Industry it is crucial for the firms to have a tight
cost control system, economies of scale, efficient production and lower input costs, as
well as a unsurpassed customer service and product assurance. It is also crucial for
competitive firms within the Packaging Industry to have economies of scope, a creative
and innovative control system, invest in research and development, provide and
produce superior product quality, matchless variety and unsurpassed customer services.
57 | P a g e By utilizing the various competitive advantages that create value for a firm, individual
firms within the two industries enable themselves to effectively grow, and successfully
compete in these particularly highly competitive industries.
FIRM COMPETITVE ADVANTAGE ANALYSIS
The MeadWestvaco Corporation is a global leader in the Paper/Paper Products
Industry, as well as, in the Packaging Industry. MeadWestvaco Corporation is able to
prevail in these two particular industries by achieving an adequate level of balance
between firm differentiation, and competitive cost leadership. The firm’s ability to
achieve such adequate balances enables them to create value, as well as, build and
sustain a competitive advantage in each industry. By utilizing a tight cost control system
MeadWestvaco establishes cost leadership through economies of scale and scope,
efficient production process, lower input costs, and lower-cost distribution.
MeadWestvaco also has the ability to differentiate itself by utilizing a creativity and
innovation control system that focuses on investing in research and development, in
order to provide superior product quality, matchless product variety, and unsurpassed
customer service.
Competitive Advantage Analysis
Early Innovations
MeadWestvaco was one of the first to deliver product value, product efficiency
in every product it produced. MeadWestvaco was the first Packaging, Paper/Paper
manufacturer to become the world’s largest supplier of paperboard beverage
packaging. It acquired pioneer of the six-pack bottle carrier in 1957. MeadWestvaco
was also one of the first Packaging, Paper/Paper manufacturers that utilized innovation
and partnerships to meet customer needs in an evolving market. For example, it
58 | P a g e received the new innovative spiral notebook product through an acquisition of WESTAB
Inc. in 1966. Effectively utilizing its innovative achievements and successful investment,
MeadWestvaco has always obtained a competitive advantage.
Modern Innovations
“Today, its end-to-end approach to packaging solutions is taking our historic
strengths to new levels, providing brand leaders with consumer insight, innovation and
global manufacturing expertise that redefine the dimensions of packaging”
(meadwestvaco.com). MeadWestvaco is currently utilizing a Center for Packaging
innovation. The Center provides a range of selections that aid in the development and
design of the packaging. The capabilities the Center offers include consumer insight
and market research, material testing and research, creative and technical design and
rapid prototyping. These particular modern innovations allow MeadWestvaco to
continue to achieve an effective competitive advantage.
Firm Implementation of Value Creation Strategies
COST LEADERSHIP
MeadWestvaco is highly successful in implementing cost leadership in both the
Paper/Paper Products Industry and the Packaging Industry. MeadWestvaco competes in
highly competitive industries, which primarily compete through price. Therefore it
implements cost leadership through economies of scale and scope, efficient production
process, lower input costs, and lower-cost distribution
Economies of Scale and Scope
In 2002 MeadWestvaco became one of the largest firms in the Paper/Paper
Products Industry and also in the Packaging Industry. Being one of the largest firms in
59 | P a g e these industries and being vertically integrated (owning its’ own forest) MeadWestvaco
is able to operate in large scale, mass production operations; this allows the firm to
establish economies of scale. With MeadWestvaco understanding the needs of
customers and consumers they serve, it operates in a variety of product categories such
as food and beverage products, media and entertainment, publishing and commercial
print, and office/school supplies. This enables the firm to establish economies of scope.
Efficient Production Process and Low Costs Inputs
MeadWestvaco competes primarily on price so it must have efficient production
process and low cost inputs in order to implement a cost leadership strategy.
MeadWestvaco must have lower input costs, sufficient technology, and labor systems to
achieve an efficient production process. The MeadWestvaco achieves lower input costs
by having vertically integrated operations, in which it can utilize its forest to provide raw
materials. This enables MeadWestvaco to reduce the cost of purchasing raw materials
such as pulp, which is the industry’s most significant cost. MeadWestvaco establishes an
efficient production process by utilizing modern technology and new equipment to
minimize costs. The company has invested in “new machines that corrugate, fold, cut
and glue paperboard to manufacture a product to exact specifications. These
investments have allowed the industry to respond better to changing client packaging
needs as their products also evolve over time. They have also reduced labor intensity
and raised the overall mechanization, accuracy and productivity across the
industry.”(ibisworld.com).
Low-Cost Distribution
In order to effectively position itself at a competitive advantage, the company
must efficiently achieve a low-cost distribution in an effort to create value through cost
leadership. Low-cost distribution allows the firm to deliver its products to customers in
60 | P a g e an economically efficient way. A firm’s proximity to its raw material and its customers
play a crucial role in obtaining a low-cost distribution. Efficient supply chains and logistic
procedure are also crucial in the distribution process. For example, MeadWestvaco
leverages its distribution by selling products “through a combination of its own sales
force, paperboard merchants, and distributors.”(MeadWestvaco 10-K) “By having
efficient supply chain and proper logistical procedures MeadWestvaco can cut costs and
increase efficiency”(investopedia.com)
Differentiation
In order to achieve a competitive advantage MeadWestvaco has the ability to
differentiate. MeadWestvaco differentiates from competitors by utilizing a creativity and
innovation control system that focuses on investing in research and development, in
order to provide superior product quality, matchless product variety, and unsurpassed
customer service.
Research and Development
For the Company to effectively differentiate itself from its competitors, it must
invest in research and development that concentrates more on the engineering of new
and innovative products. “MeadWestvaco conducts research and development in the
area of packaging and chemicals. Innovative product development and manufacturing
processes improvements are the main objectives of the research and development
efforts. The company also evaluates and adapts for the use new and emerging
technologies that may enable new product development and manufacturing costs
reductions.”(MeadWestvaco 10-K)
61 | P a g e Superior Product Quality
The company must have the ability to differentiate through product quality in
order to maintain a competitive advantage in the industries. Product quality is crucial in
building customer loyalty and company image. MeadWestvaco produces products “that
meet a variety of specific customer requirements, including durability, scratch and tear
resistance, tamper resistance, superior printability, engaging graphics and visual appeal
and a variety of protective properties to retard flame or lock in scent, taste, and
freshness.”(MeadWestvaco.com) Being able to produce superior products enables
MeadWestvaco to build customer loyalty and company image, allowing them to position
themselves at a competitive advantage.
Product Variety
MeadWestvaco also has the ability to differentiate through unmatched product
variety. Producing a variety of different products creates value for the company.
MeadWestvaco is able to produce a variety of different products such as, primary and
secondary finished packaging, paperboard, specialty chemicals, dispensing solutions,
coated cover, consumer and office products, multi-packs and packaging machinery, and
specialty paper. In producing these various products MeadWestvaco effectively
positions itself at a competitive advantage by differentiating its products to meet
customer needs and demands, which in turn creates value for the company.
Customer Service
Effectively providing unsurpassed customer service involves the understanding of
customer attitudes, needs and expectations toward a certain product produced in a
particular industry. “At MeadWestvaco, the story of how it creates the world’s most
innovative packages begins and ends with understanding the customer. They turn
62 | P a g e market insights into new designs that enhance product value and inspire lasting
connections between products and people”(MeadWestvaco.com) “MeadWestvaco also
understands that innovative package design is only as effective as the customers ability
to implement it. So MeadWestvaco designs, installs, and services advanced packaging
systems that optimize the customer’s ability to print, fill, fold, and
glue.”(meadwestvaco.com) MeadWestvaco definitely understands its customers;
therefore it is able to provide unsurpassed customer service which allows it to maintain
its competitive advantage.
Conclusion
Within the Paper/Paper Products industry and the Packaging industry it is vital
that firms construct an adequate level of balance between cost leadership and
differentiation. Without these competitive advantages no firm within these two
particular industries would be successful because there is little room for growth and the
industries are highly competitive. MeadWestvaco does an excellent job at effectively
achieving a competitive advantage position by efficiently balancing itself between the
two competitive advantage strategies; this in turn creates value throughout the firm.
63 | P a g e Formal Accounting Analysis
Accounting analysis is a necessary step in assessing the true value of a firm. In
the United States of America the Securities and Exchange Commission (SEC) operates
as an independent arm of the Federal Government and has the responsibility of
regulating the U.S. financial industry. More specifically, “The mission of the U.S.
Securities and Exchange Commission is to protect investors, maintain fair, orderly, and
efficient markets, and facilitate capital formation.” (www.sec.gov) In carrying out their
mission, the SEC requires all companies listed on U.S. stock exchanges to file scheduled
financial statements in which they must accurately and honestly disclose the nature of
their operations using a set of standards known as the Generally Accepted Accounting
Principles, or GAAP. In reality, the SEC currently delegates the authority to prescribe
GAAP to a private, not-for-profit, organization known as the Financial Accounting
Standards board, or simply FASB. Although GAAP is currently the governing body of
accounting standards for financial reporting in the U.S., as required by the SEC, the SEC
has recently announced a transition to the International Financial Reporting Standards,
or IFRS effective 2011. The change is expected to improve transparency and
consistency between international markets. GAAP currently gives public companies
substantial flexibility in interpreting and applying the accounting policies in the most
accurate manner specific to their respective industry.
Due to the ability of a firm’s management to manipulate accounting numbers
within their financial statements, formal analysis of financial statement accounting is
necessary. The six steps of the formal accounting analysis are designed to indicate and
illustrate accounting errors or earnings manipulations by removing an element of
creativity and flexibility from the company’s method of disclosure on their financial
statements. The six steps of the formal accounting analysis are as follows: Identify key
accounting policies, assess the degree of potential accounting flexibility, evaluate actual
accounting strategy, evaluate the quality of disclosure, identify potential “red flags,”
and undo accounting distortions. The six steps will be applied on an industry level as
well as the firm level, and will focus on pension plans, foreign currency rate risk,
64 | P a g e derivative risk management and goodwill within the paper and packaging industry.
Examination of these topics will undoubtedly help expose a more accurate depiction of
how firms in the paper and packaging industry account for their true nature of
operations.
Key Accounting Policies
The first step of the formal accounting analysis involves indentifying the key
accounting policies used by the firms in the paper and packaging industry used to help
support their respective key success factors. As previously discussed in the Value
Creation Analysis, the key success factors identified for MeadWest Vaco, or MWV,
include competing on a low cost strategy for their paper and paper products business
segment, and competing on a differentiation strategy for their packaging and consumer
services business segment. The accounting method used for each respective strategy
has a direct effect on the reported financial strength or weakness of the company. The
key accounting policies suspect to exhibit accounting distortions or manipulations
involve accounting for pension plans, capital and operating leases, derivative risk
management, and goodwill.
As Applied to Key Success Factors
The paper and paper products industry competes on the basis of cost leadership
and product differentiation and the companies in this industry link their accounting
policies directly to these key success factors. Because most of the industries value is
derived from cost leadership and product differentiation, this is where accounting
discrepancies are most likely to occur in a company’s attempt to be competitive.
Therefore, it is important to analyze a company’s pension plans, derivative risk
management, operating and capital leases, and disclosure of goodwill to see if the
65 | P a g e company has made attempts to misrepresent aspects of these variables to mislead
investors.
Pension Plans
Pension plans can be used and manipulated in many ways to help a company
compete with cost leadership, one of our key success factors. Almost all the variables in
configuring costs for pension’s plans are estimates, which can lead to some faulty
accounting in a company’s attempt to compete with cost leadership. As stated in the
company’s 10k, “Prior service costs are amortized on a straight-line basis over the
average remaining service period for active employees.” This is the norm across the
paper and packaging products industry for amortizing pension costs. Obligations are
calculated on a present value basis and added costs such as interest cost and service
cost are added in. Next, the plan assets that support the pension liabilities are
calculated using fair value and then compared to the obligations. If the assets cover the
PV of the obligations the pension is said to be “overfunded” The more overfunded the
better, this shows that the company can cover its obligations even if some its assets
become devalued.
66 | P a g e Pension Plan Liability Coverage Chart
9000
8000
7000
6000
5000
Asset Coverage
4000
Obligations
3000
2000
1000
0
‐1000
MWV
IP
SSCC
PKG
As you can see from the chart above, MWV is the only company who has
sufficient assets in the company’s plan to cover their pension plan liabilities. The
underfunded status of the rest of the companies can be partly explained by recent
financial market conditions and the debt markets crisis. The individual company’s plans
have different asset allocations with different risk exposures to the markets. If a
company was heavily invested in the debt or real estate markets they would have had a
recent substantial loss to the fair value of their plan assets causing their plan to be
underfunded. This will be discussed further in Accounting Strategies on page 16.
Derivative Risk Management
The firms competing in the paper and packaging industry largely operate and
compete in a global marketplace. For most of the firms a significant portion of revenue
comes from foreign operations, and the exports from their U.S. operations. For
instance, according to MeadWestvaco’s 2008 annual report, the percentage of their
67 | P a g e sales that were attributed to export sales and foreign operations for in 2007 were 14%
and 31% respectively. Therefore, 45% of MeadWestvaco’s 2007 net sales of 6.91 billion
come from overseas sales. Given that almost half of the firm’s sales come from abroad,
it is known that firms who compete and operate overseas are exposed to a substantial
amount of risk when it comes to selling their products in foreign markets.
Consequently, it is very crucial that firms in the industry disclose how they
manage certain risks that arise from the political and economic conditions of the
countries they operate in and how they account for such asset transactions. The main
risk inherent in operating in foreign markets involved foreign currency exchange rate
fluctuations. Other risks that the firms potentially face are interest rate, and energy
price fluctuations. As a result of these substantial risk involved in foreign operations it is
very important for the firms in the paper and packaging industry to utilize an effective
business strategy to manage the risks involved in selling their products in volatile
foreign, and domestic markets.
Firms in this particular industry use various derivative financial instruments as
part of an overall strategy to manage and offset exposure to market risks. According to
MeadWestvaco’s 10K they use financial derivative instruments such as “foreign currency
forward contracts to manage some of the foreign currency exchange risk associated
with certain short-term foreign intercompany loans, some foreign currency sales and
purchases of its international operations, and some foreign sales of its U.S.
operations.”[MeadWestvaco 10K] In using foreign currency forward contracts the
companies receive or pay the differences between the contract forward rate and the
exchange rate at the date of settlement. “These contracts are used to hedge the
variability of exchange rates on the company’s cash flows.”[MeadWestvaco 10K]
Another derivative financial instruments utilized by firms in this particular industry are
“interest rate swap agreements to manage a portion of its interest-rate risk on its debt
instruments. In order to maintain suitable levels of exposure to interest-rate
fluctuations, the firms have developed a targeted mix of fixed-rate and variable or
floatable-rate debt, in which they utilize interest rate swaps agreements to efficiently
68 | P a g e manage the targeted mix.”[International Paper 10K] The firms in the industry also
engage in financial hedging of future energy purchase prices in order to predict and
better control the future costs of energy consumed by each of the firms’ facilities.
In explaining how the firms in the Paper and Packaging products industry use
various derivative financial instruments to manage the exposure to the potential risks
they face, it is now necessary to discuss how management accounts for such
transactions. MeadWestvaco along with the other firms in the industry are required to
record all derivative instruments to the consolidated balance sheets as assets or
liabilities, measured at fair market value as permitted by the rules and conventions set
forth by GAAP. In estimating the value of such assets or liabilities, the firms in the
industry must “first identify the risk it faces, then consider the correct derivative
financial instrument to utilize in order to effectively reduce the risk identified, and then
establish the mutual relationship between the risk identified and the derivative financial
instrument being utilized.” [Smurfit-Stone 10-K]
According to the 10K’s of MeadWestvaco and International paper “if the
derivative being measured is designated as a fair value hedge, the changes in the fair
value of the derivative and of the hedged item attributable to the hedged risk are
recognized as earnings. If the derivative is designated as a cash flow hedge the
effective portion of the change in the fair value of the derivative is recorded in other
comprehensive income and is recognized in the consolidated statement of operations
when the hedged item affects earnings. Ineffective portions of changes in the fair value
of cash-flow hedges and financial instruments not designated as hedges are recognized
in earnings.”[MeadWestvaco and International Paper 10K’s]
Given that the firms in this industry are increasingly global in nature, it is vital to
understand how the political and economic conditions of the countries in which they are
operating in can bring forth potential risk and can adversely affect their businesses,
financial conditions and operating results; It is also crucial to understand how the firms
69 | P a g e use financial derivative instruments to off-set these risks and how they account for
these transactions.
Operating and Capital Leases
One significant liability issue that effectively translates into a key accounting
policy for the paper and packaging industry is the extent to which operating leases and
capital leases are used, as well as the relative mix of these two instruments throughout
the industry. There are several fundamental differences that distinguish between
operating lease agreements and capital lease agreements; differences that have the
potential to seriously distort the reported asset, liability, and expense accounts in the
financial reports of involved companies.
By definition, an operating lease is in effect when the lessor (property owner)
transfers to the lessee the right to use the property or asset in exchange for a
prearranged fee. “Only the right to use the property is transferred, and not the actual
ownership of the asset.” As a result, “The lessee is only required to record the
operating expense of the property and it does not affect the balance sheet.”
(www.businessfinance.com) More specifically, in the paper and packaging industry,
converting plants, storage facilities, administrative offices, or other assets, usually long
term assets, acquired through operating leases can “offer much more flexibility in terms
of adjusting to changes in technology and capacity needs” than using capital leases to
acquire assets. (www.investorwords.com)
The Financial Accounting Standards Board has mandated through the Generally
Accepted Accounting Principles (GAAP) that if a lease agreement meets any one of the
following four conditions it must be considered a capital lease:
a.) If the lease life exceeds 75% of the life of the asset
b.) If there is a transfer of ownership to the lessee at the end of the lease term
70 | P a g e c.) If there is an option to purchase the asset at a “bargain price” at the end of
the lease term
d.) If the present value of the lease payments, discounted at an appropriate
discount rate, exceeds 90% of the fair market value of the asset.
With a capital lease, the lessee recognizes the property or equipment being
leased as an asset on their balance sheet and the present value of all future lease
payments is recognized as a lease liability. (www.businessfinance.com) Although
MeadWestvaco’s (MWV) three main competitors, Smurfit-Stone Container Corp. (SSCC),
International Paper (IP), and Packaging Corp. of America (PKG), all report extensive use
of operating leases in their annual 10-K filings, only MWV reports using capital leases to
acquire the use of long term assets.
It is important to keep in mind that most of the firms in the paper and packaging
industry, including Smurfit-Stone Container Corp., International Paper, MeadWestvaco,
and Packaging Corp. of America primarily use lease instruments to secure long term
assets involving very sizeable monetary values. As a result of the sheer size of the
leases, there exists an incentive for these firms to utilize operating leases more
frequently than capital leases in order to avoid the obligation of reporting the large
lease liability on their balance sheet, a trend that increasingly leads to a misleading
representation of the companies’ financial strength. (Palepu & Healy) The following
graph and table clearly point out the amount of operating lease expenses as a
percentage of long term debt MWV and its three main competitors in the paper and
packaging industry effectively keep off their balance sheets.
71 | P a g e Operating Lease Expense as a Percentage of Total Long Term Debt
25.0
19.1
20.0
15.0
Operating Lease Expense as a Percentage of Total Long Term Debt
10.6
10.0
7.3
6.1
5.0
0.0
IP
SSCC
MWV
PKG
Operating Leasing Expense as a Percentage of Total Long Term Debt
FV
Rate
PV
LTD
%
MWV
168
.081
252
2375
10.6%
IP
596
.081
462
6353
7.3%
SSCC
290
.081
204
3359
6.1%
PKG
115
.081
76
398.5
19.1%
By using the present value of MWV’s future capital lease obligations, as stated on
their 2008 10-K report, a discount rate of 8.1% was derived which represents their cost
of capital. Since operating lease liabilities are kept off-books, a calculation to compare
the present value of future operating lease expenses as a percentage of long term debt
72 | P a g e was made using the derived cost of capital. Although the discount rate used is exclusive
to MWV in reality, none of the other three paper and packaging firms listed above
disclose any use of capital leases in their annual reports. As a result, we assumed an
industry wide cost of capital in our calculations. In reality, the cost of capital would be
different for each firm depending on the terms of their negotiated debt contracts. The
graph above displays each firm’s future operating lease expense, as stated in their
respective 2007 annual 10-K reports, as a percentage of their total long term debt. In
terms of aggressive or conservative accounting strategies, by convention, if the present
value of future operating lease expenses exceeds fifteen percent of total long term
debt, the firm is considered to be aggressive in its accounting. Of the firms listed in
chart x-1, only PKG shows a value indicative of aggressive accounting strategies.
Although PKG’s operating lease expense as a percentage of total long term debt is
greater than fifteen percent on the graph above, it is important to keep in mind that in
actuality IP might have a much smaller cost of capital, which would effectively reduce
the present value of future operating lease expenses and bring the displayed
percentage of long term debt down considerably.
Goodwill
Goodwill is an intangible asset that usually arises from acquisitions. The amount
by which the purchase price exceeds the market value of the acquired assets is the
value of goodwill. Goodwill basically serves as a tool to balance the excess amount a
purchasing firm has spent over the implied fair value of the acquired firm’ s assets.
Goodwill is important to analyze because the value and impairments of goodwill is
significantly determined by the judgment of management and not based on a
predetermined amount. Intangible assets are subject to periodic adjustments, called
impairments, whenever events occur that indicate that the carrying amount of an asset
may not be recoverable. “Impairment reviews require management to predict the
estimated cash flows that will be generated by the long-lived assets over its remaining
73 | P a g e estimated useful life.” (MeadWestvaco Corp. 10-K) Managers have the power to select
discount rates, determine cash flows and their timing, and choosing business value
comparables to be used in the computation of goodwill and other intangibles with
indefinite lives. Since these tools are based on manager’s estimates, this could allow
management to show no impairments to goodwill when in fact there is; this would
overvalue assets causing net income to be overstated.
MeadWestvaco conducts reviews for goodwill during the fourth quarter of each
year to determine impairments that are associated with goodwill. Management has
incentives to manipulate goodwill accounting numbers to show an elevated net income.
Management may not correctly account for impairments that would decrease the value
of the underlying asset. This makes goodwill extremely hard to measure and assess
precisely. Impairments can be positive or negative depending on whether the fair value
of an asset is above or below the book value of the asset. If a negative impairment
occurs then the asset is written down and booked as an expense on the income
statement. Due to possible management manipulation of the goodwill amounts we will
focus on the industry numbers and use these as a standard to compare
MeadWestvaco’s goodwill values.
The paper and packaging industries has become more concentrated due to
acquisitions and mergers of some of the major companies in the industry. When a firm
acquires another company they must pay a price over the fair market value of the
actual assets due to the acquired company’s customer relationships, status in the
market, brand name, high quality technology, and the superior perception the public
has of the company. The amount of goodwill paid by acquiring firms has become a
significant cost of the acquisition price and therefore has a substantial affect on the
company’s total assets. MeadWestvaco’s aggregate goodwill for 2006-2007 alone is
$1691 million with impairments equaling only 6.2% of total goodwill ($104 million
impairments in 2006-2007) (MeadWestvaco 10-K). The chart below computes goodwill
and the computations of goodwill as a percent of total assets for competitors in the
paper/packaging industries.
74 | P a g e Goodwill
2003
2004
2005
2006
2007
MWV
$750
$557
$559
$851
$840
IP
$4,793
$4,994
$5,043
$2,929
$3,650
PKG
$.005
$.036
$.0034
$.037
$.037
SSCC
$3,301
$3,301
$3,309
$2,873
$2,727
Goodwill as a Percent of Total Assets
2003
2004
2005
2006
2007
MWV
6.0%
4.8%
6.3%
9.2%
8.5%
IP
13.5%
14.6%
17.5%
12.2%
15.1%
PKG
.28%
.12%
1.7%
1.9%
1.8%
SSCC
33.2%
34.4%
36.3%
36.9%
36.9%
INDUSTRY
13.2%
13.48%
15.45%
15.05%
15.58%
AVERAGE
MeadWestvaco’s goodwill as a percent of their total assets remains significantly
lower than the paper/packaging industry’s average. The low values of goodwill imply
that the company is most likely not manipulating the goodwill amounts in order to
75 | P a g e represent a higher asset value in the balance sheet. In the last couple of years the
industry trend appears to be increasing values of goodwill. This is largely due to the
increased mergers and acquisitions in the industry. For example, International Paper
acquired Central Lewmar and now operates the acquired firm as a business within
International Paper’s multiple brand strategy (International Paper 10-K).
MeadWestvaco’s lower than average goodwill values indicates that management is most
likely stating goodwill accurately and that goodwill does not hold a substantial
importance to the total assets that the firm possesses.
Goodwill as a Percent of Long Term Assets
2003
2004
2005
2006
2007
MWV
7.7%
6.1%
8.1%
11.7%
10.95%
IP
20.4%
23.1%
23.6%
19.0%
20.9%
PKG
.16%
.26%
2.4%
2.8%
2.9%
SSCC
38.2%
39.7%
41.7%
41.9%
42.7%
AVERAGE
16.6%
17.3%
18.9%
18.9%
19.4%
The preceding table illustrates the goodwill as a percent of long term assets.
This is important to analyze because if goodwill is the majority of long term assets and
is continually increasing in the following years, management might be understating
impairments to goodwill which in turn would overstate assets and the value of the
company. MeadWestvaco’s percentage of goodwill compared to long term assets
remains significantly lower than the industry average. Goodwill does not have a
significant impact on total assets, but does have a substantial importance to long term
assets equally about 11% of long term assets in 2007. Since goodwill does have a
76 | P a g e significant impact on long term assets we will restate goodwill and impairment charges
in the section titled “Undoing Accounting Distortions.” The main concern is to evaluate
these values to make sure that management has not made errors when reporting
impairments and is stating the true fair value of goodwill. Valuing goodwill is difficult
because neither SEC nor GAAP require the firm to disclose the means used to measure
the fair value of goodwill.
Accounting Flexibility
The extent to which the U.S. SEC permits the management of firms within the
paper and packaging industry to interpret the covenants of GAAP as they apply to their
industry or their firm determines the amount of relative flexibility a firm has in reporting
their financial status in their financial reports. As discussed below, the specific amount
of flexibility applied to the identified key accounting policies for the paper and
packaging industry as well as for MWV can be quantified to a certain degree.
Pension Plans
In accounting there are many variables that must be estimated especially when
dealing with anything valued with a present value formula. This allows companies to
have a lot of flexibility in the end numbers they end up with on their statements. This
flexibility also must be taken into account when analyzing a company because of its
potential impact on figures such as net income. Pension plan accounting is one of the
most pure examples of flexibility in accounting. Every value in the present value formula
is an estimate produced by the company resulting in a vast range of possible PV’s. The
most efficient way to look at a company’s pension reporting is to look at the average of
the industries assumptions and see how far the company varies from this average.
There are three main variables to calculating pension costs and asset values that are
77 | P a g e used in pension plan accounting; discount rate, cost increase percentage, and the
amortization time line.
Discount Rate of Companies in Paper/Packaging Industry
Company
Discount Rate
MWV
6.22 %
PKG
6.00 %
SSCC
6.19 %
IP
5.75 %
Average
6.04 %
In the chart on the previous page, you can see that MWV has a discount rate for
its pension plan that is above the industry average. The larger the discount rate the less
the present value of your pension plan obligations will be. IP has the smallest discount
rate so their cost obligations will be the highest.
Projected Cost Increases in the Paper/Packaging Industry
Company
Projected Costs Increase Percentage
MWV
3.97 %
PKG
3.08 %
SSCC
3.78 %
IP
3.75 %
Industry Average
3.64 %
78 | P a g e The industries assumptions of their pension plans costs increases are another
variable that has flexibility. In the chart above the industries cost rates range from
3.08% to 3.97% with an average of 3.645%. Again these numbers are estimates and a
larger percentage will produce a larger estimated cost increase allowing companies to
manipulate the numbers. MWV is at the top of the range and allows for the highest
assumption of cost increases.
Amortization Timeline of Pension Costs in the Paper/Packaging Industry
Company
Amortization Timeline
MWV
10 years
PKG
10 years
SSCC
No Disclosure
IP
11 years
Industry Average
10.33 years
The last variable in the pension plan accounting is the length of time that
pension plan costs are amortized over. The fewer number of years results in the higher
the expense per year. A very large number could potentially hide a lot of expense by
spreading it out over a long period of time. The paper and packaging industry has
relatively the same time frame between the companies and only one company did not
disclose.
79 | P a g e Derivative Risk Management
There is very little room for flexibility when it comes to assessing the degree of
accounting flexibility in regards to the asset transactions of utilizing financial derivative
instruments to manage and off-set market risks. Given that all U.S. firms’ operations
and transactions must be recorded and recognized under GAAP policies and principles,
enforceable by SEC, there is in effect a small degree of flexibility for management to
manipulate the way they account for such transactions. As stated before, all derivative
financial instruments utilized must be recorded to the balance sheet as assets or
liabilities and all the adjustments must be recorded in the consolidated balance sheet
under accumulated other comprehensive income or loss. Not only are the firms’
transactions recorded under GAAP policies, all derivative financial instruments utilized to
manage exposure to foreign currency exchange rate, interest rate, and energy price
rate fluctuations are all publicly available information in which one can verify the way
management has accounted for such transactions.
Operating and Capital Lease
Fortunately for investors, the Securities and Exchange Commission (SEC) has
recognized that the undisclosed use of operating leases can be misleading to investors’
perception of a company’s financial strength. As a result, the Financial Accounting
Standards Board (FASB), the private sector arm of the SEC, has mandated through the
Generally Accepted Accounting Principles (GAAP) explicit conditions that all firms,
including firms operating within the paper and packaging industry, must use to guide
their classification of leases into either operating or capital leases. If any one of the four
conditions listed below are met, the firm must account for the lease as a capital lease:
a.) If the lease life exceeds 75% of the life of the asset
b.) If there is a transfer of ownership to the lessee at the end of the lease term
80 | P a g e c.) If there is an option to purchase the asset at a “bargain price” at the end of
the lease term
d.) If the present value of the lease payments, discounted at an appropriate
discount rate, exceeds 90% of the fair market value of the asset.
In reality, although the listed conditions are quite specific by nature, the actual
difference between an operating lease and a capital lease in the paper and packaging
industry often comes down to a single sentence of the lease contract. Specifically,
within the paper and packaging industry, if companies like PKG want to keep a
significant portion of their lease obligations off their balance sheet by calling them
operating leases, they simply ensure that their lease contracts do not meet any of the
four conditions of a capital lease. Although maneuvers of this kind do not constitute a
breach of GAAP, they certainly illustrate the substantial flexibility that exists for financial
reporting in the industry.
Goodwill
Firms within the paper/packaging industry have a large amount of flexibility
when stating goodwill impairments. When the carrying value of an intangible asset is
defined as unrecoverable an “estimate of undiscounted future cash flows produced by
the long-lived asset is compared to the carrying value to determine the amount of the
impairment.” (MeadWestvaco 10-K) The estimation of the fair value of an asset, the
discounted value of future cash flows, and the appropriate categorization of assets all
lead to possible manipulation of goodwill amounts on the balance sheet.
GAAP changed the accounting for goodwill in 2002. In previous years, before
the GAAP amendment, it was accounting procedure to amortize the total amount of
goodwill. GAAP deregulated the accounting of goodwill under the FASB statement No.
142 which no longer requires intangible assets to be amortized. This change in the
impairment accounting rule allows management to have a much more relaxed approach
81 | P a g e when valuing impairments. Under amortization the firm’s intangible assets would
decrease by allocating a sum of the asset to be written-off over a period of time. The
amortized amount occurred at the same time and was determined using the same
method. Under the new goodwill accounting policy, firms do not have to write-down
assets as aggressively as they were required to with amortization. Delaying the writeoff of intangible assets increases the possibility of inflated assets, equity, and net
income.
The FASB statement also requires goodwill to be tested annually for
impairments. This puts pressure on management to try and maintain a fair value
assessment of goodwill and impairments to intangible assets. This provides
management with considerable flexibility regarding reported amounts of goodwill
impairment. The flexibility of reporting goodwill leads to managerial incentives to take
an aggressive approach when stating goodwill. The flexibility of reporting impairments
also leads to errors or intentional manipulation in the estimation of future cash flows
which causes financial statements to be distorted. For this reason it is very important
to accurately assess the goodwill and impairment values reported by a firm.
Evaluate Accounting Strategy
Accounting strategy on both the industry level and the firm level can be
decomposed into two dimensions. Firstly, key accounting policies must be classified as
either conservative, who leads to lower reported earnings, or aggressive, which leads to
higher reported earnings. In addition, financial statements must be classified as either
high disclosure, characterized by high levels of disaggregation, segmented reporting,
and sufficient supplementary discussion and disclosure on financial reports, or low
disclosure, characterized by only a minimum level of financial statement disclosure
required to satisfy GAAP. Both dimensions come together to form the effective
82 | P a g e accounting strategy as they apply to the key accounting policies of MWV and their
competitors within the paper and packaging industry.
Pension Plans
As the previous section on accounting flexibility states there are many variables
that can be estimated which leads to different account strategies for the companies.
These strategies allow a company to be either conservative or aggressive in the
statement of costs due to pension plan liabilities. Referencing previously included
charts, it is easy to see the different strategies used in the paper and paper products
industry.
Discount Rates Used in Determining PV of Pension Cost
Company
Discount Rate
MWV
6.22 %
PKG
6.00 %
SSCC
6.19 %
IP
5.75 %
Average
6.04 %
83 | P a g e Cost Increase Rates
Company
Projected Costs Increase Percentage
MWV
3.97%
PKG
3.08%
SSCC
3.78%
IP
3.75%
Industry Average
3.645%
Amortization Time Lines
Company
Amortization Timeline
MWV
10 years
PKG
10 years
SSCC
No Disclosure
IP
11 years
Industry Average
10.33 years
In the charts on the previous page, MWV uses the largest discount rate in the
industry which makes their pension costs less than if they used the industry average
discount rate. Relative to the industry, using a higher than necessary discount rate,
classifies the company as aggressive in their accounting, and can potentially hide costs
from investors. However, they also use the highest cost increase percentage in the
84 | P a g e industry which assumes the biggest increase to costs year over year. This is a more
conservative accounting strategy and could potentially counteract the higher discount
rate used in computing the present value of future pension costs. The MWV accounting
strategy for the time of amortizing pension costs is on par with the industry average of
10.33 years. Overall MWV has a mixed strategy of accounting for pension plans
compared to the rest of the Paper and Packaging industry.
Another factor in pension plan accounting pertains to the assets in the pension
plan. The composition and risks of these assets can greatly affect the funding of a
company’s pension plan. The following charts include the industry assets allocations for
their pension asset plans.
Asset Allocations by Company
MWV
IP
Equity Securities
Equity Securities
Debt Securities
Debt Securities
Real Estate Real Estate PKG
SSCC
Equity Securities
Equity Securities
Debt Securities
Debt Securities
Other
Cash
In the charts above, it is obvious that these companies face substantial risk
exposures to current debt market conditions. Recently, debt markets have been in a
vast decline and this must affect these companies’ pension asset accounts. If asset
values continue to drop, pension obligation coverage will fall even more causing added
85 | P a g e expenses to these companies. Even with the recent market downturn most of these
companies have been increasing their debt security allocations to some extent
especially MWV and PKG.
Percent Change in Debt Security Investment 2006 to 2007
PKG
SSCC
Percent Change
IP
MWV
‐20
‐10
0
10
20
30
40
50
IP is the only company to not increase its exposure to debt securities. This
investment strategy is difficult to explain under current market conditions. The only
investment strategy that fits this would be a value investment strategy to pick up debt
securities at their bottom. However, this would not make sense because these changes
took place from 2006 to 2007, debt securities have not taken their largest devaluation
until recently in 2007. These companies are taking substantial risks that could
potentially affect their employees’ futures and the costs of the company.
Derivative Risk Management
Across the Paper and Packaging industry, the firms are characterized as being
companies with high disclosure in regards to the usage of various derivative financial
instruments to manage and off-set the exposure to potential risks associated with
86 | P a g e interest rate risk, foreign currency risk and energy price risk fluctuations. The firms also
have high disclosures on how they actually account for theses specific asset
transactions. Management of the firms in the paper and packaging industry have a
minimum degree of accounting flexibility, since the asset transactions of all the
derivative instruments used are recorded under GAAP policies and procedures, this
hinders management’s ability to manipulate the way they account for such transactions.
With this being said the firms can then be characterized as being conservative in
reporting their earnings.
As stated and discussed earlier, MeadWestvaco utilizes various derivative
financial instruments to manage their exposure to certain market risks associated with
interest rate, foreign currency exchange rate, and energy price fluctuations.
MeadWestvaco thoroughly discloses the various derivative financial instruments they
utilize and also how they actually account for the asset transactions of using the various
derivative instruments. For instance, MeadWestvaco discloses that “the company has
interest-rate swaps designated as fair-value hedges of certain fixed-rate borrowings,
there were no interest-rate swaps designated as cash flow-hedges at December 31,
2007 and 2006 and the maturity dates of the swaps matched the maturity dates of the
underlying debt. So during the years ended December 31, 2007 and 2006, the interest
rate swaps were an effective hedge and, therefore, required no charge to earnings due
to ineffectiveness in accordance with SFAS No. 133.” [MeadWestvaco 10K] They also
disclose that the forward contracts that are for terms of up to one year, are designated
as cash-flow hedges under the in which they recorded in accumulated other
comprehensive income.
The graph below displays the recording of foreign currency hedging activities in
accumulated comprehensive income (loss), net of tax:
In Millions
2005
2006
2007
Balance at January 1
$ ---
$2
$ ---
87 | P a g e 5
Net gains (losses)
(3)
(7)
---
---
(3)
1
4
(3)
1
4
$2
$---
$(3)
associated with hedging
transactions
Reclassified to earnings due
to:
Hedge Ineffectiveness
---
Realized hedge gains
(losses)
Net reclassification to
earnings
Balance at December 31
Information on natural gas (energy) hedging activities recorded in accumulated other
comprehensive income (loss), net of tax was also disclosed and is provided in the
following graph:
In Millions
2006
2007
Balance at January 1
$ ---
$(3)
Net losses associated with
(4)
(1)
Hedge ineffectiveness
---
---
Realized hedge losses
1
3
Net reclassification to earnings
1
3
Balance at December 31
$(3)
$(1)
hedging transactions
Reclassified to earnings due to:
88 | P a g e Disclosing the information above and having minimum accounting flexibility
MeadWestvaco, as with the other firms in the paper and packaging industry, is
characterized as a highly disclosed company with relatively conservative accounting
measures.
Operating and Capital Lease
As explained above, accounting strategy as it applies to firms operating within
the paper and packaging industry can be broken down into two dimensions including
the relative and absolute levels of disclosure related to industry key success factors, and
the nature, either conservative or aggressive, of chosen accounting policies.
Furthermore, this strategy analysis can be applied specifically to each firms’ use of
operating and capital leases.
Of the four firms listed in the graph below, the paper and packaging industry can
be characterized as having relatively aggressive accounting policies towards capital and
operating leases, and a relatively low level of disclosure relating to capital and operating
lease information. On a more absolute level, MWV is on par with the rest of the paper
and packaging industry regarding their level of disclosure specific to operating and
capital lease information in their annual reports, and although MWV is unquestionably
aggressive in their accounting strategy towards estimations of future lease obligations,
they are no more aggressive than other major firms within the industry.
89 | P a g e Operating Lease Expense as a Percentage of Total Long Term Debt
25.0
19.1
20.0
15.0
10.6
10.0
7.3
6.1
5.0
0.0
IP
SSCC
MWV
PKG
Operating Lease Expense as a Percentage of Total Long Term Debt
FV
Disc.
PV
LTD
%
Rate
MWV
168
0.081
252
2375 10.60%
IP
596
0.081
462
6353
7.30%
SSCC
290
0.081
204
3359
6.10%
PKG
115
0.081
76
398.5 19.10%
Most of the companies reviewed disclose in their annual reports estimated future
lease obligations segmented into operating lease obligations and capital lease
obligations on a year by year basis up to the year 2012. All estimated lease expenses
beyond the year 2012 are typically reported as one aggregate number. The only
reported estimations are minimum lease obligations, however, and no mention is made
anywhere in the annual reports of IP, MWV, SSCC, or PKG of potential or maximum
lease obligations. The aggressive accounting strategy of reporting only minimum lease
obligation estimates can lead to higher reported earnings on the balance sheet, and has
the potential to mislead investors as to the actual financial strength of the firm.
90 | P a g e Furthermore, none of the major players mentioned above include much additional
disclosure relating to the specific terms of their operating leases, an accounting strategy
that effectively classifies the industry as one of low disclosure.
Goodwill
The actual approach companies use to report goodwill and impairment values in
the financial statements can sometimes be used to hide the firm’s true financial
position. MeadWestvaco has a relatively transparent goodwill reporting strategy. This
conclusion stems from the company’s disaggregated impairment reporting, business
segmentation disclosures, and discussions found in the financial statement notes related
to goodwill and impairment accounting practices. MeadWestvaco separates goodwill
from other intangible assets and the carrying value of goodwill is summarized in a table
independent of the other intangible assets in the financial footnotes. The
disaggregation of intangible assets allows an analyst to focus on goodwill and
impairments separately from the other intangible assets; allowing for a more organized
assessment of the specific intangible being evaluated. The paper/packaging industries
all provide business segment information. MeadWestvaco moderately discloses goodwill
impairment charges per business segment by combining the impairment charges into a
“Corporate and Other Information” category in the “Financial Information per Business
Segment” note. Goodwill impairments are categorized with other expense items in the
different business segments including restructuring charges, legal settlements, interest
expense, and net pension expenses (MeadWestvaco 10-K). Impairment charges are
more extensively covered in the “Goodwill and other Intangible Assets” footnote. This
footnote provides detailed information about how goodwill is allocated to each of the
company’s business segments and discussions of how the goodwill was acquired.
MeadWestvaco does not disclose the procedure used to test the goodwill impairment
values. There is an insufficient amount of information disclosed as to how the company
obtained and valued goodwill impairments. This information could be very beneficial
91 | P a g e when analyzing the accuracy of the reported impairments; without this information
analysts are unable to understand the basis for which the company came up with the
reported impairment numbers.
When analyzing the actual accounting strategies it is also necessary to evaluate
whether the firm applies conservative or aggressive accounting practices. Aggressive
accounting practices can ultimately distort the representation of a company by
manipulating numbers in order to reflect an exaggerated level of performance.
On the
other hand, conservative accounting could decrease the importance of valuation
analysis because of understated earnings. MeadWestvaco uses a mixture of
conservative and aggressive accounting practices when reporting goodwill. In the last
four years MeadWestvaco has reported a combined amount of goodwill impairments of
$283 million. The firm annually restates goodwill and the numbers seem to be
reasonably valued in agreement with the information in the footnotes. Under a
conservative accounting practice the only concern would be that the assets are
understated presenting a modest net income amount. Management has an incentive to
avoid this problem, so most likely the goodwill impairments are stated accurately under
the conservative accounting strategy.
In addition to analyzing the accounting policies on an absolute basis it is also
important to compare the firm’s accounting policies relative to other competitors in the
industry. The flexibility of reporting goodwill leads to managerial incentives to take an
aggressive approach when stating goodwill. For example, Smurfit-Stone’s goodwill
amounts account for 42% of their long term assets; this is strong evidence that the
aggressive approach used in this case to state goodwill is most likely significantly
overstating the value of long term assets and that Smurfit-Stone is not correctly writing
off impairments to these assets. MeadWestvaco, on the other hand, seems to use a
more conservative approach when reporting goodwill because goodwill only accounts
for about 11% of long term assets which is significantly lower than that of SmurfitStone. Smurfit-Stone also states a third of its total assets as goodwill. The significant
importance goodwill holds among Smurfit-Stone’s total assets is unsettling because only
92 | P a g e 2/3 of their assets are physical assets that could be sold in order to generate cash
inflows. This could definitely be an example of a firm delaying impairment expenses in
order to show higher earnings. MeadWestvaco utilizes a rather conservative approach
compared to competitors, with the exception of the smaller Packaging Corp. of America,
lowering concerns of goodwill manipulation.
Quality of Disclosure
The quality of information disclosed by companies within the paper and
packaging industry can be evaluated on both a qualitative and a quantitative basis.
Although the Security Exchange Commission requires all publicly traded companies in
the U.S. to abide by the covenants laid out in the Generally Accepted Accounting
Principles regarding what to disclose in financial reports, the disclosure obligations
created by GAAP are often loosely interpreted by managers, in practice. Poor quality
data, often reflected by vague estimates unsupported by disclosed calculations, can
lead to a significant misrepresentation of a firm’s financial strength or weakness, and
can seriously complicate the process of valuing the firm accurately and completely. The
following analysis reviews the quality of disclosure on both a qualitative and a
quantitative basis for MWV and the paper and packaging industry.
Pension Plans
Almost all the variables in configuring costs for pension plans are estimates,
which can lead to some faulty accounting. Recent legislation has been passed that
effect the way that companies report their pension plans on the books. “In September
2006, the FASB issued SFAS No. 158, Employers’ Accounting for Defined Benefit
Pension and Other Postretirement Plans—An Amendment of FASB Statement Nos. 87,
88, 106, and 132(R). SFAS No. 158 requires an employer to recognize the overfunded
or underfunded status of a defined benefit and postretirement plan in its balance sheet
93 | P a g e and to recognize the changes in the plan’s funded status in comprehensive income in
the year in which the change occurs.” (MWV 10K) This new legislation forces companies
to disclosure whether or not the company has a fully funded pension and adds insight
to some of the risks of not meeting these obligations.
All the companies in the Paper and Packaging industry disclose relatively the
same amount of information. The only exception is with the amortization timelines used
in the charts in the previous sections. SSCC mentioned the amortization of pension
costs over an estimated timeline but failed to disclose this number.
The industry as a whole leaves a lot unsaid about how they determine the
estimates for the variables to determine pension plan costs and obligations. For an
accounting process such as pensions that consists of 3 variables that are all estimates
they disclose very little. It is impossible to know where the discount rate is obtained
from or even a basic index that is referenced. The costs of the pension plans have no
basis in how they were obtained which leaves little room for comparative analysis
besides what other companies in the industry provided. The only variable that is
relatively explained is the determination of the amortization timeline. In the MWV 10-K
it states, “Prior service costs are amortized on a straight line basis over the average
remaining service period for active employees.” However, statistics of this average are
not stated.
Derivative Risk Management
The financial information presented in the 10-K’s of the other firms in the paper
and packaging industry provides sufficient amount of information needed to conclude
which various derivative financial instruments the firms use, how they utilize the various
derivative financial instruments to manage and off-set potential market risks, and the
actual accounting for such asset transactions. MeadWestvaco discloses enough
information in their 10’K’s to conclude that they use foreign currency forward contracts
to manage the risk that comes with foreign currency exchanges. They also manage the
interest-rate risk on its debt instruments by utilizing interest-rate swap agreements, and
94 | P a g e also exercise energy price hedging to manage energy price fluctuations in order to
better control future costs of energy consumed by the firm. They also disclose enough
information to assess the actual accounting policies they use to account for the usage
of such financial derivative instruments. Their accounting flexibility information is also
made available in their 10-K which allows one to conclude that they have very minimal
accounting flexibility when it comes to managements manipulation of accounting for the
usage of the derivative instruments. They disclose enough information to see that their
accounting for utilization of such instruments is determined by GAAP policies and
principles, enforced by the SEC.
In conclusion, with the above being stated, one can say that MeadWestvaco
certainly has a high level quality of disclosure when it comes to disclosing the
information on the utilization of and accounting for their derivative risk management
strategy.
Operating and Capital Lease
In general, the overall quality of disclosure relating to the use and relative mix of
operating and capital leases by firms in the paper and packaging industry is relatively
high. For most of the firms in the paper and packaging industry, accounting for leases is
very simple since very few actually use capital leases. With most of the firms, with the
exception of MWV, using strictly operating leases, the need for disaggregated and
highly segmented reporting is eliminated to some extent. The quality of disclosure in
terms of segmentation, dis-aggregation, and transparency is acceptable and seems to
be parallel throughout most of the firms in the industry, but there simply is not much
data reported on issue. What little information reported by IP, SSCC, PKG, and MWV in
their annual reports concerning their operating lease obligations is presented in a
disaggregated manner on a year by year basis up to the year 2012, at which point all
future obligations are stated as an aggregate number. Neither MWV, nor its top three
competitors, IP, SSCC, and PKG, disclose in their annual reports the details of their
leases beyond an estimate of future lease obligations. Moreover, since no calculations
95 | P a g e are disclosed related to these estimations of future lease obligations, outsiders are
unable to interpret exactly how accurate the stated obligations actually are. An
improvement upon the quality of reported lease data would almost certainly have to
involve additional discussion and disclosure relating to lease agreements, terms of the
lease contracts, operating lease expense as a percentage of total long term debt, and
discount rates used to bring future lease expense obligations back to present value.
Apparently managers in the paper and packaging industry do not feel comfortable
disclosing such information on public reports. Although MWV is on par with the rest of
the paper and packaging industry in terms of quality of disclosed information, the real
problem lies in the fact that the industry simply has a low quantity of information in
their annual reports regarding their lease activities.
In conclusion, although the quality of disclosure related to operating and capital
lease activity within the paper and packaging industry is relatively high, the low level of
lease information disclosure across the industry, as discussed above, has led to less
than transparent financial reporting in the area of operating and capital leases. Minimal
disclosure can pose a serious threat to the ability of a firm to accurately portray their
financial strength to shareholders and potential investors alike.
Goodwill
Evaluating the quality of disclosure of a firm ultimately depends on the
transparency of the financial reports and how useful the provided information is when
making decisions based upon the disclosed information. MeadWestvaco has a relatively
transparent goodwill reporting strategy. MeadWestvaco offers a detailed account of
goodwill amounts associated with acquisitions and the basis as to why the amount paid
for an acquired business resulted in goodwill. For example, MeadWestvaco purchased
Saint-Gobain Calmar and stated that the goodwill assumed from this acquisition was
“due primarily to Calmar’s status in its markets and the enviable relationships it has
with its many customers throughout the world.” (MeadWestvaco 10-K) The Financial
96 | P a g e statement notes also state that the amount of goodwill is determined by comparing the
total cash purchase price to the total fair values of the assets acquired and liabilities
assumed (MeadWestvaco 10-K). MeadWestvaco does not address how they
determined the “fair market value,” but the majority of firms allow management to
estimate these values. As mentioned earlier, flawed estimation could significantly skew
financial statements. MeadWestvaco also provides information related to the allocation
of goodwill among the different business segments of the firm. All of the information
provided by the company allow transparency of the financial statements and result in
less ambiguity when analyzing the goodwill information.
MeadWestvaco seems to have a higher level of goodwill quality disclosure
relative to their competitors in the paper/packaging industry. Packaging Corporation of
America discloses trace amounts of information related to goodwill. This is partly due
to the smaller size of the firm, but PKG does have goodwill items in the financial
statements without any detail of the valuing method used to assess goodwill or even
any discussion of the terms of the acquisition that resulted in the goodwill amount. In
cases where weak quality of goodwill disclosure is used there is a large possibility that
financial statements have been manipulated to reflect a better economic position;
above the actual value of the firm.
Quantitative Analysis
The quantitative accounting disclosure is in place to convey a more precise view
of the manager’s perspective of the company’s financials. This information gives
investors vital information regarding the value and accounting policies of the company.
The flexibility given by GAAP to the managers allows choices in the amount of
information and format that it is disclosed. The purpose of this freedom is to give the
ability to show the true performance of the company with their professional wisdom of
their company. This privilege is usually used to portray the company in a brighter light
97 | P a g e to investors and shareholders. The personal incentives of managers alter the financials
with interesting accounting techniques. Interpreting this information is vital to give an
accurate representation of the financials.
Using diagnostic ratios, financial analysts have the ability to discover red flags in
a company’s accounting policies that confirm evidence of number manipulations. There
are two quantitative methods used to determine the validity of the business practices
and by completing these diagnostics, the irregularities of the firms are brought to the
surface. The sales manipulation diagnostics is the first step. The process divides net
sales by: inventory, cash from sales, and accounts receivable. The next step is to
analyze the expenses in accounting. The consistency of the reporting will either restate
the accuracy or show red flags in accounting practices with the deviation in expense
reporting. This process shows the validity or lack thereof in the reporting in
MeadWestvaco’s financial statements.
Sales Manipulation Diagnostics
The sales manipulation diagnostics are used to determine whether or not any
manipulations took place that would potentially alter the outlook of the firm. In order to
assess such manipulations one must analyze the firm’s balance sheet and income
statement. In the paper and packaging industry the financial statements, of a five year
period, for firms such as MeadWestvaco, International Paper, Smurfit-Stone, and
Packaging Corporation of America were analyzed to determine if such manipulations or
alterations had occurred. Tools known as sales manipulation ratios are used to diagnose
alterations, in which they allow for an examination of the impact current assets and
liabilities have on net sales and also enable one to recognize when to raise potential red
flags.
98 | P a g e Net Sales/Cash from Sales
Net Sales to cash from sales is the first sales manipulation ratio being calculated.
This ratio is calculated by dividing net sales by cash from sales. The net sales to cash
from sales ratio allows for the assessment of credibility for each of the firms’ sales
figures. This particular ratio is also a determinate of the actual amount of cash each
firm receives from their sales compared to the amount of revenue recognized from
sales during the specified period. Since firms expect to receive compensation when
selling their goods and services, the calculations of this particular ratio should always
result in a figure relatively close to 1; this applies to any firm when calculating the net
sales to cash from sales ratio. However, if the ratio produces a figure much greater
than 1 or there are substantial variances between figures from year to year, the
accounting done by the firm is then in question, and a cause to raise a ‘red flag’ arises.
Identifying a ‘red flag’ in this particular situation means that the firm may be
overstating their revenues.
Net Sales/Cash from Sales
1.04
1.03
1.02
1.01
1
MWV
0.99
IP
0.98
SSCC
0.97
PKG
0.96
0.95
0.94
2003
2004
2005
2006
2007
The chart above depicts the net sales to cash from sales ratio information for
each of the firms operating and competing in the paper and packaging industry. One
99 | P a g e can gather from the chart provided that MeadWestvaco, along with its competitors,
have net sales to cash from sales ratios relatively close to 1 and do not have substantial
variances from year to year. In other words, the net sales for the firms in the paper
and packaging industry are supported by their cash from sales, and no ‘red flags’ were
identified. The slight changes in the ratio figures from year to year can be explained by
either changes in the firms’ accounts receivables policy during the period or changes in
their sales growth. The information provided enables one to conclude that the quality of
accounting disclosure for the paper and packaging industry, as a whole, is acceptable
and the overall performance of MeadWestvaco is average amongst the other
competitors in the industry.
Net Sales/Net Accounts Receivable
The second sales manipulation ratio being calculated is the net sales to net
accounts receivables ratio. The sales to receivables ratio can be defined as: “an
accounting measure used to quantify a firm’s effectiveness in extending credit as well
as collecting debts. By maintaining accounts receivables, firms are indirectly extending
interest-free loans to their clients. A high ratio implies either the company operates
mainly on a cash basis or its extension of credit or accounts receivable supports the net
sales. A low ratio implies that the company should re-asses its credit policies in order to
ensure the timely collection of imparted credit that is not earning interest for the firm.”
[investopedia.com] Simply stated, the net sales to net accounts receivable ratio
measures the amount of credit sales (accounts receivable) comprised of the total sales
amount, and is used as a means to assess how much of the firms’ net sales is
supported by credit transactions (accounts receivables). The ratio also provides
adequate means to measuring the firms’ liquidity. The ratio is calculated by dividing a
firm’s total sales in a specific period by their accounts receivables for the previous
period.
100 | P a g e In the paper and paper products industry, firms’ commonly incur accounts
receivables for a majority of their sales because they normally do not have storefronts
to directly sell their products or services to customers. As a result, a substantial portion
of the firms’ sales are made through credit transactions. So the analysis of the net sales
to accounts receivable ratio, in respects to the paper and packaging industry, is a
functional and beneficial means of assessing the how accounts receivable impact the
firms’ net sales, and also the liquidity of the firms. The following chart illustrates the
calculated ratios for each of the firms across a 5 year time horizon.
Net Sales/Net Accounts Receivables
50
45
40
35
30
MWV
25
IP
20
SSCC
15
PKG
10
5
0
2003
2004
2005
2006
2007
In the chart provided, one can see that the Smurfit-Stone Container Corporation
has substantially higher ratio figures compared to the rest of the firms. This is largely
due to the fact that SSCC invests in a receivables securitization program “whereby they
sell on an ongoing basis, without recourse, certain of their accounts receivables to a
wholly-owned non-consolidated subsidiary of their company” [SSCC 10-K]. This enables
the firm to operate more on a cash basis and have lower amounts of receivables
recorded in their books, which in turn produces higher sales to receivables ratio.
101 | P a g e With the exception of the Smurfit-Stone Corporation, one can gather from the
given information in the chart that, for the most part, the firms in the paper and
packaging industry have consistently lower ratios that are relatively similar to one
another. This means that MeadWestvaco’s, International Paper’s, and the Packaging
Corporation of America’s net sales are supported by their accounts receivables in which
the firms’ have a substantial portion of their sales engaged in the accounts receivable
collection process. This is, more than likely, a result of firms’ issuing or offering more
relaxed, informal credit policies or terms for the collection of their accounts receivables.
The issuance of such terms can be beneficial for the firms’ in respects to potentially
increasing their sales by alluring prospective customers. Such credit policies can also
bring forth serious problems in estimating the allowance for doubtful accounts for their
accounts receivables, which would cause their accounts receivable to be stated
incorrectly. Incorrectly stating accounts receivable would result in an unexplained
change that would be depicted as an increase or decrease in the sales to accounts
receivable ratio chart. Given that the firms in the paper and packaging industry largely
operate under circumstances based on credit transactions and they all have figures
relatively close to one another, there is not a potential reason for a ‘red flag’ to be
identified.
Due to SSCC’s substantially higher ratio figures it was difficult to gather the
details of the sales to accounts receivable ratio figures for the other firms in the
industry. So the following chart below provides detailed information for the following
102 | P a g e firms: MeadWestvaco, International Paper Company, and the Packaging Corporation of
America. (This chart excludes SSCC)
Net Sales/Accounts Receivables
10
9.5
9
8.5
MWV
8
IP
7.5
SSCC
7
PKG
6.5
6
2003
2004
2005
2006
2007
Net Sales/ Inventory Ratio
An important ratio in determining the credibility of sales is the net
sales/inventory ratio. This ratio shows how much sales is generated from a set amount
of inventory and thus the higher the ratio the more efficient the company is using its
inventory. There are two variables for a company to improve their ratio. First, it can
increase sales with the existing amount of inventory or it can decrease inventory while
still maintaining sales. It can be determined which or both of these techniques are used
by a company by looking at the net sales and inventory of a company over several
years. For example, we can decipher how SSCC increased their Net Sales/ Inventory
ratio from 2005 to 2006 by looking at the two charts below. In the year 2006 SSCC
improved on both variables leading to an increase in the net sales/ inventory ratio. The
company increased net sales from $6,812 million to $7,157 million but this is not a
significant feat as companies are expected to increase sales year over year. The most
important improvement pertaining to their ratio comes from a substantial decrease in
103 | P a g e inventory from $734 million to $538 million. Decreasing inventory without having a
decrease in sales shows that the company is improving how its inventory is supporting
its sales. Decreasing inventory also decreases the holding costs for holding that
inventory and reduces overall expenses.
Net Sales in Millions
Company
2003
2004
2005
2006
2007
MWV
7,553
8,227
6,170
6,530
6,906
IP
22,138
23,359
2,1700
21,995
21,890
SSCC
7,722
8,291
6,812
7,157
7,420
PKG
1,735
1,890
1,993
2,187
2,316
Net Inventory
Company
2003
2004
2005
2006
2007
MWV
1057
1098
714
715
790
IP
2983
2371
2434
1909
2071
SSCC
711
786
734
538
540
PKG
166
179
191
204
196
104 | P a g e Net Sales/ Inventory
14
13
12
Percent
11
MWV
10
IP
9
SSCC
8
PKG
7
6
2003
2004
2005
2006
2007
In the graph above, it is possible to see that some firms in the paper and
packaging industry have had more success with the net sales/inventory ratio than
others. In recent years SSCC has separated itself from the rest of the industry and
reaching a ratio close to 14% due to the previously mentioned decreases in inventory.
This has put the company ahead of the rest of the industry in using inventory
efficiently. MWV currently is the industry laggard with a ratio of about 8.7% and has
been the laggard for as long as our research timeline. It is interesting to note that in
2004 MWV spun off a part of their paper segment decreasing inventory and sales but
still maintained relatively the same ratio.
105 | P a g e Net Sales/ Inventory (Change Form)
0.5
0.4
Axis Title
0.3
MWV
0.2
IP
0.1
SSCC
PKG
0
2003
2004
2005
2006
2007
‐0.1
‐0.2
The change form ratio of net sales/inventory gives a more in-depth view of what
is happening to a ratio than the raw form. In the chart above there is apparent volatility
that is not as obvious with just raw data. IP and SSCC are the key examples in this
industry with IP having substantial percentage increases in 2004 and 2006 and SSCC
increasing in 2006. All three of these instances are from substantial decreases in
inventory while still maintaining or slightly increasing sales. MWV has not had any
significant changes in the ratio since 2003. They increased gradually until 2005 and has
since been in a slow decline.
Conclusion
Analyzing the balance sheets and income statements for each firm in the paper
and packaging industry proved to be instrumental in determining whether any
manipulation or alteration of the firms’ sales revenues had taken place throughout a
five year period. Furthermore, examining the firms’ financial statements was beneficial
in the aspect of showing the trends or patterns between MeadWestvaco and the other
firms in the industry. Recognizing any trends or patterns between the firms allowed for
106 | P a g e the identification of any similarities or dissimilarities between the firms. Diagnosing such
similarities and dissimilarities was accomplished through a ratio analysis, which is an
analysis of how net sales were impacted by current assets and liabilities.
Fundamentally, the ratio analysis enabled one to identify any potential ‘red flags’ for
each of the firms in the paper and packaging industry. In regards to MeadWestvaco,
the ratio analysis helped illustrate that MeadWestvaco is average compared to its
competitors and did not have any substantial variances from the trends set forth by all
the firms in the industry.
Expense Manipulation Ratios
Another useful tool in determining whether any manipulations occurred within
the firm is the expense manipulation ratio. These particular ratios tend to take a closer
look at the firm’s balance sheet and income statements to also determine the
relationship between the two. The following ratios were used to assess such
relationships.
Asset Turnover
Asset turnover ratio is computed by dividing the net sales by the total assets of a
firm. This ratio analyzes a firm’s ability to generate sales from each dollar of total
assets (www.investopedia.com). Companies that have a low profit margin tend have a
higher asset turnover ratio where companies that maintain a high profit margin usually
have lower asset turnover. Therefore, firms with a higher asset turnover ratio are more
effectively creating sales with the assets they own. Dramatic changes in the asset
turnover over may result from companies that do not properly write-off assets such as
depreciation expense and goodwill impairments. Manipulating these operating
expenses could result in higher sales but, when assets increase lower expenses could
107 | P a g e also result in lower sales. Therefore, a decreasing change in a firm’s assets turnover
would indicate possible expense manipulation where assets would be inflated. When a
firm’s assets are inflated the asset turnover ratio will also reflect a lesser value.
Asset Turnover
1.2
1
0.8
MWV
0.6
IP
PKG
0.4
SSCC
0.2
0
2003
2004
2005
2006
2007
The graph above illustrates MeadWestvaco and competitor’s asset turnover
ratios. MeadWestvaco’s asset turnover has remained very stable in the past five years.
They faced an increase in asset turnover in 2004 due to an 8.9% increase in net sales
and a 6.3% decline in total assets. MeadWestvaco seems to lag behind the competition
with a lower asset turnover ratio. A low ratio could indicate that MeadWestvaco is not
performing as efficiently as their competitors, only earning about $.70 for every dollar
of assets or manipulating operating expenses. MeadWestvaco showed a minor
decrease in their asset turnover from 2004-2005, but this is directly caused by a
decrease in sales and does not support an operating expense manipulation. Another
factor that may cause this difference is the fact that MeadWestvaco is the only firm, out
of these five, that have capital leases on the balance sheet. Capital leases increase
108 | P a g e total assets as opposed to operating leases that are expensed on the income statement.
Increased amounts of total assets result in a lower asset turnover ratio. Packaging
Corporation of America has seen a rise in their asset turnover ratio over the past five
years. This increase is supportive of significant increases in PKG’s net sales and is not
derived from faulty accounting. The stable asset turnover ratio MeadWestvaco has
maintained over the past five years indicates that they are not manipulating accounting
policies such as asset write-offs.
CFFO/OI
Dividing a firm’s cash flow from operating activities by its operating income gives
some insight into the quality of the firm’s earnings by illustrating to what extent the
firm’s operating income is supported by its cash flows. Cash flow from operations is
derived by subtracting new accruals from operating income, and does not include
interest expense or income tax. Since accruals do not reach the cash flow from
operations, “manipulation of operating income through unjustified accruals will affect
this ratio.”
Although there is no universal benchmark for CFFO/OI, a larger value relative to
the industry average might indicate a more aggressive accounting strategy to
compensate for a smaller percentage of operating income coming from cash flows and
a relatively larger percentage coming from accrued accounts receivable. Conversely, a
smaller value might be indicative of a more conservative accounting strategy and a
larger share of operating income coming from operating cash flows.
109 | P a g e CFFO / OI (Raw Form)
7.00
6.00
5.00
MWV
4.00
IP
PKG
3.00
SSCC
Mean
2.00
1.00
0.00
2003
2004
2005
2006
2007
The graph above illustrates the CFFO/OI ratio for MWV and their top three
competitors in the paper and packaging industry across a five year time horizon. As you
can see, across time all four firms converge towards the industry mean. MeadWestvaco
has maintained a CFFO/OI ratio relatively near the industry average with the exception
of their 2005 value. The low value in 2005 directly relates to a change in working
capital deduction from CFFO equal to $271,000,000, which left CFFO at only
$227,000,000 for the year.
The change form of the CFFO/OI ratio helps give a better idea as to the year to
year changes in CFFO and OI. The formula used to obtain the observed values for each
of the four firms in the paper and packaging industry is listed below.
110 | P a g e CFFO / OI (Change Form)
25.00
20.00
15.00
10.00
MWV
5.00
IP
0.00
PKG
‐5.00
2003
2004
2005
2006
SSCC
2007
‐10.00
‐15.00
‐20.00
As the change form CFFO/OI graph above points out, there is slightly more
disparity between the year over year changes in CFFO/OI between these four firms.
MWV and IP in particular show significant negative correlation to each other in 2005.
IP’s announcement of their new 2005 Transformation Plan initiated a massive asset
liquidation that effectively increased their CFFO/OI value by adding a large gain on their
asset sales to CFFO. MWV’s negative change in CFFO/OI for 2005 was due to the $227
million change in working capital deduction mentioned above that significantly reduced
their CFFO for the year.
111 | P a g e CFFO/NOA
The ratio of cash flow from operations to net operating assets is an expense
manipulation links the statement of cash flows to the balance sheet and is intended to
illustrate how much cash flow is being generated by the firm’s current property, plant,
and equipment, net of depreciation. Since each industry is unique in its business
structures and its required property plant and equipment, there is no universal
benchmark with which to compare CFFO/NOA, but in general the higher the value the
better. An arithmetic mean trend line for the four listed firms has been provided in the
following graph in order to evaluate the firms on an industry relative basis.
CFFO/NOA (Raw Form)
0.30
0.25
0.20
MWV
IP
0.15
PKG
SSCC
0.10
Industry
0.05
0.00
2003
2004
2005
2006
2007
The graph above illustrates the CFFO/NOI ratio for MWV and its top three
competitors in the paper and packaging industry. Relatively large values can signify that
a firm is generating a large amount of cash flow using its current level of property plant
and equipment, and a relatively small number might signify the firm is using too much
112 | P a g e property plant and equipment to achieve its current level of operating cash flow. MWV
displays a significant amount of volatility relative to the industry trend up until 2006
where CFFO/NOA values converge on the mean. In 2004 MWV’s spike in CFFO/NOA
resulted from a large gain on the sale of assets which pushed their CFFO upward
resulting in a larger CFFO/NOI value. In 2005, as a result of a significant change in
working capital deduction from CFFO, MWV had a low value relative to the industry.
The change form ratio of CFFO/NOA gives insight into the year to year changes
in how well the firm uses their respective property, plant, and equipment to generate
cash flow. Negative values indicate a reduction in either CFFO or NOA from the previous
year, and positive values indicate an increase, if only small, in both CFFO and NOA from
the previous year. The formula used to calculate the change form ratio of CFFO to NOA
is given below.
CFFO / NOA (Change Form)
10.00
8.00
6.00
MWV
IP
4.00
PKG
SSCC
2.00
0.00
2003
2004
2005
2006
2007
‐2.00
113 | P a g e The graph above shows the year to year changes in how well MWV and its top
three competitors in the paper and packaging industry utilize their property, plant, and
equipment to generate cash flows. Relative to its top competitors, MWV does not
improve its CFFO/NOA ratio as well as the others from 2003 to 2005, but greatly
outpaces the average between 2005 and 2006. MWV’s extraordinary spike in CFFO/NOA
from 2005 to 2006 resulted from a significant reduction in NOA from roughly $4.3 billion
in 2005 to $3.8 billion in 2006 coupled with a significant increase in CFFO from roughly
$227 million in 2005 to $567 million in 2006.
Total Accruals/Sales
The total accruals to net sales ratio is calculated by subtracting the net income
from the operating cash flows and dividing the difference by the total sales. The
accrual/sales ratio determines whether total accruals are supported by the sales of a
firm. A high accrual/sales ratio is considered to be close to one which indicates that a
considerable amount of cash from sales is tied up in unpaid receivable accounts.
Total Accruals/Sales
0.16
0.14
Axis Title
0.12
0.1
MWV
0.08
IP
0.06
PKG
SSCC
0.04
0.02
0
2003
2004
2005
2006
2007
114 | P a g e As the line graph above show, there does not seem to be an industry trend
regarding the accruals to sales ratio. The firms move erratically between .008
(International Paper) and .149 (Packaging Corporation). The accruals to sales ratio for
firms in the paper/packaging industry are relatively small, which by looking at the
financial statements is largely due to net income rapidly growing at rate substantially
higher than that of cash flows from operations. For instance, MeadWestvaco
experienced a sizeable growth in net earnings of 206.5% between 2006 and 2007 and
only experienced a 13.1% growth in cash provided by operating activities while sales
only rose at a rate of 5.8%. This resulted in a 24.9% decrease of accruals in 2007;
lowering the accrual to sale ratio. The slow growth rate in operating cash flows would
explain the low accrual to sales ratio suggesting that fewer sales are supported by
accruals, so it seems to show that more sales are supported by cash inflows rather than
receivable accounts.
Conclusion
Conducting a close examination of the firms’ financial statements, with the
statement of cash flows included, again proved to be instrumental in determining
whether any manipulations or alterations of the firms’ reported accounting had taken
place during the five year period. The analysis allowed for the utilization of the expense
diagnostic ratio figures to evaluate and asses the correlations between the firms’
income statements and statement of cash flows. In comparing the correlations between
the two financial statements, the trends and patterns in the paper and packaging
industry were recognized and the ability to identify any irregularities and potential ‘red
flags’ was enabled.
115 | P a g e Potential Red Flags
The accounting analysis of MeadWestvaco showed several red flags in their
accounting practices. Red flags are displays that can possibly indicate problematic
accounting. Red flags are examined with more scrutiny by the analyst. Analysis of the
past and present financials of the company is vital to the discovery of red flags. These
indicators show the areas that should be reevaluated and adjusted in the financial
statements to convey proper valuation of the company.
Pension Plans
Pension plans have many variables that are estimated leading them to be easily
manipulated. These manipulations can lead to substantial numerical differences on the
financial statements and mislead investors. In determining postretirement pension costs
a company must estimate health care cost increases to determine the PV of future
pension costs. In estimating this healthcare costs MWV used 8.97% in 2006 and then
decreased this percentage to 8.46% in 2007. This brings a red flag in that healthcare
costs are increasing substantially and this may be a way for MWV to increase pension
coverage and understate potential future expenses.
Undoing Accounting Distortions
Restating the company’s financials removes distortions that were reported and
generates an unambiguous depiction of revenues, expenses, liabilities, retained
earnings, and assets. It is common to find that expenses have been understated in
order to overstate income. At times, companies can opt to overstate impairment or
depreciation with the intention of exaggerating expenses and minimizing earnings. The
choice to understate earnings is referred to as taking a “big bath.” These actions
inaccurately depict a significant increase in earnings in the next period due to the
116 | P a g e distortions in the accounting of the previous period. Consequently, it is vital to restate
the distorted accounting in order to generate flawless financials that allow investors and
outsiders the straightforward information necessary to make wise decisions on the
value of the company.
Goodwill
MeadWestvaco’s reported goodwill in 2007 was about 11% of total long term
assets with small impairments written off in previous years. With this information we
feel that goodwill needs to be restated in order to provide a more concrete evaluation
of the value of the firm.
Goodwill as a Percent of Long Term Assets Before Restatement
Year
2003
2004
2005
2006
2007
% of LT
7.7%
6.1%
8.1%
11.7%
10.95%
Assets
To undo this distortion we started with the ending balance of goodwill in 2002
($743 million) and amortized impairments to goodwill and additional goodwill added
each following year at a 20% discount rate through 2007. The following tables
represent the amortized calculations.
117 | P a g e Goodwill, Acquired GW, and Impairments Before Restatement
Year
2003
2004
2005
2006
2007
GW before
$750
$557
$559
$851
$840
Acquired GW
$13
$53
0
$302
$24
Impairments
0
$238
0
$10
$35
Restatement
Goodwill and Impairments After Restatement (20% rate)
Year
2003
2004
2005
2006
2007
Beginning GW
$756
$657.5
$525.90
$722.7
$602.2
$151.2
$131.6
$105.2
$144.5
$120.4
$604.8
$525.9
$420.7
$578.2
$481.8
+ Acquired
Impairment
(20 % rate)
GW after
Restatement
118 | P a g e Goodwill as % of Long Term Assets Before and After Restatement
Year
2003
2004
2005
2006
2007
Before
7.7%
6.1%
8.1%
11.7%
10.95%
6.0%
5.8%
6.1%
6.2%
6.3%
Restatement
After
Restatement
The absent impairment charges ,before the restatement, were not written off as
an expense on the income statement, consequently dramatically understating expenses
while overstating net income. After restating goodwill impairments at a significantly
higher value the average percentage of goodwill compared to long term assets was
almost cut in half (from 10.95% to 6.3%) resulting in a more truthful representation of
net income.
Changes in Net Income Due to Restatement
2003
2004
2005
2006
2007
NI before
(6)
($349)
$28
$93
$285
Restated
($157.2)
($242.6)
($77.2)
($41.5)
$199.6
NI
The net income after restatement was determined by adding the value of
impairments that the firm originally wrote off back to the end of the year net income
and then subtracting the restated impairment amount using the 20% amortization
schedule. The restated net income is incredibly different than the previously stated net
income accounted. This should be a major concern for an analyst because it is
119 | P a g e evidence that MeadWestvaco, contrary to their conservative reporting of goodwill when
compared to competitors in the paper/packaging industry, did in fact manipulate
accounting numbers when reporting impairments to goodwill in order to portray an
exaggerated net income. This manipulation caused the portrayed value of the company
in the financial statements to be dramatically higher than what should have been
reported.
In conclusion, the information above shows that the asset value for
MeadWestvaco is overstated. There are other factors that could have led to the
misleading overstatement of net income, but it does seem like the failure to write off
adequate impairment charges to goodwill played a role in the inflated earnings amount.
We believe that by restating goodwill we have given a more honest interpretation of net
income earned by the company.
120 | P a g e Financial Analysis, Forecast Financials, and Cost of
Capital Estimation
When valuing a firm it is crucial to evaluate financial statements of the industry
as a whole, the competitors, and the individual firm. This is accomplished through ratio
analysis, forecasting the financial statements, and estimating the cost of capital. Ratio
analysis is used to compare firm’s within an industry using an established benchmark,
industry averages, to evaluate a firm’s financial performance. The key performance
ratios used in our analysis of the paper/packaging industry are liquidity, profitability,
and capital structure ratios. The ratio analysis provided a benchmark to measure how
well MeadWestvaco stacked up to industry competitors in the past and also provides an
approach to identify industry trends. The industry trends facilitate forecasting the
financial statements of MeadWestvaco and identify areas where performance lagged or
was above the industry average. The final step in the financial analysis is to calculate
the estimated cost of capital using the CAPM model and regression analysis. These
calculations provide the means to further examine the value of the firm.
Financial Analysis
Financial ratios are calculated using numbers from companies’ financial
statements. Ratios are useless information unless compared to other companies within
the industry.
Calculating competing firm’s ratios provide a benchmark to compare the
performance of a firm with the industry average to determine how well a firm stacks up
to their competition. Another benefit of performing a ratio analysis is to identify
industry trends, and use this information to make predictions about future financial
conditions of a firm (www.investopedia.com). The ratios used in our financial analysis
include: liquidity, profitability, and capital structure ratios. After evaluating the
121 | P a g e industry’s ratios an analyst has the relevant information about historical industry trends
and is able to translate this information into forecasting future performance.
Liquidity Ratio Analysis
Liquidity ratios are derived from accounts on the balance sheet and are used to
assess the cash availability of a firm. These ratios illustrate how well a company
provides sufficient cash inflows or convertible assets to cover short term liabilities.
These ratios include: current ratio, quick asset ratio, accounts receivable turnover, days
sales outstanding, inventory turnover, days supply inventory, and working capital
turnover. It is important to manage cash inflows and outflows because a firm requires
liabilities to be met on time, on the other hand an excess of cash can indicate a loss of
economic efficiency due to a lack in investments. High liquidity ratios are preferred
because they suggest that the firm has sufficient liquid assets to meet liabilities
ensuring short term survival.
Current Ratio
The current ratio, also known as the liquidity ratio, is defined as “a measure of a
firm’s ability to payback its short-term liabilities (debt and payables) with its short-term
assets (cash, inventory, and receivables). The higher the current ratio, the more
capable the firm is of paying its obligations. A ratio under 1 indicates that the firm
would be unable to pay off its obligations if they came due at that point, showing that
the firm is not in good financial health.”[investopedia.com] Basically, the ratio shows
that for every dollar incurred in current liabilities, the firm has a certain dollar amount of
coverage. The current ratio can be calculated by dividing a firm’s current assets by its
current liabilities. The following chart illustrates the calculated figures for each firm in
the paper and packaging industry. With the information provided one is can see that
MeadWestvaco’s current ratio figures are all greater than 1 and maintain a constant
122 | P a g e rate, with no substantial variances occurring over the five year period. Therefore,
MeadWestvaco would be able to meet all short-term obligations using their short-term
assets. In respects to the industry, MeadWestvaco’s current ratio figures remain
constant relative to the industry average over the five year period.
Current Ratio
3
2.5
2
MWV
IP
1.5
SSCC
1
PKG
0.5
Industry Avg.
0
2003
2004
2005
2006
2007
Quick Asset Ratio
Also known as the acid test ratio, the quick asset ratio is used as a means of
measuring whether a firm has a sufficient amount of current assets (not including
inventory) that it can be quickly converted to cash in order to cover its current liabilities.
The firm’s inventory has been excluded in this particular ratio because it allows for a
more accurate measure of the firm’s liquidity. A high ratio figure is desired by firms
because the higher the ratio, the better a firm’s position is in converting their current
assets (not including inventory) into cash. The quick ratio is calculated by first adding
all of the firm’s cash or cash-like assets such as cash, securities, and accounts
receivables (assets above inventory) and dividing them by the firm’s current liabilities.
The following chart depicts the quick ratio figures for the firms in the paper and
123 | P a g e packaging industry. Given the provided information in the chart, one can gather that
there is not a set trend for the industry as a whole over the five year period. In regards
to MeadWestvaco, it has ratio figures that remain relatively close to one over the five
years. In comparison with the other firms in the industry, MeadWestvaco maintains
higher ratio figures that are above the industry average, which means that they are in a
better position when it comes to converting their current assets (excluding inventory)
into cash to meet their current liability obligations.
Quick Asset Ratio
1.4
1.2
1
MWV
0.8
IP
0.6
SSCC
0.4
PKG
0.2
Industry Avg.
0
2003
2004
2005
2006
2007
Working Capital Turnover
Working capital turnover ratio is a “measurement comparing the depletion of
working capital to the generation of sales over a given period.”[investopedia.com] The
ratio is used as an assessment to provide information on how effective a firm is in using
the money to fund its operations in relation to the sales it generates from the
operations. Simply stated, the ratio measures ‘the bang for buck’ for a firm which is for
every dollar a firm invests in working capital, it generates a certain dollar amount in
sales. As with most ratios, firms’ desire higher ratio figures because a high ratio figure
indicates that the firm has generated large amounts of sales compared to the money
124 | P a g e required to fund the generation of those particular sales. The working capital turnover
ratio figures are computed by dividing sales by working capital; working capital can be
calculated by subtracting current liabilities from current assets. The following chart
illustrates the working capital turnover ratio figures over a five year period for each
firm.
Working Capital Turnover
45
40
35
30
MWV
25
IP
20
SSCC
15
PKG
10
Industry Avg.
5
0
2003
2004
2005
2006
2007
The previous chart shows, with the exception of SSCC, that the firms in the industry
tend to follow relatively close to the industry average turnover of 11 turns.
MeadWestvaco has an average working capital turnover of about 9, which is consistent
with the industry average. This means that, in comparison with its competitors,
MeadWestvaco’s ‘band for buck’ measurement is average throughout the five year
period.
125 | P a g e Accounts Receivable Turnover
The accounts receivable turnover ratio is used to analyze the relationship
between the firm’s net sales compared to its account receivables. More specifically, it
measures the amount of accounts receivable that are comprised of total net sales and is
a good indicator on how effective and efficient the firm is in respects to the issuance of
accounts receivable, and the amount of time it takes to collect them and convert them
into cash. The more efficient a firm is in collecting and converting its account
receivables, the higher the accounts receivable turnover ratio will be. A firm with a low
ratio figure implies that the firm has a substantial amount of cash still caught up in the
accounts receivable collection process for longer periods of time.
This particular ratio can be calculated by dividing the firm’s total net sales by its
accounts receivable. Given the information illustrated in the following chart, with the
exception of SSCC, one can see that, for the most part, the firms in the paper and
packaging industry have relatively similar ratio figures and do not have any abnormal
changes over the five year period. Regarding MeadWestvaco, one can gather that the
firm has lower ratio figures that remain relatively constant over the five year period.
The lower ratio figures are largely due to the firm selling its products and services
though credit sales.
The firms in the paper and packaging industry generally operate on credit sales
because they typically do not have store fronts to directly sell their products to their
customers, so they make the majority of their sales through credit transactions.
Therefore, the firm tends to have more cash that’s owed to them in the accounts
receivable collection and conversion process.
126 | P a g e Accounts Receivables Turnover
50
45
40
35
MWV
30
25
IP
20
SSCC
15
PKG
10
Industry Avg.
5
0
2003
2004
2005
2006
2007
Also with the information depicted in the chart above one can see that SSCC has
substantially higher ratio figures compared to the other firms in the industry this is due
to the firm operating more on a cash sales basis rather than on credit sales. The
following chart (excluding SSCC) has been provided to give a more detailed illustration
of the ratio figures for the other firms in the industry.
Accounts Receivable Turnover
14
12
10
MWV
8
IP
6
SSCC
4
PKG
2
Industry Avg.
0
2003
2004
2005
2006
2007
127 | P a g e Days Sales Outstanding
The day’s sales outstanding ratio is used to measure the number of days it takes
the firm, after making a credit sale transaction, to collect what is owed to them from
issuing such account receivables. It is vital for a firm to quickly collect its receivables
because it enables them to use the cash received for further investments. DSO is also
used to indicate how effective or ineffective the firms is in collecting its receivables and
whether or not a firm is trying to make themselves look better by puffing up their sales.
A higher ratio figure (lower A/R turnover) implies that the firm is not very efficient in
collecting its receivables and a lower ratio implies the exact opposite. The DSO can be
computed by dividing the number of days in the year (365) by the calculated accounts
receivable ratio figure for that specific year. Since the DSO calculation involves using
the A/R turnover ratio figures, the DSO chart is directly related to the A/R turnover
ratio. The following chart illustrates the calculated DSO figures for each firm over a five
year period.
Days Sales Outstanding
60
50
40
MWV
30
IP
SSCC
20
PKG
10
Industry Avg
0
2003
2004
2005
2006
2007
In examining the chart above, MeadWestvaco has substantially higher DSO ratio
figures compared to the other firms in the industry. On average, over the five year
128 | P a g e period, MeadWestvaco has a DSO ratio figure of 52 days which is well above the
industry DSO average of 36 days. This means that MeadWestvaco tends to have 16
more days of sales outstanding than the industry average or, in other words, it takes
MeadWestvaco approximately 16 more days to collect its receivables than the industry
average. Since it takes MeadWestvaco an extensive amount of time to collect their
receivables, they are in an unfavorable position against their competitors when it comes
to the ability of re-investing the cash owed to them.
Inventory Turnover
The inventory turnover ratio is “a ratio showing how many times a firm’s
inventory is sold and replaced over a certain period. A low turnover implies poor sales
and therefore, excess inventory. A high ratio implies either strong sales of ineffective
buying. High inventory levels (low inventory turnover) are unhealthy because they
represent an investment with a rate of return of zero, it also opens the firm up to
potential trouble should prices begin to fall. This ratio should be compared against the
industry average.” [investopedia.com] The inventory turnover ratio is computed by
taking the firm’s cost of goods sold and dividing it by their inventory. The following
chart illustrates the calculated inventory turnover ratio figures, over a five year period,
for MeadWestvaco and its competitors in the paper and packaging industry.
Inventory Turnover
14
12
10
MWV
8
IP
6
SSCC
4
PKG
2
Industy Avg.
0
2003
2004
2005
2006
2007
129 | P a g e In examining the inventory turnover chart provided, one can compare each firm’s
inventory turnover ratio figures against the industry average to see how efficient they
are in selling and replacing their inventories. MeadWestvaco’s inventory turnover figures
are consistently lower than the industry average. More specifically, over the five year
period, MeadWestvaco’s average inventory turnover is just over 6 while the industry
averages a little over 8. This means that MeadWestvaco has a large amount of excess
inventory being held at the end of each year but seeing how they are increasingly
progressing toward the industry average, it is safe to say that they are improving the
selling and replacing of their inventories.
Days’ Supply of Inventory
The days supply of inventory is used to measure the number of days it takes the
firm to sell and replace (turnover) its inventory. The faster a firm turns over its
inventory, the less time its supply’s spends in inventory. More specifically, the higher
the firm’s inventory turnover, the smaller its DSI will be. This indicates that the number
of day’s supply of inventory is directly related to the inventory turnover ratio. The DSI is
calculated by simply taking the number of days in a year (365) divided by the inventory
turnover ratio figure. The following chart illustrates the relationship between DSI and
inventory turnover for the firms’ in the paper and packaging industry.
130 | P a g e Days Supply of Inventory
70
60
50
MWV
40
IP
30
SSCC
20
PKG
10
Industry Avg
0
2003
2004
2005
2006
2007
In viewing the previous chart, one can gather that the firms have DSI figures
that stay relatively close to the industry average. The relationship between the firm’s
inventory turnover and DSI can be gathered by seeing that SSCC had the highest
inventory turnover ratio figures, therefore, it has the lowest DSI number.
MeadWestvaco, on the other hand, had lower inventory turnover ratio figurers, so it has
the highest DSI numbers. In viewing the chart one can see that MeadWestvaco has
progressively lowered their DSI numbers throughout the five year period. For instance,
in 2004 the industry average was about 48 days and MeadWestvaco had a DSI of 62,
meaning that MeadWestvaco had their supplies in inventory for 14 more days than the
industry average. In 2007 the DSI industry average was approximately 43 days and
MeadWestvaco had a DSI of 50, in which, now their supplies was in inventory for only 7
days longer than the industry average. In comparing their performance over the five
year period one can see that, although MeadWestvaco has some of the higher DSI
figures in the industry, they are progressively growing more efficient in managing how
long their supplies stays in their inventory. Since the DSI and inventory turnover are
directly related, MeadWestvaco is also becoming more efficient in managing their
inventory turnover.
131 | P a g e Cash to Cash Cycle
The cash to cash cycle is used to determine “the length of time, in days, that it
takes for a firm to convert resource inputs into cash flows.”[investopedia.com] More
specifically the cash to cash cycle “measures the amount of time required for a firm to
sell its inventory and the amount of time needed to collect its accounts receivables.”
[investopedia.com] The cash to cash cycle is calculated by adding the firm’s days’ sales
outstanding (DSO) with the firm’s days’ sales of inventory (DSI). The lower the cash to
cash cycle figures the better because the lower the figure the more liquid a firm is and
the more efficient it is in converting its resources into cash flows. The following chart
depicts the cash to cash cycle figures, over a five year period, for each firm in the paper
and packaging industry.
Cash to Cash Cycle
120
100
80
MWV
IP
60
SSCC
40
PKG
Industry Avg.
20
0
2003
2004
2005
2006
2007
Over the given five year time period, with the exception of SSCC, the chart
above illustrates that the firms in the industry generally tend to have cash to cash
cycles that are greater than the industry average. In viewing the chart one can see that
MeadWestvaco has the longest cash to cash cycles in the industry. The chart shows
that it takes MeadWestvaco, on average, approximately 22 more days to convert its
132 | P a g e resource inputs into cash flows. This could raise concerns on how efficient the firm is in
selling its inventory and collecting its account receivables. However, since
MeadWestvaco operates largely on credit transactions it is going to have more of its
resource inputs tied up in the business collection process.
Conclusion
In calculating, comparing and evaluating the liquidity ratios, one can conclude
that MeadWestvaco, for the most part, is average amongst its competitors in the paper
and packaging industry. It had average current and quick ratios figures that stayed
relatively close to the industry trend. Also, MeadWestvaco had turnover ratio figures
that were also average amongst its competitors, so one can now conclude that
MeadWestvaco’s liquidity efficiency is about average.
Profitability Ratio Analysis
Profitability ratios reflect a company’s ability to generate revenues in excess of
expenses. These ratios provide analyst with information to evaluate how well a
company is able to handle costs associated with operations and the efficiency of the
operations to provide a profit. Ratios related to operating efficiency include gross profit
margin, operating profit margin, net profit margin. Other profitability ratios include
asset turnover, return on assets, and return on equity. All of these ratios measure the
profitability and growth of a company.
133 | P a g e Gross Profit Margin
The gross profit margin percentage represents the relationship between gross
profit and sales of a firm. It is calculated by taking the revenues less cost of goods
sold, gross profit, and dividing the gross profit by total sales. A higher gross profit
margin indicates a firm’s ability to efficiently convert inventory into a profit.
Gross Profit Margin
30%
25%
20%
MWV
15%
SSCC
PKG
10%
IP
5%
0%
2003
2004
2005
2006
2007
The preceding graph shows MeadWestvaco’s gross profit margin is currently
lower than the industry’s gross profit margin average of 19%. This indicates that
MeadWestvaco is less efficient at sustaining a lower cost of goods sold relative to other
companies operating in the paper/packaging industry. Over the past five years
MeadWestvaco’s cost of goods sold averaged 82% of total sales and a gross profit
margin of 17%. This low gross profit margin can be expected since MeadWestvaco’s
profits are based on sales volume rather than creating valuing through production of
superior products.
134 | P a g e Operating Expense Ratio
The operating expense ratio shows the percentage of a firm’s income that is
being used towards paying selling and administration expenses. The ratio is computed
by taking the S&A expense and dividing it by the total sales. A lower operating expense
ratio is preferable indicating that sales are able to efficiently cover selling and
administration costs resulting in a higher gross profit. Therefore, gross profit margin
and operating expense ratios are inversely related. The following graph shows
MeadWestvaco’s average operating expense ratio leading the industry average by 3%.
This assessment shows that an average of $.12 of every sales dollar is used to cover
selling and administration expenses. When comparing the operating expense graph
and the gross profit margin graph (preceding section), for the paper/packaging
industry, it correctly shows the inverse relation between the two ratios ranking
MeadWestvaco below the industry’s average gross profit margin and above the
industry’s average operating expense ratio.
Operating Expense Ratio
16%
14%
12%
10%
MWV
8%
SSCC
6%
PKG
4%
IP
2%
0%
2003
2004
2005
2006
2007
135 | P a g e Operating Profit Margin
The operating profit margin is calculated by dividing the operating income (gross profit –
operating expense) by total revenue. This ratio is important because it shows how much profit
a company has left over after paying operation costs. A higher operating profit margin
indicates a firm’s ability to maintain high levels of operating efficiency while also managing
costs associated with the production process. MeadWestvaco lagged behind the industry
average of 9.5% only averaging 4.1% in the past five years. The low operating profit margin
MeadWestvaco has established over the past couple of years is an indicator of their inability to
match their sales to their operation costs. The competitors within the industry have been able
to provide increasing sales to offset the increased cost of production and have been able to
adequately control these costs. If the inability to control these expenses continues,
MeadWestvaco will most likely suffer decreasing profits.
Operating Profit Margin
0.2
0.18
0.16
0.14
0.12
MWV
0.1
IP
0.08
SSCC
0.06
PKG
0.04
0.02
0
2003
2004
2005
2006
2007
Net Profit Margin
Net profit margin is derived by dividing net income by sales. This ratio is an
indicator of both profitability and how efficiently a firm is able to control costs. The net
profit margin percentage shows the amount of net income produced from a company’s
136 | P a g e annual revenues. A high net profit margin is preferred representative of cost control
and a high net income. It is important to evaluate this ratio because it shows how
many dollars of sales will be converted to income after all expenses and taxes are paid
(www.investorwords.com).
Net Profit Margin
8%
6%
4%
2%
MWV
0%
SSCC
‐2%
2003
2004
2005
2006
2007
PKG
IP
‐4%
‐6%
‐8%
MeadWestvaco’s net profit margin has increased substantially since 2004 and is
currently above the industry average. The drastic decline in MeadWestvaco’s net profit
margin in 2004 is directly related to a reported loss of $349 million due to impairment
charges, costs associated with the sale of the company’s paper business and forestland,
and restructuring charges (MeadWestvaco 2004 annual report). The steady annual
increase in net profit margin in the last four years is a positive sign for MeadWestvaco
indicating that they consistently increasing net income by more efficiently controlling
their costs. This is can be seen by a 181% increase in net income from 2004 to 2007,
with net income increasing from -$349 million to $285 million in 2007.
137 | P a g e Asset Turnover
Asset turnover is calculated by dividing sales by total assets of the previous year.
This ratio shows how well a company uses their assets to generate revenue. A high
asset turnover indicates that a company is efficiently using assets in order create sales
revenue. Profit margin and asset turnover are inversely related; therefore companies
with low profit margins tend have a higher asset turnover.
Asset Turnover
1.2
1
0.8
MWV
0.6
SSCC
PKG
0.4
IP
0.2
0
2003
2004
2005
2006
2007
MeadWestvaco has not kept up with industry standards in regards to their asset
turnover. In the last five years they have had the lowest asset turnover relative to their
top competitors, but has been increasing the last two years. The slow down occurred
because of increasing investment in expensive machinery in previous years. The
insufficient inflow of revenue generated by new assets could reflect a poor investment
choice on behalf of MeadWestvaco.
138 | P a g e Return on Assets
Return on assets is a profitability percentage that measures how well a firm
utilizes their operating assets to generate a profit. The ROA is found by dividing the net
income by the previous year’s total assets. The reason for using the lag year is to
measure the profit performance of the assets that are actually being used to produce
the profits of the current year. A higher return on assets figure is better, because it
indicates that the company is making wise asset investment decisions and also shows
that the production process is working efficiently.
Return on Assets
10.0%
8.0%
6.0%
MWV
4.0%
SSCC
2.0%
PKG
IP
0.0%
2003
2004
2005
2006
2007
‐2.0%
‐4.0%
All of the firms in the paper/packaging industry had a low or negative return on
assets in 2003 and 2004. These low returns are a result of very low net profit margins
in these two years. ROA is a function of both net profit margin and asset turnover, so
in this case the drastic decline in net profit margins between 2003 and 2004 caused the
return on assets to be lower as well. The last couple of years MeadWestvaco have
experienced an increase in their return on assets, but their returns are lower than the
139 | P a g e other firms in the industry. This could be a consequence of a loss of asset utilization or
not working at capacity.
Return on Equity
The return on equity is a measurement of how much net income is drawn from
shareholder equity. ROE is found by dividing net income in the current year by
shareholder’s equity in the previous year. The return on equity is determined by two
factors: ROA and financial leverage. Therefore, it is a complete measure of the firm’s
performance because it shows how well the company is utilizing shareholder’s funds to
generate income.
Return on Equity
30%
25%
20%
15%
MWV
10%
5%
SSCC
0%
PKG
‐5%
2003
2004
2005
2006
2007
IP
‐10%
‐15%
‐20%
MeadWestvaco’s return on equity is lower than the industry average. The return
on equity is even lower when calculated using the restated financials. This is caused by
large amounts of goodwill being expensed each year that lower net income resulting in
a lower ROE. The low ROE values show that the firm uses debt to finance investing
activities rather than equity. The restated financials resulted in even a lower Return on
140 | P a g e Equity due to the goodwill impairment write offs that decreased the company’s equity
on the balance sheet.
Conclusion
After performing the profitability analysis it can be concluded that MeadWestvaco
is not as profitable as the other companies in the paper/packaging industry.
MeadWestvaco was under the industry average in their gross profit margin, operating
expense ratio, asset turnover, return on assets, and return on equity. This indicates
that MeadWestvaco is not effectively generating profits in excess of their costs. The
only ratio that MeadWestvaco outperformed the industry average was their net profit
margin. This is due to MeadWestvaco’s increasing net income in the past couple of
years. MeadWestvaco needs to implement cost control and productivity strategies in
order to compete with the other firms in the industry.
Capital Structure Analysis
Capital structure ratios are used to “calculate or measure the financial
leverage of a firm in order to get an idea of the firm’s methods of financing and its
ability to meet financial obligations; The capital structure ratios are also used to
measure the firm’s credit worthiness, its ability in paying off liabilities and covering
its interest payments.” [investopedia.com] A firm can finance its assets through
equity (selling shares of the firm as stock) or through debt (borrowing funds from
a lender). The way a firm finances its assets is shown on the balance sheet
through the owner’s equity and liability sections. The capital structure ratios that
will be calculated are debt to equity, times interest earned, and debt service
margin.
141 | P a g e Debt to Equity
A firm may have a portion of debt financing and a portion of equity
financing. The debt to equity ratio is used to “determine what portion of equity
and debt is being used to finance the firm’s assets.” [investopedia.com] The debt
to equity ratio indicates how many dollars of debt financing the firm is using for
each dollar invested by its shareholders. [Palepu and Healy, Business Analysis and
Valuation] It is vital to understand the difference between the two possible ways
for a firm to finance its activities; this is discussed in the capital structure ratio
introduction. If the firm is financing a large portion of its activities through debt,
the more difficult it may be for the firm to continuously pay of it debtors and in
turn can bring forth a higher chance for the firm to default on the funds borrowed.
A high debt to equity ratio indicates that the majority of the firm’s financing is
through debt and a low ratio figure indicates the exact opposite. The debt to
equity ratio is calculated by taking the firm’s total debt (short- term debt + long
term-debt) and dividing it by the total owner’s equity. The following chart depicts,
over a five year period, the information for the debt to equity calculations for the
firms in the paper and packaging industry.
142 | P a g e Debt to Equity 4.5
4
3.5
3
MWV
2.5
IP
2
SSCC
1.5
PKG
1
Industry Avg.
0.5
Restatement
0
2003
2004
2005
2006
2007
The chart above illustrates that the industry average remains relatively constant
throughout the five year period. In comparing the firms in the industry, SSCC has
the highest debt to equity ratio figures and MeadWestvaco having the lowest ratio
figures. This indicates that MeadWestvaco has lower amounts of debt used to
finance their activities and SSCC has higher amounts of debt used to finance their
activities. In other words, MeadWestvaco uses an average of 1.62 dollars of debt
financing for every dollar invested by its shareholders, while SSCC uses an average
of 3.38 dollars of debt financing for every dollar invested by their shareholders.
One can also gather that the industry trend is progressively moving towards the
industry average of approximately 2, meaning that the firms’ are shifting towards
using a lower amount of debt to finance their activities. The following information
is the numerical data illustrated in the chart above in table format.
Debt To Equity
2003
2004
2005
2006
2007
MWV
1.61
1.69
1.55
1.62
1.65
IP
3.3
3.1
2.4
2.02
1.8
143 | P a g e SSCC
3.45
3.24
3.84
3.37
2.98
PKG
1.64
1.69
2.05
2.00
1.80
Times Interest Earned
“The times interest earned ratio is used to measure the firm’s ability to
meet its debt obligations. It is crucial for the firm to be able to meet its interest
payment obligations because failure to do so could potentially force the firm into
bankruptcy. The ratio indicates how many times the firm can cover its interest
charges on a pre-tax basis.”[investopedia.com] This ratio also indicates the dollars
of earnings available for each dollar of required interest payment. A high times
interest earned ratio figure can either imply that the firm has an undesirable lack
of debt or is paying too much debt with earnings that could be used for other
investments.” [investopedia.com] The times interest earned ratio is computed by
taking the firm’s earnings before interest and taxes (EBIT) and dividing it by the
firm’s interest expense. The following chart provides the information from
calculating this particular ratio for each firm in the paper and packaging industry,
over a five year period.
144 | P a g e Times Interest Earned
12
10
8
MWV
IP
6
SSCC
4
PKG
Industry Avg.
2
0
2003
2004
2005
2006
2007
According to the graph above one can see that, for the most part, the firms in the
industry have relatively low ratio figures, which indicates that the firms’ are just
barely covering its interest expense using their earnings before interest and taxes.
In regards to MeadWestvaco, one can see that the firm has ratio figures that
follow relatively close to the industry average but are just below it. This means
that, on average, MeadWestvaco has 1.87 dollars of earnings available to each
dollar of required interest payments. Although MeadWestvaco has just enough
earning to cover its interest expense, one can see that their times interest earned
ratio figures are progressively growing larger which enables them to have more
interest expense coverage. The following table is the numerical data from the
times interest earned chart.
Times Interest Earned
2003
2004
2005
2006
2007
145 | P a g e MWV
1
2.55
1.64
1.46
2.82
IP
2.6
3.4
2.5
2.3
6.4
SSCC
.14
.77
.73
.81
1.07
PKG
4.5
4.7
4.1
7.2
11.4
Debt Service Margin
The debt service margin ratio indicates that for every dollar in long-term
debt due at current period the firm has a certain dollar amount of coverage from
the cash provided by operations to cover that expense. The debt service margin
also measures the “adequacy of cash provided by operations to cover required
annual installment payments on the principal amount of long-term
liabilities.”[Notes from Financial Statement Analysis 3321] This particular ratio can
be calculated by taking the firm’s cash flow provided from operations and dividing
it by the previous year’s installments due on long-term debt (found under current
liabilities section). The following chart illustrates the debt service margin
calculations, over a five year period, for each firm in the industry.
146 | P a g e Debt Service Margin
50
45
40
35
30
MWV
25
IP
20
SSCC
15
PKG
10
Industry Avg.
5
0
2003
2004
2005
2006
2007
In viewing the chart above one can gather that the debt service margin ratio
figures do not have an industry trend. They have huge variances from year to
year, this is due to either each firm having extremely different takes on this
particular calculation or the firms have a wide range of long-term debt currently
due from year to year. For instance, MeadWestvaco did not have any long-term
debt currently due in 2002 and 2003, so they had a debt service margin ratio
figure that was off the charts. Between the years of 2004-2007 the firm’s longterm debt currently due that ranged from as little as 13 in 2005 to as large as 211
in 2006. This is more than likely the reason to why their ratio figures drastically
change from year to year.
147 | P a g e Z-Score
The Altman’s Z-score is often used as a method to predict the chance of
bankruptcy by a firm, and is determined by five weighted financial ratios developed to
quantitatively measure the financial strength or weakness of the firm. The chart below
depicts each firm’s Z-score across the five year time horizon starting in 2003. Typically,
a firm with a Z-score greater than a value of 2.99 is considered “safe,” a Z-score
between the values of 1.8 and 2.99 is considered to be in the “grey” zone, and a Zscore value below 1.80 is said to signify a firm in “distress.” For any firm the Altman’s Zscore is calculated as follows:
Z = 1.2(Working Capital/ Total Assets) + 1.4(Retained Earnings/Total
Assets) + 3.3(EBIT/Total Assets) + .6(Market Value of Equity/Book Value of
Total Liabilities) + .999(Sales/Total Assets).
As the graph shows, MWV follows very closely to the industry trend thoughout
the time horizon with PKG displaying less bankruptcy risk than any other firm and SSCC
showing signs of distress.
148 | P a g e Growth Rate Analysis
The internal and sustainable growth rate analysis helps measure the growth of a
company and also facilitates in calculating future profits and growth. This is important
to analyze because it offers insight to the future profitability of the firm and also
examines how the firm stacks up to the other competitors in their industry.
Internal Growth Rate
The internal growth rate (IGR) is the highest growth a firm can achieve without
receiving funds from outside sources. Therefore, the only way a company can grow is
through the use of cash flows and retained earnings. IGR can be found by multiplying
a company’s return on assets (ROA) by 1 minus the dividend payout ratio (dividends /
net income). High internal growth rates are beneficial to a firm showing their ability to
finance capital and assets using only internal funds provided through operations.
Internal Growth Rate
4.00%
3.00%
2.00%
1.00%
MWV
0.00%
SSCC
‐1.00%
2003
2004
2005
2006
2007
PKG
IP
‐2.00%
‐3.00%
‐4.00%
149 | P a g e MeadWestvaco has averaged a .13% internal growth rate over the last five years, which
means the company can grow at this rate without receiving any funding from sources
outside of the company. MeadWestvaco experienced a drastic drop in their internal
growth rate in 2004 directly related to a $367 million loss of net income from 2003 to
2004. The negative IGR between 2004 and 2006 was caused by yearly increased
dividend payouts while net income decreased over the three years. Another reason for
the low and negative IGR’s in the paper/packaging industry is due to the relatively low
return on assets for the industry as a whole resulting in a reduced IGR value.
Sustainable Growth Rate
The sustainable growth rate is “a measure of how much a firm can grow without
borrowing more money” (www.investopedia.com). After departing from this rate, the
firm must borrow funds for other sources to aid in financing activities and future
growth. The SGR is found by multiplying the return on equity (ROE) of a firm by 1
minus the payout ratio (dividends / net income). This is an important measure,
because it calculates how much a company can grow without increasing their leverage
(financing using debt).
Sustainable Growth Rate
15.00%
10.00%
5.00%
MWV
0.00%
2003
‐5.00%
‐10.00%
2004
2005
2006
2007
SSCC
PKG
IP
‐15.00%
‐20.00%
150 | P a g e MeadWestvaco once again underperformed compared the competition within the
paper/packaging industry with an average SGR of -1.21%. MeadWestvaco does pay
regular yearly dividends, which in turn lowers the amount of funds that are available to
be reinvested into the firm. The low sustainable growth MeadWestvaco possesses
could be a negative indicator of low future potential growth. MeadWestvaco has shown
an increasing SGR in the last two years; implying that they have the opportunity for
growth in the future if they are able to maintain proximity with their competitors SGR.
Estimating Cost of Capital
Cost of Equity
The cost of equity is the minimum return required by potential stockholders
based on the risk associated with investing in the firm. Typically, the more uncertainty
associated with the future cash flows of the firm will correspond directly to a higher
cost of equity for the firm. In other words, as risk increases so does the return
demanded by the stockholders for bearing the additional risk above and beyond the risk
of the market. In most cases the cost of equity is greater than that required by debt
holders since debt holders have a prior claim to the assets of the firm in the event of
default. Although there are several ways to estimate the cost of equity, we used the
Capital Asset Pricing Model (CAPM) to estimate the cost of equity for MWV.
Ke = RF + β(Rm – RF)
In the CAPM formula above, Ke is the cost of equity, RF is the risk free rate, Rm
is the the market return, (Rm – RF) is the market risk premium, and beta is the
coefficient that relates the risk of the individual firm to the systematic risk of the
market.
For our calculation the risk free rate of 4.02% was taken from the St. Louis
Federal Reserve treasury yield curve, and the risk premium was found to be 8.0% by
subtracting the risk free treasury rate from the S&P 500 yield, a market yield proxy.
Through a series of regressions using seven years of MWV monthly stock prices, seven
151 | P a g e years of S&P 500 monthly yields, and treasury yields as stated by the St. Louis Federal
Reserve on 3 month, 6 month, 2 year, 5 year, and 10 year basis, a beta coefficient was
calculated over a 24 month, 36 month, 48 month, 60 month, and 72 month time
horizon.
The beta coefficient of a firm is a measure of systematic risk, and is used to
determine exactly how much undiversifiable risk the firm shares with the market. By
definition, a beta coefficient equal to one would signify that the risk associated with the
firm’s securities exactly matches the risk associated with the market as a whole.
Similarly, a beta of less than one corresponds to a stock that is less volatile than the
market, and a beta of greater than one would mean the security is relatively more
volatile than the market.
Since our calculation of MWV’s cost of equity required several regressions, the
adjusted r^2 value was needed to determine which beta coefficient would be most
accurate. R^2 is the product of regression analysis that tells how much of the variation
of the dependent variable is explained by variation in the independent variable. In other
words, the regression with the highest r^2 value holds the most explanatory power in
terms of the beta coefficient.
As the table below points out, the 24 month regression displays the highest
adjusted r^2 value. As a result, the beta coefficient is observed to be -.0186, and the
most accurate cost of equity for MWV is observed to be 3.817%. The negative beta
coefficient shows that the returns generated by MWV are less volatile than the returns
from the broad market.
Months β estimate risk free rate mrp ke r2 upper β lower β 72 60 48 36 24 0.00198227 0.00269711 0.01214822 0.01383398 0.01857655 4.02 4.02 4.02 4.02 4.02 8 8 8 8 8 4.035858181
3.998423156
3.922814432
3.90932812
3.871387594
0.012798195 0.014902049 0.017394772 0.032221337 0.056472344 4.134499
4.116548
4.067344
4.062174
4.071309
3.937218
3.880298
3.778285
3.756482
3.671466
152 | P a g e The relative stability of MWV’s beta value over time, as shown above, is likely an
indication that MWV has held their capital structure relatively constant through time.
Alternative Cost of Equity
In order to verify the cost of equity calculation from the Capital Asset Pricing
Model outlined above, an alternative cost of equity was computed for MWV. By using
.67 for the market to book, M/B, estimate as quoted by www.yahoofinance.com, 6.26%
for the long run return on equity, (ROE), average over the forecast period, and 4% for
g, the average earnings growth rate over the forecast period we were able to
manipulate the formula M/B = 1 + (ROE – ke)/(ke – g) to arrive at 7.27% for MWV’s
alternative cost of equity before adjusting for size. In addition, an alternative cost of
equity was calculated using our restated financial forecasts after goodwill impairment.
MWV’s long run return on equity value over the forecast period using restated financials
was 6.36%, a slightly higher ROE value due to the drop in equity after goodwill
impairment, which led to the higher restated alternative Ke value of 7.52%.
For the size adjustment we took the calculated alternative cost of equity and
added a size premium of 1.5% to arrive at a size adjusted restated Ke of 9.02%, and a
size adjusted Ke before restatement of 8.77%. The size adjustment of 1.5% is derived
from the difference between the average return on the S&P 500, the market index used
in the CAPM estimate of Ke, and the average return on firms close to MWV’s size. The
adjustment attempts to incorporate the notion that big firms like MWV are not as
sensitive to market shifts as smaller firms are. (Palepu & Healy) This estimate seems
much more reasonable than the previous calculation because, unlike the CAPM cost of
equity, it is larger than the cost of debt. For this reason we will use the alternative cost
of equity in our subsequent calculation of the weighted average cost of capital.
As
Stated
Restated
M/B
ROE
g
Size Adjusted
Ke
0.67
0.67
6.26%
6.36%
4%
4%
8.77%
9.02%
153 | P a g e Cost of Debt
Since the total value of a firm can be decomposed into equity and debt, a cost of
debt estimation must be calculated in addition to our previous estimation of equity. In
reality, the cost of debt is usually lower than the cost of equity since debt holders bear
less risk due to their prior claim to the firm’s assets in the event of default. Firms use
many different types of debt financing, each corresponding to a different interest rate
depending on the time to maturity and risk involved. Since the Capital Asset Pricing
Model requires only one rate for the cost of debt, a weighted average of short term and
long term debt must be calculated. First, the weight of every liability account must be
calculated as a percentage of total liabilities. Next, each weight must individually be
multiplied by its corresponding interest rate as stated in the firm’s annual reports to get
weighted rates for each liability account. These weighted rates are then summed to get
the weighted average cost of debt for the firm.
As the following data points out, at 5.89% MeadWestvaco currently pays a
higher premium for debt financing than the other three firms listed. For MWV, current
liabilities made up 23.74% of total liabilities with the other 76.26% made up of long
term liabilities. The calculated weighted average cost of debt shown below will now be
used as a key input to help determine the weighted average cost of capital for MWV.
Firm
Weighted avg. Kd 5.89% 4.66% 4.43% 5.07% MWV IP PKG SSCC 154 | P a g e Weighted Average Cost of Debt Calculations MWV
2007
LIABILITIES AND SHAREHOLDERS EQUITY
Accounts payable
Accrued expenses
Notes payable and current maturities of LTD
Current Liabilities of Discontinued Operations
Current liabilities
640
747
68
1455
Long-term debt
Other long-term obligations
Deferred income taxes
Non Current Liabilities of Discontinued Operations
2375
1071
1228
Commitments and Contingencies
Total Liabilities
weighted
rate
weight
rate
0.10442
0.12188
0.01109
0.0215
0.0215
0.055
0.00224506
0.00262041
0.00061021
0.082
0.082
0.0363
0.03177517
0.01432893
0.00727303
MWV
Kd
0.058853
.2374
0.3875
0.17474
0.20036
6129
SSCC
2007
Current liabilities
Current maturities of long-term debt
Accounts payable
Accrued compensation and payroll taxes
Interest payable
Income taxes payable
Current deferred taxes
Other current liabilities
11
582
193
66
10
21
106
Total current liabilities
989
weight
rate
0.00199
0.10521
0.03489
0.01193
0.00181
0.0038
0.01916
0
0.054
0.0215
0.054
0.054
0.054
0.0363
0.0215
weighted
rate
0.00010738
0.00226193
0.00188395
0.00064425
9.7614E-05
0.0001378
0.00041197
0
0
155 | P a g e Long-term debt, less current maturities
Other long-term liabilities
Deferred income taxes
Total Long Term Liabilities
Total Liabilities
3348
834
361
4543
5532
0.60521
0.15076
0.06526
0.05665
0.05665
0.0363
Kd
0.03428492
0.00854051
0.00236882
0.050739
PKG
Liabilities and shareholders equity
Current liabilities:
Short-term debt and current maturities
of long-term debt
Accounts payable
Dividends Payable
Accrued interest
Accrued federal and state income taxes
Accrued liabilities
Total current liabilities
Long-term liabilities:
Long-term debt
Deferred income taxes
Pension and postretirement benefit plans
Other liabilities
Total long-term liabilities
Total Liabilities
IP
2007
weight
rate
278747
0.21863
0.0488
132197
31534
12828
6062
101209
562577
0.10368
0.02473
0.01006
0.00475
0.07938
0.44124
0
0
0.31255
0.18879
0.03787
0.01955
0.55876
1
0.0215
0.0215
0.0215
0.0363
0.0215
398501
240707
48284
24927
712419
1274996
2007
NP & CMLTD
A/P
Accrued Payroll
Liabilities of acquired businesses
Other Accrued Liabilities
267
2145
400
4
1026
Weight
0.01724
0.1385
0.02583
0.00026
0.06625
Total Current Liabilities
3842
0.24808
weighted
rate
0.0575
0.0363
0.075
0.0568
0.01066894
0
0.00222921
0.00053175
0.00021632
0.00017259
0.00170667
0
0
0
0.01797167
0.00685309
0.00284024
0.00111048
PKG Kd
0.044301
Rate
0.061
0.0215
0.0215
0.0215
0.0215
Weighted
rate
0.00105164
0.00297781
0.0005553
5.547E-06
0.00142435
156 | P a g e Long Term Debt
Deferred Income Taxes
Other Liabilities
Minority Interest
Total Liabilities
6353
2919
2145
228
0.41022
0.18848
0.1385
0.01472
15487
0.061
0.0363
0.057
0.057
0.02502312
0.00684186
0.00789467
0.00083915
IP Kd
0.046613
Weighted Average Cost of Capital
As we have seen, the assets of a firm are either financed by issuing debt or by
issuing equity. Essentially, the weighted average cost of capital (WACC) is the percent
of assets financed by debt times the cost of debt for the firm, plus the percent of assets
financed by equity times the cost of equity for the firm. Furthermore, the WACC is the
interest rate a firm can expect to pay for financing in the long run.
Using the formula WACC = (VL/VA)*Kd + (Ve/VA)*ke, we calculated MWV’s
WACC using our original cost of debt calculation of 5.89% for Kd, the current market
capitalization of $2.52 billion, according to www.yahoofinance.com, for the market
value of equity, and $6.37 billion for book value of liabilities, from MWV’s June 2008
10-Q report. The market value of assets was computed by summing the market value
of equity and the book value of liabilities. For the cost of equity figure we took the
calculated alternative cost of equity of 7.52% and added a size premium of 1.5% to
arrive at a size adjusted Ke of 9.02%. The size adjustment of 1.5% is derived from the
difference between the average return on the S&P 500, the market index used in the
CAPM estimate of Ke, and the average return on firms close to MWV’s size. The
adjustment attempts to incorporate the notion that big firms like MWV are not as
sensitive to market shifts as smaller firms are. (Palepu & Healy)
Using the figures outlined in the chart below WACC was calculated both before
tax, WACCbt, and after tax, WACCat, assuming a 35% tax rate. These calculations
seem credible since Kd < WACC < Ke, as it should be.
157 | P a g e VL
Kd
t
Ve
Ke
Vf
6371 M
5.89%
35%
2520 M
9.02%
8891 M
WACCbt =
6.78%
WACCat =
5.30%
MWV
Conclusion
In summary, the weighted average cost of debt, Kd, is effectively the interest
rate a firm pays to finance assets with debt. Kd was calculated for MWV, as well as for
their three closest competitors within the industry. Likewise, the weighted average cost
of equity, Ke, is the effective interest rate paid by a firm to finance assets with equity.
In order to calculate an accurate Ke using the Capital Asset Pricing Model, CAPM, we
used regression analysis to estimate a beta coefficient. For the original cost of equity
we used the S&P 500 index to proxy the return on the market, and we used the
treasury yield curve from the St. Louis Federal Reserve to arrive at a risk free rate.
Since our original estimate of Ke was not greater than Kd as it should be we calculated
an alternative Ke which we ultimately used in our Weighted Average Cost of Capital,
WACC, calculation. Finally, WACC was calculated both before and after tax to show the
overall return required from the firm by investors. For MeadWestvaco, their original Ke
using CAPM was found to be 3.87%, alternative Ke was found to be 7.52%, weighted
average Kd was found to be 5.89%, and WACCbt came out to be 6.78%.
158 | P a g e Financial Forecasting
Financial forecasting is used to make logical estimations of future performance
based on expected future market conditions. The estimations of financials based on
future market conditions are based on previous company reactions to similar market
conditions. This use of past performance to estimate future performance is needed
most in the current recessionary market. By looking at a company’s financials in a past
recession it is possible to determine an educated guess in how the company will
perform in the current market.
Income Statement Forecasting
The income statement is the most important forecast in the financials because of the
inclusion of the benchmark of sales. Almost every forecast in the financials relates in
some manner back to this line in the financials and therefore the forecast for sales must
be based on sound logic and a solid understanding of expected future market
conditions. To determine future sales it is necessary to create a expected sales growth
rate. In MeadWestVaco’s financials for the last five years there is little consistency in
sales growth or in some instances, loss. As seen below the sales growth numbers of
4%, -20%, 2%, 6%, and 6% give little consistency to base a forecast. However, MWV
spun off a division of the company in 2004, which caused the drastic decrease in sales.
This spin off from the company has made the company more efficient and has given a
gradual increase in sales to 6% where it was consistent the last two years. The average
of returns excluding the uncommon -20% is 4%. However, forecasting out based on
this average would not be logical due to the recession in the current market. Upon
researching past economic downturns and MWV’s financials during these times it has
shown that MWV merely slows during these times rather than taking a large hit. This is
due largely to MWV being in a commodity market that has relatively stable demand.
Another factor to counter the recession is the paper company’s push into China that has
159 | P a g e been providing sales increase as this rising countries expansion is exploited. This
business expansion can counter the sight decrease in demand from current market
conditions. Taking all these considerations MWV should only have a slower increase in
sales percentage increase of 2% for the next two years and then a more normal
increase thereafter of 4%.
Another vital forecasting measure on the income statement is the forecasting of the
cost of goods sold. A decrease in COGS while maintaining or increasing sales creates
increases the efficiency of the company and raises gross profits. MWV has had an
average of 82.7% of net sales go towards COGS. Since the company spinoff in 2004
the percentages of COGS has been 82%, 83%, and 83% which is significantly less than
the prespin-off 87%. COGS has had a slight increase since the spinoff due to increases
in commodity prices. MWV should expect decreases in COGS due to the recent
decreases in commodity prices, the efficiency increase due to the spin-off, and
economies of scale with expansions into China. Because of these factors MWV forecast
for COGS is consistent for the next two years at 82.72% and then begins a gradual
decrease for the years thereafter.
The forecasting of gross income is a product of the two previously forecasted lines on
the income statement and is therefore dependant on them. Because we chose a
consistent rate of 2% for sales growth and 82.7% COGS for 2008 and 2009 gross profit
is 17.3% of sales for the same years. However, in the years after, gross profit increases
consistently because of increases in sales growth and decreases in COGS.
Continuing down from gross profit, operating profit is achieved by deducting selling,
general and administrative expenses. Selling, general and administrative expenses are
difficult to forecast due to the many accounts contained in this line that are not
detailed. We assumed a decrease in these accounts as a whole due to the sell off of a
business segment and the increased efficiency of the company due to this. In effect this
would lead to a gradual increase in operating profit as a percentage of sales.
160 | P a g e The last forecasted line in the income statement is net income. Logically, net income
would be obtained by deducting the forecasted interest expense and taxes from
operating profit, however, this is not feasible because of the uncertainty involved in
expected future interest expense. It is logical to assume that increases in sales will
cause an increase in net income holding COGS and expense ratios relatively constant.
Therefore, our growth in net income correlates with sales growth percentage.
161 | P a g e MWV
Income Statement
Actual Financial Statements
Forecasted Financial Statements
2002
2003
2004
2005
2006
$7,242
$7,553
$6,060
$6,170
$6,530
Cost of sales
6,201
6,557
4,925
5,087
5,399
5,710 5,825 5,942 6,157 6,388 6,611 6,867 7,124 7,409 7,687 7,994
Gross Profit
1,041
996
1,135
1,083
1,131
1,196 1,219 1,243 1,315 1,383 1,471 1,538 1,617 1,682 1,768 1,839
Selling, general and administrative expenses
856
865
800
756
905
Operating Profit
185
131
335
327
226
314 334 341 374 404 453 479 507 527 567 590
Interest expense
309
291
209
208
211
219
Other income, net
Net sales
2007
(131)
(197)
(16)
(83)
(305)
(15)
(29)
323
135
98
400
Income tax provision
(12)
(27)
99
16
5
115
(3)
(2)
224
119
93
285
(34)
0
(573)
(91)
0
0
(352)
(4)
0
0
0
0
($389)
($06)
($349)
$28
$93
Basic
‐2.02
0.09
($1.73)
$0.14
$0.52
$1.56
Diluted
(2.02)
0.09
(1.72)
$0.14
$0.52
$1.56
Cumulative effect of accounting change
Net income
2010
2011
2012
2013
2014
2015
2016
2017
882
(109)
Discontinued operations
2009
$6,906 7,044 7,185 7,472 7,771 8,082 8,405 8,742 9,091 9,455 9,833
Earnings Before Income Tax Provision
Income from continuing operations
2008
$285 141 144 224 311 323 336 350 364 378 393
Net income per share basic and diluted:
162 | P a g e MWV
Income Statements
Common Size Financial Statements
2002
Sales Growth
Net sales
100%
Common Size Financials Forecasting
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
4%
‐20%
2%
6%
6%
2%
2%
4%
4%
4%
4%
4%
4%
4%
2017
4%
100%
100%
100%
100%
100%
100.0%
100.0%
100.0%
100.0%
100.0%
100.0%
100.0%
100.0%
100.0%
100.0%
Cost of sales
86%
87%
81%
82%
83%
83%
82.7%
82.7%
82.4%
82.2%
81.8%
81.7%
81.5%
81.5%
81.3%
81.3%
Gross Profit
14%
13%
19%
18%
17%
17%
17.3%
17.3%
17.6%
17.8%
18.2%
18.3%
18.5%
18.5%
18.7%
18.7%
Selling, general and administrative expenses
13%
4.75%
4.75%
5.00%
5.20%
5.60%
5.70%
5.80%
5.80%
6.00%
6.00%
2%
2%
3%
4%
4%
4%
4%
4%
4%
4%
12%
11%
13%
12%
14%
Operating Profit
3%
2%
6%
5%
3%
5%
Interest expense
4%
4%
3%
3%
3%
3%
Other income, net
‐2%
‐2%
‐3%
0%
‐1%
‐4%
Earnings Before Income Tax Provision
0%
0%
5%
2%
2%
6%
Income tax provision
0%
0%
2%
0%
0%
2%
Income from continuing operations
0%
0%
4%
2%
1%
4%
Discontinued operations
0%
0%
‐9%
‐1%
0%
0%
Cumulative effect of accounting change
‐5%
0%
0%
0%
0%
0%
Net income
‐5%
0%
‐6%
0%
1%
4%
Basic
‐2.02
0.09
($1.73)
$0.14
$0.52
$1.56
Diluted
(2.02)
0.09
(1.72)
$0.14
$0.52
$1.56
Net income per share basic and diluted:
163 | P a g e Restated Income Statement Forecasting
Previously in the analysis we concluded that goodwill had to be restated and
should be shown in the statements to reflect the change. The change in goodwill raised
expenses on the income statement after gross profit, thus reducing our operating profit
and net income substantially. These changes are not forecasted out as they are a part
of selling, general and administration expenses and cannot be reasonably predicted.
The forecasting percentage used in the stated statements is used with the new figures
to forecast out net income. The chart on the following page illustrates the restated
income statement forecasts.
164 | P a g e MWV
Restated Income Statement
Restated Financial Statements
Restated Forecasted Financial Statements
2002
2003
2004
2005
2006
$7,242
$7,553
$6,060
$6,170
$6,530
Cost of sales
6,201
6,557
4,925
5,087
5,399
5,710 $5,825.49
Gross Profit
1,041
996
1,135
1,083
1,131
1,196
856
1,016
906
861
1,040
967
Net sales
Selling, general and administrative expenses
2007
2009
2010
2011
2012
2013
2014
2015
2016
2017
$6,906 7,044.12 7,185.00 7,472.40 7,771.30 8,082.15 8,405.44 8,741.65 9,091.32 9,454.97 9,833.17
Operating Profit
185
(20)
229
222
91
Interest expense
309
291
209
208
211
219
Other income, net
(305)
1,219
$5,942.00
$6,157.26
$6,388.01
$6,611.20
$6,867.24
$7,124.45
$7,409.43
$7,686.89
$7,994.37
1,243
1,315
1,383
1,471
1,538
1,617
1,682
1,768
1,839
229 292.18 298.02 328.79 357.48 404.11 428.68 454.57 472.75 510.57 530.99
(109)
(131)
(197)
(16)
(83)
Earnings Before Income Tax Provision
(15)
(29)
323
135
98
400
Income tax provision
(12)
(27)
99
16
5
115
285
Income from continuing operations
2008
(3)
(2)
224
119
93
(34)
0
(573)
(91)
0
0
Cumulative effect of accounting change
(352)
(4)
0
0
0
0
Net income
‐389
‐157.2
‐242.6
‐77.2
‐41.5
199.6 140.88 143.70 171.87 194.28 234.38 252.16 279.73 290.92 321.47 334.33
Discontinued operations
Net income per share basic and diluted:
Basic
‐2.02
0.09
($1.73)
$0.14
$0.52
$1.56
Diluted
(2.02)
0.09
(1.72)
$0.14
$0.52
$1.56
165 | P a g e MWV
Restated Income Statement
Common Size Financial Statements
2002
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
4%
‐20%
2%
6%
6%
2%
2%
4%
4%
4%
4%
4%
4%
4%
4%
100.0%
100.0%
100.0%
100.0%
100.0%
100.0%
100.0%
100.0%
100.0%
100.0%
100.0%
100.0%
100.0%
100.0%
100.0%
100.0%
Sales Growth
Net sales
Common Size Financials Forecasting
2003
2017
Cost of sales
85.6%
86.8%
81.3%
82.4%
82.7%
82.7%
82.7%
82.7%
82.4%
82.2%
81.8%
81.7%
81.5%
81.5%
81.3%
81.3%
Gross Profit
14.4%
13.2%
18.7%
17.6%
17.3%
17.3%
17.3%
17.3%
17.6%
17.8%
18.2%
18.3%
18.5%
18.5%
18.7%
18.7%
Selling, general and administrative expenses
14.0%
4.1%
4.1%
4.40%
4.60%
5.00%
5.10%
5.20%
5.20%
5.40%
5.40%
2.0%
2.0%
2.3%
2.5%
2.9%
3.0%
3.2%
3.2%
3.4%
3.4%
11.8%
13.5%
15.0%
14.0%
15.9%
Operating Profit
2.6%
‐0.3%
3.8%
3.6%
1.4%
3.3%
Interest expense
4.3%
3.9%
3.4%
3.4%
3.2%
3.2%
‐4.4%
Other income, net
‐1.5%
‐1.7%
‐3.3%
‐0.3%
‐1.3%
Earnings Before Income Tax Provision
‐0.2%
‐0.4%
5.3%
2.2%
1.5%
5.8%
Income tax provision
‐0.2%
‐0.4%
1.6%
0.3%
0.1%
1.7%
Income from continuing operations
0.0%
0.0%
3.7%
1.9%
1.4%
4.1%
Discontinued operations
‐0.5%
0.0%
‐9.5%
‐1.5%
0.0%
0.0%
Cumulative effect of accounting change
‐4.9%
‐0.1%
0.0%
0.0%
0.0%
0.0%
Net income
‐5.4%
‐2.1%
‐4.0%
‐1.3%
‐0.6%
2.9%
Net income per share basic and diluted:
Basic
‐2.02
0.09
($1.73)
$0.14
$0.52
$1.56
Diluted
(2.02)
0.09
(1.72)
$0.14
$0.52
$1.56
166 | P a g e Balance Sheet Forecasting
The balance sheet breaks down the relationship between equity, liabilities, and
how they support the company’s assets. It is important in forecasting the balance sheet
to tie the balance sheet to the income statement, most significantly to sales. In order to
tie the statements together we use asset turnover (previous year’s total assets/sales).
We determined the appropriate trend rate from the company’s past performance. In
determining all the averages of ratios used for forecasting on the balance sheet we
used only the financial information from after 2004 for computing averages due to the
companies spin off of a business segment. We obtained an average asset turnover ratio
of .67 for the past 3 years and felt this ratio was inconsistent with the performance of
MWV since the restructuring and instead used .83 to show the expected continued
efficiency improvement of the company in order to forecast total assets. After obtaining
total assets, it allows us to compute noncurrent assets which averaged out to be 78%
of total assets. Now, to compute current assets you subtracted noncurrent assets from
total assets and the remainder is current assets. Next, we break down current assets
down further into accounts receivable and inventories. To find accounts receivable you
must use the accounts receivable turnover (sales/accounts receivable), MWV’s average
for the past three years is 6.67 times and seems to be consistent and we see no reason
to expect a change in this ratio. Inventory is forecasted by using the inventory turnover
ratio by taking COGS and dividing by inventory. MWV has also been consistent on this
ratio for the last three years with an average of 7.3 times, which was used to forecast
out inventories.
Now we are able to continue on to forecasting liabilities and equity as many of
these accounts forecasting are products of each other. The first step was to determine
current liabilities; this is achieved by using the current ratio (current assets/ current
liabilities) and tying the asset side of the balance sheet to liabilities. We obtained a
average ratio of 1.6 and used this to forecast out current liabilities. There are not any
more liability accounts that can be determined without first knowing equity so we now
compute retained earnings. The formula for retained earnings is as follows; end of
167 | P a g e previous years retained earnings+current net income-current dividends. We followed
this formula to forecast out retained earnings, using the previous year’s answer to
compute the next. Acquiring retained earnings allows us to determine total
shareholder’s equity by taking the change in retained earnings and adding it to the
previous year’s shareholders equity, again using the previous year’s numbers to
compute the next. Since we have total equity and total assets we can now determine
total liabilities by using the balance sheet equation Total Assets=Total Liabilities+Total
Equity or rearranged Total Liabilities=Total Assets-Total Equity. The final step in
forecasting the balance sheet is to find noncurrent liabilities by subtracting current
liabilities from total liabilities. In order to demonstrate the links between the balance
sheet and the income statement please not that the retained earnings equation,
accounts receivable turnover ratio, inventory turnover, and asset turnover ratio all use
income statement numbers to be computed. This again shows the importance of
correctly forecasting the income statement.
168 | P a g e MWV
Balance Sheet
Assets
Cash and cash equivalents
Accounts receivable, net
Inventories
Other current assets
Current Assets of Dicontinued Operations
Total Current assets
Property, plant, equipment and forestlands, net
Prepaid pension asset
Goodwill
Other assets
Non Current Assets of Discontinued Operations
Total Non Current Assets
Total Assets
LIABILITIES AND SHAREHOLDERS EQUITY
Accounts payable
Accrued expenses
Notes payable and current maturities of long-term debt
Current Liabilities of Discontinued Operations
Total Current liabilities
Long-term debt
Other long-term obligations
Deferred income taxes
Non Current Liabilities of Discontinued Operations
Total Noncurrent Liabilities
Total Liabilities
Shareholders equity:
Common stock, $0.01 par
Shares authorized: 600,000,000
Shares issued and outstanding: 2007 173,839,186
(2006 182,107,136)
Additional paid-in capital
Retained earnings
Accumulated other income (loss)
Shareholders equity:
Total Liabilities and sharehlders equity
Actual Financial Statements
2,004
2,005
2,002
2,003
372
894
1,002
163
2,431
7,834
970
743
943
10,490
12,921
225
943
1,098
160
2,426
7,378
1,015
770
898
10,061
12,487
270
845
735
140
537
2,527
4,688
1,040
557
834
2,000
9,119
11,646
1,257
363
1,620
4,233
532
1,705
6,470
8,090
1,232
269
1,501
3,969
571
1,678
6,218
7,719
432
722
234
257
1,645
3,282
778
1,470
154
5,684
7,329
2,006
2,007
297
922
714
97
2,030
4,487
994
559
838
6,878
8,908
156
1,011
715
133
2,015
4,523
920
851
976
7,270
9,285
245
1,009
790
123
2,167
4,211
1,213
840
1,406
7,670
9,837
416
613
13
1,042
2,417
814
1,152
4,383
5,425
552
702
211
1,465
2,372
738
1,177
4,287
5,752
640
747
68
1,455
2,375
1,071
1,228
4,674
6,129
2
2
2
2
2
2
3,908
1,104
(183)
4,831
12,921
3,928
914
(76)
4,768
12,487
3,952
394
(31)
4,317
11,646
3,294
243
(56)
3,483
8,908
3,370
168
(7)
3,533
9,285
3,080
276
350
3,708
9,837
Forecasted Financial Statements
2,011
2,012
2,013
2,014
2,008
2,009
2,010
2,015
2,016
2,017
1,057
798
1,078
814
1,121
843
1,166
875
1,213
905
1,261
941
1,312
976
1,364
1,015
1,419
1,053
1,475
1,095
2,382
2,477
2,576
2,679
2,786
2,898
3,014
3,134
3,260
3,380
8,360
10,742
8,695
11,172
9,042
11,618
9,404
12,083
9,780
12,567
10,171
13,069
10,578
13,592
11,001
14,136
11,441
14,701
11,962
15,342
1,489
1,548
1,610
1,675
1,741
1,811
1,884
1,959
2,037
2,113
5,574
7,063
5,971
7,519
6,302
7,912
6,561
8,236
6,824
8,566
7,099
8,911
7,379
9,262
7,662
9,621
7,949
9,986
8,300
10,413
247
221
275
416
569
727
898
1,083
1,283
1,497
3,679
10,742
3,653
11,172
3,707
11,618
3,848
12,083
4,001
12,567
4,159
13,069
4,330
13,592
4,515
14,136
4,715
14,701
4,929
15,342
169 | P a g e MWV
Common Sized Balance Sheet
Common Size Financial Statements
2002
2003
2004
2005
Common Size Financials Forecasting
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
7%
7%
7%
7%
7%
7%
7%
7%
7%
7%
22%
22%
22%
22%
22%
22%
22%
22%
22%
22%
ASSETS
Cash and cash equivalents
3%
2%
2%
3%
2%
2%
Accounts receivable, net
7%
8%
7%
10%
11%
10%
Inventories
8%
9%
6%
8%
8%
8%
Other current assets
1%
1%
1%
1%
1%
1%
Current Assets of Dicontinued Operations
0%
0%
5%
0%
0%
0%
Current assets
19%
19%
22%
23%
22%
22%
Property, plant, equipment and forestlands, net
61%
59%
40%
50%
49%
43%
Prepaid pension asset
8%
8%
9%
11%
10%
12%
Goodwill
6%
6%
5%
6%
9%
9%
Other assets
7%
7%
7%
9%
11%
14%
Non Current Assets of Discontinued Operations
Total Non Current Assets
Total Assets
0%
0%
17%
0%
0%
0%
81%
81%
78%
77%
78%
78%
78%
78%
78%
78%
78%
78%
78%
78%
78%
78%
100%
100%
100%
100%
100%
100%
100%
100%
100%
100%
100%
100%
100%
100%
100%
100%
170 | P a g e Restated Balance Sheet Forecasting
A red flag was raised in analyzing MWV’s financials and caused us to restate
goodwill which in turn caused some changes in the balance sheet forecasting. Restating
goodwill caused an increase in expenses that is shown in net income. The most direct
effect on the balance sheet is on retained earnings because of the computation
including NI. A decrease in retained earnings also decreases shareholders equity.
Forecasting of assets is not affected due to the effect of a decrease in goodwill not
effecting sales or cogs which are then used to forecast asset accounts.
171 | P a g e MWV
Restated Balance Sheet
Restated Financial Statements
Restated Forecasted Financial Statements
2002
2003
2004
2005
2006
2007 2,008 2,009 2,010 2,011 2,012 2,013 2,014 2,015 2,016 2,017
$372
$225
$270
$297
$156
$245
894
943
845
922
1,011
1,009 1,057 1,078 1,121 1,166 1,213 1,261 1,312 1,364 1,419 1,475
1,002
1,098
735
714
715
790 798 814 843 875 905 941 976 1,015 1,053 1,095
163
160
140
97
133
123
Assets
Cash and cash equivalents
Accounts receivable, net
Inventories
Other current assets
Current Assets of Dicontinued Ope
0
0
537
0
0
Total Current assets
2,431
2,426
2,527
2,030
2,015
2,167 2,448 2,546 2,648 2,754 2,864 2,978 3,098 3,221 3,350 3,542
0
Property, plant, equipment and for
7,834
7,378
4,688
4,487
4,523
4,211
Prepaid pension asset
970
1,015
1,040
994
920
1,213
Goodwill
743
605
526
421
578
482
Other assets
943
898
834
838
976
1,406
Non Current Assets of Discontinued
0
0
2,000
0
0
10,490
9,896
9,088
6,740
6,997
7,312 8,294 8,626 8,971 9,330 9,703 10,091 10,494 10,914 11,351 11,765
$12,921
$12,322
$11,615
$8,770
$9,012
$9,479 10,742 11,172 11,618 12,083 12,567 13,069 13,592 14,136 14,701 15,307
Accounts payable
$1,257
$1,232
$432
$416
$552
$640
Accrued expenses
363
269
722
613
702
747
Notes payable and current maturit
0
0
234
13
211
68
Current Liabilities of Discontinued 0
0
257
0
0
Total Current liabilities
1,620
1,501
1,645
1,042
1,465
1,455 1,530 1,591 1,655 1,721 1,790 1,861 1,936 2,013 2,094 2,214
Long‐term debt
4,233
3,969
3,282
2,417
2,372
2,375
532
571
778
814
738
1,071
1,705
1,678
1,470
1,152
1,177
1,228
Total Non Current Assets
Total Assets
0
LIABILITIES AND SHAREHOLDERS EQ
Other long‐term obligations
Deferred income taxes
Non Current Liabilities of Discontin
0
0
0
154
0
0
Total Noncurrent Liabilities
6,470
6,218
5,684
4,383
4,287
4,674 5,533 5,928 6,309 6,683 7,034 7,391 7,738 8,092 8,434 8,764
0
Total Liabilities
8,090
7,719
7,329
5,425
5,752
6,129 7,063 7,519 7,964 8,404 8,823 9,252 9,674 10,105 10,528 10,978
2
2
2
2
2
2
Additional paid‐in capital
3,908
3,928
3,952
3,080
Shareholders equity:
Common stock, $0.01 par
Shares authorized: 600,000,000
Shares issued and outstanding: 200
(2006 182,107,136)
3,294
3,370
Retained earnings
1,104
914
394
243
168
Accumulated other income (loss)
(183)
(76)
(31)
(56)
(7)
Shareholders equity:
4,831
4,768
4,317
3,483
3,533
3,708 3,679 3,653 3,654 3,679 3,743 3,817 3,918 4,030 4,173 4,329
$12,921
$12,487
$11,646
$8,908
$9,285
$9,837 10,742 11,172 11,618 12,083 12,567 13,069 13,592 14,136 14,701 15,307
Total Liabilities and sharehlders eq
276 247 221 222 247 311 385 486 598 741 897
350
172 | P a g e MWV
Restated Balance Sheet
Common Size Financial Statements
2002
2003
2004
2005
Common Size Financials Forecasting
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
ASSETS
Cash and cash equivalents
3%
2%
2%
3%
2%
3%
Accounts receivable, net
7%
8%
7%
11%
11%
11%
10%
10%
10%
10%
10%
10%
10%
10%
10%
10%
Inventories
8%
9%
6%
8%
8%
8%
7%
7%
7%
7%
7%
7%
7%
7%
7%
7%
Other current assets
1%
1%
1%
1%
1%
1%
23%
23%
23%
23%
23%
23%
23%
23%
23%
23%
Current Assets of Dicontinued Ope
0%
0%
5%
0%
0%
0%
Current assets
19%
20%
22%
23%
22%
23%
Property, plant, equipment and for
61%
60%
40%
51%
50%
44%
Prepaid pension asset
8%
8%
9%
11%
10%
13%
Goodwill
6%
5%
5%
5%
6%
5%
Other assets
7%
7%
7%
10%
11%
15%
Non Current Assets of Discontinued
0%
0%
17%
0%
0%
0%
Total Non Current Assets
81%
80%
78%
77%
78%
77%
77%
77%
77%
77%
77%
77%
77%
77%
77%
77%
Total Assets
100%
100%
100%
100%
100%
100%
100%
100%
100%
100%
100%
100%
100%
100%
100%
100%
173 | P a g e Statement of Cash Flows
Of the forecasted financial statements, the statement of cash flows is the most
difficult to predict with any amount of certainty, and is often the most inaccurate
estimate as a result. Much like the income statement and balance sheet forecasting
process, we first began by looking for relatively stable relationships between different
cash flows through time. With regard to exactly which cash flows relate to each other
and in what way, every firm, and certainly every industry, is unique.
The structure of the statement of cash flows divides cash flows into one of three
categories, either cash flow from operations, cash flow from investing, or cash flow
from financing. Beginning with cash flow from operations, net income is the first
forecastable item. According to MWV’s restated income statement, we assume a net
earnings growth rate of 2% is indicative of MWV’s historical growth, and can be used as
an indication of future performance. Due to the economic uncertainty in the global
market today, and considering MeadWestVaco operates in a global marketplace, net
income is forecasted to grow more slowly in the near future and pick up to around
2.5% by the year 2011. In other words, we used a historical growth rate in earnings as
a benchmark before also factoring in current unfavorable market conditions.
Net cash from operating activities for MWV was forecasted based on the
relationship between CFFO and sales. Although CFFO/NI and CFFO/OI were calculated
in addition to CFFO/Sales, CFFO/Sales proved to be the most stable relationship over a
five year time horizon. Historically, cash flows from operations have been very close to
8% of sales. We assume this relationship between CFFO and Sales will continue for
MeadWestVaco, and, as a result, our forecasted CFFO is a function of our forecasted
sales from the income statement.
Cash flows from investing activities proved a much tougher challenge to forecast
accurately. After taking every individual investing cash flow as a percentage of net cash
provided by investing activities (CFFI), we found no reliable or relatively stable
relationship on which to base our forecast. In addition, since CFFI from year to year has
174 | P a g e been very volatile and unpredictable over the past five years, we could not simply
assume a smooth or steady growth rate going into the future. As a result, although the
correlation is less than desirable, we assumed a growth rate slightly smaller than the
8% used for CFFO would be relatively indicative of the expected growth in investing
cash flows.
The final forecastable item on the statement of cash flows is the expected
dividend payment. MeadWestVaco has had a very predictable dividend payment over
the past ten years with a 5% increase about every five years. Since we have no reason
to believe this trend will change, we assumed a five percent increase in dividend
payments every five years.
In summary, although the statement of cash flows is the most difficult to
forecast into the future with any degree of accuracy, stable relationships such as
CFFO/Sales can be reasonably indicative of future performance. Strong assumptions
must be made regarding the growth of cash flows, and it is important to keep in mind
that the accuracy of forecasts in never certain.
175 | P a g e MWV
Statement of Cashflows
Actual Financial Statements
Forecasted Financial Statements
2002
2003
2004
2005
2006
‐389
$28
$93
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
In millions
Cash flows from operating activities
Net income
Discontinued operations
Depreciation, depletion and amortization
$18
($349)
34
62
573
91
0
0
674
479
489
491
517
$285 140.88 143.70 224.17 310.85 323.29 336.22 349.67 363.65 378.20 393.33
520
Deferred income taxes
‐29
(8)
58
(17)
(56)
(13)
Gains on sales of assets
‐101
(83)
(165)
(56)
(60)
(274)
0
0
0
0
(21)
Gain on sale of debt security
Loss on early retirement of long‐term debt
Pension income before settlements, curtailments
0
0
26
1
90
0
0
‐124
(83)
(86)
(67)
(50)
(54)
and termination benefits
Impairment of long‐lived assets
Cumulative effect of accounting change
Appreciation of cash surrender value policies
Changes in working capital, excluding
49
15
35
10
352
0
0
0
0
0
0
4
0
0
(32)
43
(33)
46
143
16
(62)
78
(271)
129
14
11
(1)
6
4
21
496
379
633
305
567
641
the effects of acquisitions and dispositions
Other, net
Net cash provided by operating activities
of continuing operations
Discontinued operations
Net cash provided by operating activities
‐2
91
289
(78)
0
0
494
470
922
227
567
641
‐377
(309)
(317)
(305)
(302)
(347)
563.5296
574.8002
597.7922
621.7039
646.5720
672.4349
699.3323
727.3056
756.3978
786.6538
Cash flows from investing activities
Additions to property, plant and equipment
Additions to equipment leased to customers
‐33
0
0
0
0
0
Payments for acquired businesses, net of cash acquired
111
(56)
(101)
(5)
(714)
(52)
0
0
0
2,186
0
Proceeds from sale of business
0
Proceeds from sale of debt security
0
0
0
0
109
0
Proceeds from dispositions of assets
0
224
281
109
165
191
(40)
Purchase of short‐term investments
0
(701)
0
0
0
Contribution to joint venture
0
0
0
0
0
(13)
Sale of short‐term investments
0
30
706
5
0
0
Other
‐25
(12)
(8)
(7)
(19)
(15)
Discontinued operations
530
68
(67)
2
0
0
Net cash provided by (used in) investing activities
206
(95)
(207)
1,985
(761)
(236)
1362
331
2
1
7
12
‐259.6
‐285.56
‐314.116
‐345.5276
‐170
‐170
‐170
‐170
‐380.08036 ‐418.088396 ‐459.897236 ‐505.886959 ‐556.475655 ‐612.123221
Cash flows from financing activities
Proceeds from issuance of long‐term debt
Proceeds from secured borrowing (non‐recourse
0
0
0
0
0
338
‐1080
‐709
‐525
‐1133
(2)
(50)
0
0
‐711
(47)
(486)
Dividends paid
‐206
‐184
‐186
‐178
(167)
(169)
Notes payable and other short‐term borrowings,net
‐537
0
‐20
‐19
148
(128)
0
‐7
22
‐14
43
(21)
36
53
162
to MeadWestvaco)
Repayment of long‐term debt
Stock repurchased and put option
Changes in book overdrfts
37
19
Other Financing Activities
0
0
0
0
0
Discontinued operations
Proceeds from issuance of common stock and excercises of stock optio
0
3
‐39
‐163
0
0
Net cash used in financing activity
0
‐547
‐672
‐2181
35
(339)
Effect of exchange rate changes on cash
‐6
15
74
12
‐170
‐178.5
‐178.5
‐178.5
3
‐4
18
Increase (decrease) in cash and cash equivalents
270
27
55
27
(141)
89
beginning of period
102
372
215
270
297
156
23
end of period
372
215
270
297
156
245
176 | P a g e ‐178.5
‐178.5
Common Size Financial Statements
MWV
Common Size Statement of Cashflows
2002
2003
2004
4%
‐38%
Common Size Financials Forecasting
2005
2006
2007
12%
16%
44%
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
100%
100%
100%
100%
100%
100%
100%
100%
100%
100%
100%
100%
100%
100%
100%
100%
100%
100%
100%
100%
100%
100%
100%
100%
100%
100%
100%
100%
100%
100%
Cash flows from operating activities
Net income
Discontinued operations
‐79%
7%
13%
62%
40%
0%
0%
136%
102%
53%
216%
91%
81%
Deferred income taxes
‐6%
‐2%
6%
‐7%
‐10%
‐2%
Gains on sales of assets
‐43%
Depreciation, depletion and amortization
‐20%
‐18%
‐18%
‐25%
‐11%
Gain on sale of debt security
0%
0%
0%
0%
‐4%
Loss on early retirement of long‐term debt
0%
6%
0%
40%
0%
0%
‐25%
‐18%
‐9%
‐30%
‐9%
‐8%
Pension income before settlements, curtailments
Impairment of long‐lived assets
10%
3%
4%
4%
Cumulative effect of accounting change
71%
0%
0%
0%
0%
0%
0%
1%
0%
0%
‐6%
‐5%
Appreciation of cash surrender value policies
Changes in working capital, excluding
8%
0%
7%
3%
‐13%
8%
‐119%
23%
22%
100%
81%
69%
134%
100%
100%
0%
19%
31%
‐34%
0%
0%
100%
100%
100%
100%
100%
100%
Additions to property, plant and equipment
‐183%
325%
153%
‐15%
40%
147%
Additions to equipment leased to customers
‐16%
0%
0%
0%
0%
0%
Payments for acquired businesses, net
54%
59%
49%
0%
94%
22%
of cash acquired
0%
0%
0%
0%
Proceeds from sale of business
0%
0%
0%
110%
0%
0%
Proceeds from sale of debt security
0%
0%
0%
0%
‐14%
0%
5%
‐22%
‐81%
Net cash provided by operating activities
Discontinued operations
Net cash provided by operating activities
Cash flows from investing activities
Proceeds from dispositions of assets
0%
0%
0%
‐236%
‐136%
Purchase of short‐term investments
0%
42%
339%
0%
0%
0%
Contribution to joint venture
0%
0%
0%
0%
0%
6%
Sale of short‐term investments
0%
‐32%
‐341%
0%
0%
0%
Other
‐12%
13%
4%
0%
2%
6%
Discontinued operations
257%
‐72%
32%
0%
0%
0%
Net cash provided by (used in) investing
100%
100%
100%
100%
100%
100%
Cash flows from financing activities
0%
‐61%
0%
0%
20%
‐4%
Proceeds from secured borrowing (non‐recourse
0%
0%
0%
0%
0%
‐100%
to MeadWestvaco)
Proceeds from issuance of long‐term debt
0%
0%
0%
0%
0%
Repayment of long‐term debt
0%
130%
78%
52%
‐6%
15%
Stock repurchased and put option
0%
0%
0%
33%
‐134%
143%
0%
Dividends paid
0%
34%
28%
8%
‐477%
50%
Notes payable and other short‐term borrowings,
0%
0%
3%
1%
423%
38%
net
0%
0%
0%
0%
0%
Changes in book overdrfts
0%
1%
‐3%
1%
123%
6%
Proceeds from issuance of common stock and excercises of stock optio
0%
‐3%
‐11%
‐2%
151%
‐48%
Other Financing Activities
Discontinued operations
Net cash used in financing activity
0%
0%
0%
0%
0%
0%
‐1%
0%
‐1%
6%
7%
0%
0%
100%
100%
100%
100%
100%
100%
177 | P a g e Restated Financial Statements
MWV
Restated Cashflow Statement
Restated Forecasted Financial Statements
2002
2003
2004
2005
2006
2007
2008
2009
2010
‐389
‐157.2
‐242.6
‐77.2
‐41.5
199.6 140.88 143.70 171.87 194.28 234.38 252.16 279.73 290.92 321.47
2011
2012
2013
2014
2015
2016
34
62
573
91
0
674
479
Cash flows from operating activities
Net income
Discontinued operations
Depreciation, depletion and amortization
489
491
517
Deferred income taxes
‐29
‐8
58
‐17
‐56
‐13
Gains on sales of assets
‐101
‐83
‐165
‐56
‐60
‐274
Gain on sale of debt security
0
0
0
0
‐21
0
Loss on early retirement of long‐term debt
0
26
1
90
0
0
‐124
‐83
‐86
‐67
‐50
‐54
Pension income before settlements, curtailments
334.33
0
520
and termination benefits
Impairment of long‐lived assets
Cumulative effect of accounting change
Appreciation of cash surrender value policies
Changes in working capital, excluding
49
15
35
10
352
0
0
0
0
0
0
4
0
0
‐32
43
‐33
46
143
16
‐62
78
‐271
129
14
11
‐1
6
4
21
496
379
633
305
567
641
‐2
91
289
‐78
0
0
494
294.8
1028.4
121.8
432.5
555.6
‐377
‐309
‐317
‐305
‐302
‐347
the effects of acquisitions and dispositions
Other, net
Net cash provided by operating activities
Discontinued operations
Net cash provided by operating activities
563.5296
574.8002
597.7922
‐259.6
‐285.56
‐314.116
‐170
‐170
‐170
621.7039
646.5720
672.4349
699.3323
727.3056
756.3978
786.65
‐345.5276 ‐380.08036 ‐418.088396 ‐459.897236 ‐505.886959 ‐556.475655
612.123
Cash flows from investing activities
Additions to property, plant and equipment
Additions to equipment leased to customers
‐33
0
0
0
0
0
Payments for acquired businesses, net
111
‐56
‐101
‐5
‐714
‐52
0
of cash acquired
Proceeds from sale of business
0
2186
0
Proceeds from sale of debt security
0
0
0
0
109
0
Proceeds from dispositions of assets
0
224
281
109
165
191
Purchase of short‐term investments
0
‐40
‐701
0
0
0
Contribution to joint venture
0
0
0
30
706
5
0
0
‐25
‐12
‐8
‐7
‐19
‐15
Discontinued operations
530
68
‐67
2
0
0
206
‐95
‐207
1985
‐761
‐236
1362
331
2
1
7
12
338
Net cash provided by (used in) investing
0
0
0
Other
Sale of short‐term investments
0
0
‐13
Cash flows from financing activities
Proceeds from issuance of long‐term debt
Proceeds from secured borrowing (non‐recourse
0
0
0
0
0
‐1080
‐709
‐525
‐1133
‐2
‐50
0
0
‐711
‐47
‐486
Dividends paid
‐206
‐184
‐186
‐178
‐167
‐169
Notes payable and other short‐term borrowings,
‐537
0
‐20
‐19
148
‐128
0
‐7
22
‐14
43
‐21
36
53
162
to MeadWestvaco)
Repayment of long‐term debt
Stock repurchased and put option
Changes in book overdrfts
37
19
Other Financing Activities
0
0
0
0
0
Discontinued operations
Proceeds from issuance of common stock and excercises of stock options
0
3
‐39
‐163
0
0
Net cash used in financing activity
0
‐547
‐672
‐2181
35
‐339
23
Effect of exchange rate changes on cash
74
‐170
‐170
‐178.5
‐178.5
‐178.5
3
‐6
15
12
‐4
18
Increase (decrease) in cash and cash equivalents
270
27
55
27
‐141
89
beginning of period
102
372
215
270
297
156
end of period
372
215
270
297
156
245
178 | P a g e ‐178.5
178.5
Common Size Financial Statements
MWV
Restated Common Sized Cashflow Statement
2002
2003
2004
2005
Common Size Financials Forecasting
2006
2007
‐10%
36%
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
100%
100%
100%
100%
100%
100%
100%
100%
100%
100%
100%
100%
100%
100%
100%
100%
100%
100%
100%
100%
100%
100%
100%
100%
100%
100%
100%
100%
100%
100%
Cash flows from operating activities
Net income
‐53%
‐24%
7%
21%
56%
75%
0%
0%
136%
162%
48%
403%
120%
94%
Deferred income taxes
‐6%
‐3%
6%
‐14%
‐13%
‐2%
Gains on sales of assets
‐20%
‐28%
‐16%
Discontinued operations
Depreciation, depletion and amortization
‐79%
‐63%
‐46%
‐14%
‐49%
Gain on sale of debt security
0%
0%
0%
0%
‐5%
0%
Loss on early retirement of long‐term debt
0%
9%
0%
74%
0%
0%
‐25%
‐28%
‐8%
‐55%
‐12%
‐10%
0%
0%
0%
0%
0%
0%
Impairment of long‐lived assets
10%
10%
Cumulative effect of accounting change
Pension income before settlements, curtailments
and termination benefits
5%
3%
8%
71%
0%
0%
0%
0%
0%
Appreciation of cash surrender value policies
0%
1%
0%
0%
‐7%
‐6%
Changes in working capital, excluding
3%
‐21%
8%
‐222%
30%
26%
the effects of acquisitions and dispositions
0%
0%
0%
0%
0%
Other, net
Net cash provided by operating activities
of continuing operations
Discontinued operations
8%
0%
3%
4%
0%
5%
1%
4%
100%
129%
62%
250%
131%
115%
0%
0%
0%
0%
0%
0%
0%
31%
28%
‐64%
0%
0%
100%
100%
100%
100%
100%
100%
Additions to property, plant and equipment
‐183%
325%
153%
‐15%
40%
147%
Additions to equipment leased to customers
‐16%
0%
0%
0%
0%
0%
Payments for acquired businesses, net
54%
59%
49%
0%
94%
22%
of cash acquired
0%
0%
0%
0%
Proceeds from sale of business
0%
0%
0%
110%
0%
0%
Proceeds from sale of debt security
0%
0%
0%
0%
‐14%
0%
Proceeds from dispositions of assets
0%
‐236%
‐136%
5%
‐22%
‐81%
Purchase of short‐term investments
0%
42%
339%
0%
0%
Contribution to joint venture
0%
0%
0%
0%
0%
6%
Sale of short‐term investments
0%
‐32%
‐341%
0%
0%
0%
Net cash provided by operating activities
Cash flows from investing activities
13%
4%
0%
0%
2%
0%
0%
Other
‐12%
Discontinued operations
257%
‐72%
32%
0%
0%
0%
Net cash provided by (used in) investing
100%
100%
100%
100%
100%
100%
6%
Proceeds from issuance of long‐term debt
0%
‐61%
0%
0%
20%
‐4%
0%
‐100%
Cash flows from financing activities
Proceeds from secured borrowing (non‐recourse
0%
to MeadWestvaco)
0%
0%
0%
0%
0%
Repayment of long‐term debt
0%
130%
0%
78%
0%
52%
0%
‐6%
15%
Stock repurchased and put option
0%
0%
0%
33%
‐134%
143%
Dividends paid
0%
34%
28%
0%
8%
‐477%
50%
Notes payable and other short‐term borrowings,
0%
0%
3%
1%
423%
38%
net
0%
0%
0%
0%
0%
0%
Changes in book overdrfts
0%
1%
‐3%
1%
123%
6%
Proceeds from issuance of common stock and excercises of stock options
0%
‐3%
‐11%
‐2%
151%
‐48%
Other Financing Activities
0%
0%
0%
0%
0%
‐1%
Discontinued operations
Net cash used in financing activity
0%
‐1%
6%
7%
0%
0%
100%
100%
100%
100%
100%
100%
179 | P a g e Valuation Analysis
Method of Comparables
The method of comparables is a set of ratios used by some analysts for evaluation
purposes. The use of these ratios is flawed in that there is no theory to support their use. The
ratios compare a company’s ratios to that of their industry in an attempt to see if the company
is over or undervalued compared to the industry that they are in. We will compare
MeadWestvaco’s share price as of the valuation date, $14.71 on November 1, 2008, to the
industry in order to determine the values of the company’s securities. We will base our price
valuation results on a 15% margin of error. Therefore, our margin of error price will lie
between $12.50 and $16.92. However, it is important to keep in mind that these ratios explain
little and should only be used as a quick evaluation or a screening tool.
Trailing P/E Ratio
P/E Trailing
Price Per Share
EPS
P/E Trailing
Computed Price
MWV
$14.71
1.65
$13.62
MWV Restated
$14.71
1.15
$10.04
IP
$16.18
1.97
8.21
SSCC
$1.26
0.18
6.89
PKG
$15.89
1.43
11.1
Average
8.73
The trailing P/E ratio is a function of a company’s current price per share divided by its
earnings per share. It is used in an attempt to judge how “expensive” a company is when
compared to its earnings. To make this ratio slightly more valid you can compute this ratio with
numbers obtained through forecasting. This ratio is commonly used on investment sites as a
main evaluation ratio and also frequently referenced by TV financial personalities, but as stated
earlier there is little theory to support it unless it is in the form of a self fulfilling prophecy.
180 | P a g e MWV’s competitors have a trailing P/E ratio average of 8.73, from this number we can figure
out MWV’s price per share using the trailing valuation method. By setting price over MWV’s
earnings and setting this equal to the industry average trailing P/E we can solve for the price by
multiplying the industry average by the earnings per share and obtain MWV’s price. Solving for
x gives MWV a price of $13.62 and says that the company’s estimated stock price lies within the
15% safety margin and is therefore fairly valued. The restatement of MeadWestvaco’s
financials causes the earning per share to decline to $1.15 resulting in lower price of $10.04,
falling outside the 15% margin. According to the restated financials the November price is
overvalued.
Forecasted P/E Ratio
Forecasted P/E
PPS
Forecasted EPS
P/E Forecasted
Computed Price
MWV
$14.71
0.81
$6.83
MWV Adjusted
$14.71
0.81
$6.83
IP
$16.18
1.97
11.01
SSCC
$1.26
0.18
6.3
PKG
$15.89
1.43
11.19
Average
9.5
As stated earlier, a more relevant form of the P/E ratio is the forecasted P/E ratio. With
this ratio we take the forecasted earnings for the companies to obtain the average P/E ratio and
compute MWV’s share price similarly to the trailing P/E ratio. This ratio is useful for valuing
securities in the long run. Again, we calculated the industry P/E average excluding
MeadWestvaco. The industry average of the forecasted P/E ratio is 9.5 and by using the same
formula to compute the stock price as computing the trailing P/E, MWV’s price should be $6.83.
By using the forecasted P/E ratio, it shows that MWV is much overvalued at the November price
of $14.71. The $7.88 difference in the November price and the forecasted price initiated a 54%
price margin overvaluation.
181 | P a g e Price to Book Ratio
Price to Book
PPS
BPS
P/B
Computed Price
MWV
$14.21
47.39
$51.11
MWV Adjusted
$14.21
21.33
$23.02
IP
$16.18
20.7
0.78
SSCC
$1.26
6.88
0.18
PKG
$15.89
6.99
2.27
Average
1.079
The price to book ratio is used to compare a company’s stock market value verses its
book ratio. The ratio is calculated by taking each company’s current price per share (PPS) and
dividing it by their book price per share (BPS). The BPS is calculated by dividing the book value
of equity by the number of shares outstanding. Next we determined the industry price/book
average of 1.08, excluding MeadWestvaco, and multiplied the average by MWV’s book value of
equity on a per share basis to determine a price of $51.11. This is an unrealistic share price
that indicates that the current stock price is harshly under priced. One reason for the unlikely
outcome of the price to book ratio is that the book value is affected by company’s accounting
policies. This can be seen when examining MWV’s restated financials. The increased goodwill
write-offs in the restated financials caused the book value of equity to decrease, which in turn
caused an over 50% decrease in the BPS to 21.33. If accounting policies vary between firms
within the same industry, it makes it difficult to compare the price to book ratio across firms.
182 | P a g e Price Earnings Growth
P.E.G
P/E
Growth
PEG
Computed Price
MWV
8.61
4.13%
$11.38
MWV Restated
12.36
4.13%
$7.93
IP
8.21
4.92%
1.67
SSCC
6.89
N/A
N/A
PKG
11.1
N/A
N/A
Average
1.67
The price earnings growth (PEG) comparable is a derivative of the P/E ratio that seeks
to relate the P/E ratio to a company’s growth rate. The PEG ratio is calculated by dividing the
P/E ratio by the expected earnings growth rate. The industry average of 1.67 was calculated by
dividing each firm’s P/E ratio by their expected 5 year earnings growth. This is not an accurate
industry average because Smurfit-Stone and Packaging Corporation of America lacked sufficient
information in order to compute their P.E.G ratio. Given the information available to us, the
industry average is solely based on International Paper’s PEG ratio and leaves ample room for
error when calculating MWV’s stock price. The resulting estimated stock was $11.38 which is
lower than the current market price, indicating that MWV is currently overvalued. The restated
stock price dropped 30% to $7.93 from the initial estimated price.
183 | P a g e Price/EBITDA
P/EBITDA
Market
EBITDA
Capitalization
($ Billions)
P/EBITDA
Industry Avg.
Computed
Price
($ Billions)
MWV
2.470
1.14
2.56
$16.79
MWV -Restated
2.470
1.14
2.56
$16.79
IP
4.98
2.82
1.77
SSCC
0.136
.551
0.247
PKG
1.44
.421
3.42
Outlier
EBITDA is an accounting figure meaning earnings before interest, taxes, depreciation,
and amortization. The market capitalization serves as the price function in this particular ratio
and is found by multiplying the company’s current price per share by the number of shares
outstanding. We found MeadWestvaco’s competitors shares outstanding and analyst’s opinion
of EBITDA on Yahoo Finance. Next, we divided the market capitalization figure by the
corresponding company’s EBITDA in order to calculate the price/EBITDA ratio. An industry
average of 2.56 was derived, excluding Smurfit-Stone because it was labeled an outlier due to
their significantly lower ratio. The final step was to multiply the industry average by MWV’s
price per share and divide this number by the total number of MWV’s shares outstanding. This
final figure will represent an estimated per share price of $16.79. The model indicates that
MWV is fairly valued, because the price falls within the 15% margin of error.
184 | P a g e Enterprise Value/EBITDA
EV/EBITDA
EV
EBITDA
EV/EBITDA
($ Billions)
($ Billions)
MWV
8.35
1.14
IP
15.97
2.82
6.58
SSCC
3.78
.551
7.35
PKG
1.9
.421
5.31
Industry Avg.
Computed
Price
6.41
$36.87
Enterprise value over EBITDA is used to value shares and is often used as an alternate
to the P/E ratio. The main difference between the P/E and EV/EBITDA ratios is that the latter is
unaffected by a company’s capital structure. The advantage of this ratio is that it compares the
value of a business (ignoring debt) to earnings before interest, taxes, depreciation, and
amortization.
The first step in calculating the EV/EBITDA is to determine the enterprise value. The EV
is a composition of the firm’s book value of liabilities plus the market value of equity and
subtracting the firm’s cash and financial investments. Next, we found the EBITDA calculation
for MWV by taking the income before interest and taxes (found in the income statement) and
adding back interest charges, depreciation, and amortization. The enterprise value is then
divided by the firm’s EBITDA. An average was calculated using the competitors EV/EBITDA
ratio. MeadWestvaco’s price per share was determined through the manipulation of the
EV/EBITDA ratio by multiplying the industry average of 6.41 by MWV’s EBITDA in order to
obtain the enterprise value. The EV/EBITDA model estimated MWV’s stock price to be $36.87,
which indicates that the current stock price is harshly undervalued. The absence of debt is
most likely the reason for the large price discrepancy between the model’s estimated stock price
and the current market price.
MeadWestvaco carries a large amount of goodwill on their balance sheet, so in order to
obtain a more accurate estimate of the EV/EBITDA ratio we have computed the ratio excluding
goodwill. The mathematics is equivalent to the previous calculations, except goodwill was
subtracted from each company’s enterprise value. The following table presents the restated
calculations.
185 | P a g e EV/EBITDA – Excluding Goodwill
EV
EBITDA
EV/EBITDA
($ Billions)
($ Billions)
MWV
7.51
1.14
IP
15.67
2.82
5.56
SSCC
3.76
.551
6.82
PKG
1.89
.421
4.49
Industry Avg.
Computed
Price
5.6
$32.21
Calculating the estimated stock price using the EV/EBITDA model, but excluding goodwill from
the enterprise value proved to decrease the price by roughly 15%. The difference in the prices
was not necessarily substantial, but does demonstrate how carrying an asset that does not
drive value within the firm can inflate the estimated price.
Price to Free Cash Flows
Price to Free Cash Flows
Mkt. Cap
FCF
($ Billions)
P/FCF
Industry
Computed
($Billions)
Average
Price
2.22
$17.04
MWV
2.470
.066
IP
4.98
2.24
2.22
SSCC
0.136
-0.004
-323.82
Outlier
PKG
1.44
-.001
-128.99
Outlier
The Price to Free Cash Flows ratio compares a company’s market value to the free cash
flows they are able to generate. In this model, to determine the estimated price you simply
divide the market cap by free cash flows. Free cash flows are determined by
subtracting/adding investment activities to the cash provided from operations. Next, an
industry average is calculated consisting of only International Paper because Smurfit-Stone and
PKG both experienced negative cash flows. The industry average equaled 2.22. The estimated
price of $17.04 indicates that MWV’s current stock price is undervalued, only slightly extending
past the 15% safety margin.
186 | P a g e Dividends/Price
D/P
DPS
PPS
D/P
MWV
.23
$14.71
IP
1
$16.18
.062
SSCC
0
$1.26
0
PKG
1.2
$15.89
.076
Industry
Computed
Average
Price
.069
$3.35
Outlier
The dividend yield model is a comparable method that informs investors about the yield
they can expect when purchasing a stock. This ratio is computed by dividing the annual
dividend paid per share by the current price per share. The industry average, excluding
MeadWestvaco and SSCC, is determined to be .o69. The computed estimate price was $3.35.
This model suggests that MWV’s current stock price is significantly overvalued by $11.36. The
restated financials did not impact this model’s stock price estimation because the goodwill
amount has not impact on the dividends paid per share.
Conclusion
After conducting the comparables analysis we found that the stock price valuation
results varied dramatically. The future P/E ratio, P.E.G, and dividend/price ratios concluded that
MeadWestvaco’s current stock price was overvalued. Conversely, the price/book, EV/EBITDA,
and price to free cash flow ratios computed an estimated stock price higher than the current
market price revealing an undervalued stock price. The P/EBITDA computation established that
MeadWestvaco was a fairly valued company. These results were so diverse that it makes it
difficult to construct an accurate conclusion. As stated before, the comparable method ratios
are not supported by financial theory. Therefore, the results are not an accurate indicator of
the stock value and should not be used as the foundation for determining the value of a
company.
187 | P a g e Intrinsic Valuation Models
Intrinsic valuation models produce share values that are far more credible than
those derived through the methods of comparables method for most industries. Unlike
the method of comparables which derives share value by equating the firm being
valued to industry average values, the intrinsic valuation models use forecasting to
predict the future cash flows of the firm based on their own past performance. For our
analysis we forecasted cash flows for the next ten years from 2008 to 2018 and
assumed a constant perpetuity and growth rate thereafter. Share values, then, are
simply a function of both the present value of these future cash flows and the number
of shares outstanding. The calculated share values we ultimately arrived at using the
intrinsic valuation models are current as of November 03, 2008, and were benchmarked
against MWV’s observed NYSE closing share price for that same day. Based on this
comparison we classified MWV stock as either overvalued or undervalued based on a
15% tolerance. Share prices and sensitivity analyses were calculated as stated using
our original forecast of MWV’s financial statements and recalculated using our restated
MWV financial statements forecast after the impairment of goodwill. Our intrinsic share
price valuation analysis includes the discounted dividends model, discounted free cash
flows model, residual income model, long run residual income model, and the abnormal
earnings growth model.
Discounted Dividends Model
The discounted dividends model comes from the financial assumption that a
financial instrument is the present value of all future expected cash flows. This makes
this model the most ineffective of the intrinsic models for equity valuation for several
reasons. First, this model assumes an infinite amount of cash flows in the form as a
present value perpetuity added to the end of the forecasted cash flows. This is untrue
in that a company may go bankrupt at any point in time or even decide to not pay a
dividend. This is even more relevant in today’s market because of the drastic change in
market conditions can cause profitable companies to suddenly go bankrupt. This
188 | P a g e valuation also does not consider any added value by appreciation in stock price caused
by expected increases in firm value.
To derive this valuation we first forecasted out dividends out from 2008 to 2017.
MWV has had a consistent 5% increase every five years and therefore we continued
this trend out for our forecasting. Next, we computed the PV factor for each forecasted
year by dividing 1 by 1 plus our size adjusted backdoor cost of equity of .0752 raised to
the year forecasted out. After computing the PV factor, we multiplied it by the
correlating year’s dividend to find its worth today. In year 10, a perpetuity must be
derived to value the PV of the endless streams of cash flow. To do this we divided the
year 10 dividend by MWV’s cost of equity the dividend growth rate. We then took this
number and multiplied by the present value factor for year 10 to find its worth today.
Finally, we added together the PV’s of the cash flows for years 1-10 and added it to the
terminal value of the perpetuity to find the implied share price of 15.5. However, this
price must be time adjusted so we multiplied this price by 1 plus the perpetuity growth
rate raised to (10/12) and obtained a price of 14.71.
Discounted Dividends Model
Dividend Growth Rate
Ke
0.1000
0.0900
0.0871
0.0772
0.0765
0.0760
0.0752
0.0632
0.0532
0.0432
0
10.95
12.09
12.48
13.98
14.1
14.19
14.29
16.93
19.99
24.47
0.005
11.2
12.42
12.85
14.48
14.62
14.72
14.88
17.78
21.31
26.68
Price > $16.92 = UNDERVALUED
0.01
11.47
12.8
13.26
15.06
15.21
15.32
15.5
18.79
22.93
29.55
0.015
11.78
13.22
13.73
15.73
15.9
16.02
16.22
20.01
24.97
33.45
0.02
12.13
13.71
14.27
16.52
16.71
16.85
17.08
21.51
27.63
39.02
0.025
12.52
14.27
14.9
17.46
17.68
17.84
18.11
23.4
31.23
47.66
0.03
12.97
14.92
15.63
18.6
18.86
19.05
19.36
25.86
36.39
62.83
Price < $12.50=OVERVALUED
189 | P a g e Due to the uncertainty of market conditions and unforeseen events it is
necessary to compute a sensitivity analysis to determine the variability of prices with
changes to the cost of equity and the dividend growth rate. As seen in the chart above,
our analysis revealed that all combinations of reasonable values for the Ke and dividend
growth rate yielded a fairly or undervalued result. Therefore, we extended our
sensitivity analysis until we found the points at which the company was overvalued.
Free Cash Flow Valuation Model
Similar to the discounted dividend valuation model, the discounted free cash flow
valuation model attempts to derive an intrinsic share price based on the PV of a
forecasted cash flow stream in addition to a subsequent cash flow perpetuity.
Unfortunately, the discounted free cash flow valuation model has the lowest adjusted rsquared value of any of the five intrinsic valuation models due to the inherent volatility
and unpredictability of year to year cash flows. When computing the ending perpetuity
it is illogical to have a set discount rate for such an unpredictable string of cash flows.
Also, the inputs of cash flow forecasts into this model are the most difficult to estimate
and cause this valuation to be less reliable than some of the other intrinsic models. The
cash flows for each year are computed by taking the forecasted cash flows from
operations and adding in the cash flows from investing operations. It is essential to use
the before tax WACC as the discount rate when calculating the present value of these
future cash flows to avoid double taxation on income streams. In our valuation model
we used an after tax WACC of .0632 and a growth rate of 0% to compute forecasted
cash flow through year ten and then discounted years 1 through 9 back to find their
present value. We then calculated a perpetuity using the expected cash flow from year
ten using the WACCbt and then discounted back to year 0. Adding the PV of the
perpetuity to the total PV of the cash flows gave us a market value of assets of $4268
million. The equation to find the market value of equity is Equity = Assets - Liabilities,
so after computing total assets we took our market value of debt and preferred stock
and solved for equity of $1978 million. To find the per share price we took the MV of
190 | P a g e equity and divided by shares outstanding to get a share price of 18.57 or a time
consistent price of 19.61.
Stated Free Cash Flow Evaluation Model
Perpetuity Growth Rate
WACC
0.0950
0.0900
0.0780
0.0772
0.0765
0.0760
0.0678
0.0632
0.0532
0.0432
0
12.27
13.33
16.35
16.57
16.78
16.93
19.61
21.39
26.19
32.99
0.01
14.19
15.48
19.23
19.52
19.78
19.97
23.49
25.89
32.72
43.38
0.02
16.63
18.24
23.11
23.5
23.85
24.11
28.99
32.48
43.19
62.72
0.03
19.81
21.92
28.61
29.17
29.67
30.04
37.39
43.03
62.69
111.37
Price > $16.92 = UNDERVALUED
0.04
24.15
27.07
37.01
37.89
38.68
39.27
51.85
62.68
111.72
464.04
0.05
30.41
34.8
51.4
53.01
54.49
55.61
82.54
112.1
467.21
0
0.06
40.26
47.67
81.77
85.71
89.47
92.35
191.94
470.4
0
0
Price < $12.50 = OVERVALUED
Restated Free Cash Flow Evaluation Model
WACC
0.0950
0.0900
0.0780
0.0772
0.0765
0.0760
0.0678
0.0632
0.0532
0.0432
0
10.12
11.13
14.01
0.01
12.04
13.28
16.9
Perpetuity Growth Rate
0.02
0.03
0.04
14.47
17.65
21.99
16.04
19.71
24.87
20.78
26.28
34.68
14.23
17.18
21.16
14.43
17.44
21.51
14.57
17.62
21.76
17.17
21.04
26.54
18.89
23.39
29.97
23.56
30.1
40.57
30.24
40.62
59.96
Price > $16.92 = UNDERVALUED
26.83
27.33
27.69
34.95
40.53
60.06
108.61
35.55
36.34
36.92
49.4
60.18
109.09
461.28
0.05
28.26
32.59
49.06
0.06
38.11
45.47
79.44
50.67
52.15
53.25
80.1
109.6
464.58
0
83.37
87.12
90
189.5
467.9
0
0
Price < $12.50 = OVERVALUED
191 | P a g e Clearly, the above MWV’s sensitivity analysis returned an overwhelmingly
undervalued or fairly valued share price at all Ke values between our upper and lower
bounds WACC values. As a result, we expanded our sensitivity analysis WACC values to
higher values until we reached an overvalued share price. We reached this limit with a
WACCbt of 9.5% and 0% growth rate. This chart also shows the volatility of the free
cash flow evaluation model with values ranging from $466.02 to $11.38. This range in
prices is caused by the valuation of the perpetuity using different growth rates.
Residual Income
To achieve a viable value of a firm’s equity, one must consider the best valuation
model available. The residual income valuation model is the most reliable since it is the
valuation model that is the least sensitive to the changes in the terminal value
perpetuity growth rate and changes in cost of equity. With the model being the least
sensitive to such changes it empowers the firm’s book value of equity and the present
value of the firm’s annual residual income to be the focal point. “Unlike the discounted
dividends and free cash flow models, in which a significant portion of the estimated
value is the terminal value, the residual income model relies more on book value. This
can be an advantage since forecasting errors tend to magnify over time and using the
residual income model results in smaller errors.” [financial-education.com] The only
potential disadvantage in using the residual income model is that it the initial book
value of equity is an accounting assumption.
The main parts that go into the calculation of the residual income model are the
book value of equity, cost of equity, perpetuity growth rate, and forecasted dividends
and earnings. The initial step in the residual income model is to find the book value of
equity in a given time period (t). This is found by taking the difference between net
income in time “t” and the total dividends of the same period “t” then adding it the
book value of equity of the previous time period (t-1). After calculating the book value
of equity, a benchmark income estimate value must be calculated which is done by
taking the new book value of equity and multiplying it by the firm’s cost of equity. The
192 | P a g e cost of equity for MeadWestvaco, after the size adjustment, was smaller than the cost
of debt, so an alternative cost of equity (backdoor method cost of equity) was used to
find the benchmark income value estimate. The backdoor method cost of equity is
calculated by setting the market to book ratio equal to one plus the return on equity
minus the cost of equity over the cost of equity minus the growth rate. Once the
benchmark income value is calculated the annual residual income must be calculated
which is done by taking the difference between the forecasted net earnings and the
benchmark income. After each figure has been calculated they must be discounted back
to the current year’s dollars. This is done by taking each figure and multiplying it by one
plus its present value factor raised to the time “t”. This is followed by the summation of
all the residual income figures for each period and then adding this figure to the
terminal value perpetuity. This gives you the market value of equity which can then be
divided by the number of shares to get a share price that must then be converted to a
time consistent price.
Residual Income Model (As Stated)
Return to Equilibrium
Ke
0.1772
0.1572
0.1559
0.1545
0.0772
0.0765
0.0760
0.0752
0.0632
0.0532
0.0432
-0.1
11.93
13.24
13.33
13.43
20.9
20.99
21.06
21.16
22.78
24.25
25.83
-0.2
11.97
13.30
13.39
13.49
21.11
21.2
20.58
21.37
23.05
24.57
26.22
-0.3
12
13.33
13.42
13.53
21.2
21.3
20.68
21.47
23.16
24.71
26.38
-0.4
12.01
13.35
13.44
13.55
21.26
21.35
20.76
21.53
23.23
24.78
26.47
-0.5
12.02
13.36
13.46
13.56
21.3
21.39
21.46
21.57
23.27
24.83
26.52
Price > $16.92 = UNDERVALUED
Price < $12.50 = OVERVALUED
193 | P a g e Restated Residual Income Model
Return to Equilibrium
-0.2
11.15
12.35
12.44
-0.3
11.17
12.38
12.47
-0.4
11.19
12.41
12.49
12.47
12.53
0.1545
0.0747
19.5
19.71
0.0741
19.57
19.78
0.0734
19.65
19.87
0.0727
19.73
19.95
0.0721
19.8
20.03
0.0714
19.89
20.11
0.0707
19.97
20.2
Price > $16.92 = UNDERVALUED
Price < $12.50 = OVERVALUED
12.56
12.58
12.6
19.81
19.88
19.97
20.06
20.13
20.22
19.87
19.94
20.03
20.11
20.19
20.28
19.91
19.98
20.07
20.15
20.23
20.32
20.3
20.37
20.41
0.1772
0.1572
0.1559
Ke
-0.1
11.11
12.30
12.38
-0.5
11.2
12.42
12.50
The sensitivity analysis of the residual income model was done in order to see
how manipulating the range of variables affected MeadWestvaco intrinsic value. The
above chart is the residual income table which one can see that MeadWestvaco is a
undervalued investment. It is only when the cost of equity is reaches 15.45% that is
reaches the point of being an overvalued investment. The firm is not a completely
overvalued investment until the cost of equity reach the point of 17.72%. In viewing
the chart above one can conclude that MeadWestvaco is undervalued investment that
one would want to buy.
Abnormal Earnings Growth Valuation Model
The abnormal earnings growth model attempts to calculate share value based
upon the idea that shareholders are willing to pay more or less than book value per
share if the firm earns a rate of return abnormally higher or lower than the rate of
return required by shareholders. Regression analysis of this model and its findings has
historically returned very high r-squared values signifying a great deal of explanatory
power. Abnormal earnings are calculated year by year over the first ten years of the
forecast period as the difference between the cumulative dividend earnings, which is
the forecasted net income plus the yearly forecasted Dividends plus the yearly dividend
194 | P a g e from the previous year grown at the current cost of equity, and the normal earnings
benchmark. A key assumption of this model is that all dividend payments are reinvested
at the current cost of equity. The normal earnings benchmark figure is the result of
reinvesting the previous year’s net earnings at the current cost of equity. The resulting
year by year abnormal earnings growth (AEG) figures are then discounted back to the
present using the after tax cost of capital to avoid double taxation since net income has
already been taxed.
For the forecast period from 2008 to 2017, year by year AEG calculations were
made and discounted back to the present before being summed at time zero. For the
perpetuity AEG value, we looked at the percent change in AEG over the forecast period
excluding extreme values in either direction and settled on a constant AEG perpetuity
value of 1.94% beginning in 2018 as the next logical value in the AEG sequence. This
perpetuity was then discounted back to time zero and summed with the present value
of the total year by year AEG values from the first ten forecast years to arrive at the
total present value of all future AEG. We then added the core net income value from
2007 to this AEG present value figure and divided by the number of MWV shares
outstanding (173.84 million) to find the intrinsic share price for MWV stock at the end of
2007. This share price was then grown at the cost of equity for ten months to give us a
final time consistent undervalued MWV share price of $23.80 assuming an observed
share price of $14.71 on November 03, 2008.
195 | P a g e Stated AEG Model
Return to Equilibrium
Ke
0.0772
0.0765
0.0760
0.0752
0.0632
0.0532
0.0432
-0.10
16.46
16.45
16.45
16.44
16.29
16.16
16.09
-0.20
16.44
16.43
16.43
16.42
16.26
16.14
16.01
-0.30
16.43
16.42
16.42
16.41
16.26
16.13
16.00
-0.40
16.43
16.42
16.41
16.40
16.25
16.12
15.99
-0.50
16.42
16.42
16.41
16.40
16.25
16.12
15.99
Price > $16.92 = UNDERVALUED
Price < $12.50 = OVERVALUED
0.0747
0.0741
0.0734
Ke
0.0727
0.0721
0.0714
0.0707
Price > $16.92
Restated AEG Model
Return to Equilibrium
-0.10
-0.20
-0.30
-0.40
22.36
21.97
21.79
21.68
22.35
21.96
21.78
21.67
22.34
21.95
21.77
21.66
22.33
21.94
21.76
21.65
22.32
21.93
21.75
21.64
22.30
21.92
21.73
21.63
22.29
21.90
21.72
21.62
= UNDERVALUED
-0.50
21.62
21.61
21.59
21.58
21.57
21.56
21.55
Price < $12.50 = OVERVALUED
Once the present value of future AEG was found for MWV, we performed the
sensitivity analysis found above. The x-axis of the sensitivity analysis shows the rate at
which the abnormal earnings return to equilibrium, and the y-axis is the cost of equity.
Clearly, MWV stock is undervalued at every cost of equity rate regardless of the speed
at which earnings converged upon the normal earnings benchmark. Intuitively, the
share price should be relatively higher if the earnings decline is slower and relatively
lower if the earnings are very quickly reverting back to normal.
196 | P a g e Long Run ROE Residual Income Valuation Model
The long run ROE residual income valuation model attempts to calculate an
accurate share price by dividing a derived market capitalization value by the number of
shares outstanding. In deriving the market value of equity figure, the model uses the
formula given below:
MVE = BVE + BVE[(ROE – Ke)/(Ke-g)]
The ROE value of 6.16% used here is MWV’s average long run return on equity over
the ten year forecast period from 2008 to 2018. Once again, return on equity at time (t)
is calculated as the net income at time (t) divided by the book value of equity from the
previous year (ROE = NIt/BVE(t-1)). Like the other four intrinsic valuation methods
covered, our Ke input value is MWV’s alternative cost of equity adjusted for size
calculated as M/B = 1 + (ROE – ke)/(ke – g) to arrive at a 7.52% cost of equity. The
1.57% growth figure for this valuation model corresponds to the average year by year
growth rate in the book value of equity over the forecasted time horizon. With 173.84
million shares of stock outstanding, the derived price per share of MWV stock according
to this valuation model is $11.65. According to our conservative 15% price tolerance,
this valuation model classifies the November 03, 2008 share price as slightly
overvalued.
Stated Long Run Residual Income
BVE Growth
0
0.0052
27.12
27.45
0.0900
0.0772
23.26
23.31
18.59
18.29
0.0617
ROE 0.0463
13.95
13.30
0.0309
9.31
8.32
0.0154
4.64
3.3
0.0010
0.3
0
Price > $16.92 = UNDERVALUED
Price < $12.50 = OVERVALUED
0.0105
27.84
23.36
17.93
12.54
7.14
1.72
0
0.0157
28.29
23.42
17.52
11.65
5.79
0
0
0.0209
28.83
23.49
17.03
10.60
4.17
0
0
0.0262
29.5
23.58
16.42
9.29
2.17
0
0
0.0314
30.31
23.69
15.67
7.71
0
0
0
197 | P a g e Stated Long Run Residual Income
ROE
0.0316 0.0416
5.87
9.56
0.0772
5.93
9.66
0.0765
5.98
9.74
0.0760
Kе
6.05
9.86
0.0752
7.51
12.24
0.0632
9.44
15.38
0.0532
12.77
20.81
0.0432
Price > $16.92 = UNDERVALUED
Price < $12.50 = OVERVALUED
0.0516
13.25
13.39
13.50
13.67
16.97
21.32
28.84
0.0616
16.94
17.12
17.26
17.48
21.69
27.26
36.88
0.0716
20.63
20.85
21.02
21.29
26.42
33.2
44.91
0.0816
24.32
24.58
24.78
25.10
31.14
39.14
52.95
0.09
27.42
27.72
27.94
28.29
35.11
44.13
59.7
0.0262
20.65
20.92
21.12
21.46
28.15
38.27
60.31
0.0314
20.41
20.72
20.94
21.31
29.08
42.09
77.15
Stated Long Run Residual Income
BVE
Growth
0
0.0052
0.0772
21.34
21.24
0.0765
21.53
21.44
21.66
21.58
0.0760
Ke 0.0752
21.88
21.82
0.0632
25.79
26.09
0.0532
30.39
31.27
0.0432
37.13
39.19
Price > $16.92 = UNDERVALUED
Price < $12.50 = OVERVALUED
0.0105
21.13
21.34
21.50
21.75
26.45
32.39
41.96
0.0157
21
21.23
21.39
21.67
26.89
33.79
45.72
0.0209
20.84
21.09
21.27
21.57
27.44
35.65
51.23
Revised using restated ROE
ROE
Kе
0.0747
0.0741
0.0734
0.0727
0.0721
0.0714
0.0707
0.0316
6.1
6.16
6.24
6.31
6.37
6.45
6.53
Price < $12.50 = OVERVALUED
0.0416
9.94
10.04
10.16
10.28
10.38
10.5
10.63
0.0516
13.78
13.92
14.08
14.24
14.39
14.56
14.74
0.0616
17.62
17.79
18.00
18.21
18.4
18.62
18.84
0.0716
21.46
21.67
21.92
22.18
22.4
22.67
22.95
0.0816
25.3
25.55
25.84
26.15
26.41
26.73
27.05
0.0916
29.14
29.42
29.76
30.11
30.42
30.78
31.16
Price > $16.92 = UNDERVALUED
198 | P a g e Revised using restated ROE
BVE Growth
0
0.0052
0.0747
18.68
18.38
0.0741
18.82
18.53
18.99
18.71
0.0734
Ke
0.0727
19.16
18.90
0.0721
19.31
19.06
0.0714
19.49
19.25
0.0707
19.67
19.44
Price > $16.92 = UNDERVALUED
Price < $12.50 = OVERVALUED
0.0105
18.03
18.19
18.38
18.58
18.75
18.96
19.17
0.0157
17.62
17.79
18.00
18.21
18.4
18.62
18.84
0.0209
17.13
17.32
17.54
17.77
17.97
18.21
18.45
0.0262
16.53
16.73
16.97
17.22
17.43
17.69
17.96
0.0314
15.8
16.01
16.27
16.54
16.77
17.06
17.35
Revised using restated ROE
BVE Growth
0
0.0052
0.0105
0.0157
0.0209
0.0262
0.0314
0.0316
9.83
8.84
7.67
6.31
4.67
2.63
0.11
0.0416
12.94
12.20
11.31
10.28
9.04
7.49
5.59
0.0516
16.05
15.55
14.94
14.24
13.40
12.35
11.06
0.0616
19.16
18.90
18.58
18.21
17.17
17.22
16.54
0.0716
22.27
22.25
22.21
22.18
22.13
22.08
22.01
0.0816
25.38
25.06
25.85
26.15
26.5
26.94
27.49
0.0916
28.49
28.95
Price > $16.92 = UNDERVALUED
Price < $12.50 = Overvalued
29.49
30.11
30.87
31.81
32.96
ROE
In addition to performing the long run ROE residual income valuation of MWV
stock using the current Ke, g, and BVE values as per November 03, 2008, we performed
three sensitivity analyses using Ke, BVE, and ROE values before restatement and three
sensitivity analyses using the restated values to observe their effect on the calculated
intrinsic share price.
199 | P a g e Analyst Summary
Based on our complete evaluation of MeadWestVaco’s business strategies, their
individual performance within the paper and packaging industry, their key accounting
policies, and financial analysis, we strongly believe MWV is an undervalued company,
and accordingly give an unequivocal buy recommendation.
MeadWestVaco’s earnings have remained much more stable than the industry
average through the current recession largely due to strong sales in their international
business segments. Even with today’s economic uncertainty, MWV has maintained a
7.9% dividend yield, an impressive bottom end yield by any investment standard.
Furthermore, of the five intrinsic valuation methods we used to calculate the “true”
economic value of MWV stock, including the discounted free cash flow method, the
discounted dividend method, the residual income method, the long run return on equity
residual income method, and the abnormal earnings growth method, four of the five
had MWV stock at least 15% undervalued using their November 03, 2008 NYSE close as
a benchmark stock price. Lastly, throughout our valuation computations and sensitivity
analyses we have maintained the credibility of our reported findings, whether
overvalued or undervalued, by taking a stance as 15% analysts to account for the
relative unpredictable nature of future cash flow magnitudes and timings in such an
uncertain economic environment.
200 | P a g e Appendices
Liquidity Ratios
Current Ratio MWV IP SSCC
PKG Industry Avg. Quick
Asset
Ratio
MWV
IP
SSCC
PKG
Industry
Avg.
2003 1.62 1.5 1.24 1.5 1.5
2003
0.78
0.44
0.46
1.06
0.68
2004 1.54 1.7 1.13 1.91 1.57
2004
0.68
0.72
0.23
1.28
0.73
2005 1.95 2.4 1 1.4 1.68
2005
1.17
0.08
0.19
0.88
0.58
2006 1.38 1.9 0.87 1.57 1.43
2006
0.8
0.5
0.16
1.09
0.64
2007 1.49 1.8 1.01 1.25 1.39
2007
0.86
0.15
0.18
0.86
0.51
A/R
Turnover
MWV
IP
SSCC
PKG
Industry
Avg.
DSO
MWV
IP
SSCC
PKG
Industry
Avg
2003
8.01
12.8
14.63
9.09
11.13
2003
45.57
28.5
24.96
42.22
35.31
2004
7.17
8.8
32.64
8.73
14.33
2004
50.9
41.5
11.18
41.11
36.17
2005
6.67
9.8
30.41
9.35
14.06
2005
54.54
37.2
12
41.51
36.31
2006
6.46
8.9
43.11
8.31
16.69
2006
56.51
41
8.47
41.03
36.75
2007
6.84
7.7
43.65
8.39
16.64
2007
53.33
47.4
8.36
41.65
37.69
Inventory
Turnover
MWV
IP
SSCC
PKG
Industry
Avg.
DSI
MWV
IP
SSCC
PKG
Industry
Avg
2003
5.97
5.9
9.39
8.64
7.48
2003
61.13
61.86
38.87
40.14
50.5
2004
5.84
7.3
9.13
8.88
7.79
2004
62.5
50
39.97
41.83
48.56
2005
7.12
6.7
8.25
8.79
7.72
2005
51.26
54.48
44.24
39.03
47.25
2006
7.55
8.5
11.5
8.9
9.11
2006
48.34
42.94
31.74
43.92
41.74
2007
7.23
7.8
11.86
8.76
8.91
2007
50.48
46.79
30.77
43.48
42.88
201 | P a g e Working
Capital
Turnover
MWV
IP
SSCC
PKG
Industry
Avg.
Cash to
Cash
Cycle
MWV
IP
SSCC
PKG
Industry
Avg.
2003
8.16
6.3
27.38
9.49
12.83
2003
106.7
90.36
63.83
82.36
85.81
2004
6.87
4.4
19.16
5.86
6.55
2004
113.4
91.5
51.15
82.94
84.75
2005
6.24
6.4
16.81
12.51
7.99
2005
105.8
91.68
56.24
80.54
83.57
2006
11.87
5.5
42.07
9.35
12.19
2006
99.85
83.94
40.21
84.95
77.24
2007
9.7
7.6
21.71
15.94
13.73
2007
103.81
94.19
39.13
85.13
80.57
Profitability Ratios
Gross
Profit
Margin
MWV
SSCC
PKG
IP
Operating
Expense
Ratio
MWV
SSCC
PKG
IP
2003
13%
14%
20%
26%
2003
10%
10%
7%
9%
2004
19%
13%
15%
26%
2004
13%
9%
7%
8%
2005
18%
11%
16%
25%
2005
12%
10%
7%
8%
2006
17%
14%
17%
26%
2006
14%
9%
7%
8%
2007
17%
14%
19%
26%
2007
12%
9%
7%
8%
Operating
Profit
Margin
MWV
IP
SSCC
PKG
2003
0.017
0.172
0.0216
0.098
2004
0.055
0.179
0.1345
0.0855
2005
0.053
0.165
0.0101
0.0803
2006
0.035
0.177
0.0412
0.01303
2007
0.0455
0.1845
0.0516
0.1535
Net Profit
Margin
MWV
SSCC
PKG
IP
2003
0%
-3%
6%
1.4%
2004
-6%
-1%
3%
-0.2%
2005
0%
-5%
4%
5.1%
2006
1%
-1%
-2%
4.8%
2007
4%
-1%
3%
5.3%
202 | P a g e Asset
Turnover
MWV
SSCC
PKG
IP
2003
0.58
0.71
0.87
0.66
2004
0.49
0.82
0.95
0.66
2005
0.53
0.71
0.95
0.63
2006
0.73
0.79
1.1
0.76
2007
0.74
0.95
1.1
0.91
Return
on
Assets
MWV
SSCC
PKG
IP
2003
0.0%
-2.0%
-2.0%
0.9%
2004
-1.0%
0.0%
3.0%
-0.1%
2005
0.0%
2.0%
2.0%
3.2%
2006
1.0%
5.0%
6.0%
3.6%
2007
3.0%
7.0%
8.0%
4.9%
Return on
Equity
MWV
SSCC
PKG
IP
2003
0%
-8%
-1%
4%
2004
-4%
-2%
8%
0%
2005
0%
-15%
6%
13%
2006
2%
-3%
18%
13%
2007
5%
-6%
24%
15%
203 | P a g e Capital Structure Ratios
Debt
to
Equity
MWV
IP
SSCC
PKG
Industry
Avg.
2003
1.61
3.3
3.45
1.64
2.5
2004
1.69
3.1
3.24
1.68
2.43
2005
1.55
2.4
3.84
2.06
2.46
2006
1.62
2.02
3.37
2
2.25
2007
1.65
1.8
2.98
1.81
2.06
Times
Interest
Earned
MWV
IP
SSCC
PKG
Industry
Avg.
2003
0.9
2.6
0.14
4.5
2.04
2004
2.55
3.4
0.77
4.7
2.86
2005
1.64
2.5
0.73
4.1
2.24
2006
1.46
2.3
0.81
7.2
2.94
2007
2.82
6.4
1.07
11.4
5.4
Z‐Score MWV Debt
Service
Margin
MWV
IP
SSCC
PKG
Industry
Avg.
2003
0
0.14
2.25
2.15
1.51
2004
0
0.18
1.39
1.9
1.16
2005
0.97
0.11
11.63
2.22
3.73
2006
43.61
0.11
7.57
2.08
13.34
2007
3.03
0.29
2.89
2.51
2.18
IP SSCC PKG 2003 1.29 1.47 0.96 2.54 2004 1.32 1.61 1.14 2.72 2005 1.65 1.64 0.67 2.59 2006 1.45 2.18 0.93 2.89 2007 1.49 2.17 1.04 3.33 204 | P a g e Sales Diagnostic Ratios
Net
Sale/Cash
From
Sales
MWV
IP
SSCC
PKG
2003
1.0065
0.9993
1.0319
1.0088
2004
0.9882
0.999
0.9746
1.0137
2005
1.0126
0.9851
0.9956
0.9982
2006
1.0138
1.0132
0.9919
1.0233
2007
0.9997
1.0208
1.0005
1.0055
Net
Sales/Acct.
Rec.
MWV
IP
SSCC
PKG
2003
8.45
7.96
33.34
9.88
2004
8.72
8.45
17.64
9.90
2005
7.30
7.91
26.82
9.20
2006
7.08
9.10
31.95
10.26
2007
6.83
8.09
44.69
8.80
MWV
Net
Sales/Inventory
2003 IP
SSCC
PKG
8.009
8.006
16.429
9.093 2004 9.736
8.515
32.64
8.729 2005 6.691
8.981
30.41
9.352 2006 6.458
8.134
43.114
8.31 2007 6.844
6.944
43.647
8.393 205 | P a g e Expense Manipulation Diagnostic
Asset
Turnover
MWV
IP
PKG
SSCC
Total
Accruals
MWV
IP
PKG
SSCC
2003
0.6057
0.5597
0.8743
0.7756
2003
0.059
0.063
0.149
0.046
2004
0.7043
0.6055
0.9075
0.8652
2004
0.072
0.095
0.078
0.038
2005
0.6926
0.7542
1.0103
0.7474
2005
0.032
0.019
0.095
0.081
2006
0.7032
0.9152
1.1007
0.9203
2006
0.073
0.008
0.056
0.045
2007
0.702
0.9061
1.1376
1.0045
2007
0.052
0.033
0.056
0.047
CFFO/NOA MWV IP PKG SSCC Industry
CFFO/OI
MWV
IP
PKG
SSCC
2003 0.06 0.11 0.18 0.03 0.09
2003
0.07
0.35
-0.14
1.64
2004 0.14 0.14 0.16 0.06 0.12
2004
-0.60
4.39
1.05
-0.38
2005 0.05 0.11 0.18 0.05 0.10
2005
0.34
0.26
-1.14
0.13
2006 0.13 0.13 0.20 0.07 0.13
2006
9.44
0.06
-0.06
-0.09
2007 0.15 0.17 0.25 0.07 0.16
2007
-0.24
0.40
-1.41
0.08
206 | P a g e Weighted Average Cost of Debt Calculations
MWV
2007
weight
rate
weighted rate
LIABILITIES AND SHAREHOLDERS EQUITY
Accounts payable
640
0.10442
0.0215
0.00224506
Accrued expenses
747
0.12188
0.0215
0.00262041
68
0.01109
0.055
0.00061021
Notes payable and current maturities of LTD
Current Liabilities of Discontinued Operations
Current liabilities
1455
.2374
Long-term debt
2375
0.3875
0.082
0.03177517
Other long-term obligations
1071
0.17474
0.082
0.01432893
Deferred income taxes
1228
0.20036
0.0363
0.00727303
MWV Kd
0.058853
Non Current Liabilities of Discontinued Operations
Commitments and Contingencies
Total Liabilities
6129
Weighted Average Cost to Capital
VL
Kd
t
Ve
Ke
Vf
6371 M
5.89%
35%
2520 M
9.02%
8891 M
WACCbt =
6.78%
WACCat =
5.30%
207 | P a g e Regression
SUMMARY OUTPUT Regression Statistics Multiple R 0.312242 R Square Adjusted R Square 0.097495 Standard Error 0.067392 0.056472 Observations 24 ANOVA df Regression SS MS 1 0.010794 0.010794 Residual 22 0.099916 0.004542 Total 23 0.11071 Coefficients F Significance F 2.376604 0.137427 Standard Error t Stat P‐value Lower 95% Upper 95% Lower 95.0% Upper 95.0% Intercept ‐0.06783 0.04581 ‐1.48064 0.152884 ‐0.16283 0.027176 ‐0.16283 0.027176 X Variable 1 SUMMARY OUTPUT ‐0.01858 0.01205 ‐1.54162 0.137427 ‐0.04357 0.006414 ‐0.04357 0.006414 Regression Statistics Multiple R 0.244688 R Square 0.059872 Adjusted R Square 0.032221 Standard Error 0.060725 Observations 36 ANOVA Regression df SS MS F 2.165294 1 0.007985 0.007985 Residual 34 0.125375 0.003688 Total 35 0.13336 Coefficient
s Standard Error Significance F 0.150354 t Stat P‐value Lower 95% Upper 95% Lower 95.0% Upper 95.0% Intercept ‐0.05538 0.038844 ‐1.42579 0.163045 ‐0.13432 0.023557 ‐0.13432 0.023557 X Variable 1 ‐0.01383 0.009401 ‐1.47149 0.150354 ‐0.03294 0.005272 ‐0.03294 0.005272 208 | P a g e SUMMARY OUTPUT Regression Statistics Multiple R 0.195707 R Square 0.038301 Adjusted R Square 0.017395 Standard Error 0.061336 Observations 48 ANOVA df Regression SS MS F 1.832027 1 0.006892 0.006892 Residual 46 0.173055 0.003762 Total 47 0.179947 Coefficients Standard Error Significance F 0.182502 t Stat P‐value Lower 95% Upper 95% Lower 95.0% Upper 95.0% Intercept ‐0.04885 0.035718 ‐1.36778 0.178027 ‐0.12075 0.023043 ‐0.12075 0.023043 X Variable 1 SUMMARY OUTPUT ‐0.01215 0.008975 ‐1.35352 0.182502 ‐0.03021 0.005918 ‐0.03021 0.005918 Regression Statistics Multiple R 0.047955 R Square Adjusted R Square 0.0022997 Standard Error 0.0648175 ‐0.014902 Observations 60 ANOVA SS MS F 1 0.0005617 0.0005617 0.1336889 Residual 58 0.2436762 0.0042013 Total 59 0.2442379 Regression df Significanc
e F 0.7159676 Coefficient
s Standard Error t Stat P‐value Lower 95% Upper 95% Intercept ‐0.0062907 0.0272167 ‐
0.2311335 0.8180245 ‐0.0607709 0.0481895 X Variable 1 ‐0.0026971 0.0073765 ‐0.365635 0.7159676 ‐0.0174628 0.0120686 Lower 95.0% ‐
0.0607709 ‐
0.0174628 Upper 95.0% 0.0481895 0.0120686 209 | P a g e SUMMARY OUTPUT
Regression Statistics
Multiple R
0.030567487
R Square
0.000934371
Adjusted R Square ‐0.01333799
Standard Error
0.065632793
Observations
72
72
60
48
36
24
beta est.
risk free rate mrp
‐0.00353203
4.02
‐0.01390238
4.02
‐0.01925223
4.02
‐0.02084529
4.02
‐0.03030842
4.02
8
8
8
8
8
ke
3.99174372
3.90878096
3.86598214
3.85323765
3.77753265
r2
upper beta
‐0.01333799 4.21199759
‐0.00364414
4.1599305
0.00886628 4.12610615
0.015670554 4.12482005
0.037598063 4.14247621
lower beta
3.771489858
3.65763142
3.605858133
3.581655265
3.412589096
ANOVA
df
Regression
Residual
Total
72 months
Intercept
X Variable 1
1
70
71
SS
MS
F
Significance F
0.00028201 0.00028201 0.06546716 0.798805084
0.301536442 0.004307663
0.301818452
Coefficients Standard Error
t Stat
P‐value
Lower 95%
Upper 95% Lower 95.0% Upper 95.0%
‐0.0067381
0.056168956 ‐0.11996131 0.90485744 ‐0.118763551 0.10528735 ‐0.11876355 0.10528735
‐0.00353203
0.013804263 ‐0.25586551 0.79880508 ‐0.031063768 0.0239997 ‐0.03106377
0.0239997
ANOVA
df
Regression
Residual
Total
60 months
Intercept
X Variable 1
1
58
59
SS
MS
F
Significance F
0.003264674 0.003264674 0.78577656 0.379041069
0.240973204 0.00415471
0.244237878
Coefficients Standard Error
t Stat
P‐value
Lower 95%
Upper 95% Lower 95.0% Upper 95.0%
‐0.05443658
0.065526721 ‐0.83075395 0.40951946 ‐0.185602564 0.0767294 ‐0.18560256
0.0767294
‐0.01390238
0.015683378 ‐0.88644039 0.37904107 ‐0.045296073 0.01749131 ‐0.04529607 0.01749131
ANOVA
df
Regression
Residual
Total
48 months
Intercept
X Variable 1
1
46
47
SS
MS
F
Significance F
0.005390181 0.005390181 1.42044292 0.239443186
0.174557057 0.003794719
0.179947239
Coefficients Standard Error
t Stat
P‐value
Lower 95%
Upper 95% Lower 95.0% Upper 95.0%
‐0.08326324
0.068746593 ‐1.21116174 0.23201913 ‐0.221642954 0.05511647 ‐0.22164295 0.05511647
‐0.01925223
0.016153596 ‐1.19182336 0.23944319 ‐0.051767733 0.01326327 ‐0.05176773 0.01326327
ANOVA
df
Regression
Residual
Total
36 months
Intercept
X Variable 1
1
34
35
SS
MS
F
Significance F
0.005840386 0.005840386 1.55720105 0.220601627
0.127519264 0.003750567
0.13335965
Coefficients Standard Error
t Stat
P‐value
Lower 95%
Upper 95% Lower 95.0% Upper 95.0%
‐0.08969138
0.072438259 ‐1.23817689 0.22413207 ‐0.236903632 0.05752088 ‐0.23690363 0.05752088
‐0.02084529
0.016704584 ‐1.24787862 0.22060163 ‐0.054793092 0.01310251 ‐0.05479309 0.01310251
ANOVA
df
Regression
Residual
Total
24 months
Intercept
X Variable 1
1
22
23
SS
MS
F
Significance F
0.008794974 0.008794974 1.89853878 0.182097099
0.101914915 0.004632496
0.110709888
Coefficients Standard Error
t Stat
P‐value
Lower 95%
Upper 95% Lower 95.0% Upper 95.0%
‐0.12437604
0.090995614 ‐1.3668356 0.18548326 ‐0.313089395 0.06433731 ‐0.3130894 0.06433731
‐0.03030842
0.021996498 ‐1.37787473 0.1820971 ‐0.075926363 0.01530953 ‐0.07592636 0.01530953
210 | P a g e Z-Score
T1
T2
T3
T4
T5
Z‐Score
Zone
0.010490911
0.028765241
0.036708577
0.024340334
0.031920301
0.77082524
0.95400697
0.99202949
0.94590751
0.93455702
0.604869064
0.520350335
0.692635833
0.703284868
0.702043306
1.292746363
1.325404353
1.579583435
1.446862762
1.493548487
Distress
Distress
Distress
Distress
Distress
1.473015225
1.61931829
1.646368453
2.188269943
2.178215094
Distress
Distress
Distress
Grey
Grey
MWV
2003
2004
2005
2006
2007
0.07407704 0.073196124
0.075734158 0.0338313584
0.11091154 0.0272788505
0.059235326 0.0180936995
0.072379791 0.0280573346
IP
2003
2004
2005
2006
2007
0.107698804
0.153490955
0.089152271
0.166264459
0.119748334
0.086755806
0.074875062
0.110249904
0.155488059
0.181091933
0.0423927
0.0530730
0.0445935
0.0693185
0.0777764
0.76646511
0.78862227
0.80733301
1.04678614
1.03191967
0.6231668
0.6826724
0.7542317
0.9151619
0.9060805
SSCC
2003
2004
2005
2006
2007
0.02791526430
0.01544401544
(0.00043888523)
(0.01813038447)
0.00175984838
‐0.14354
‐0.15726
‐0.20255
‐0.25010
‐0.27860
0.00465
0.02744
‐0.02776
0.03549
0.04129
0.59406
0.64844
0.49895
0.44948
0.48906
0.76440
0.86518
0.74742
0.92028
1.00447
PKG
2003
2004
2005
2006
2007
0.112616025
0.16418344
0.091924788
0.1300368
0.083728867
0.150554171
0.145796904
0.125882659
0.135530575
0.164088146
0.048790858
0.06745379
0.058848689
0.11370394
0.144141755
1.944603
1.99152864
1.84196186
1.7849684
2.32275239
0.874268938
0.907484441
1.010317752
1.100690698
1.137607406
0.967974565 Distress
1.142315113 Distress
0.670348526 Safe
0.934267454 Safe
1.045226686 Distress
2.547081383
2.72522744
2.595230691
2.891581016
3.335987064
Grey
Grey
Grey
Grey
Safe
Avg. Z ‐ score 1.754928617
211 | P a g e Method of Comparables
P/E Trailing
Price Per
Share
EPS
P/E Trailing
Computed
Share Price
MWV
$14.71
1.65
$13.62
MWV
Restated
$14.71
1.15
$10.04
IP
$16.18
1.97
8.21
SSCC
$1.26
0.18
6.89
PKG
$15.89
1.43
11.1
Average
8.73
Forecasted P/E
PPS
Forecasted
P/E
Computed
EPS
Forecasted
Share Price
MWV
$14.71
0.81
$6.83
MWV
$14.71
0.81
$6.83
IP
$16.18
1.97
11.01
SSCC
$1.26
0.18
6.3
PKG
$15.89
1.43
11.19
Average
9.5
Adjusted
212 | P a g e Price to Book
PPS
BPS
P/B
Computed
Price
MWV
$14.21
47.39
$51.11
MWV Adjusted
$14.21
21.33
$23.02
IP
$16.18
20.7
0.78
SSCC
$1.26
6.88
0.18
PKG
$15.89
6.99
2.27
Average
1.079
P.E.G
P/E
Growth
PEG
Computed
Price
MWV
8.61
4.13%
11.38
MWV Restated
12.36
4.13%
7.93
IP
8.21
4.92%
1.67
SSCC
6.89
N/A
N/A
PKG
11.1
N/A
N/A
Average
1.67
213 | P a g e P/EBITDA
Market
EBITDA
P/EBITDA
Capitalization
Industry
Computed
Avg.
Price
($ Billions)
($ Billions)
MWV
2.470
1.14
2.56
$16.79
MWV -
2.470
1.14
2.56
$16.79
IP
4.98
2.82
1.77
SSCC
0.136
.551
0.247
PKG
1.44
.421
3.42
Restated
Outlier
EV/EBITDA
EV
EBITDA
EV/EBITDA
($ Billions)
($ Billions)
MWV
8.35
1.14
IP
15.97
2.82
6.58
SSCC
3.78
.551
7.35
PKG
1.9
.421
5.31
Industry
Computed
Avg.
Price
6.41
$36.87
214 | P a g e EV/EBITDA – Excluding Goodwill
EV
EBITDA
EV/EBITDA
($ Billions)
($ Billions)
MWV
7.51
1.14
IP
15.67
2.82
5.56
SSCC
3.76
.551
6.82
PKG
1.89
.421
4.49
Industry
Computed
Avg.
Price
5.6
$32.21
Price to Free Cash Flows
Mkt. Cap
FCF
($ Billions)
($Billions)
P/FCF
Industry
Computed
Average
Price
2.22
$17.04
MWV
2.470
.066
IP
4.98
2.24
2.22
SSCC
0.136
-0.004
-323.82
Outlier
PKG
1.44
-.001
-128.99
Outlier
215 | P a g e Discounted Free Cash Flows Model
Discounted Free Cash Flow
WACC(BT)
0
2007
Cash Flow From Operations (Millions)
Cash Flow From Investing Activities
FCF Firm's Assets
PV Factor
PV YBY Free Cash Flows
Ke
Kd
0.0678
0.0752
0.0589
1
2008
2
2009
3
2010
4
2011
5
2012
563.5296
574.8002
597.7922
621.7039
-259.60
-285.56
-314.12
-345.53
6
2013
7
2014
8
2015
9
2016
10
2017
646.5720 672.4349
699.3323
727.3056
756.3978
786.6538
-380.08
-459.90
-505.89
-556.48
-612.12
-418.09
303.93
289.24
283.68
276.18
266.49 254.35 239.44
221.42
199.92
174.53
0.95859 0.91889 0.88084 0.84436 0.80940 0.77588 0.74375 0.71295 0.68343 0.65513
291.343558 265.780727 249.87348 233.192965 215.698117 197.3427 178.080009 157.86051 136.631877 114.339471
Total PV YBY Free Cash Flows
2040.143
Perp.
PV of Perpetuity @ 2007
Market Value of Assets (11/3/2008)
Book Value Debt & Preferred Stock
Market Value of Equity
-36764.7
-34724.6
2,290
(37,015)
PV Perp @ 2017
Divide by Shares to get PPS at 11/3/08
Time Consistant Price
Observed Share Price at 11/3/08
(212.92)
-220.56
14.71
Bt WACC
Growth Rate (g)
0.0432
0.05
WACC
9.50%
9.00%
7.80%
7.72%
7.65%
7.60%
6.78%
6.32%
5.32%
4.32%
250
-36764.71
Stated Free Cash Flow Evaluation Model
Perpetuity Growth Rate
0
0.01
0.02
0.03
0.04
0.05
12.27
14.19
16.63 19.81
24.15
30.41
13.33
15.48
18.24 21.92
27.07
34.8
16.35
19.23
23.11 28.61
37.01
51.4
16.57
19.52
23.5 29.17
37.89
53.01
16.78
19.78
23.85 29.67
38.68
54.49
16.93
19.97
24.11 30.04
39.27
55.61
19.61
23.49
28.99 37.39
51.85
82.54
21.39
25.89
32.48 43.03
62.68
112.1
26.19
32.72
43.19 62.69
111.72
467.21
32.99
43.38
62.72 111.37
464.04
0
Price > $16.92 = UNDERVALUED
Price < $12.50 = OVERVALUED
0.06
40.26
47.67
81.77
85.71
89.47
92.35
191.94
470.4
0
0
216 | P a g e Restated Discounted Free Cash Flows
Discounted Free Cash Flow
WACC(BT)
0
2007
Cash Flow From Operations (Millions)
Cash Flow From Investing Activities
FCF Firm's Assets
PV Factor
PV YBY Free Cash Flows
Ke
Kd
0.0678
0.0752
0.0589
1
2008
2
2009
3
2010
4
2011
5
2012
563.5296
574.8002
545.4854
505.1344
-259.60
-285.56
-314.12
-345.53
6
2013
7
2014
8
2015
9
2016
10
2017
557.6684 588.3806
629.3991
654.5751
699.6680
727.6569
-380.08
-459.90
-505.89
-556.48
-612.12
-418.09
303.93 289.24
231.37
159.61
177.59 170.29 169.50
148.69
143.19
115.53
0.95859 0.91889 0.88084 0.84436 0.80940 0.77588 0.74375 0.71295 0.68343 0.65513
291.343558 265.780727 203.799518 134.765899 143.739679 132.1266 126.067171 106.007221 97.8612038 75.6891384
Total PV YBY Free Cash Flows
1577.181
Perp.
PV of Perpetuity @ 2007
Market Value of Assets (11/3/2008)
Book Value Debt & Preferred Stock
Market Value of Equity
-36764.7
-35187.5
2,290
(37,478)
PV Perp @ 2017
Divide by Shares to get PPS at 11/3/08
Time Consistant Price
Observed Share Price at 11/3/08
(215.59)
-223.32
14.71
Bt WACC
Growth Rate (g)
0.0432
0.05
WACC
9.50%
9.00%
7.80%
7.72%
7.65%
7.60%
6.78%
6.32%
5.32%
4.32%
250
-36764.71
Restated Free Cash Flow Evaluation Model
Perpetuity Growth Rate
0
0.01
0.02 0.03
0.04
0.05
10.12
12.04
14.47 17.65
21.99
28.26
11.13
13.28
16.04 19.71
24.87
32.59
14.01
16.9
20.78 26.28
34.68
49.06
14.23
17.18
21.16 26.83
35.55
50.67
14.43
17.44
21.51 27.33
36.34
52.15
14.57
17.62
21.76 27.69
36.92
53.25
17.17
21.04
26.54 34.95
49.4
80.1
18.89
23.39
29.97 40.53
60.18
109.6
23.56
30.1
40.57 60.06
109.09
464.58
30.24
40.62
59.96 108.61
461.28
0
Price > $16.92 = UNDERVALUED
Price < $12.50 = OVERVALUED
0.06
38.11
45.47
79.44
83.37
87.12
90
189.5
467.9
0
0
217 | P a g e Discounted Dividends Model
Discounted Dividends Approach
Perp
0
2007
EPS
DPS
BPS
Cash From Operations
Cash Investments
DPS
PV Factor
pv of year by year dividends
total pv of yby dividend
terminal value perp.
implied share price (12/31/2007)
Time consistant price (11/2008)
Observed Share Price (11/4/2008)
Initial Cost of Equity
Perpetuity Growth Rate
1
2
3
4
5
2008
2009
2010
2011
2012
0.81
0.83
0.99
1.12
1.35
0.98
0.98
0.98
0.98
0.98
21.16
21.01
21.02
21.16
21.53
563.53 574.80 597.79 621.70 646.57
0.98
0.93
0.91
0.98
0.87
0.85
0.98
0.80
0.79
0.98
0.75
0.73
0.98
0.70
0.68
6
2013
1.45
1.03
21.96
672.43
7
2014
1.61
1.03
22.54
699.33
8
2015
1.67
1.03
23.18
727.31
9
2016
1.85
1.03
24.01
756.40
10
2017
1.92
1.03
24.90
786.65
1.03
0.65
0.67
1.03
0.60
0.62
1.03
0.56
0.58
1.03
0.52
0.54
1.03
6.36
8.23
14.59
15.50
$14.71
0.0752
0.01
15.80 Perp
8.23 PV of perp
Perp. Growth
10.00%
9.00%
8.70%
Ke
7.72%
7.65%
7.60%
7.52%
6.32%
5.32%
4.32%
0
10.95
12.09
12.48
0.005
11.2
12.42
12.85
0.01
11.47
12.8
13.26
0.015
11.78
13.22
13.73
0.02
12.13
13.71
14.27
0.025
12.52
14.27
14.9
0.03
12.97
14.92
15.63
13.98
14.10
14.19
14.29
16.93
19.99
14.48
14.62
14.72
14.88
17.78
21.31
15.06
15.21
15.32
15.5
18.79
22.93
15.73
15.9
16.02
16.22
20.01
24.97
16.52
16.71
16.85
17.08
21.51
27.63
17.46
17.68
17.84
18.11
23.4
31.23
18.6
18.86
19.05
19.36
25.86
36.39
24.47
26.68
29.55
33.45
39.02
47.66
62.83
Discounted Dividends Model
Dividend Growth Rate
0 0.005
0.01 0.015
0.02
0.025
0.03
10.00% 10.95
11.2 11.47 11.78
12.13
12.52
12.97
12.8 13.22
13.71
14.27
14.92
9.00% 12.09 12.42
14.27
14.9
15.63
8.70% 12.48 12.85 13.26 13.73
16.52
17.46
18.6
Ke
7.72% 13.98 14.48 15.06 15.73
14.1 14.62 15.21
15.9
16.71
17.68
18.86
7.65%
16.85
17.84
19.05
7.60% 14.19 14.72 15.32 16.02
15.5 16.22
17.08
18.11
19.36
7.52% 14.29 14.88
21.51
23.4
25.86
6.32% 16.93 17.78 18.79 20.01
27.63
31.23
36.39
5.32% 19.99 21.31 22.93 24.97
4.32% 24.47 26.68 29.55 33.45
39.02
47.66
62.83
Price > $16.92 = UNDERVALUED
Price < $12.50=OVERVALUED
218 | P a g e Residual Income Valuation
MWV - Residual Income Valuation
0
2007
Net Income (Millions)
Total Dividends (Millions)
Book Value Equity (Millions)
% Growth in BVE
Annual Normal Income (Benchmark)
Annual Residual Income
Change in RI
pv factor
YBY PV RI
RI growth rate
Book Value Equity (Millions)
Total PV of YBY RI
Terminal Value Perpetuity
MVE (11/3/2008)
divde by shares
implied share price (12/31/2007)
Time consistant price (11/2008)
Observed Share Price (11/3/2008)
Initial Cost of Equity
Perpetuity Growth Rate
3708
1
2
3
4
5
6
7
8
9
10
2008
2009
2010
2011
2012
2013
2014
2015
2016
140.88
143.70
224.17
310.85
323.29
336.22
349.67
363.65
378.20
170
170
170
170
170
178.5
178.5
178.5
178.5
178.5
3,679
3,653
3,707
3,848
4,001
4,159
4,330
4,515
4,715
4,929
-0.79%
-0.71%
1.48%
3.80%
3.98%
3.94%
4.12%
2017
393.33
4.28%
4.42%
4.56%
278.84
276.65
274.67
278.75
289.34
300.87
312.73
325.60
339.52
354.54
(137.96)
(132.95)
(50.50)
32.10
33.95
35.35
36.94
38.05
38.68
38.79
5.01
82.45
82.61
1.84
1.40
1.59
1.11
0.62
0.11
0.9300595 0.86501072 0.80451146 0.74824354 0.695911 0.6472387 0.6019705 0.559868 0.520711 0.484292
(128.31)
(115.00)
(40.63)
24.02
23.62
22.88
22.24
21.31
20.14
(0.04)
(0.62)
(1.64)
0.06
0.04
0.04
0.03
0.02
%value
3708
111%
(149.74)
-4%
-222.182
-7%
3,336.08
100%
173.84
19.19
20.39
$14.71
0.0752
0
0.00
Perp
YR 10 PV YR 0 PV
-34.5
-458.7766 -222.1819
Stated Residual Income Model
Return to Equilibrium
-0.1
11.93
13.24
13.33
-0.2
11.97
13.30
13.39
-0.3
12
13.33
13.42
-0.4
12.01
13.35
13.44
-0.5
12.02
13.36
13.46
15.45% 13.43
13.49
13.53
13.55
13.56
21.11
21.2
20.58
21.37
23.05
24.57
26.22
21.2
21.3
20.68
21.47
23.16
24.71
26.38
21.26
21.35
20.76
21.53
23.23
24.78
26.47
21.3
21.39
21.46
21.57
23.27
24.83
26.52
17.72%
15.72%
15.59%
Ke
7.72%
7.65%
7.60%
7.52%
6.32%
5.32%
4.32%
20.9
20.99
21.06
21.16
22.78
24.25
25.83
Price > $16.92 = UNDERVALUED
Price < $12.50 = OVERVALUED
219 | P a g e Restated Residual Income
MWV - Residual Income Valuation
0
2007
Net Income (Millions)
Total Dividends (Millions)
Book Value Equity (Millions)
% Growth in BVE
Annual Normal Income (Benchmark)
Annual Residual Income
Change in RI
pv factor
YBY PV RI
RI growth rate
Book Value Equity (Millions)
Total PV of YBY RI
Terminal Value Perpetuity
MVE (11/3/2008)
divde by shares
implied share price (12/31/2007)
Time consistant price (11/2008)
Observed Share Price (11/3/2008)
Initial Cost of Equity
Perpetuity Growth Rate
1
2
3
4
5
6
7
8
9
2008
2009
2010
2011
2012
2013
2014
2015
2016
140.88
3708
143.70
171.87
194.28
279.73
290.92
321.47
334.33
170
170
170
170
178.5
178.5
178.5
178.5
178.5
3,679
3,653
3,654
3,679
3,743
3,817
3,918
4,030
4,173
4,329
-0.71%
0.05%
0.66%
1.75%
1.97%
2.65%
2.87%
3.55%
3.73%
262.16
260.10
258.24
258.37
260.09
264.64
269.85
277.00
284.95
295.06
(121.27)
(116.40)
(86.37)
(64.09)
(25.70)
(12.47)
9.89
13.92
36.52
39.27
4.88
30.02
22.29
38.38
13.23
22.36
4.03
22.60
2.75
0.710658552 0.6637327 0.61990535
0.578972023
0.540741593
0.505035577
0.9339684 0.87229703 0.81469789 0.76090211
(113.27)
(101.53)
(70.37)
(48.76)
(18.27)
(8.28)
6.13
8.06
19.75
(0.04)
(0.26)
(0.26)
(0.60)
(0.51)
(1.79)
0.41
1.62
%value
111%
-10%
-1%
100%
0.08
Perp
YR 10 PV YR 0 PV
-34.5
-60.45208 -30.53045
Restated Residual Income Model
Return to Equilibrium
17.72%
15.72%
15.59%
0.0727
252.16
170
-0.79%
3708
(326.54)
-30.530
3,350.93
173.84
19.28
20.41
$14.71
0.0707
-0.5
234.38
10
2017
-0.1
11.11
12.30
12.38
15.45% 12.47
7.47% 19.5
7.41% 19.57
7.34% 19.65
7.27% 19.73
7.21% 19.8
7.14% 19.89
7.07% 19.97
Price > $16.92 = UNDERVALUED
Price < $12.50 = OVERVALUED
Ke
-0.2
11.15
12.35
12.44
-0.3
11.17
12.38
12.47
-0.4
11.19
12.41
12.49
-0.5
11.2
12.42
12.50
12.53
12.56
12.58
12.6
19.71
19.78
19.87
19.95
20.03
20.11
20.2
19.81
19.88
19.97
20.06
20.13
20.22
20.3
19.87
19.94
20.03
20.11
20.19
20.28
20.37
19.91
19.98
20.07
20.15
20.23
20.32
20.41
220 | P a g e Long Run ROE Residual Income Model
Price > $16.92 = UNDERVALUED
MWV Long Run ROE RI Valuation Model
complete
Price < $12.50 = OVERVALUED
ROE as stated
ROE as stated
0.0726
0.001 0.0616 ROE restated
Book Value Equity (Millions)
MVE (11/3/2008)
Shares Outstanding (11/3/08)
Estimated share price (12/31/2007)
Time consistant price (11/3/2008)
3708
49.31
173.84
0.28
0.30
Observed Share Price (11/3/2008)
14.71
Ke 0.0752
g 0.0000
Stated Long Run Residual Income
BVE Growth
0
0.0052 0.0105 0.0157
0.0209
9.00% 27.12
27.45
27.84
28.29
28.83
7.72% 23.26
23.31
23.36
23.42
23.49
6.17% 18.59
18.29
17.93
17.52
17.03
ROE
4.63% 13.95
13.30
12.54
11.65
10.60
3.09%
9.31
8.32
7.14
5.79
4.17
1.54%
4.64
3.3
1.72
0
0
0.10%
0.3
0
0
0
0
Price > $16.92 = UNDERVALUED
Price < $12.50 = OVERVALUED
0.0262
29.5
23.58
16.42
9.29
2.17
0
0
0.0314
30.31
23.69
15.67
7.71
0
0
0
Stated Long Run Residual Income
ROE
0.0316 0.0416 0.0516 0.0616
0.0716
5.87
9.56 13.25
7.72%
16.94
20.63
5.93
9.66 13.39
7.65%
17.12
20.85
5.98
9.74 13.50
7.60%
17.26
21.02
6.05
9.86 13.67
Kе
7.52%
17.48
21.29
7.51
12.24 16.97
6.32%
21.69
26.42
9.44
15.38 21.32
5.32%
27.26
33.2
12.77
20.81 28.84
4.32%
36.88
44.91
Price > $16.92 = UNDERVALUED
Price < $12.50 = OVERVALUED
0.0816
24.32
24.58
24.78
25.10
31.14
39.14
52.95
0.09
27.42
27.72
27.94
28.29
35.11
44.13
59.7
Stated Long Run Residual Income
BVE Growth
0
0.0052 0.0105 0.0157
0.0209
7.72% 21.34
21.24
21.13
21
20.84
7.65% 21.53
21.44
21.34
21.23
21.09
7.60% 21.66
21.58
21.50
21.39
21.27
Ke
7.52% 21.88
21.82
21.75
21.67
21.57
6.32% 25.79
26.09
26.45
26.89
27.44
5.32% 30.39
31.27
32.39
33.79
35.65
4.32% 37.13
39.19
41.96
45.72
51.23
Price > $16.92 = UNDERVALUED
Price < $12.50 = OVERVALUED
0.0262
20.65
20.92
21.12
21.46
28.15
38.27
60.31
0.0314
20.41
20.72
20.94
21.31
29.08
42.09
77.15
Price > $16.92 = UNDERVALUED
Price < $12.50 = OVERVALUED
221 | P a g e Restated Long Run ROE Residual Income Model
Price > $16.92 = UNDERVALUED
Price < $12.50 = OVERVALUED
MWV Long Run ROE RI Valuation Model
0.0726
ROErestated
0.0616
Book Value Equity (Millions)
MVE (11/3/2008)
Shares Outstanding (11/3/08)
Estimated share price (12/31/2007)
Time consistant price (11/3/2008)
Observed Share Price (11/3/2008)
Ke
ROE as stated
0.0916 ROE restated
0.0752 Ke as stated
0.072739 Ke restated
3708
5117.04
173.84
29.44
g 0.0157
14.71
P
31.16
ROE
0.0916
0.0707
Revised using restated ROE
ROE
0.0316 0.0416 0.0516 0.0616
6.1
9.94 13.78
7.47%
17.62
7.41%
6.16
10.04 13.92
17.79
6.24
10.16 14.08
7.34%
18.00
6.31
10.28 14.24
Kе
7.27%
18.21
7.21%
6.37
10.38 14.39
18.4
6.45
10.5 14.56
7.14%
18.62
6.53
10.63 14.74
7.07%
18.84
Price > $16.92 = UNDERVALUED
Price < $12.50 = OVERVALUED
0
7.47%
18.68
7.41%
18.82
7.34%
18.99
Ke
7.27%
19.16
7.21%
19.31
7.14%
19.49
7.07%
19.67
Price > $16.92 = UNDERVALUED
Price < $12.50 = OVERVALUED
0
3.16%
9.83
4.16%
12.94
5.16%
16.05
ROE
6.16%
19.16
7.16%
22.27
8.16%
25.38
28.49
9.16%
Price > $16.92 = UNDERVALUED
Price < $12.50 = OVERVALUED
0.0716
21.46
21.67
21.92
22.18
22.4
22.67
22.95
0.0816
25.3
25.55
25.84
26.15
26.41
26.73
27.05
0.0916
29.14
29.42
29.76
30.11
30.42
30.78
31.16
Revised using restated ROE
BVE Growth
0.0052 0.0105 0.0157
18.38
18.03
17.62
18.53
18.19
17.79
18.71
18.38
18.00
18.90
18.58
18.21
19.06
18.75
18.4
19.25
18.96
18.62
19.44
19.17
18.84
0.0209
17.13
17.32
17.54
17.77
17.97
18.21
18.45
0.0262
16.53
16.73
16.97
17.22
17.43
17.69
17.96
0.0314
15.8
16.01
16.27
16.54
16.77
17.06
17.35
Revised using restated ROE
BVE Growth
0.0052 0.0105 0.0157
8.84
7.67
6.31
12.20
11.31
10.28
15.55
14.94
14.24
18.90
18.58
18.21
22.25
22.21
22.18
25.06
25.85
26.15
28.95
29.49
30.11
0.0209
4.67
9.04
13.40
17.17
22.13
26.5
30.87
0.0262
2.63
7.49
12.35
17.22
22.08
26.94
31.81
0.0314
0.11
5.59
11.06
16.54
22.01
27.49
32.96
222 | P a g e Abnormal Earning Growth Model
WACC(BT) 0.0678
WACC(AT) 0.0530
Kd
0.0589
Ke
0.0752
Stated AEG Model
Net Income (Millions)
Total Dividends (Millions)
0
2007
285
170
Core Net Income
Total PV of AEG
Continuing (Terminal) Value
PV of Terminal Value
Total PV of AEG
Total Average Net Income Perp (t+1)
Shares Outstanding (11/3/08)
Average EPS Perp
Capitalization Rate (perpetuity)
199.6
2.00
0.10
0.81
2.81
203.21
173.84
1.17
0.0752
Intrinsic Value Per Share (12/31/2007)
time consistent share price (11/3/2008)
Nov 3, 2008 observed price
Ke
g
$ 15.54
$ 16.51
$ 14.71
0.0752
-
Dividends Reinvested at 7.52% (Drip)
Cum-Dividend Earnings
Normal Earnings
Abnormal Earning Growth (AEG)
PV Factor
PV of AEG
Residual Income Check Figure
AEG - Resid. Income Check Fig.
1
2008
2
2009
3
2010
4
5
2011 2012
6
2013
7
2014
8
2015
140.88
143.70
224.17 310.85 323.29
336.22
349.67
363.65 378.20 393.33
170.00
12.784
153.67
306.43
-152.77
0.9497
-145.077
170.00
12.784
156.48
151.48
5.01
0.9019
4.516
5.01
0.000
178.50
12.784
349.00
347.60
1.40
0.7336
1.030
12.94
11.535
178.50
13.4232
363.09
361.50
1.59
0.6966
1.106
22.03
20.442
170.00
12.784
236.96
154.51
82.45
0.8565
70.616
30.14
-52.307
170.00
12.784
323.64
241.03
82.61
0.8134
67.189
22.28
-60.329
170.00
12.784
336.07
334.23
1.84
0.7724
1.423
38.27
36.432
178.50
13.4232
377.08
375.96
1.11
0.6616
0.738
3.58
2.462
AEG Perp
AEG PV₁₀
9
10
2016 2017
178.50
13.4232
391.62
391.00
0.62
0.6283
0.391
22.09
21.470
178.5
13.423
406.75
406.64
0.11
0.5966
0.066
2.11
1.997
0.10
1.353
Stated AEG Model
Return to Equilibrium
-0.10 -0.20 -0.30 -0.40 -0.50
7.72% 16.46 16.44 16.43 16.43 16.42
7.65% 16.45 16.43 16.42 16.42 16.42
7.60% 16.45 16.43 16.42 16.41 16.41
Ke 7.52% 16.44 16.42 16.41 16.40 16.40
6.32% 16.29 16.26 16.26 16.25 16.25
5.32% 16.16 16.14 16.13 16.12 16.12
4.32% 16.09 16.01 16.00 15.99 15.99
Price > $16.92 = UNDERVALUED
Price < $12.50 = OVERVALUED
223 | P a g e Restated Abnormal Earning Growth Model
Restated AEG Model
WACC(BT) 0.0678
WACC(AT) 0.0530
Net Income (Millions)
Total Dividends (Millions)
0
2007
199.6
170
Core Net Income
Total PV of AEG
Continuing (Terminal) Value
PV of Terminal Value
Total PV of AEG
Total Average Net Income Perp (t+1)
Shares Outstanding (11/3/08)
Average EPS Perp
Capitalization Rate (perpetuity)
199.6
62.48
1.94
2.01
64.49
266.10
173.84
1.53
0.0752
Intrinsic Value Per Share (12/31/2007)
time consistent share price (11/3/2008)
Nov 3, 2008 observed price
Ke
g
$ 20.36
$ 21.55
$ 14.71
0.0707
(0.500)
Dividends Reinvested at 7.52% (Drip)
Cum-Dividend Earnings
Normal Earnings
Abnormal Earning Growth (AEG)
PV Factor
PV of AEG
Residual Income Check Figure
AEG - Resid. Income Check Fig.
1
2008
140.88
170.00
12.784
153.67
214.61
-60.94
0.9497
-57.876
2
2009
143.70
170.00
12.784
156.48
151.48
5.01
0.9019
4.516
5.01
0.000
3
2010
171.87
170.00
12.784
184.65
154.51
30.14
0.8565
25.817
30.14
0.000
Kd
0.0589
4
2011
194.28
170.00
12.784
207.07
184.79
22.28
0.8134
18.119
22.28
0.000
5
2012
234.38
170.00
12.784
247.17
208.89
38.27
0.7724
29.564
38.27
0.000
6
2013
252.16
178.50
12.784
264.95
252.01
12.94
0.7336
9.492
12.94
0.000
Ke
0.0752
7
2014
279.73
178.50
13.4232
293.16
271.13
22.03
0.6966
15.347
22.03
0.000
8
2015
290.92
178.50
13.4232
304.35
300.77
3.58
0.6616
2.366
3.58
0.000
9
2016
321.47
178.50
13.4232
334.89
312.80
22.09
0.6283
13.880
22.09
0.000
10
2017
334.33
178.5
13.423
347.75
345.64
2.11
0.5966
1.257
2.11
0.000
1.94
3.371
AEG Perp
AEG PV₁₀
Restated AEG Model
Return to Equilibrium
-0.10 -0.20 -0.30 -0.40
7.47% 22.36 21.97 21.79 21.68
7.41% 22.35 21.96 21.78 21.67
7.34% 22.34 21.95 21.77 21.66
Ke 7.27% 22.33 21.94 21.76 21.65
7.21% 22.32 21.93 21.75 21.64
7.14% 22.30 21.92 21.73 21.63
7.07% 22.29 21.90 21.72 21.62
Price > $16.92 = UNDERVALUED
-0.50
21.62
21.61
21.59
21.58
21.57
21.56
21.55
Price < $12.50 = OVERVALUED
224 | P a g e Sources
MeadWestvaco Corp 10-K
Paper Manufacturing in the U.S. Industry Report, www.ibisworld.com
Packaging and Labeling Services in the U.S. Industry Report, www.ibisworld.com
www.yahoofinance.com
www.paperonweb.com
www.firstresearch.com
www.meadwestvaco.com
www.wikipedia.com
www.investopedia.com
www.dictionary.com
Coulter, Strategic Management in Action-Fourth Edition (Pearsons Education, Inc, 2008)
Healy and Palepu, Business Analysis and Valuation (Thomson South-Western, 2008)
Wall Street Journal, March 17, 2008; Jim Carlton, “International Paper Thinks Inside the
Box”
Wall Street Journal, September 11, 2008; Dominic Chopping, “Two Paper Firms to Cut
Capacity, Jobs”
Wall Street Journal, August 18, 2008; Gustav Sandstrom, “Investors See Opportunity in
Paper Makers”
Wall Street Journal, August 12, 2008; Shawn Walters, “Axing European Paper
Production”
Wall Street Journal, September 8, 2008; Jim Carlton, “MWV named to Dow Jones
Sustainability Index for Fifth Consecutive Year”
Wall Street Journal, August 5, 2008; Shara Tibken, “Weyerhauser Posts Loss”
225 | P a g e 226 | P a g e