equity analysis and valuation - texas tech...

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Equity Analysis and Valuation

Stephanie Berg

Aaron Gonzalez

Rachel Hilz

Roland Morgan

Sonya Wiley

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Table of Contents

Executive Summary ......................................................................................... 1

Industry Analysis ................................................................................................ 2

Accounting Analysis ............................................................................................ 3

Financial Analysis, Forecast Financials, and Cost of Capital Estimation ..................... 4

Valuations .......................................................................................................... 6

Business and Industry Analysis ....................................................................... 7

Business Overview .............................................................................................. 7

Industry Overview .............................................................................................. 8

Five Forces Model .......................................................................................... 10

Rivalry among Existing Firms ............................................................................. 12

Industry Growth Rate ..........................................................................................................13

Concentration and Balance of Competitors ............................................................................14

Differentiation .....................................................................................................................15

Switching Cost ....................................................................................................................15

Economies of Scale .............................................................................................................15

Learning Economies ............................................................................................................17

Fixed and Variable Costs ......................................................................................................18

Excess Capacity ..................................................................................................................18

Exit Barriers ........................................................................................................................19

Threat of New Entrants ..................................................................................... 21

Economies of Scale .............................................................................................................21

First Mover Advantage .........................................................................................................22

Access to Distribution Channels and Relationships .................................................................22

Legal Barriers ......................................................................................................................23

Threat of Substitute Products ............................................................................ 24

Customers Willingness to Switch ..........................................................................................28

Bargaining Power of Customers ......................................................................... 29

Price Sensitivity ...................................................................................................................29

Relative Bargaining Power ...................................................................................................29

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Customer Switching Costs ....................................................................................................31

Bargaining Power of Suppliers ........................................................................... 32

Price Sensitivity ...................................................................................................................32

Relative Bargaining Power ...................................................................................................33

Value Creation Analysis ................................................................................. 34

Research and Development ............................................................................... 34

Superior Product Variety .................................................................................... 35

Superior Product Quality ................................................................................... 35

Tight Cost Control System ................................................................................. 36

Firm Competitive Advantage Analysis ........................................................... 37

Research and Development ............................................................................... 37

Superior Product Variety .................................................................................... 38

Superior Product Quality ................................................................................... 38

Tight Cost Control System ................................................................................. 39

Formal Accounting Analysis ........................................................................... 40

Key Accounting Policies ..................................................................................... 41

Research and Development Expenses .........................................................................41

Goodwill ....................................................................................................................44

Defined Benefit Pension Plans .....................................................................................47

Litigation Expenses ....................................................................................................49

Accounting Flexibility ........................................................................................ 50


Goodwill ....................................................................................................................51



Accounting Strategy .......................................................................................... 53


Goodwill ....................................................................................................................54



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Quality of Disclosure ......................................................................................... 56


Goodwill ....................................................................................................................57



Quantitative Accounting Measures and Disclosures .............................................. 60

Sales Manipulation Diagnostics ....................................................................................61

Expenses Manipulation Diagnostics .............................................................................67

Potential Red Flags ........................................................................................... 74

Undoing Accounting Distortions ......................................................................... 74

Financial Analysis and Forecasting Financials ............................................... 80

Liquidity Ratio Analysis ...................................................................................... 80

Current Ratio .............................................................................................................81

Quick Asset Ratio .......................................................................................................82

Working Capital Turnover ...........................................................................................83

Accounts Receivable Turnover ....................................................................................84

Day’s Sales Outstanding .............................................................................................85

Inventory Turnover ....................................................................................................86

Day’s Supply in Inventory ...........................................................................................87

Cash to Cash Cycle ....................................................................................................88

Profitability Ratio Analysis .................................................................................. 90

Gross Profit Margin ....................................................................................................90

Operating Expense Ratio ............................................................................................91

Operating Profit Margin ..............................................................................................92

Net Profit Margin .......................................................................................................93

Asset Turnover ..........................................................................................................94

Return on Assets .......................................................................................................95

Return on Equity ........................................................................................................96

Capital Structure Analysis .................................................................................. 98

Debt to Equity Ratio ...................................................................................................98

Times Interest Earned .............................................................................................. 100

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Debt Service Margin ................................................................................................. 101

Credit Risk ...................................................................................................... 102

Firm Growth Rate ............................................................................................ 102

Internal Growth Rate ............................................................................................... 103

Sustainable Growth Rate .......................................................................................... 104

Financial Statement Forecasting ................................................................. 106

Income Statement ........................................................................................... 106

Balance Sheet ................................................................................................. 110

Statement of Cash Flows .................................................................................. 115

Cost of Capital Estimation ........................................................................... 118

Cost of Equity .................................................................................................. 118

Regression Analysis Results .............................................................................. 119

Cost Debt ........................................................................................................ 121

Weighted Average Cost of Capital ..................................................................... 122

Valuation Analysis ....................................................................................... 123

Method of Comparables ................................................................................... 123

Price to Earnings Trailing .................................................................................. 124

Price to Earnings Forward ................................................................................. 125

Price to Book ................................................................................................... 126

Price Earnings Growth ...................................................................................... 127

Price over EBITDA ........................................................................................... 128

Price over Free Cash Flows ............................................................................... 129

Enterprise Value over EBITDA ........................................................................... 130

Discounted Dividends Model ............................................................................. 132

Discounted Free Cash Flows Model .................................................................... 135

Residual Income Model .................................................................................... 137

Abnormal Earnings Growth Model ..................................................................... 139

Long Run Residual Income Model ..................................................................... 141

Appendix ..................................................................................................... 144

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SNA ‐ NYSE (6/1/2008) Altman Z‐Score52 Week Range $38.39 ‐ $58.00 2003 2004 2005 2006 2007Revenue $22.74 billion Initial 3.02 2.77 3.03 3.64 3.33Market Capitalization $61.45 billionShares Outstanding 1.33 billion Market Price (6/1/2008) $44.13

Book Value Per Share Initial Revised Comparables Based Valuations Initial RevisedROE Trailing P/E 54.90 76.10ROA Forward P/E 47.00 65.50

P.E.G. 15.80 11.30Cost of Capital P/B 56.20 113.40Estimated R‐Squared Beta Alternate Estimate Ke P/EBITDA 47.00 72.003‐Month 0.307 1.20 0.131 P/FCF 49.00 ‐6‐Month 0.308 1.20 0.131 EV/EBITDA 42.30 ‐2‐Year 0.309 1.20 0.1315‐Year 0.310 1.20 0.13110‐Year 0.310 1.20 0.131 Intrinsic Valuations

Discounted Dividends 16.61Back Door Ke 10.9 Free Cash Flows 20.04Published Beta 0.85 Residual Income 26.7Cost of Debt 0.28 LR ROE RI 49.94WACC (BT) 0.11 A.E.G. 28.6

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Industry Analysis

Wyeth is a world leader in the pharmaceutical, consumer healthcare, and animal

healthcare industry. In 1860, John and Frank Wyeth opened a drug store in

Philadelphia, Pennsylvania called John Wyeth and Brother. Since then the company has

become a major supplier of pharmaceutical products to hospitals, doctors, pharmacies,

and wholesalers around the world. Wyeth is a leader in the immunization field, and

was the first to mass produce Penicillin. All of the products produced by Wyeth are

made in the United States, Puerto Rico and a total of 13 other countries. During the

past five years, Wyeth has increased their net revenue from 15.8 billion in 2003 to 22.4

billion in 2007, an increase of 41.32%. Wyeth comprises 5.5% of the total

Pharmaceutical Industry Market Capitalization.

The direct competitors in the industry to Wyeth are Pfizer, Eli Lilly, and Abbott. The

pharmaceutical industry is a highly competitive industry, so in order to capture market

share, a firm must compete on product differentiation, innovation, and tight cost

control. The large amounts of Research and Development invested by firms in the

industry, is an excellent measure of the value of product differentiation and innovation.

Major Drug Manufacturers must constantly produce new products that will benefit the

public, in order to grow the firm.

As a whole, the pharmaceutical industry has high competition among existing firms.

The switching costs for pharmaceutical firms are high because most of their net

working capital is tied up in R&D. Economies of scale are also high, so this makes

rivalry among existing firms high. Rivalry among existing firms is so high that the best

advantage a firm in this industry has is firm recognition. There is a low threat of new

entrants, because there is a great first mover advantage, as well as difficult barriers to

entry. The amount of capital needed to invest in R&D each year is so high, it would

take new entrants a long time to catch up to the existing firms. The industry has a high

threat of substitute products, because once a patent for a drug has expired, other firms

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will make a cheaper generic. Relative bargaining power of buyers is mixed, and

suppliers possess low bargaining power.

The key success factors in the pharmaceutical industry are Research and Development,

superior product variety, superior product quality, and tight cost control. The value

creation policies, if utilized, give firms an advantage in the market. Wyeth operates its

business based on these four key success factors.

Accounting Analysis

By evaluating the financial statements of a firm and their competitors, an analyst can

determine the degree of accounting that captures the underlying business reality. A

formal accounting analysis allows the analyst to evaluate a company based on the

amount and quality of disclosure on financial statements. Companies have the ability to

hide certain facts about the company, or present values that are misleading. A formal

accounting analysis highlights the key accounting policies a firm utilizes and then relates

them to the firm’s key success factors.

The key accounting policies used by firms within the pharmaceutical industry are

research and development, goodwill, defined pension plans, and litigation expenses. All

investments associated with research and development is expensed as GAAP requires.

Pharmaceutical companies obtain a large amount of goodwill and must test for

impairments in order to decide whether to amortize it or not. Managers have

accounting flexibility when it comes to deciding if goodwill should be written down or

not. Pension plans are either defined benefit or defined contribution plans, and firms

decide the appropriate discount rate to use. Firms in the pharmaceutical industry

identify possible litigation expenses and set reserves to cover them.

Wyeth’s overall accounting strategy is mixed. Research and development is well

documented in the 10-K. All expenses related to R&D are expensed immediately, so

the is no flexibility when it comes to these investments. Wyeth’s disclosure of goodwill

in their 10-K is mixed. They clearly state their policies pertaining to goodwill and

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impairments, and disclose the amount of goodwill obtained when purchasing a new

entity. However, the accounting for impairing goodwill is never stated. The pension

plan accounting clearly shows the logic behind the discount rates, and shows their

pension obligations. Litigation expense is very transparent and is of great quality.

After analyzing the sales and expense diagnostic ratios, we determined that there were

no red flags present. No questionable accounting practices were evident after the

analysis of the financials.

In order to have a better understanding of the value of Wyeth, restating the financial

records was necessary. We made adjustments to the Balance Sheet and Income

Statement to reflect what they would look like if R&D were an asset and if goodwill was

amortized. If R&D were listed as an asset and then capitalized, rather than expensed

the assets would increase, expenses would decrease, and net income and retained

earnings would increase. If goodwill was amortized 20% per year, the assets would

decrease expenses would increase, and net income and retained earnings would

decrease. R&D is a much larger value, so after restatement, the net change on the

financials followed the R&D trend.

Financial Analysis, Forecast Financials, and Cost of Capital Estimation

Through the use of liquidity, profitability, and capital structure ratios, an analysis of a

firm’s finances can be drawn. After computing these ratios for Wyeth and their

competitors, we were able to see if Wyeth deviated from the norms of the industry,

either positively or negatively. A firm’s financial strength, relative to competitors, is

expressed through the use of these ratios.

Liquidity ratios are used to determine a company’s ability to meet its short-term

obligations. The current ratio and quick ratio for Wyeth are consistently above 1,

suggesting that the firm is capable of meeting its short-term debt obligations by turning

assets into cash. Wyeth’s operating efficiency is above the industry average, and are

also managing their accounts receivable and inventory better than the industry average.

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Profitability ratios are used to evaluate the ability of a company to generate earnings in

relation to their associated revenues, income and assets. Wyeth consistently performs

close to the industry average on these ratios. Wyeth has found a way to generate

earnings through constant sales growth. Wyeth continues to earn profits and returns at

an industry average.

Capital structure analysis is a method performed to determine how a company finances

its assets. Wyeth has consistently lowered their debt to equity ratio over the last six

years, improving their leverage.

Understanding these ratios and analyzing them for Wyeth and their competitors allowed

us to accurately forecast Wyeth’s financial statements for the next ten years. The

Income Statement was the first statement to be forecasted. The first three years after

2007 were forecasted as a running average while a constant change was used for the

following years until 2018. The future sales growth percentages were calculated by

averaging the past five years of financials and using this percentage growth extended

until 2018. Sales growth was relatively steady for the past five years and this is the

reason why the average of sales growth was used. Ultimately, net sales were increased

by a constant percentage of 8.96%. The cost of goods sold for past couple of years

never changed by more than one percentage point. The forecasted cost of goods sold

is the average of the past six years. After calculating the gross profit by subtracting

cost of goods sold from net revenue, the selling, general and administrative expenses

were forecasted.

We used ratios that link the balance sheet with the income statement to forecast with

the most accuracy possible. Assets are linked to sales by the asset turnover ratio. We

estimated a constant asset turnover of .58 from 2008 to 2018. We forecasted the

current ratio to calculate the current assets and current liabilities for Wyeth from 2008

to 2018. We used a running average of the past six years, as our forecasted current

ratio due to the variability in the trend, of 2.16. To forecast values of current liabilities,

we multiplied the current asset values we forecasted by the forecasted current ratio.

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Retained earnings are calculated by using the beginning balances of retained earnings,

adding net income and subtracting dividends paid. In order to forecast dividends, we

must calculate the dividend payout ratio. Using past years’ net income, we were able to

divide dividends by net income and averaged these payout ratios to forecast them for

the next ten years at .46. Next, we had to use the forecasted net incomes and multiply

them by the respective year’s payout ratios to calculate the forecasted dividends.

Finally, we calculated forecasted retained earnings using the forecasted net income and

dividend amounts. Once we had the retained earnings forecasted, we could forecast

total shareholder’s equity. Adding the difference in the beginning and ending retained

earnings balances to the previous year’s total shareholder’s equity amount gave us the

current year’s forecasted total shareholder’s equity.

The cost of equity was calculated by finding the risk free rate on June 1 10-year

Treasury bill rate (June 1 is the date we are valuing the company), which was 3.98%.

We ultimately chose the 10-year Treasury bill with a 72 month regression. The Beta

was found to be 1.016. We used the CAPM formula to find Wyeth’s Ke (cost of equity)

to be 13.1%. Wyeth’s cost of debt was found to be 5.19%, and WACC before tax to be

11% and after tax, 10%.

Valuation Analysis

Method of comparables is the simple and fast way to value a company, but being a

simple form of measurement it is not reliable. There are eight different ratios based on

easy to find data. Occasionally some competitors were omitted from the industry

averages. The stock prices ranged between $42.33 - $56.26 per share for Wyeth

before restatement, and $65.58 – $113.41 after restatement. The method of

comparables proved to be an inaccurate measure based on the wide range of share

prices. These inaccuracies could occur because the valuations for these methods are

based on historical prices. The resulting indication of Wyeth’s value was unclear

because there was no consistent trend.

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The intrinsic valuation models proved to be a more accurate picture of the firm.

Intrinsic valuation models use the present value of future cash flows to determine share

price. Wyeth’s observed share price on June 2, 2008 was $44.13. The discounted

dividend model valued Wyeth at $16.61, but this value only reflects the value of the

firm based on dividends and so it is not very accurate. Based on 15% confidence

intervals we made the following chart.

50.76 or >= undervalued

37.51-50.75 fair valued

37.50 or < = overvalued

The discounted free cash flows model demonstrated that Wyeth’s share price is

estimated to be $22.42, and so Wyeth is again overvalued. The residual income model

showed an initial time consistent price of $28.94, and $14.30 using the restated

financial statements. Again, Wyeth was found to be overvalued. The abnormal

earnings growth model found an initial time consistent price of $27.29, and $19.12

using the restated financial statements. The results of the abnormal earnings growth

model are in agreement with the previous method findings that Wyeth is overvalued.

According to the long run residual model Wyeth is undervalued. Our final conclusion is

that Wyeth is overvalued based on the results of the majority of the models tested.

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Business and Industry Analysis

Business Overview

In 1860, John and Frank Wyeth opened a drug store in Philadelphia, Pennsylvania

called John Wyeth and Brother. The small drug store housed a research lab, where the

two manufactured medicines for doctors and eventually wrote a book on preparing

drugs. During the Civil War the pair made and distributed drugs for the Union soldiers.

The first major achievement for the company came when, “Henry Bower, an employee

of John Wyeth and Brother, developed the first rotary compressed tablet machines in

the United States for mass-producing medicines with unprecedented precision and

speed” (www.wyeth.com). In 1926, the firm became known as American Home

Products. In 1944, Wyeth was selected by the government, along with 22 other

companies, to manufacture Penicillin. Wyeth is now based out of Madison, New Jersey.

Wyeth has three divisions: Consumer Healthcare, Pharmaceuticals, and Animal Health.

“The Consumer Healthcare segment develops, manufactures, distributes and sells over-

the-counter health care products” (Wyeth 10-K). This segment is well-known for the

sale of Robitussin, Dimetapp, Advil, and Chapstick. “These products are generally sold

to wholesalers and retailers and are promoted primarily to consumers worldwide

through advertising” (Wyeth 10-K). “The Pharmaceuticals segment develops,

manufactures, distributes and sells branded human ethical pharmaceuticals,

biotechnology products, vaccines and nutrition products” (Wyeth 10-K). The majority of

the sale of these goods is to hospitals, doctors, pharmacies and wholesalers around the

world. “The Animal Health segment develops, manufactures, distributes and sells

animal biological and pharmaceutical products” (Wyeth 10-K). These products sold in

the Animal Health segment are targeted to veterinarians and other animal health

providers. All of the products produced by Wyeth are made in the United States, Puerto

Rico and a total of 13 other countries.

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During the past five years, Wyeth has increased their net revenue from 15.8 billion in

2003 to 22.4 billion in 2007, an increase of 41.32%. Wyeth comprises 5.5% of the

total Pharmaceutical Industry Market Capitalization. Wyeth continues to protect its

market share and products through the use of patents. Wyeth currently finds itself

protecting one of its most profitable drugs, Protonix, in a patent infringement suit with

Sandoz and their generic form of the drug. According to an article in the Wall Street

Journal dated May 21, 2008, “The suit seeks a court ruling that Sandoz has infringed

the Protonix I.V. patent and a permanent injunction barring Sandoz from selling a

generic version until the patent expires in 2010.” By protecting their market share,

Wyeth continues to be one of the major Pharmaceutical producers.

Industry Overview

The pharmaceutical industry is a growing sector where there is potential for large

amounts of profit. Improvements in technology have played a significant role in

improving medicine in the last century. With the baby boomer generation aging,

demand for more advanced and specialized medicine is increasing constantly. It is no

surprise that the increased expected life span of the population in the United States is a

direct result of improved healthcare practices and medicines.

These variables have caused this industry to expand in various areas including medical

instruments, nutritional supplements, over the counter medication and prescription

based drugs. The most prominent field in this industry is undoubtedly pharmaceuticals.

Companies that focus on the development and production of drugs receive most of their

revenue from pharmaceutical sales, especially those under patent protection. When

their important patents end, generic substitutes appear in the market and force prices

to decrease. This makes it imperative for drug manufacturers to develop a drug and

secure that patent as soon as possible.

It is crucial for those all important patents to be made before competitors. Because of

this, pharmaceutical companies spend millions of dollars in research and development.

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The costs of research and development have also increased substantially in the past

couple of years. According to PhRMA, the cost of developing a drug has increased from

802 million dollars in 2001 to 1,318 million in 2006. The time to develop a drug has

also increased to a period of 10-15 years. This span of time costs drug companies a

considerable amount of money, especially if the drug does finish the development cycle

or does not get approved by the FDA.

The United States Food and Drug Administration is the regulatory agency for the

pharmaceutical industry as well as other medical products, food and supplements. This

organization has the final say as to whether a drug is permitted to enter the market as

well as the developmental process and testing phases. Drug manufacturers have fallen

under strong scrutiny involving unsafe drugs as of late. According to the Wall Street

Journal, only 19 new drugs were approved by the FDA last year. This is the lowest

number since 1983. (WSJ) The pharmaceutical companies claim that the FDA has been

stricter lately but the FDA says it has not changed its standards.

This is just a small glimpse of the pharmaceutical industry. There are many

components but these are the most important. The expansion of the medicinal field,

research and development and regulatory concerns all play a big role in shaping this

industry.

The Five Forces Model

The five forces model, developed by Michael Porter, is an industry analysis tool used to

define the competitive forces of any given industry. The five forces model consists of

five major factors. First, the rivalry among existing firms which sets the basis of

competition within the industry. When opposition is strong, price setting becomes more

aggressive. Second, the threat of new entrants determines price in regards to the ease

of entering the industry. As barriers to entry increase price competition decreases. Next,

the threat of substitute products is an alternative option for the consumer that with

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fulfill their original “desire” at a lower cost. Substitute products are only made effective

by the customer’s willingness to switch. In addition, the bargaining power of buyers is

the degree a customer drives the market price. Finally, the bargaining power of

suppliers exists when the customer has few choices of substitutes in regards to

supplies. Once the five forces model is established for an industry it enables a company

to decide if they compete on basis of commodities in a cost leadership industry, or

specialization in a differentiation industry. Our analysis described in the following

sections show that the pharmaceuticals industry has aspects of both cost leadership

and differentiation. Using the five forces model, the following chart outlines the degree

of each competitive force for the pharmaceutical industry.

Five Forces Competition

Rivalry Among Existing Firms High

Threat of New Entrants Low

Threat of Substitute Products High

Bargaining Power of Buyers Mixed

Bargaining Power of Suppliers Low

Overall Mixed

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Competitive Force 1: Rivalry among Existing Firms

Porter’s Five Forces of Competition model outlines characteristics of an industry which

contribute to the high or low competition among existing firms. These particular

characteristics which define the high competition among players in the pharmaceuticals

industry include: industry growth rate (based on revenue), concentration of

competitors, differentiation, switching costs for the firm, economies of scale, learning

economies, fixed-variable costs, excess capacity, and exit barriers. The chart below

indicates each characteristic and whether it contributes to low, moderate or high rivalry

among the existing firms for the pharmaceuticals industry.

Industry Growth Rate Moderate

Concentration of Competitors Moderate

Differentiation High

Switching Costs High

Economies of Scale High

Learning Economies High

Fixed-Variable Costs High

Excess Capacity High

Exit Barriers High

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Industry Growth Rate

For the pharmaceuticals industry, a good indicator of industry growth is revenue growth

rate. High revenue growth rates for an industry indicate that there is low competition

for market share, therefore providing potential for high profitability. Revenue growth

from year-to-year is based on the number of drugs that are developed and sold in the

market.

Industry Revenue Growth

$0

$50,000

$100,000

$150,000

$200,000

$250,000

$300,000

$350,000

2003 2004 2005 2006 2007

(WSJ.com, Annual Earnings)

The past five years revenue data for the industry indicate that pharmaceuticals are

growing at an average rate of about 8.93%. Competition exists amongst firms in an

industry where there is constant growth. Pharmaceutical firms must compete for market

share by capitalizing on the opportunity for producing differentiated products.

Investment in research and development and the launch of new drugs is the only way a

firm can stay competitive in the industry. Pharmaceuticals are developing, protecting

and marketing new drugs to account for the older drugs that compete on price with

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generics as their patents expire. The industry growth increases pressures for innovation

and differentiation, as well as price competition.

Concentration and Balance of Competitors

Industries that are low-concentration can control price as there are fewer the number

of firms in that market. Highly concentrated industries have many players and

therefore, price must be an element of competitive strategy in order to be successful.

The top drug manufacturers in the pharmaceuticals industry which hold the most

market share of revenue comprise about 92.3% of the industry’s total market. The rest

of the market which comprises the rest of the market includes over 150 firms. There

are many firms in the pharmaceuticals industry, yet the extreme majority of its sales

volume lies with only a handful of firms. Moderate concentration exists in this industry

because in order to be successful, firms have to must take price control in their overall

competitive strategy; yet, at the same time, they must invest in research and

development to produce highly differentiated products.

Market Share

0%

10%

20%

30%

40%

50%

60%

2003 2004 2005 2006 2007

% o

f Ind

ustry

Sal

es

PFEABTWYELLY

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Differentiation

As patents expire and generics are launched into the market, firms must compete on

price for those specific products. Pharmaceuticals must perpetuate the cycle of revenue

growth by pushing newly patented drugs into the market to replace the loss of revenue.

When the volume of patented drugs sold in the market outweighs the volume of older

drugs which compete with generics, the industry grows. Product differentiation is the

core competitive strategy that perpetuates revenue growth. Research and development

is the vehicle which carries out this differentiation strategy. Money spent on R&D is

directly linked to revenue growth as a firm’s survival in the pharmaceuticals industry

relies continuous product differentiation. Industries that rely heavily on differentiation,

R&D, and a first mover advantage must continuously evolve and create, rather than cut

costs for a more homogenous product. For the pharmaceuticals industry, product

differentiation contributes to high competition.

Switching Costs

For highly differentiated industries, switching costs for the firm are typically high as

well. Pharmaceutical firms have most of their net working capital tied up in research

and development. Pending lawsuits also contribute to high switching costs for the firm.

Major drug manufacturers often file lawsuits against each other for patent infringement.

Also, many firms are filed suit against by customers as long-term effects of their drugs

are sometimes found to be harmful or possibly fatal. Switching costs contribute to high

competition amongst existing pharmaceutical firms in the industry.

Economies of Scale

Industries where growth is stable do not need to utilize economies of scale as their

fixed costs will help contribute to revenue growth as opposed to hindering it.

Economies of scale exist when a firm carries very little fixed costs and can adjust their

production capacity by minimizing or maximizing variable costs. When there is rapid

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revenue growth, firms must be able to utilize economies of scale in order to be

competitive in their industry. Firms in the pharmaceutical industry have economies of

scale in order to control production costs competitively as new products are pushed

through the pipeline and older patents expire. Production fluctuates in response to

newly marketed drugs, obsolescence of older drugs and lawsuits filed against or by the

firms. The following chart illustrates the amount of total assets held by four of the

industry’s leaders:

Industry Assets

0

5000000

10000000

15000000

2000000025000000

30000000

35000000

40000000

45000000

2002 2003 2004 2005 2006 2007

Tota

l Ass

ets Wyeth

Eli LillyPfizerAbbott

In order to be competitive, economies of scale must be utilized and therefore,

contribute to a high degree of pressure for existing firms in the pharmaceuticals

industry.

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Learning Economies

Learning curves for industries determine the ease with which a new firm can enter a

market. The steeper the curve, the more capital and time it takes firms to begin

competing in the market and eventually experience profitability.

This graph shows how new products contribute to price and volume growth, which

causes the overall growth of the industry. Drug manufacturers generally spend half or

more of their cost of goods on research and development. The research and

development scientists are the integral part of the success of a pharmaceutical firm.

Average time spent in the pipeline for a single drug, from research and development to

production, is about 10 to 15 years (PHRMA, annual report). Research and development

departments begin a project with 5,000 chemical compounds and out of those, only one

gets approved by the FDA for sale to customers. High investment in research and

development contribute to the high learning curves for the pharmaceuticals industry,

making pressure for competition high.

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Fixed-Variable Costs

Pharmaceutical companies carry much more variable than fixed costs as research and

development is the main component of the cost of goods manufactured. The chemical

compounds purchased for production are expensed as well as all research and

development. Research and development as a portion of cost of goods sold is about

50% or more for the pharmaceuticals industry. This means that fixed and overhead

costs account for the smaller percentage of the cost of goods, therefore pharmaceutical

firms carry a low fixed-to-variable cost ratio and can compete effectively on economies

of scale.

Excess Capacity

Firms that have excess capacity must counteract this loss of efficiency by creating new

products or creating new needs for customers so as to increase demand which

increases production. Pharmaceutical firms change their product mix fairly often. New

drugs that are created must efficiently take the place in production facilities of the older

drugs competing with generic brands whose demand has slowed. Pharmaceutical firms

must carefully manage the timing of beginning production on newer drugs so a gap

does not exist between them and the declining production of older drugs. The following

chart from Wyeth’s 10K (2007) illustrates how they keep track of the expiration of their

patents.

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Product Expiration

Year BENEFIX 2011rhBMP-2 2014EFFEXOR/EFFEXOR XR 2008ENBREL 2012LYBREL 2018PREMPRO 2015PROTONIX 2010RAPAMUNE 2014REFACTO 2010TORISEL 2014TYGACIL 2016ZOSYN 2007

Inefficient production can affect earnings as the release of newer drugs is delayed due

to problems with FDA approval, prototypes and trials. Drug manufacturers try to

counteract this gap by continuously researching and developing new drugs so that

patent expirations for approved drugs are staggered as well. Efficient expiration of

patents and release of new drugs is necessary to counteract excess capacity in the

pharmaceutical industry. Streamlining the development and production of drugs that

are in a firm’s pipeline, helps firms to control excess capacity, which contributes to a

high degree of competition amongst existing firms.

Exit Barriers

For any company, there are barriers to exit the industry including resources, debts and

equity. Some industries are easier to exit at a lower cost than others which contributes

to a lower degree of price competition. The drug manufacturing industry is highly

competitive and similarly the exit barriers are very high as well. Assets held by

pharmaceutical industries include production facilities and research and development

labs. Ongoing research increases exit barriers and therefore increases rivalry among

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existing firms. Research and development expense for the year only affects future cost

of goods sold expense, but from this chart we can see that money spent on R&D now is

almost the same amount, or close to, the amount for goods sold this year. When it

takes 10-15 years to produce one drug, high R&D expenses pressure firms to be

extremely competitive as they will not reap the benefits of those expenses until the

drug is created and can be sold. Ongoing lawsuits against the firm by customers or by

the firm for patent infringement are very costly, not only in terms of expenses, but

market share and corporate image of firms. Lawsuits can be long and costly, especially

for the pharmaceuticals industry. As an exit barrier, pending lawsuits are very costly

and contribute to a high degree of pressure on the firms to be competitive against

existing firms.

Conclusion

Analysis of the rivalry among existing firms for the major drug manufacturing industry

according to characteristics outlined in Porter’s Five Forces of Competition model

indicate that there is very high pressure for competition of existing firms.

Pharmaceutical companies must compete to stay alive in their industry in response to

the moderate to high pressure from industry growth rate, concentration of competitors,

product differentiation, switching costs for the firm, economies of scale, learning

economies, fixed-variable costs, excess capacity and exit barriers. Competitive

strategies that respond to these pressures will guide firms in the drug manufacturing

industry to success and stability.

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Competitive Force 2: Threat of New Entrants

The relative threat of new competitors is determined by how well a company can

overcome the obstacles of entering into an industry. These obstacles include

economies of scale, first mover advantage, access to channels of distribution and

relationships, and legal barriers. The complex nature of the pharmaceutical industry

makes it difficult for potential entrants to break through these barriers and be

successful.

Economies of Scale

Economies of scale pertains to the advantage existing companies have over new

entrants. In the pharmaceutical industry, a large amount of money is poured into the

research and development of a drug. According to the Pharmaceutical Research and

Manufacturers of America (PhRMA), the industry spent an estimated $58.8 billion on

research and development in 2007. The following figure illustrates the R&D process.

Figure (pharma.org Industry Profile 2008)

(Phrma.org 2008 Industry Profile)

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Through the development and clinical testing periods, the company must meet strict

guidelines set by the Federal Drug Administration. This entire process takes

approximately 10 to 15 years, with no guarantee that the drug will be approved.

PhRMA also states that “only two out of ten approved drugs actually bring in enough

revenue to recover their cost of development”. For a new company, the likelihood of

going into debt is a harsh reality. This demonstrates a major cost disadvantage new

firms face in comparison to already existing companies when trying to enter into this

industry.

First Mover Advantage

First mover advantage is a favorable position gained by being the first to occupy an

area of the market share. In the pharmaceutical industry, a company’s ability to be the

first to get a new drug out on the market is critical to their survival and success. As

previously mentioned, the process of developing a drug takes approximately 10 to 15

years. The new entrants will again find themselves at a competitive disadvantage.

Established companies already have years of experience and are consistently working

on new innovations. Not only do these new firms lack the years of experience of the

industry leaders, but they will also be constantly trying to catch up to the new drugs

that those companies have been researching and developing for quite some time. In

addition, the use of patents by existing companies on their products further increases

the difficulty of entering this industry.

Access to Channels of Distribution and Relationships

The pharmaceutical industry expends billions of dollars each year in marketing and

advertising. These companies have several effective routes of getting their product and

information to consumers through relationships they have established. These

affiliations include suppliers, distributors, retailers, insurance companies, and health

care providers. Information is also relayed through the television industry in direct-to-

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consumer (DTC) drug marketing. According to the article “New Rules on Drug Ads

Sought” in the Wall Street Journal, “In 2007, drug makers spent more than $5 billion on

direct-to-consumer ads; more than half of that was spent on television” (WSJ 5-08-

2008). Not only will the new firms lack these crucial alliances, but they will again be at

a cost disadvantage.

Legal Barriers

Legal barriers pertaining to this industry include strict FDA regulations, licensing rights,

patents, and the inevitable liability issues brought about by lawsuits.

After completing the clinical trials, the pharmaceutical companies must be granted

permission by the FDA to market their drug. If approved, the company may proceed

with the manufacturing and marketing of their product. However, the FDA might

require the company to do additional testing or reject it all together. For a new firm,

the risk of losing millions of dollars and years of research in the approval process alone

is a significant barrier of entry.

Patents are another form of legal barrier used in many industries. As defined by the

United States Patent and Trademark Office, a patent is “the right to exclude others from

making, using, offering for sale, or selling” the invention in the United States for a term

up to 20 years. As previously stated, this protection on products further increases the

difficulty of entering this industry.

There is always a risk of adverse side effects when taking any medication. Therefore,

high costs associated with lawsuits are a relevant issue that can deter potential new

entrants in the pharmaceutical industry.

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Conclusion

The threat of new competitors in the pharmaceutical industry is limited due to the

difficult barriers of entry. These barriers include economies of scale, first mover

advantage, access to channels of distribution and relationships, and legal barriers. The

current companies have invested large amounts of money and time in the research and

development, manufacturing, and marketing of their products. They have also gained

favorable positions in the industry through their years of experience and exclusive rights

to their inventions. In addition, these companies have formed crucial alliances that aid

in getting their product and information to the consumer. As is apparent, potential new

entrants pose little threat to the established firms of the pharmaceutical industry.

Competitive Force 3: Threat of Substitute Products

The threat of substitute products is included within the five-factor model because it is a

source of rivalry between competitors in every industry. The threat of substitutes is

imperative to address because it affects the customers willingness to switch to a

competitor’s products. Specifically, the pharmaceutical industry is one based on

knowledge, which makes it exceedingly competitive. Rivalry creates a close

competition; the top ten industry leaders are only separated by a mere 6%

differentiation in terms of market share (http://www.p-d-r.com/ranking/ranking.html).

With the pharmaceutical industry continuously showing profit it has driven those

already established companies to expand in market share, causing substitute products

to be more vastly available to the market.

The research and development sector determines the company’s future plans to expand

its product line and return an increase in profits. Over decades the pharmaceutical

industry has become more competitive, making diversity within the company a new

industry factor. Innovation is key every company strives to be the first to enter the

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market with a new product. FDA regulations allow protection for products in the form of

patents. A patent lasts for roughly 15-20 years, and after that the general market can

reproduce a patented product. Thus, when a patent expires price competition increases.

Since most cost incurred by the pharmaceutical industry is experienced in the research

and development department, $58.8 billion in 2007 (see figure A below), once a

product is already on the market a competitor can copy the formula without

experiencing the extensive R&D costs. The result of this process has not only increased

the amount of substitutes, but also controversy in the industry.

(phrma.org 2008 Industry Profile)

Consumer Healthcare Segment Substitutes

As mentioned earlier the pharmaceutical industry has begun to expand not only its

product lines, but also its companies target market. We are now seeing many forms of

divisions within the pharmaceutical industry. Lilly Eli & Co separates their company in

terms of principal products (subcategorizing them in divisions of purpose i.e.,

cardiovascular), animal health care, and other pharmaceuticals (Lilly & Eli Co 10k 2007).

Similar, Wyeth pharmaceutical divides their company between a consumer healthcare

section, a pharmaceutical segment, and an animal health segment. Each segment faces

its own set of substitute products.

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First, the consumer healthcare segment faces the largest possibility of substitutes.

Products included in Wyeth’s consumer division are commonly known items such as

Chapstick, Advil, Dimetapp, etc. these products are sold to wholesalers and retailers.

Substitutes for the before mentioned over the counter products are retailer stores own

label brands which are often offered at a discounted price. For instance, at CVS you can

buy a bottle of Advil for $5.69 or you can purchase CVS brand ibuprofen for $3.19

(cvs.com). With such options it comes down to the consumer’s choice. Also, one of

Pfizer Inc.’s over the counter drugs, Zyrtec Allergy, can be purchased at Wallgreens for

$22.99 or you can purchase Wallgreens brand for $14.99. They can choose the

established quality of Advil or Zyrtec or risk using a retail label brand, which has the

same results, but comes in a less attractive packaging cutting down cost. The

consumer’s healthcare sector is challenged to establish brand recognition and customer

loyalty to maintain sufficient revenues in their highly competitive division.

Animal Healthcare Segment Substitutes

Another area to examine is the obstacle in regards to the animal health care segment

and their specific substitutes. This sector is actually controlled by the veterinarians a

company would distribute their products too. Unlike a prescription distributed by a

doctor that is later filled at a pharmacy a veterinarian’s prescription is filled directly in

the clinic. Thus, the amount of money a pharmaceutical company invests in sales

representatives will largely effect who has control within the industry. Pfizer Inc.

contributed their animal healthcare sector to contribute $2.6 billion in revenue. This is

becoming a more competitive and profitable sector for the pharmaceutical industry. The

money and time spent educating sales representatives will make a larger impact when a

company is introducing a medicine to the market. The veterinarian can pick whichever

prescription he chooses, the more time spent promoting a specific drug or vaccine the

more convinced the doctor will be the product will work. Even though the customer is

not making the direct choice in prescription for their pet, substitutes are readily

available; awareness of product will be the key defendant of substitutes.

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Pharmaceutical Segment Substitutes

Finally, the pharmaceutical division faces the most controversial substitutes in the

industry. This sector is generally the most competitive because each company wants to

be the first to storm the market with a new product. Patents are necessary in the

prescription drug manufacturing industry. An average patent lasts for twenty years if it

is not available for renewal. According to PhRMA’s 2008 industry profile it estimates it

takes 10-15 years to research and develop a new drug (phrma.com 2). This means on

average once a new drug enters the market the developing manufacturer only has

exclusive control for 5-10 years. The prescription drug is most profitable when it is

under patent, and is not competing with any cheaper generic brands. In this economic

state of welfare the pharmaceutical industry faces two main substitution obstacles.

First, the substitute of private health care versus public heath care is a new obstacle the

industry is facing. With an election year approaching the discussion of government

funded or subsidized health care is a hot topic, which would result in cheaper

substitutions available for the public. Wyeth sites this as a competitive force in there

2007 10-K. The other issue is the increased efforts of competitors to try and introduce a

generic before a patent is up. The amount of lawsuits between pharmaceutical

companies and competing manufacturers has continued to increase the FTC is trying to

limit the number of issues that are actually brought to trial. According to the article

“Settlements to use Cheaper Drugs” in the Wall Street Journal, “In a 12-month period

that ended last Sept. 30, 14 of 33 agreements to settle patent litigation between brand-

name drug companies and generics included both a restriction on the generic

company's ability to market a drug and compensation to the generic manufacturer (WSJ

5-22-2008).” As substitutes become a bigger issue companies themselves will attempt

to release their own generic brand before anyone else can. Generic substitutes are

storming the industry taking away profit from leading competitors.

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Customer’s Willingness to Switch

Overall, we have concluded the threat of substitutes in regards to the pharmaceutical

industry is extremely high. The drug manufacturers must maintain a high sense of

quality encouraging customers to stick with their established brands. The

pharmaceutical industry has many sources of customers. Since most companies are

segmented each section has there own form of customers. For the healthcare segment

the customers are wholesalers, because they are responsible for distributing the

products to the market. The healthcare segment will face the largest issues with their

customers. Generic products are common on the market giving the customer the upper

hand. The animal healthcare section would include veterinarians and pet owners as

customers. Also, the prescription drug segment’s customers tend to be doctors and

patients alike. Customers must be persuaded with other benefits when cost is the only

deterrent. The pharmaceutical industry will always continue to grow. As technology

and knowledge increases it will only lead to better and more beneficial products. High

profits will occur when a company can maintain some sort of manufacturing advantage

to prevent customers from finding alternative solutions to their products.

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Competitive Force 4: Bargaining Power of Customers

The bargaining power of buyers greatly affects the business strategy of pharmaceutical

companies. The more power that buyers hold, the more likely the company will focus

on a low cost strategy in order to directly compete against competition. If buyers hold

little power, companies are at the liberty to pursue other business strategies. In this

industry, buyers consist of wholesalers, doctors, pharmacies, hospitals, retailers and

other healthcare institutions. The three main factors that determine the bargaining

power of buyers in the pharmaceutical industry include price sensitivity and relative

bargaining power.

Price Sensitivity

Price sensitivity is defined as how prices exclusively affect a customers desire to

purchase a product. The pharmaceutical industry is a highly competitive market with

price sensitive buyers. Companies, however, hold the power over buyers while patents

for their products are still in effect. The company that holds the patent for a drug owns

the sole rights to produce and distribute the drug. Since no one else can produce the

product, this is the opportune time for a drug company to recover expenses that have

been incurred during the development phase of the drug. Companies will tend to

increase the price of their drug, especially if it is popular among doctors and hospitals.

When the patent for the drug runs out, consumers gain the upper hand. It is at this

time when other companies make generic drugs that perform exactly the same but cost

a lot less. Generic drugs pose a major threat to large pharmaceutical companies by

providing consumers with alternatives that contain little switching costs. Healthcare

institutions such as insurance companies are likely to promote generic brands to reduce

their own costs and the costs of the public. While the United States has some of the

strongest patent policies in the world, other countries tend to be more forgiving and

generic products are more numerous. This is a significant issue for United States based

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pharmaceutical companies because a large percentage of sales results from foreign

consumers. Foreign consumers therefore tend to be more price sensitive and will favor

less expensive drugs.

Relative Bargaining Power

Relative bargaining power is based off many variables including number of buyers

relative to the number of suppliers, volume of purchases by individual buyers, number

of alternative products, and the costumer’s switching costs. The pharmaceutical

industry is highly specialized with few substitutes until the patent on a particular drug

expires. On the other hand the primary customers are very large agencies. These

agencies are able to dictate prices and essentially bully the pharmaceutical companies.

Secondly, government agencies pay very close attention to pharmaceutical activities

and regulate the market. The FDA has the power to tell a drug company how to go

about developing and introducing a drug into the market. Prices can also be controlled

by the FDA through programs such as Medicare and Medicaid. These healthcare

agencies try to find the best price for the public, forcing drug companies to reduce

prices further. The government has a lot of power in the drug industry.

Finally, insurance companies can dictate what medicine they will cover. In fact, there

are insurance companies that will not cover a certain type of medication unless it is the

less expensive generic brand, upon availability. This is yet another example of the

customers bargaining power over the industry.

Wholesalers, which represent a large portion of revenue for the most prominent

pharmaceutical companies purchase in bulk. This gives them an excuse to demand

lower prices from drug manufacturers. The drug companies can do nothing but accept

these decreasing prices in order to maintain these important customers.

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All of these examples show that customers in the pharmaceutical industry have a lot of

buying power. Large agencies, the government and wholesalers all play a role in

controlling the price of products.

Customer Switching Costs

Whether the customer is an individual in the doctor’s office or a large healthcare

agency, the switching costs are relatively high. This is because medicine is very

specialized and almost always focuses on a particular illness. Even when a patent

expires doctors are hesitant to prescribe generics because they are not familiar with the

side effects or efficiency of these cheaper products. In reference to Johnson and

Johnson’s new schizophrenia drug Invega, doctors are not comfortable prescribing it to

patients. The chairman of the psychiatry department at Columbia University’s medical

school told the wall street journal that Invega is “basically a me-too drug and the

company has not done the studies that would be required to really distinguish it.” (WSJ)

In the end the switching costs are too high for customers in the pharmaceutical market.

Conclusion

After analyzing the pharmaceutical market in regards to customer’s price sensitivity,

relative bargaining power and switching costs, it is apparent that the bargaining power

of customers is mixed. Price sensitivity is high among large buyers, which account for

the majority of buyers in this industry. Relative bargaining power is high, especially

when patents expire. Finally switching costs tend to be high, making this factor about

the pharmaceutical industry mixed.

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Competitive Force 5: Bargaining Power of Suppliers

The bargaining power of a supplier dictates the actual profits that suppliers and

customers can actually earn in an industry. The bargaining power of any supplier will

determine the input costs, such as labor, materials, and resources that a customer will

incur. When suppliers in a certain industry are scarce, they hold the power over the

customer firms. The number of suppliers available is not the only characteristic of a

supplier having high level of bargaining power. A supplier who possesses a specialty or

differentiated product is able to charge a premium to firms that need these inputs. The

bargaining power of suppliers means that they have the upper hand in negotiating

trade and shipping terms. The threat of forward integration by a supplier is also a

concern of the customer firm, because they do not want the supplier to move into their

industry when they already possess the inputs needed. When a supplier does not hold

these characteristics, they are forced to abide by the demands of the customer firm,

and thus are weak relative to the customer firm.

Price Sensitivity

Suppliers in the major drug manufacturing industry are somewhat price sensitive. The

majority of materials supplied in the drug manufacturing industry are commodities, so

they are dictated by the market. Firms have many companies that they can choose to

buy supplies from. The availability of inputs for firms in the pharmaceutical industry

creates substantial price competition among the suppliers. Switching costs for the

customers (pharmaceutical companies) are relatively low, knowing they will be able to

find another supplier with ease. However, the prices of products, such as chemicals,

are low in comparison to the pharmaceuticals total expenditures, so they will not

necessarily expend resources to find another supplier.

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Relative Bargaining Power

The bargaining power of suppliers in the pharmaceutical industry is minimal. The

products sold by suppliers are readily available, simple, and undifferentiated. The large

number of suppliers in the industry, paired with the undifferentiated product, takes

bargaining power away from the supplier and transfers it to the drug manufacturers.

Upon examination of the 10-K reports for the firms in this industry, it is clear that inputs

are purchased from several sources around the world. Suppliers will only have

bargaining power if they are able to prove that the quality of their raw materials

exceeds that of other suppliers, or if a pharmaceutical company is producing a product

that requires a scarce resource. Suppliers can gain bargaining power through forward

integration to become a pharmaceutical company.

Conclusion

The number of suppliers, the products they sell, the availability of the products, and the

switching cost incurred by their customers dictate the bargaining power of suppliers in

the pharmaceutical industry. The competition and fragmented nature of the chemical

industry is the main reason why suppliers have very little bargaining power.

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Value Creation Analysis

In a specialized industry it is important to identify the key success factors to create a

competitive advantage for your company. As we established earlier with the five forces

model the pharmaceutical industry competes on the basis of a mixed strategy, thus it

includes factors of both cost leadership and differentiation. To gain an advantage in the

industry a company should focus on; research and development, tight cost control,

superior product quality and variety. Research and development, although expensive,

allows a company to compete in terms of innovation creating value in new products.

Tight cost control keeps variable costs down allowing sales to be more profitable.

Quality and variety allows a company to obtain a loyal and satisfied customer base,

increasing overall company worth. Focusing on these four strategies enables a

pharmaceutical manufacturer to obtain a percentage of the market share.

Research and Development

To be competitive in the pharmaceutical industry, a firm must continually expend large

amounts of money into the research and development of new drugs. In 2007,

America’s pharmaceutical companies invested nearly $60 billion in R&D alone.

According to PhRMA, “This record R&D investment reflects the continued commitment

of America’s research companies to lead the world in the pursuit of new life saving and

life enhancing medicines.” The Congressional Budget Office has stated, “The

pharmaceutical industry is one of the most research intensive industries in the United

States. Pharmaceutical firms invest as much as five times more in research and

development, relative to their sales, than the average U.S. manufacturing firm.” As

stated earlier, developing a drug is a process that takes approximately 10 to 15 years,

with no guarantee that the drug will be approved. Although these costs are not

recognized as assets, they are the most valuable key to the success of the

pharmaceutical company. In order to stay competitive, “Companies need to have a full

pipeline of new products that are in different stages of development…you need to have

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those pipelines robust, the only way you’re going to develop those is by having the best

scientists and product development teams available” (WSJ 5-15-2008).

Superior product variety

To compete in the pharmaceutical industry more efficiently, companies have begun to

expand into other business sectors creating more diversified product lines. First, since

patents enable a company to have sole rights over a specific drug for a period of time,

research and development teams now focus on creating treatments for multiple

illnesses. For example, Abbott Laboratories has many divisions including manufacturing

of vascular, diagnostics, and nutritional products (Abbott 2007 10K). Similarly, Lilly & Eli

Co contains sectors in neurosciences, endocrinology, oncology, and cardiovascular (Lilly

2007 10-k). Also, once a patent expires, a company can no longer monopolize the

formula and manufacturing for a drug, so they lose the cost control. Attempting to

maintain market share they have expanded their target consumers. Companies like

Pfizer now contributes their animal hath care sector to growing 14% in 2007 and credit

them for $2.6 billion worth of revenue (Pfizer 2007 10-K). Overall, the pharmaceutical

industry continues to grow even with harsher regulations from the FDA and more

litigation battles companies are managing to expand their product and gain new

customers.

Superior Product Quality

The products made by pharmaceutical firms not only improve consumers’ health, but in

many cases, these drugs can save lives. Superior product quality is essential to the

sustainability of the drug manufacturing industry as human lives depend on it. The Food

and Drug Administration is responsible for making sure that every drug manufacturer

complies with their very strict guidelines so as to eliminate the risk of faulty or

unhealthy drugs being released in the market. Recently, the FDA announced that it is

hiring “1300 scientists and pharmacologists this year” to improve inspection its

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processes of all new drugs pending its approval (Mundy, par 1). The industry requires

that firms adhere to standards above the FDA’s in that failure to do so will result a

drastic loss of market share.

Tight Cost Control System

The competitiveness of the pharmaceutical industry drives companies to use a cost

control system. Reducing costs is a significant way for drug manufacturers to gain the

upper hand in among competitors. With inexpensive generic products stealing business

and increasing research and development costs, the larger pharmaceutical companies

must lower prices and find ways to reduce costs in order to improve profits. Some

ways that companies reduce costs include outsourcing production, closing down excess

facilities, reducing employees and lowering raw material costs. Drug manufacturers can

also improve their cost strategy by allocating resources to make strategic acquisitions.

These acquisitions have the potential to reduce costs and improve innovative

capabilities and the drug portfolio of companies. (Bio-Medicine.org)

Conclusion

Companies within the pharmaceutical industry use the above value creation policies to

give themselves an advantage in the market. The only way a firm can grow in the drug

sector is by focusing a lot of attention on research and development to improve its

product line. Product quality and variety are important in ensuring that customers are

getting a product that is effective for a specific illness and meetings standards set by

the FDA. Large companies that have shown continuous growth and profit follow all of

these strategies to ensure success in the pharmaceutical industry.

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Firm Competitive Advantage Analysis

Firm competitive advantage analysis is a part of the overall business strategy analysis.

It is the first step when attempting to analyze and value a corporation. It is followed by

an accounting analysis, financial analysis, and finally the prospective analysis. Firm

competitive advantage analysis is significant because it outlines the specific

expectations of the industry and whether the individual corporation is complying with

the success factors established. In regard to the pharmaceutical industry, there are four

key categories a pharmaceutical firm needs in order to be profitable; efficient research

and development, tight cost control, product quality and product variety. Major

competitors like Wyeth, Eli Lilly, Abbott, and Pfizer are industry leaders in these areas

which enables them to be profitable, as well as capture most of the market share.


The mission of Wyeth’s research and development is “focused on discovering,

developing, and bringing to the market new products to treat and/or prevent some of

the most serious health care problems” (Wyeth 10-K). Every year Wyeth consistently

invests more money into research and development. In 2005, they invested $2.75

billion; in 2006, $3.11 billion; and 2007, $3.26 billion. Of this amount, 93% were for

expenditures in the pharmaceuticals segment (Wyeth 10-K). An issue that could

possibly affect the future success of R&D for Wyeth is the outcome of the upcoming

presidential race of 2008. If Universal Health Care insurance programs are enacted,

they could possibly decrease potential returns from research and development

activities. Wyeth strongly supports research and development activities as one their

competitive advantages.

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Superior Product Variety

Wyeth excels in value creation in terms of superior product variety. Wyeth has three

manufacturing segments pharmaceuticals, consumer healthcare, and animal health

products. The pharmaceuticals division is responsible for roughly 95.5% of Wyeth’s

income before tax. The division has three main products, EFFEXOR (17% of net

revenue), ENBREL (14% of net revenue), and PREVNAR (11% of net revenue). The

consumer health care segment manages over the counter products ranging from

Chapstick to Centrum. Although this sector is not responsible for earning the most

revenue, it includes the most recognizable products Wyeth manufactures. Finally, the

animal health segment specials in vaccines like the WEST NILE – INNOVATOR and

parasite controls known as CYDECTIN. (Wyeth 10-K 2007) Not only does Wyeth have a

diverse product line it has multiple selling methods. Wyeth floods the market through

sells to pharmacies, hospitals, physicians, retailers, and wholesalers. Also, Wyeth’s

products are sold in over 145 countries worldwide. Overall, Wyeth diversifies not only

their products but their ability to sell them permitting larger overall profits.

Superior Product Quality

Wyeth is one of the top five competitors in the pharmaceuticals industry. They identify

product quality as one of the main factors that contributes to their competitive strategy

(10K). The industry requires that firms adhere to standards above the FDA’s in that

failure to do so will result a drastic loss of market share; therefore, Wyeth’s success as

an industry leader can be attributed to their superior product quality. Total quality

control and ever-evolving processes with specific checks and balances helps to keep

Wyeth’s products above the qualifications of the FDA. For their nutrition division, “every

batch…is subjected to nearly 800 quality checks before it is made available for sale”

(WyethNutrition.com). In order to keep the industry leader position they have, Wyeth

constantly tests the quality of “nearly every component from ingredients to packaging”

(WyethNutrition.com) to effectively utilize their competitive strategy.

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Tight Cost Control

Wyeth is following a tight cost control system by implementing a productivity initiative

called Project Springboard. This initiative has been used over the past couple of years

for innovation, cost saving, process excellence and accountability. Project Springboard

is being used primarily in the pharmaceutical segment of the company. Closure of

manufacturing facilities and layoffs has taken place because of the program. “In

addition we are improving our drug development process including establishing early

clinical development centers, improving logistics for shipping clinical materials and

instituting remote data capture.” (Wyeth 10-K) In 2008 Wyeth is starting a new

program called Project Impact. According to Wyeth’s 10-K, this program will redefine

their business model to facilitate long term growth and address short term fiscal issues.

Conclusion

By creating a competitive strategy which incorporates the four key success factors

identified for the pharmaceuticals industry, Wyeth has implemented these strategies

into all business activities to compete as one of the top five major drug manufacturers.

The industry demands that in order to be competitive and ultimately profitable, firms

must understand and utilize four key success factors: research and development,

superior product quality, superior product variety and tight cost control. These key

success factors have been integrated into every aspect of the firm, therefore continuous

focus and innovation in their competitive strategy will lead to further capture of market

share and leadership in their industry.

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Formal Accounting Analysis

Accounting analysis is used to identify the accounting strategies a firm implements. We

then evaluate the quality of disclosure of the financial statements of the firm and their

competitors, an analyst can determine the degree of accounting that captures the

underlying business reality. Generally Accepted Accounting Principles (GAAP) are the

accounting guidelines set forth by the Financial Accounting Standards Board (FASB) and

enforced by the Securities and Exchange Commission (SEC), for legal financial

reporting.

Flexibility in accounting allows managers to manipulate data that can create static in

accounting reporting. Managers might use accounting flexibility to meet debt

covenants set forth by their lenders, overstate earnings to receive monetary

compensation, adjust inventory reporting to receive special tax treatment, or increase

profits to make shareholders happy. The flexibility in accounting reporting allows

companies to potentially manipulate reports, so it is imperative that a formal accounting

analysis be done in order to have a clear understanding of the financial operations of a

firm.

A formal accounting analysis involves six steps that will improve the reliability of

conclusions that are drawn about a firm’s economic performance. The first step of a

formal accounting analysis is to identify a company’s principle accounting policies, which

will link a firm’s competitive strategy to the key success factors for the industry.

Identifying the accounting policies will determine how a company is managing risk and

their own success factors. The second step is to assess accounting flexibility by

determining areas where a firm’s managers are able to choose accounting policies and

estimates. After the areas of flexibility have been identified, analysts will evaluate the

accounting strategy to decide if a firm used flexibility to show or hide true performance.

The next step is to qualitatively and quantitatively evaluate the quality of a firm’s

disclosure on financial documents. The fifth step identifies potential “red flags”, areas

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that may include questionable accounting practices. The final step of a formal

accounting analysis is to undo accounting distortions, which include misleading

numbers. By restating these values, more accurate conclusions of a firm’s economic

status and activities can be drawn.

Key Accounting Policies

The accounting analysis begins with the identification of key accounting policies that

directly relate to the success factors of the industry. These policies confirm how a

company is managing and measuring those factors. As mentioned, the success factors

of the pharmaceutical industry include research and development, superior product

quality, superior product variety, and tight cost control. The accounting policies directly

related to these factors consist of research and development expenses, goodwill,

defined benefit pension plans, and litigation expenses. Firms in the pharmaceutical

industry must understand their key success factors and then relate their key accounting

policies in order to stay competitive in this industry.

Research and Development Expenses

The Statement of Financial Accounting Standards (SFAS) No. 2 states that all research

and development costs must be expensed as incurred. In the pharmaceutical industry,

significant amounts of money are spent on R&D because this leads to the discovery of

new products, which in part, determines the future success of a company. The chart

below shows the research and development expenses reported on the income

statements of Wyeth, Abbott, Eli Lilly, and Pfizer.

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Most products in this industry are a result of R&D expenditures. In many instances, the

benefits of R&D are not usually seen for a minimum of ten years, if ever. Although

R&D is classified as an expense due to GAAP regulations, the knowledge gained from

this process could be considered an intangible asset since its results are the new

products of the firm. The resulting products made possible by R&D are the driving

force behind sales in this industry.

In order to value a company within the pharmaceutical industry, it is necessary to find

the inherent value of these expenses. Because pharmaceutical companies spend

millions each year in R&D, the total expenses incurred are high which results in a lower

net income. When you expense these research costs, the unforeseen value that could

be created is lost. If this outlay was reported as an asset instead of an expense, the

firm would experience higher earnings because assets would increase and expenses

would decrease. When R&D is expensed, as GAAP requires, the impact of conservative

accounting is shown in the following situation:

If R&D were to be put into the asset account, it would make sense to depreciate these

assets at 20% per year. This chart shows the assets being depreciated at 20% and the

bottom line shows the R&D depreciation expense that would result per year. Having

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the R&D costs in the asset account would greatly increase the assets of the company

while decreasing the expenses. This results in higher earnings and higher owner’s

equity.

Goodwill

Goodwill is considered an intangible asset by the Financial Accounting Standards Board

(FASB) and is very difficult to account for. The excess between the purchase cost and

the fair value cost of net assets is the measure of goodwill. FASB defined how goodwill

should be recorded through Accounting Principles Board Opinion 17. This stated that

Goodwill was a finite asset (having a limited life) and should be amortized over a period

of time, no longer then 40 years (www.fasb.org). However, companies realized as

goodwill continued to grow it became a more significant percentage of their overall

assets, and by amortizing goodwill yearly it did not represent a proper economical

standing of the company. Thus, in June of 2001 the FASB issued Statement No. 142,

this altered the original method in which goodwill should be recorded. Now, goodwill is

not amortized but it is tested for impairments. The impairment test is required to be

done at least annually. Impairment occurs if the fair value is less than the carrying

amount (http://cpaclass.com/gaap/sfas/gaap-sfas-141.htm.) If impairment exists the

company is to reduce the carrying amount of goodwill and recognize the impairment

loss. If an impairment fails to be recognized this will cause the overall assets to be

overstated.

This table shows why the measurement of goodwill as an asset is so controversial.

Since the change by the FASB it has allowed management to practice a certain element

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of discretion. Management can fail to report impairments and it would significantly alter

their financial statements, ultimately overstating net income putting the company in a

better economical situation then what may be true.

In the pharmaceutical industry goodwill is a big part of a company’s overall assets. As

major pharmaceutical companies continue to grow they acquire possession over smaller

firms domestically and internationally. When they purchase these said companies they

pay an overall premium. This premium, known as Goodwill, covers items such as

research and development, established brand name, and patents on certain products.

Goodwill can be related to the key success factor of product quality. Goodwill increases

the more reputable a company’s products becomes. For instance, Wyeth’s goodwill is

high because of established product quality in their well known items like Chapstick and

Advil. As the industry grows and ventures to new markets, goodwill seems to follow.

* In Millions

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As shown in the graph above the percentage of goodwill follows a steady trend, when a

company gains a new entity they can experience a jump. In regards to Wyeth’s 2007

goodwill expense, they had an addition of $157 million from completing the acquisition

of a Japanese company once known as Takeda (Wyeth 2007 10-K). However, since

overall assets of the company also increased the change in percentage of goodwill to

assets actually showed a slight decrease. It was not because of any write-downs from

impairments. The footnotes in a company’s 10-K reveal imperative information about

goodwill, it will disclose how the company measures the asset. The graph shows

goodwill is still recognized as one of the largest assets for a company participating in

the pharmaceutical industry. If the goodwill was not impaired, assets would remain

high, and the true value of the firm would be hard to determine. If goodwill is

impaired, the assets would decrease, expenses would increase and lower net income as

well.

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Defined Benefit Pension Plans

With tens of thousands of employees, the profitability of pharmaceutical companies can

be affected by pension plan costs. Pension plans are fixed amounts of money paid to

past employees at regular intervals. Rising healthcare costs necessitate a well

organized pension plan system that will take into affect increases in inflation and

volatility in the market. Pension plans are liabilities recorded as the present value of

future payments given to employees. Discount rates are used to calculate the present

value of these payments. This rate is the primary way for individuals to know how

much the company owes in liabilities as a result of pension plans. As a general rule, if

the discount rate is too high the liabilities for the company will be understated.

Liabilities will be overstated if the discount rate is too low.

Pension Plan Discount Rate

2002 2003 2004 2005 2006 2007

Abbott 6.5% 5.8% 5.6% 5.5% 5.7% 6.2%

Eli Lilly 6.8% 6.2% 5.9% 5.8% 5.7% 6.4%

Pfizer 6.9% 6.3% 6.0% 5.8% 5.9% 6.5%

Wyeth 6.75% 6.25% 6.0% 5.69% 5.9% 6.45%

According to Wyeth’s 10-K, assumed discount rates are calculated by matching the

projected stream of benefit payments to the yields provided by high-quality corporate

bonds. The chart above shows that the average discount rate used by the prominent

pharmaceutical competitors is about 6.39% in 2007. The average inflation rate for

2007, according to the Department of Labor, is 2.8%. This demonstrates that returns

will be able to more than compensate for inflation increases. Finally the 2007 Treasury

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bond rate, which is considered the risk-free rate, is 4.0995. This shows that returns will

be greater than the risk-free rate. It is apparent that Abbott, Eli Lilly, Pfizer and Wyeth

are all estimating their discount rates in a similarly conservative fashion. Wyeth is

overstating its liabilities as can be seen in the chart below.

The disclosed expected rate of return for Wyeth’s pension plan assets is 9% for the

past three years. These rates of returns are derived on an annual basis from the

company and an outside investment consultant. Historical returns and forward-looking

factors are used in calculating the returns. Wyeth clearly states that these numbers

represent the best estimate of normalized capital market returns over the next decade

or more. In conclusion, companies in the drug manufacturing industry are using a

conservative approach in determining the present value of future benefit plan

payments.

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Litigation Expenses

Litigation expenses and the reserves established to protect patents are necessary to

accurately present financial position. Accounting policies for the disclosure, or accrual,

of litigation estimates are proscribed by the FASB in Statement No. 5, “Accounting for

Contingencies”. In regards to the disclosure of litigation reserves, firms must identify

and consider three elements: “the period in which the cause for action of the pending

litigation occurred, the degree of probability of an unfavorable outcome, and the ability

to make a reasonable estimate of the amount of loss” (FASB, Statement No. 5).

Disclosure of litigation estimates relates to the key success factor product quality.

Pharmaceutical firms are very susceptible to lawsuits from customers who have been

harmed by drugs that were manufactured by the firm. It is common in the drug

manufacturing industry for firms to be involved in several lawsuits at a time in which

they must defend the quality of their products. Usually a nationwide settlement is

reached, in which customers who can prove they have been harmed by the drug will be

awarded restitution. Treatment of the disclosure of litigation estimates regarding

consumer lawsuits against the firm is a key accounting policy for the pharmaceuticals

industry.

Product variety is one of the key success factors for firms in the pharmaceuticals

industry. Patents protect the drugs that firms produce; if they do not aggressively

defend these patents, revenue and subsequently, net income, can easily be affected. It

is very common for a firm to file a lawsuit against those who infringe upon its current

patents. Following in accordance with the FASB Statement No. 5, the industry discloses

the treatment of awarded settlements as outcomes are probable and amounts are

estimable. It is very important that firms in the pharmaceutical industry identify

litigation disclosure as a key accounting policy to be utilized in their accounting strategy.

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Conclusion

The key accounting policies confirm how a company is managing and measuring their

key success factors. The accounting policies related to those factors include research

and development expenses, goodwill, defined benefit pension plans, and litigation

expenses. The regulations associated with recording resources greatly influence the

amount of accounting flexibility allowed by firms.

Accounting Flexibility

Accounting flexibility is a measure of the firm’s right to choose accounting policies and

estimates. Accounting guidelines set forth by GAAP and FASB limit this freedom by

specifying how resources are to be classified. When a firm has little flexibility in its

accounting policy choices, the data is likely to be less informative for understanding the

firm. If firms have a high level of accounting flexibility, they can choose policies and

estimates which lead to a more accurate picture of the firm’s economics. All firms are

able to make choices along the lines of depreciation, inventory, and estimation of

pension policies. The flexibility in these areas provides firms with accounting policy

choices that can impact the financial reports.


There is no flexibility in accounting policies with regards to research and development.

GAAP sets forth that R&D is to be expensed as incurred. Initially, the knowledge gained

from research and development activities could be viewed as an intangible asset.

Palepu and Healy state, “The economic benefits from research and development are

generally considered highly uncertain—research projects may never deliver promised

new products, the products they generate may not be economically viable, or products

may be made obsolete by competitor’s research.” The fact that 1 out of 5,000

compounds are actually approved reinforces the SEC’s policy that R&D outlays should

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be expensed. Had those 4,999 failed expenditures been reported as assets, then the

expenses would have been significantly understated and assets overstated on the

balance sheet. Due to GAAP regulations, there is no accounting flexibility for research

and development.

Goodwill

The pharmaceutical industry deals with extraordinary amounts of goodwill, making it

imperative for analysts to pay attention to how goodwill is accounted for. Since the

change in 2001 by the FASB goodwill is no longer required to be amortized yearly, it is

now at management’s discretion to record impairments. Statement No. 142 has enabled

the accounting policy of goodwill to become extremely flexible. Whatever stance

management choices to take with accounting (i.e. aggressive or conservative) will affect

the overall financial statements. If goodwill is not impaired in a timely fashion it will

cause an overstatement of assets and net income. This flexibility can enable

management to create an altered perspective of the company from what may actually

exist. Overall, the footnotes in regards to goodwill should be closely examined in order

to recognize any “red flags” that might have occurred due to the high degree of

flexibility.


The present value of future benefit plan payments is calculated using a discount rate.

This discount rate is a number derived from managers based on data they have

available. Managers can easily choose this rate to reflect a conservative or aggressive

accounting strategy. Wyeth demonstrates that they are using a reasonable discount

rate and it is very similar to its competitors. They can very well change the rate to give

off an impression to investors that their liabilities are relatively low. This in turn will

reduce expenses and improve net income. On the other hand managers need to make

sure that pension payments do not fall below expected healthcare costs for a given

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year. There is an underlying pressure to meet this standard. In conclusion there the

discount rate is an arbitrary number derived from managers but there are boundaries

that this rate must follow giving pensions a moderate amount of flexibility.

Litigation Expenses

Pharmaceutical firms have very limited flexibility in the disclosure of litigation

contingencies. According to the FASB Statement No. 5, firms should disclose litigation to

the financial statements when the outcome is probable and amounts are reasonably

estimable. Managers calculate reasonable estimates based on information about specific

cases when they believe that a certain income is probable. If estimates for litigation

liabilities do not follow FASB guidelines, a firm can accrue too little expense or recognize

too little a non-current liability. When the courts decide on a settlement to be paid by a

firm that has manipulated their estimates to reflect higher earnings or lower liabilities,

the firm will not be able to meet their debt obligations. Research of the industry's top

competitors reveals that pharmaceutical firms follow the FASB statements regarding

“Accounting for Contingencies” (FASB.org), therefore providing for little flexibility in

accounting policies.

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Accounting Strategy

The accounting strategy that the managers of a firm use is based on the amount of

flexibility at their discretion. The amount of flexibility will allow the managers to either

hide or show the firm’s true performance through the accounting strategy they choose

to undertake. The two strategies are conservative and aggressive accounting methods.

Aggressive accounting is used when there is an opportunity to misconstrue accounting

statements to show only what the firm wants disclosed. Conservative accounting shows

the lower of cost or market values as opposed to their present fair values.


In any industry, the SEC prescribes that all financial reporting is done following the

rules of GAAP. GAAP mandates that all research and development expenses are

expensed immediately and not capitalized. Research and development is the driving

force behind the pharmaceutical industry, without it, growth of the industry and its

firms would level off. Investment in R&D is the largest expense incurred by firms in the

pharmaceutical industry. On average, substances will be in the R&D stages for ten to

fifteen years before they are approved, if ever. Once a firm receives approval for a

drug, they can receive a patent on the substance that will last up to 20 years. While

possessing the patent, it is important for a firm to use its market share to recapture the

R&D expenses for that product. Once the patent has expired, other drug

manufacturers will produce generic substances that will claim market share.

Since there is no flexibility in the reporting of research and development expenses, it is

difficult to determine the value of firms in the pharmaceutical industry. Pharmaceutical

companies show extremely high expenses, and thus report low net income. If

pharmaceutical companies were able to report R&D investment as an intangible asset,

then expenses would decrease and net income would increase, as well as owner’s

equity. In this hypothetical situation, liabilities and revenues would be left unchanged.

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Every year, firms in the pharmaceutical industry continue to spend billions of dollars on

R&D to ensure that they continue to be solvent and continue to hold or increase their

market share. The firms in this industry cannot deviate from the accounting strategy

set forth by GAAP regulations, and they will continue to expense R&D costs as they are

incurred. The real problem with having to expense such large amounts of money from

R&D is that it might trigger firms to start hiding other expenses that are incurred.

Because R&D is the foundation of this industry, and it must be expensed, firms wanting

to show a higher net income could choose to capitalize or underestimate other firm

related expenses.

Goodwill

As established earlier the flexibility in regards to goodwill enables management the

possibility to skew the overall financial view of the company. The best way to determine

if a company is sufficiently reporting goodwill impairments is to compare the process of

competitors in the same industry. The graph (refer to page 36) shows for the most part

a company’s goodwill to total assets ratio ranges between 10-20%. If the ratio seems

exceptional high it might be a sign that a company is taking an aggressive standpoint

failing to recognize impairments when they occur. If the ratio seems to be low the

company is probably using conservative accounting practices and writing down

impairments immediately. An unusual jump like in Eli Lilly might mean a possible

change in policy. According to Wyeth’s 10-K they follow the rules set by the FASB in

statement 142, no longer treating goodwill as a finite asset but they include it in their

intangible assets, and test annually for impairments (Wyeth 10-K 2007). They measure

impairment in the fourth quarter by calculating the fair value of each unit (i.e.

pharmaceuticals, animal heath, and consumer healthcare) and comparing it to the

carrying value of the unit. If the carrying value is greater than the fair value impairment

is recognized and the asset is written down. Wyeth’s 2007 10-K accounts for their

being no impairment recognized for both 2006 and 2007. However, goodwill increased

because of the company’s completed purchase of the Japanese company Takeda.

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Wyeth appears to be taking an “aggressive stance” revealing that it reports goodwill in

accordance to FASB, but leaving out any specific details.


The accounting strategy that Wyeth uses when discussing pension plans is adequate.

The company provides the proper information required by the GAAP including discount

rates, expected healthcare cost growth rates and estimated future benefit payments.

The beginning of the pension plan section of the Wyeth’s 10-K clearly explains the

defined benefit and defined contribution plans they offer employees and how each of

them operate. Later in this section the 10-K explains how and why different

calculations are made regarding pension obligations. Wyeth is a high disclosure

company because they clearly explain what they are doing with the pension funds and

follow conservative policies because discount rates are overstating liabilities.

Litigation Expenses

Product Liability Litigation

(In thousands) 2007.00 2006.00

Accrued expenses $1,458,309 $2,089,890

Other noncurrent liabilities 800,000 650,000

Total litigation accrual $2,258,309 $2,739,890

(Wyeth 10K, 2008)

In regards to litigation settlements, Wyeth discloses its estimates to an account called

“Total Litigation Accrual”. The estimate for “Total Litigation Accrual” consists of two

accounts: “Accrued Expenses” and “Other Non-Current Liabilities”. Wyeth's accounting

strategy is to slightly overestimate the amount of litigation liability to be disclosed

because the court ruling is decided after the estimates are made. Excess from previous

liability estimations is carried over in the “Other Non-Current Liabilities”. Wyeth

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efficiently estimates their litigation liabilities and discloses them accordingly; which is

why their accounting strategy allows them to be competitive as an industry leader.

Conclusion

Generally Accepted Accounting Principles regulate the amount of flexibility a company

has in their accounting policies and numbers. The amount of flexibility allowed

determines how accurately the firm is portrayed through their financial statements.

There is no freedom in reporting research and development because it is expensed

immediately and never capitalized. The accounting policy of goodwill, an intangible

asset, has become extremely flexible due to management’s discretion in recording

impairments. Defined benefit pension plans have moderate flexibility and high

disclosure through their explanation in the 10-K. Pharmaceutical firms have very limited

flexibility in the disclosure of litigation contingencies.

Quality of Disclosure

The amount and quality of information that a company’s managers choose to disclose,

is in direct proportion to the understanding of the reality of business activities.

Managers have several ways and reasons to disclose information from their SEC filings.

Analysis of the quality of disclosure on financial statements is a key component

necessary to draw conclusions about a firm’s economic status and activities. When a

manager chooses to only offer the minimum requirements for SEC filings, a concise

conclusion about the value of the firm cannot be inferred. In fact, minimum disclosure

could lead to investors and analysts to raise questions concerning what a firm might be

hiding. Quality is measured by the firm’s ability to disclose areas such as, adequately

explaining accounting policies in footnotes, portraying the firm’s key accounting policies,

explaining current performance, and the amount of additional disclosure that is not

required under GAAP.

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Pharmaceutical companies show their research and development expenses on the

income statements in their 10-K filings. All expenses related to R&D must be expensed

immediately, so there is no flexibility when it comes to expensing these investments. If

pharmaceutical companies were to cut their R&D investments, their entire industry

would no longer produce break through medicines, and their growth rates would come

to a halt. Although R&D is an expense, firms in this industry do not want to hide the

millions of dollars of R&D expenses on their financial statements. Research and

development expenses, in this industry, are very important to investors and analysts

because they are a measure of the steps that a firm is undertaking to claim a larger

market share, and in turn produce higher profit margins. These expenses are clearly

disclosed on each firm’s financial records, so the quality of disclosure of research and

development is documented well.

Goodwill

Wyeth’s disclosure of goodwill in their annual 10-K is very mixed. Wyeth very clearly

states their policy of goodwill and impairments. They efficiently disclose the amount of

goodwill breaking it into segments, showing additions and currency adjustments for all

three. It gives the reader a clear understanding of what segments are actually gaining

or possibly loosing. In addition, when they are purchasing new entities they release the

specific amount of new goodwill being contributed to that specific situation, like the

acquisition of Takeda. On the other hand, they outline how they measure for

impairment, but they never show the accounting behind it. Wyeth claimed in their 10-K

that goodwill in both 2006 and 2007 was free of impairment and would not experience

a write off. It would be beneficial to their investors if Wyeth forecasted the future

expectations the company has for goodwill. The fact that goodwill is not currently being

impaired, and the company is discrete on what they reveal makes it seem that

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management might be skewing the results. When analyzing the quality of Wyeth’s

accounting, goodwill is an area where a misrepresentation may exist.


The quality of disclosure for discount rates is decent. The reasoning behind

management’s selection of the discount rate is logical. Wyeth’s main competitors also

have pension discount rates that are within a tenth of a percent of Wyeth’s. After

taking into effect assumed healthcare trends and changes in inflation the discount rate

is a reliable piece of information that the company provided. At first glance it is easy to

mistaken pension benefits and other postretirement benefits as having a deficit but

after further investigation it is clearly stated that a new rule has been put in place for a

specific chart called “Recognition of funded status”.

SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other

Postretirement Plans” was issued in September 2006 and states that, “the recognition

of the funded status of defined benefit pension plans, retiree health care and other

postretirement benefit plans and postemployment benefit plans on the consolidated

balance sheet.” (Wyeth 10-K) SFAS No. 158 also says that overfunded plans are

recognized as an asset and underfunded plan is a liability. Secondly, this requires that

unrecognized prior service costs or credits and net actuarial gains and losses as well as

subsequent changes in the funded status be recognized as a component of

Accumulated other comprehensive income (loss) within stockholders’ equity.

Up until 2006 Net Recognized in chart “recognition of funded status” would transfer to

projected benefit obligations as of January 1st of the next year in chart “change in

benefit obligations”. Afterwards benefit obligation as of December 31st of 20X1 would

transfer to benefit obligation as of January 1st of 20X2. This is how the accounting

department computed unrecognized net actuarial loss, unrecognized service cost and

unrecognized net transition obligations prior to September 2006. In the reconciliation

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of funded status chart, pensions were labeled as a negative figure. The funded status

was labeled as a negative figure. Unrecognized net actuarial loss was a positive

number if investments declined in value. Finally unrecognized prior service costs were

positive if costs increased, adding to obligation of pensions.

This proves that the quality of disclosure is satisfactory and Wyeth clearly explains what

they are doing with their pension finances. Discount rates are fully clarified and other

various costs and unrecognized expenses are included.

Litigation Expenses

Wyeth discloses litigation liabilities in accordance with the FASB Statement No. 5

“Accounting for Contingencies”. In the pharmaceutical industry, it is sometimes difficult

to understand how accrued liabilities are estimated, especially an aggregate of all

pending litigation. As for their 10K’s, Wyeth provides extensive information regarding

the disclosure and current status of pending lawsuits. They include specific details

describing the legal action, parties and dollar amount of settlements estimated to be

paid (or which have already been paid) for each lawsuit. Wyeth’s quality of disclosure

related to litigation and estimating contingent liabilities are very transparent and of

great quality.

Conclusion

Analysis of the quality of disclosure on financial statements is a key component

necessary to draw conclusions about a firm’s economic status and activities. The

expenses of research and development are completely disclosed and well documented

on Wyeth’s income statement. The disclosure of goodwill in their annual 10-K was

mixed due to the lack of showing complete information on impairments. The quality of

disclosure is satisfactory on their pension finances; discount rates are fully clarified and

other various costs and unrecognized expenses are included. Pharmaceutical firms

have very limited flexibility in the disclosure of litigation contingencies.

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Quantitative Accounting Measures and Disclosures

After evaluating the quality of financial disclosure, it is imperative that a quantitative

analysis be discussed. GAAP sets forth certain accounting techniques and guidelines

firms must follow when preparing SEC filings, however, these are only minimum

standards. Therefore, a firm’s manager possesses a level of accounting flexibility at

their discretion. The ability to make estimates and hide certain facts is not a bad thing.

In fact, flexible accounting practices allow firms to stay keep trade secrets in an effort

to stay competitive in their industry. Managers use this capability to determine what an

appropriate level of information to disclose is. Accounting is a very powerful tool that

can be used to inform investors or hide the true financial state of a company from

them. By using diagnostic ratios, analysts can determine the what a company is doing

financially, beyond what is presented in the balance sheet, income statement,

statement of cash flows, and other accounting data presented in a firm’s 10-K. In

essence, quantitative accounting analysis allows an analyst to make the numbers

presented in these reports more meaningful for the purposes of valuing a company.

There are several ratios that an analyst can perform to find the underlying value of a

company’s financial operations. These ratios can be broken down into two sub

sections, sales manipulation diagnostics and the expense manipulation diagnostics.

Sales manipulation diagnostics use net sales as the numerator in all of the ratios.

These ratios will provide information about a firm’s income and provide indications of

possible “red flags.” Expense manipulation diagnostics are used to determine if a

company is manipulating their expenses. By performing these diagnostic ratios for

Wyeth, Abbott, Pfizer, and Eli Lilly, industry wide trends will appear and deviations will

be noted as possible “red flags” distorting accounting figures.

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Sales Manipulation Diagnostics

After establishing the possible flexibility in key accounting policies for the

pharmaceutical industry it is necessary to run certain ratios to uncover if any potential

“red flags” exist within an individual company. Sales manipulation diagnostics

specifically deal with net sales and how they may be affected by changes in different

current assets. To form the net sales to cash from sales, the net sales to accounts

receivable, and the net sales to inventory ratios we extracted important financial

statement information from six years worth of 10-Ks. To evaluate the specific

performance of Wyeth we compared their ratios over five years with their most similar

competitors: Abbott, Pfizer, and Eli Lilly. If any of Wyeth’s ratios appear different from

the industry’s this would be an indication that a distortion exists, and further

investigation would be required.

Net Sales/Cash from Sales

Net sales from cash sales ratio shows the amount of cash received for every dollar

worth of sales. For instance Wyeth shows in 2007 their ratio is .993, this means for

every dollar in the operating cycle they earn $.993 in cash. A profitable company would

want to keep this ratio as close to 1 as possible. The closer the ratio is to one means

they have a low accounts receivable balance, and their allowance for doubtful accounts

is minimal.

Out of the industry comparison Wyeth sets the bar, since 2003 they have managed to

keep their ratio in the .9 range, a desirable trait for any company. The fact that the

competitors are following the trend determines that the pharmaceutical industry relies

heavily on cash sales. With Wyeth having a diverse sales strategy, this ratio shows they

have developed good relationships with their wholesalers as well as their individual

retailers. They are receiving a lot of cash in a timely manner, and not relying on

accounts receivables to come due. Net sales from cash sales ratio for Wyeth do not

suggest suspicion of a “red flag” or any distortion present.

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Net Sales/Net Accounts Receivable

Net sales to accounts receivable ratio is the portion of sales that results in an increase

to the accounts receivable balance. As we discussed earlier the pharmaceutical industry

is one that relies heavily on cash sales. We can deduct that the net sales/accounts

receivable ratio should be low throughout the industry. This is a positive trend that will

provide companies with more liquid assets and fewer sales based on credit.

Overall, Wyeth’s ratio declines except for a slight jump in 2006 to 1007. This is because

of an overall increase to Wyeth’s 2007 accounts receivable, but is not significant

because they still follow within the trend of the industry. In 2006 and 2007 respectively

accounts receivables only accounted for 19.42% and 20.33% of total sales, meaning

the other 80.58% and 79.67% can most likely be contributed to cash sales. Wyeth’s net

sales to accounts receivable ratio closely mimics the ratio trend of the industry,

discouraging the possibility of any distortions present.

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Net Sales/Inventory

The ratio that is computed by dividing net sales by inventory determines how effective

the inventory is in generating revenue. If the ratio is too small compared to

competitors then the company is not making enough revenue for a given amount of

inventory. If the ratio is large then the company is using its inventory wisely and

efficiently. If the ratio is 1:1 then for every dollar that is placed in inventory will result

in a dollar’s worth of sales. The graph above shows that Wyeth, as well as its

competitors, has a relatively high amount of sales compared to inventory. This means

that firms in the pharmaceutical industry make a large amount of revenue for a small

amount of product. This is reasonable considering that prescription drugs are rather

expensive, especially if they are still protected by a patent. The figures that Wyeth

discloses do not result in a red-flag.

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Conclusion

Sales ratios are calculated and review to find potential red-flags. Sales manipulation

diagnostics specifically deal with net sales and how they may be affected by changes in

different current assets. The ratios included net sales to cash from sales, the net sales

to accounts receivable, and the net sales to inventory. No red-flags can be seen from

these sales ratios.

Sales Manipulation Diagnostics Wyeth 2003 2004 2005 2006 2007 Net Sales/Cash from Sales 0.926 0.985 0.988 0.976 0.993Net Sales/Net Accounts Receivable 6.266 6.202 6.189 5.749 6.072 Net Sales/Inventory 6.571 7.005 8.037 8.204 7.380 Net Sales/Unearned Revenue N/A N/A N/A N/A N/ANet Sales/Warranty Liabilities N/A N/A N/A N/A N/A Abbott 2003 2004 2005 2006 2007 Net Sales/Cash from Sales 0.8962 0.8913 0.8937 0.9939 0.8829Net Sales/Net Accounts Receivable 5.2153 5.3245 7.7195 5.3121 5.2385Net Sales/Inventory 6.3103 7.5101 8.7876 8.0089 8.7802Net Sales/Unearned Revenue N/A N/A N/A N/A N/ANet Sales/Warranty Liabilities N/A N/A N/A N/A N/A Pfizer 2003 2004 2005 2006 2007 Net Sales/Cash from Sales 0.7824 0.871 1.0243 1.0644 0.999Net Sales/Net Accounts Receivable 5.1802 5.6065 5.2533 5.1502 4.919Net Sales/Inventory 7.8498 7.8853 8.4945 9.1232 7.9231Net Sales/Unearned Revenue N/A N/A N/A N/A N/ANet Sales/Warranty Liabilities N/A N/A N/A N/A N/A Eli Lilly 2003 2004 2005 2006 2007 Net Sales/Cash from Sales 0.893 0.916 0.949 0.938 0.864Net Sales/Net Accounts Receivable 6.747 6.731 6.331 6.826 6.969Net Sales/Inventory 6.4098 6.0473 7.7983 6.9114 7.3834Net Sales/Unearned Revenue N/A N/A N/A N/A N/ANet Sales/Warranty Liabilities N/A N/A N/A N/A N/A

72

Expense Manipulation Diagnostics

Expense manipulation diagnostics are used to show the trends of each firm in the

industry. These ratios allow for the comparison of the firms and indicate any deviations

from the industry norm. Any variation found from the norm signals a possible red flag.

To evaluate the specific performance of Wyeth, we compared their ratios over five

years with their most similar competitors: Abbott, Pfizer, and Eli Lilly.

Asset Turnover

Asset turnover measures the amount of sales that are generated for every dollar of

assets. This ratio calculates the efficiency of a firm’s ability to make revenue from

assets as well as determining price strategies. Usually the raw asset turnover ratio will

be around one. Special attention should be made for years where the ratio jumps a

considerable amount or falls too fast. A large jump in ratios from one year to the next

is indicative of a problem in accounting calculations. As the graph above shows, the

raw asset turnover ratio for Wyeth is relatively steady without changing by more than a

tenth. This demonstrates that the revenue is sufficiently explained by the amount of

assets that Wyeth possesses. In conclusion Wyeth’s raw asset turnover does not

represent any abnormalities. The asset turnover change represents the change in sales

from one year to the next over the change in assets from one year to the next. The

asset turnover change chart shows these figures with their respective companies.

74

CFFO/OI

The cash flow from operations ratio is calculated by dividing the cash flow from

operations by operating income. This ratio gives one a basic understanding of the

company’s quality of earnings. It is relatively easy to report satisfactory income without

showing a decent amount of cash increases. If there are large changes from year to

year it could be derived from noncash expenses. The graph above shows that Wyeth’s

ratio changes from year to year but not by a large number. This ratio follows the trend

of other competitors in the pharmaceutical industry and a significant jump from one

year to the next is not evident. This shows that operating income sufficiently explains

the cash flow from operations figure that is reported in Wyeth’s statements and no red-

flags are present.

75

CFFO/NOA

The ratio above explains how effective a company is in making cash from the

equipment at hand. It is calculated by dividing cash flow from operations by net

operating assets. Net operating assets are derived from adding together plant,

property and equipment less depreciation expenses. The higher this ratio is the more

efficient the company is in regards to using these operating assets. Wyeth’s

information has disclosed that they are not very efficient with their equipment

compared to similar competitors in the pharmaceutical industry. The change graph

shows the difference between the changes in cash flow from operations between two

years divided by the change in net operating assets for those two years.

77

Conclusion Expense ratios are calculated and reviewed to find potential red-flags. Three ratios

were used including the net asset turnover and the relationship between cash flows

from operations and net operating assets as well as operating income. All of these

measurements show that Wyeth is very similar to its competitors. While some of the

ratios for Wyeth appear to be lower than competitors in this industry they at stable

levels and any large fluctuations do not exist. No red-flags can be seen from these

expense ratios.

78

Wyeth 2003 2004 2005 2006 2007Asset Turnover(Raw) 0.511 0.516 0.523 0.558 0.524Asset Turnover(Change) 0.254 0.580 0.632 2.501 0.328CFFO/OI(Raw) 0.787 0.694 0.528 0.632 0.967CFFO/OI(Change) 22.01 -0.072 -1.716 1.3 2.837CFFO/NOA(Raw) 15.92 15.33 13.25 18.37 32.24CFFO/NOA(Change) -1.13 -6.63 51.55 -2829.89 517.84Total Accruals/Change in Sales(Raw) 0.679 1.091 0.933 0.591 0.615Total Accruals/Change in Sales(Change) -3.596 -3.394 -22.094 2.742 0.923Pension Expenses/SG&A(Raw) 0.067 0.07 0.071 0.073 0.078Pension Expenses/SG&A(Change) 1.497 3.704 1.852 1.677 0.698Other Employment Expenses/SG&A(Raw) 0.024 0.021 0.025 0.022 0.024Other Employment Expenses/SG&A(Change) 0.959 -0.063 0.502 -0.005 1.08

Abbott 2003 2004 2005 2006 2007Asset Turnover(Raw) 0.664 0.684 0.767 0.621 0.653Asset Turnover(Change) 1.124 0.88 7.112 0.02 0.972CFFO/OI(Raw) 1.138 1.105 1.157 2.577 1.132CFFO/OI(Change) 1.508 0.996 1.598 -0.093 -0.031CFFO/NOA(Raw) 0.54 0.72 0.84 0.76 0.69CFFO/NOA(Change) -0.59 -3.36 -156.64 0.23 -0.14Total Accruals/Change in Sales(Raw) 0.316 0.446 0.63 25.595 0.459Total Accruals/Change in Sales(Change) 0.004 1.21 0.528 0.657 0.573Pension Expenses/SG&A(Raw) 0.001 0.001 0.001 0.001 0.001Pension Expenses/SG&A(Change) -2.051 2.255 1.016 1.514 1.255Other Employment Expenses/SG&A(Raw) N/A N/A N/A N/A N/AOther Employment Expenses/SG&A(Change) N/A N/A N/A N/A N/A

Eli Lilly 2003 2004 2005 2006 2007Asset Turnover(Raw) 0.58 0.557 0.596 0.715 0.696Asset Turnover(Change) 0.571 0.4 -2.752 -0.398 0.609CFFO/OI(Raw) 1.041 0.784 0.524 0.964 1.073CFFO/OI(Change) 9.052 -4.953 94.644 4.325 1.74CFFO/NOA(Raw) 1.793 2.631 4.135 2.05 1.664CFFO/NOA(Change) 0.791 -1.302 -0.378 0.116 0.359Total Accruals/Change in Sales(Raw) 0.722 0.831 0.04 1.255 0.748Total Accruals/Change in Sales(Change) -0.075 3.264 -0.347 2.637 0.153Pension Expenses/SG&A(Raw) 0.114 0.123 0.132 0.128 0.107Pension Expenses/SG&A(Change) 1.953 2.26 5.98 -0.368 0.376Other Employment Expenses/SG&A(Raw) 0.024 0.026 0.032 0.035 0.028Other Employment Expenses/SG&A(Change) 0 0.05 0.151 0.071 0.001

Pfizer 2003 2004 2005 2006 2007Asset Turnover(Raw) 0.383 0.427 0.436 0.419 0.42Asset Turnover(Change) N/A 1.234 0.221 1.45 -0.169CFFO/OI(Raw) 0.933 0.801 0.837 1.003 0.992CFFO/OI(Change) 5.926 0.591 0.577 -46.902 1.04CFFO/NOA(Raw) 0.645 0.889 0.862 1.058 0.849CFFO/NOA(Change) N/A 20.205 1.241 -6.247 4.723Total Accruals/Change in Sales(Raw) 0.627 0.64 -5.458 -0.595 110.83Total Accruals/Change in Sales(Change) N/A -1.598 0.364 -6.584 -3.764Pension Expenses/SG&A(Raw) 0.067 0.072 0.093 0.098 0.093Pension Expenses/SG&A(Change) N/A 0.99 1.081 2 -2.825Other Employment Expenses/SG&A(Raw) 0.009 0.009 0.01 0.011 0.011Other Employment Expenses/SG&A(Change) N/A 0.011 0.001 0.083 -0.135

Expense Manipulation Ratios

79

Potential Red Flags

Red flags are signals pointing to questionable accounting practices. When red flags

appear, they indicate that certain items have been distorted and that further evaluation

of material facts and estimates are needed. After analyzing the sales and expense

diagnostic ratios we determined that there were no red flags present. There were no

questionable practices involving the key accounting policy of research and development.

R&D was expensed in compliance with SEC regulations. The analysis of R&D as an

asset is a theory that represents the value added to a firm by investments in research

and development.

Undoing Accounting Distortions

Financial filings with the SEC and financial statements used for the purpose of investor

education portray the economic activities to the user. It is imperative that these

statements represent factual numbers, precise estimates, and a good amount of

disclosure in order for accurate conclusions about the firm’s economic status to be

drawn.

Goodwill Restatement

Wyeth clearly follows the rules established by the FASB in regards to impairing goodwill.

However, since they have not recognized any impairment for the last two years we

have chosen to amortize the intangible asset. Since the pharmaceutical industry is one

based on knowledge we recognize that the goodwill for a company should be relatively

substantial. Patents are finite, over time individual companies loose their monopoly on

certain products and goodwill should be impaired for this instance.

We have chosen to amortize goodwill at a rate of 20%. We took the 20% of the original

amount of goodwill to get the amortization expense for 2002. For the following years

we took 20% from the difference in goodwill and added the total amount of the

previous year’s amortization expense. The 2003 goodwill amortization expense was

80

calculated as (goodwill t-1 * .20) + ((goodwill t – goodwill t-1) *.20). By amortizing

goodwill it reduced the overall percentage goodwill was of total assets that were

discussed earlier. This graph shows the extreme difference in Wyeth’s total assets by

simply expensing a percentage of goodwill. Clearly since Wyeth is continuing to

purchase new entities goodwill should not always be amortized. Our method of

restatement is aggressive compared to Wyeth’s current accounting standards. We

believe Wyeth should adapt a moderate stance in regards to amortizing goodwill.

Goodwill as a percentage of total assets

0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

12.00%

14.00%

2002 2003 2004 2005 2006

Restated Goodwill/TotalAssetsGoodwill/Total Assets

Research and Development Restatement

It was determined that research and development is the driving force behind the

pharmaceutical industry. If the costs associated with research and development were

placed in the asset account and then depreciated 20% per year, assets would increase,

and expenses would decrease creating an increased net income. The table below

shows the adjusted net income if R&D expenses were capitalized.

81

We have chosen to depreciate R&D at a rate of 20%. We took the 20% of the original

amount of R&D to find the R&D depreciation expense for 2002. For the following years

we took 20% from the difference in R&D and added the total amount of the previous

year’s depreciation expense. The 2003 R&D depreciation expense was calculated as

(R&D t-1 * .20) + ((R&D t – R&D t-1) *.20).

The net income of Wyeth would increase if the expenses in R&D were able to be on the

balance sheet in the asset section. Since the net income has increased, the owner’s

equity section of the balance sheet would increase as well. This would represent a

favorable statistic to investors as well as analysts. The assets of the company would

also be increased, changing the expense and revenue diagnostics.

The following Income Statements and Balance Sheets show the effects of restating

Goodwill and Research and Development. Notice that total assets as well as net income

increase after restating R&D and Goodwill.

82

Wyeth Balance Sheets 2002 2003 2004 2005 2006 2007Assets:Cash and cash equivalents 2,943,604 6,069,794 4,743,570 7,615,891 6,778,311 10,453,879 Marketable securities 1,003,275 1,110,297 1,745,558 618,619 1,948,931 2,993,839 Accounts Receivable 2,379,819 2,529,613 2,798,565 3,030,580 3,383,341 3,528,009 Inventories 1,992,724 2,412,184 2,478,009 2,333,543 2,480,459 3,035,358 Other current assets including deferred taxes 1,776,330 2,840,354 2,672,327 4,446,208 2,923,199 2,972,513

Property, plant and equipment:Land 173,743 182,849 187,732 177,507 177,188 182,250 Buildings 3,401,490 4,130,838 4,630,910 6,492,605 7,154,928 7,921,068 Machinery and equipment 3,782,533 4,184,292 4,657,716 4,860,953 5,491,987 6,170,239 Construction in progress 2,477,219 3,188,273 3,600,993 1,516,033 1,659,391 1,947,624 Total PP&E 7,235,692 8,661,051 9,524,350 9,353,353 10,146,259 11,072,158 Goodwill 3,745,749 3,817,993 3,856,410 3,836,394 3,925,738 4,135,002 Other intangibles, net of accumulated amort. 145,915 133,134 212,360 279,720 356,692 383,558 Other assets including deferred taxes 3,309,537 3,457,502 5,598,555 4,326,818 4,535,785 4,142,966 Total Non-Current Assets 14,436,893 16,069,680 19,191,675 17,796,285 18,964,474 19,733,684

Total Assets 26,042,592 31,031,922 33,629,704 35,841,126 36,478,715 42,717,282 Liabilities:Loans payable 804,894 1,512,845 330,706 13,159 124,225 311,586 Trade accounts payable 672,633 1,010,749 949,251 895,216 1,116,754 1,268,600 Accrued expenses 3,798,500 5,461,835 7,051,557 8,759,136 5,679,141 5,333,528 Accrued taxes 209,479 444,081 204,028 280,450 301,728 410,565 Total Current Liabilities 5,485,506 8,429,510 8,535,542 9,947,961 7,221,848 7,324,279

Long-term debt 7,546,041 8,076,429 7,792,311 9,231,479 9,096,743 11,492,881 Accrued postretirement benefit obligations 965,081 1,007,540 1,024,239 1,104,256 1,600,751 1,676,126 Other noncurrent liabilities 3,890,052 4,224,062 6,429,709 3,563,061 3,100,205 3,511,621 Total Liabilities 17,886,680 21,737,541 23,781,801 23,846,757 21,019,547 24,004,907

Stockholders EquityCommon stock 442,019 444,151 445,031 447,783 448,417 445,929 Additional paid-in capital 4,582,773 4,764,390 4,817,024 5,097,228 6,142,277 7,125,544 Retained earnings 3,286,645 4,112,285 4,118,656 6,514,046 8,734,699 10,417,606 Accumulated other comprehensive income (155,571) (26,487) 467,152 (64,725) (672,666) 221,433 Total Stockholders Equity 8,155,912 9,294,381 9,847,903 11,994,369 14,652,755 18,210,535

Total Liabilities and Stockholders Equity 26,042,592 31,031,922 33,629,704 35,841,126 36,478,715 42,717,282

Asset Turnover (Raw) N/A 1 1 1 1 1

Total Current Assets 11,605,699 14,962,242 14,438,029 18,044,841 17,514,241 22,983,598 Current Ratio 2 2 2 2 2 3

Dividends paid (1,219,173) (1,223,158) (1,227,034) (1,259,398) (1,358,769) (1,423,494) Net Income 4,447,205 2,051,192 1,363,844 3,656,298 4,196,706 4,615,960

83

Wyeth Restated Balance Sheets 2002 2003 2004 2005 2006 2007Assets:Cash and cash equivalents 2,943,604 6,069,794 $4,743,570 $7,615,891 $6,778,311 $10,453,879Marketable securities 1,003,275 1,110,297 1,745,558 618,619 1,948,931 2,993,839Accounts Receivable 2,379,819 2,529,613 2,798,565 3,030,580 3,383,341 3,528,009Inventories 1,992,724 2,412,184 2,478,009 2,333,543 2,480,459 3,035,358Other current assets including deferred taxes 1,776,330 2,840,354 2,672,327 4,446,208 2,923,199 2,972,513Total Current Assets 11,605,699 14,962,242 14,438,029 18,044,841 17,514,241 22,983,598Property, plant and equipment:Land 173,743 182,849 187,732 177,507 177,188 182,250Buildings 3,401,490 4,130,838 4,630,910 6,492,605 7,154,928 7,921,068Machinery and equipment 3,782,533 4,184,292 4,657,716 4,860,953 5,491,987 6,170,239Construction in progress 2,477,219 3,188,273 3,600,993 1,516,033 1,659,391 1,947,624Total PP&E 7,235,692 8,661,051 9,524,350 9,353,353 10,146,259 11,072,158Goodwill after amortization 2,996,599 3,054,394 3,085,128 3,069,115 3,140,590 3,308,002 Other intangibles, net of accumulated amort. 145,915 133,134 212,360 279,720 356,692 383,558Other assets including deferred taxes 3,309,537 3,457,502 5,598,555 4,326,818 4,535,785 4,142,966Research and Development 1,664,152 1,674,824 1,968,488 2,199,512 2,487,248 2,605,428Total Non-Current Assets 25,186,880 28,667,157 33,466,232 32,275,616 35,150,068 37,733,293

Total Assets 36,792,579 43,629,399 47,904,261 50,320,457 52,664,309 60,716,891Sales 14,584,035 15,850,632 17,358,028 18,755,790 20,350,655 22,399,798TAT 0.43 0.40 0.39 0.40 0.43

Liabilities:Loans payable 804,894 1,512,845 $330,706 $13,159 $124,225 $311,586Trade accounts payable 672,633 1,010,749 949,251 895,216 1,116,754 1,268,600Accrued expenses 3,798,500 5,461,835 7,051,557 8,759,136 5,679,141 5,333,528Accrued taxes 209,479 444,081 204,028 280,450 301,728 410,565Total Current Liabilities 5,485,506 8,429,510 8,535,542 9,947,961 7,221,848 7,324,279

Current Ratio 2.12 1.77 1.69 1.81 2.43 3.14

Long-term debt 7,546,041 8,076,429 7,792,311 9,231,479 9,096,743 11,492,881Accrued postretirement benefit obligations 965,081 1,007,540 1,024,239 1,104,256 1,600,751 1,676,126Other noncurrent liabilities 3,890,052 4,224,062 6,429,709 3,563,061 3,100,205 3,511,621Total Liabilities 17,886,682 21,737,543 23,781,803 23,846,759 21,019,549 24,004,910

Stockholders EquityCommon stock 442,019 444,151 445,031 447,783 448,417 445,929Additional paid-in capital 4,582,773 4,764,390 4,817,024 5,097,228 6,142,277 7,125,544Retained earnings 14,036,678 16,709,804 18,393,253 20,993,414 25,726,734 28,919,078Accumulated other comprehensive income (155,571) (26,487) 467,152 (64,725) (672,666) 221,433Total Stockholders Equity 18,905,899 21,891,858 24,122,460 26,473,700 31,644,762 36,711,984

84

Wyeth Incom

e Statements

20022003

20042005

20062007

Net Revenue14,584,035

15,850,632

17,358,028

18,755,790

20,350,655

22,399,798

Cost of goods sold

3,918,387

4,377,086

4,947,269

5,431,200

5,587,851

6,313,687

Gross Profit

10,665,648

11,473,546

12,410,759

13,324,590

14,762,804

16,086,111

Selling, general and administrative expenses

5,010,507

5,468,174

5,799,791

6,117,706

6,501,976

6,753,698

Research and development expenses

2,080,191

2,093,533

2,460,610

2,749,390

3,109,060

3,256,785

Operating Incom

e(EBITDA)3,574,950

3,911,839

4,150,358

4,457,494

5,151,768

6,075,628

Interest expense, net

202,052

103,140

110,305

74,756

(6,646)

(90,511)

Other incom

e, net(382,931)

(332,264)

(330,100)

(397,851)

(271,490)

(290,543)

G

ains related to Imm

unex/Amgen com

mon stock transactions

(4,082,216)

(860,554)

-

-

-

-

Diet drug litigation charges1,400,000

2,000,000

4,500,000

-

-

-

Special charges

340,800

639,905

-

-

-

-

Income before federal and foreign taxes

6,097,245

2,361,612

(129,847)

4,780,589

5,429,904

6,456,682

Provision for federal and foreign taxes1,650,040

310,420

(1,363,844)

1,124,291

1,233,198

1,840,722

Net Incom

e4,447,205

2,051,192

1,363,844

3,656,298

4,196,706

4,615,960

Wyeth

Restated

Inco

me S

tatemen

ts2

00

22

00

32

00

42

00

52

00

62

00

7 N

et Revenue

14,584,035

15,850,632

17,358,028

18,755,790

20,350,655

22,399,798

Cost of goods sold

3,918,387

4,377,086

4,947,269

5,431,200

5,587,851

6,313,687

Gross Profit

10,665,648

11,473,546

12,410,759

13,324,590

14,762,804

16,086,111

Selling, general and administrative expenses

5,010,507

5,468,174

5,799,791

6,117,706

6,501,976

6,753,698

Operating Incom

e5,655,141

6,005,372

6,610,968

7,206,884

8,260,828

9,332,413

Interest expense, net

202,052

103,140

110,305

74,756

(6,646)

(90,511)

Research and developm

ent depreciation expense416,038

418,706

492,122

549,878

621,812

651,357

G

oodwill am

ortization expense749,150

763,599

771,282

767,279

785,148

827,000

O

ther income, net

(382,931)

(332,264)

(330,100)

(397,851)

(271,490)

(290,543)

Gains related to Im

munex/Am

gen comm

on stock transactions(4,082,216)

(860,554)

-

-

-

-

D

iet drug litigation charges1,400,000

2,000,000

4,500,000

-

-

-

Special charges

340,800

639,905

-

-

-

-

Income before federal and foreign taxes

6,097,245

2,361,612

(129,847)

4,780,589

5,429,904

6,456,682

Provision for federal and foreign taxes1,650,040

310,420

(1,363,844)

1,124,291

1,233,198

1,840,722

Net Incom

e5,362,208

2,962,420

2,431,203

5,088,531

5,898,806

6,394,388

85

Financial Analysis and Forecasting Financials

Now that the pharmaceutical industry has been analyzed, key success factors identified

and important accounting policies reviewed one must delve further into the company to

determine its value. Analyzing the financial statements of Wyeth and its competitors

involves three steps that include ratio analysis, forecasting and calculating the cost of

capital. The ratio analysis involves studying liquidity, profitability and capital structure

ratios for the firm and its competitors in the drug manufacturing industry. The ratios in

this initial step are compared with the industry. These ratios along with the common

sized financial statements will allow one to forecast specific items. The forecasts will

provide potential results for the firm. Finally, interest rates and pricing data will be

used to calculate the cost of equity.

Liquidity Ratio Analysis

Liquidity ratios are used to determine a company’s ability to meet its short-term

obligations. Liquidity refers to how quickly the assets of a firm can be converted into

cash. The liquidity ratios used in this analysis include the current ratio, quick asset

ratio, working capital turnover, accounts receivable turnover, days’ sales outstanding,

inventory turnover, days’ supply in inventory, and cash to cash cycle. For this analysis,

we compared Wyeth with three other competitors in the pharmaceutical industry.

86

Current Ratio

The current ratio is calculated by dividing total current assets by total current liabilities.

The purpose of this ratio is to illustrate the capability of a firm to pay off its short term

debt with funds that can be turned into cash relatively easily. If this ratio is equal or

greater than one then the company can pay off its obligations quickly and without

issues. When the current ratio is lower than one then the firm likely has a liquidity

problem. As the chart above shows, Wyeth has a very high current ratio since 2002

with an upward trend starting in 2004. The reasons for the large jumps in the past two

years include a 30% decrease in liabilities from 2005 to 2006 and a 30% increase in

assets from 2006 to 2007. Compared to the average of Wyeth and its competitors

Wyeth consistently shows higher current ratios. Over the past seven years the current

ratio of Wyeth demonstrates that this firm is very liquid over time. Wyeth has plenty of

easy to convert assets that will satisfy current obligations.

87

Quick Asset Ratio

The quick asset ratio measures the liquidity of a company in a similar fashion to the

current ratio. This ratio is measured by adding cash, securities and accounts receivable

and dividing this sum by the current liabilities. Analysts use this ratio because it gives a

more realistic image of the firm’s ability to repay its debts with specific assets that can

be turned into cash fast rather than the entire current asset figure that is used in the

current ratio formula. Inventory is the notable asset item left out of the quick asset

ratio. Many companies that produce consumer goods will have a large sum of money

invested in inventory. If the quick asset ratio is much lower than the current ratio, then

the company might be relying too much on inventory figures, which might their worth

before they are sold. The above chart shows that even with inventory taken out of the

equation; Wyeth is still able to pay off its liabilities without trouble.

88

Working Capital Turnover

Working capital is calculated by subtracting current assets by current liabilities. This

figure gives individuals the amount of funds the company is using to generate sales. If

the sales figure is divided by working capital, this ratio will determine how effective the

company is in generating sales from operations. The working capital ratio should be at

least one. If it is higher then the firm is very effective in generating sales with the

funds for operations they possess. As can be seen in the graph above, Wyeth and its

competitors have relatively stable working capital turnover ratios. Wyeth’s lowest

working capital turnover ratio was in 2007 when it dropped to 1.4. This is credited to

an increase in current assets in 2007 which increases the denominator in the equation.

Abbott’s low ratio in 2006 is attributed to a large amount of liabilities that were added

to the balance sheet.

89

Accounts Receivable Turnover

Accounts receivable turnover demonstrates how effective the firm is in collecting

receivables. All of the companies in the pharmaceutical industry have a significant

amount within accounts receivables so the possibility of operating solely on cash is not

present. High receivables turnover signifies that the company collects money owed to

the firm very quickly. When the receivables turnover is low special attention should be

taken to address why collections are not being made because this is potential revenue

being lost. This ratio is measured by dividing sales by accounts receivables. All of

these pharmaceutical firms have a high accounts receivable turnover ratio indicating

that all of them are efficient in collecting receivables. Wyeth consistently has a

receivables turnover ratio above six since 2002.

90

Day’s Sales Outstanding

The day’s sales outstanding ratio measures the number of days it takes a company to

collect on their accounts receivables. This is simply calculated by dividing the

receivables turnover by 365. A company would desire the ratio to stay relatively low,

because it is a sign that liquidity can be easily created. Wyeth’s 2007 days sales

outstanding ratio is 57.6, which are much lower, then the industry’s average of 63.5. 58

days might seem like a lot of time to collect on receivables. However, if Wyeth’s

receivable terms were established as net 60, requiring their customers to send payment

within 60 days of the sell then they would be operating efficiently. Although Wyeth is

not the lowest in the industry it is closely following the industry trend without any rapid

changes, proving Wyeth is receiving cash quickly enough for the industry standards.

91

Inventory Turnover

The inventory turnover ratio is a component of measuring a company’s overall

operating efficiency. The formula to calculate the inventory turnover is: cost of goods

sold over inventory. The higher the ratio the more productive a company is with

managing their inventory. Overall, the pharmaceutical industry maintains a low

inventory turnover ratio. Abbott has consistently been the industry leader in this

aspect, but Wyeth has once again followed the overall trend. The lower ratio may be

contributed to pharmaceutical companies keeping a high amount of inventory on hand.

Since drug manufactures go through extensive R&D and long testing trials, once they

receive the patent on a specific drug they more then likely mass produce it so they can

start the developing process of a new drug. This would keep the costs of goods sold

constant over time, but would result in an excess of inventory, making the ratio lower.

Since Wyeth is above most of their competitors and only experienced a 0.2 drop from

2006-2007 it seems they are managing their inventory moderately.

92

Day’s Supply in Inventory

Day’s supply of inventory is the assessment, in terms of days, it takes inventory to be

sold and become collectables in accounts receivable. This is measured by simply

dividing the inventory turnover ratio by 365. A company’s day’s supply of inventory

should relatively be the opposite of their inventory turnover. Thus, since Abbott had

the highest inventory turnover they have the lowest day’s supply of inventory. Wyeth

once again will follow the overall industry trend, but is now downward slopping. The

recent jump from 2006 to 2007 from 162 to 175.5 days shows Wyeth’s inventory has

increased and is not being sold as quickly, and should be taken notice of.

93

Cash to Cash Cycle

The cash to cash cycle is simply the amount of time it takes a company to earn 1 dollar

of revenue for every dollar they put into their inventory. A company’s cash to cash cycle

is their day’s supply of inventory plus their day’s sales outstanding. This sums up the

importance of all the operating efficiency measurements and gives a better

understanding of what a company is overall achieving. Once again Abbott has been

leading the industry over the pass six years averaging a 169 day cash to cash cycle

were adversely Pfizer has averaged 317 days. In regards to Wyeth they continue the

pattern of following the industry’s trend. They are slightly below the industry’s 6 year

average of 250 days with an average 236 day cash to cash cycle. They are

outperformed by Abbott, but are second in the overall industry, meaning the amount of

time to receive revenue from sales is proficient.

94

Conclusion

The current ratio and quick ratio for Wyeth are consistently above 1, suggesting that

the firm is capable of meeting its short term debt obligation by turning their assets into

cash. Wyeth, therefore, has no problem with liquidity. The working capital turnover for

Wyeth is always positive, around 1, showing that the firm effectively generates revenue

through the use of their working capital. Inventory turnover and accounts receivable

turnover measure the firm’s operating efficiency. These ratios show that Wyeth has

operating efficiency above the industry average, and are managing their accounts

receivable and inventory better than the industry. Wyeth does not possess the lowest

day’s sales outstanding in the industry, but they are doing a good job of managing their

receivables. Wyeth overall has done well by industry standards in managing their days

supply of inventory, but the jump from 162 days in 2006 to 175.5 days in 2007,

indicates that they are not pushing inventories through the cycle as well as they have in

the past. After analyzing Wyeth’s cash to cash cycle, it is evident that Abbott does a

better job of converting inventory to sales and then receiving the cash. However,

Wyeth still performs above the industry average.

95

Profitability Ratio Analysis


relation to their associated revenues, incomes and assets. The profitability ratios used

for this analysis include the gross profit margin, operating expense ratio, operating

profit margin, net profit margin, asset turnover ratio, return on assets, and return on

equity. For this analysis, we compared Wyeth with three other competitors in the

pharmaceutical industry for the years 2002 through 2007.

Gross Profit Margin

Gross profit margin is calculated by dividing a firm’s gross profit by its sales. Gross

profit is found by subtracting cost of goods sold from net sales. This ratio is used to

determine how profitable a company’s operating activities are, excluding the associated

costs. A high gross profit margin indicates that a firm has the ability to make a profit

on its sales, as long as they manage their costs. As seen in the chart below, Wyeth’s

gross profit margin stayed consistent with the industry average. Two of Wyeth’s main

competitors, Pfizer and Eli Lilly, have continually had a higher gross profit margin.

Wyeth has maintained an overall average of 72.1% throughout the past six years.

96

Operating Expense Ratio

The operating expense ratio is found by dividing the selling, general, and administrative

expenses by net sales. This ratio indicates what proportion of a company’s sales are

being spent on operating expenses. For this ratio, a smaller percentage is best because

it suggests that a firm has a greater ability to generate a profit, due to lower operating

expenses, should their earnings decrease. As illustrated below, Wyeth’s operating

expense ratio was the most unfavorable because it remained the highest among its

competitors from 2002 to 2006. Overall, Abbott performed the best with the lowest

ratio among the industry.

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Operating Profit Margin

Operating profit margin is calculated by dividing income from operations by sales. This

ratio is another way of measuring management’s efficiency within a company. A firm

with a higher operating profit margin tends to have lower fixed costs and operating

expenses. The chart below shows that despite a few up and downs, Pfizer has overall

outperformed the industry in its operating profit margin. Wyeth and Eli Lilly exhibited

similar ratio patterns and were both below the industry average for several years.

However, Wyeth did show an increase above Eli Lilly and nearly matched Pfizer’s

margin in 2007. Abbott’s operating profit margin remained below its industry

competitors throughout the last six years.

98

Net Profit Margin

Net profit margin is computed by dividing net income by sales. This ratio indicates how

much profit a company makes for every dollar of sales they generate. In relation to

competitors, the higher the net profit margin, the better. This ratio could be considered

one of the most important, as it is directly tied to earnings of company and its

performance. Looking at the chart below, Pfizer appears to have unstable earnings

with its sales. Abbott’s net profit margin steadily went down from 2002 to 2006, but

then showed an increase in 2007. Eli Lilly and Wyeth again showed similar trends

throughout the six years. In 2007, Wyeth closed out the year with the highest net

profit margin among its competitors at 20.7%. The restatement shown for Wyeth was

the result of recording research and development as an asset, depreciating it over a five

year term, and amortizing goodwill. This action raised the net income, which in turn

raised the net profit margin. There was however a decrease in 2007 due to the large

amounts of R&D being written off simultaneously that year.

99

Asset Turnover

Asset turnover is calculated by taking net sales of the current year over total assets of

the previous year. This ratio measures how efficiently a firm generates net revenue

using its assets. For this analysis, a higher ratio is indicative of better performance. As

illustrated in the chart, the industry generated an overall average of $0.62 in sales for

every $1 of assets. In comparison to the other firms, Abbott achieved a superior asset

turnover from 2002-2006. Pfizer trailed in the industry with an average of $0.42 in

sales for every $1 of assets. Without restatement of the total assets, Wyeth’s turnover

was consistent with that of the industry. By restating this ratio, we are theoretically

increasing the total assets of Wyeth by no longer expensing R&D, but rather classifying

it as an asset and depreciating it over a five year life. In doing this, Wyeth’s asset

turnover greatly decreased to an average of $0.40 in sales for every $1 of assets. The

amount of goodwill that is depreciated each year does not significantly impact the asset

turnover ratio.

100

Return on Assets

Return on assets is found by taking the net income of the current year over the total

assets of the previous year. This ratio indicates the amount of profit that results from

each dollar of invested capital. The more efficiently a company uses the resources at

its disposal, increases the potential ROA. The industry had an overall average of

10.8%. Upon restating R&D and goodwill, the overall return on assets for Wyeth

decreased significantly due to the addition to assets.

101

Return on Equity

Return on equity is calculated by taking the net income of the current year and dividing

it by the owners’ equity from the previous year. This ratio indicates how much money

has been earned through the money the shareholders’ have invested in the company.

Typically a higher return signals that a firm is growing. In 2005, the spike in Wyeth’s

return on equity could be contributed to a new product reaching the market. As Wyeth

continues to be above the industry average from 2005 to 2007, it is likely that they

have gained a larger share of the market resulting in higher profitability. As can be

seen, the return on equity for the pharmaceutical industry has large fluctuations. This

could be attributed to the utilization of retained earnings and the release of new

products. Through the restatement of owners’ equity, Wyeth shows a significant drop

due to the large amounts of retained earnings from the increased net income.

102

Conclusion


relation to their associated revenues, incomes and assets. After calculating these

ratios, it is evident that Wyeth consistently performs close to the industry average. The

charts show that Wyeth never really has any large dips or spikes in relation to their

ability to generate earnings and manage expenses. Wyeth has found a way to

generate income through constant sales growth. Overall, Wyeth continues to earn

profits and returns at an industry average.

103

Capital Structure Analysis

Capital structure analysis is a method performed to determine how a company finances

its assets. The liabilities and owner’s equity are analyzed in order to determine if the

firm uses debt or equity to finance its ongoing activities, such as acquiring new assets.

Use of the ratios related to capital structure analysis focus on two specific areas, the

amount of debt relative to the owner’s equity and the ability to meet interest payments.

Three ratios were used to determine the capital structure of Wyeth relative to its

competitors. These ratios were debt to equity ratio, times interest earned, and debt

service margin.

Debt to Equity Ratio

The debt to equity ratio explains how a company finances its operations. By dividing

total liabilities by total equity a business can determine whether they rely more on their

own capital or by borrowing money. The lower the debt to equity ratio the better the

company stands financially. As the ratio approaches one, it would show a company to

have a balanced capital structure. The graph shows Wyeth has the highest debt to

equity ratio compared to the industry; this may be alarming to future and current

investors. Since a company must pay their debts before their shareholders receive any

benefits this may discourage potential investors, because they would see a decrease in

dividends. Wyeth has been consistently improving their debt to equity ratio; Wyeth’s

six-year average was 1.93 but is currently 1.3. Wyeth is being outperformed by the

industry but is striving to cut back on debt financing. The debt to equity ratio for

Wyeth dropped significantly after the restatement of R&D and goodwill because owners’

equity increased due to larger retained earnings. Therefore, Wyeth’s overall risk

decreased through the restatement.

105

Times Interest Earned

Times Interest Earned demonstrates the company’s portion of operating income that

covers that period’s interest expense. The ratio is calculated by dividing income from

operations by the current portion owed of long-term debt. This ratio can constantly

change due to shifting interest rates, acquiring new debt, and completing payments on

older loans.

Unfortunately due to the volatile debt to equity trend of Pfizer the industry average is

inadequate in comparing other companies. Wyeth has a five-year average of 11.08,

meaning they earn 11 times more then what they pay in interest. Wyeth has displayed

a downward trend, which is unfavorable and should attempt to lower their interest

expense. This ratio discloses imperative information for an individual company. A spike

does not necessarily mean the company is in peril, but it might have acquired new

territory forcing them to get a new loan. On the other hand a decrease might simply

mean a company has finished payments on a older loan, the 10-k should be examined

to explain each individual move.

106

Debt Service Margin

The debt service margin is calculated by taking operating cash flows of the current

period divided by current notes payable from the previous period. This measure shows

the ability to pay debt by using cash flows generated from operations of the firm.

Wyeth’s spike in 2005 is due to less current notes payable on the balance sheet. After

2002, Wyeth restructured their debt and from there on their debt service margin was

above one. This means they always had enough cash from their current operations to

cover the current portion of their debt obligations.

Conclusion

Capital structure analysis ratios are used to determine the means of financing a

company, either through debt or equity. Over a six year period, Wyeth has consistently

lowered their debt to equity ratio, improving their leverage. Wyeth has the highest

debt to equity ratio among their competitor’s but are improving their standing. The

debt service margin for Wyeth shows that they have performed similarly to their

107

competitors over the last six years, except for a spike in 2005. This could be attributed

to having much less current notes payable on their books.

Credit Risk

The Altman Z-Score is used to predict the likelihood of a company defaulting on a loan.

This model uses five financial ratios which measure liquidity, cumulative profitability,

return on assets, market leverage, and sales generating potential of assets. Each of

these ratios is weighted based on their degree of relevance; the result is a score that

predicts the probability of a firm defaulting on a loan. There are three ranges a

company’s score may fall relative to risk:

Z‐Score Levels of Risk

Z > 2.67 low

1.81 ≤ Z ≤ 2.67 neutral

Z < 1.81 high

Formula for calculating the Altman Z-Score:

Z-Score = 1.2(net working capital/total assets) + 1.4(retained earnings/total assets) + 3.3(earnings before interest and taxes/total

assets) + 0.6(market value of equity/book value of total liabilities) + 1.0(sales/total assets)

108

As the chart indicates, all of the firms in this industry have remained in the low credit

risk range throughout the past six years by maintaining a z-score greater than 2.67.

Internal Growth Rate

The rate of growth of a firm is extremely important when analyzing the reliability of a

company. Growth is essential if a company is willing to successfully compete in the

industry. The two most widely used growth rates include the internal growth rate and

the sustainable growth rate. The internal growth rate measures the company’s ability

to grow without outside funding. The sustainable growth rate illustrates how much a

firm can grow without increasing the leverage already being used.

The internal growth rate is calculated by multiplying the return on assets by one minus

the dividend payout rate. This growth rate signifies the highest rate that a firm can

grow without borrowing funds from an outside source. The chart above shows that

Wyeth’s growth rate reduced to 8.3% before rising up past the industry average of

12.8% in 2006. Wyeth, along with all of its competitors, has been steadily increasing

dividend payments over the past several years. This indicates that the net income of

these pharmaceutical companies has been increasing at a greater rate than dividend

payouts. The chart also illustrates a convergence around 15% for Wyeth and its

109

competitors. Due to capitalized research and development net income has increased

but total assets have increased by a greater amount. This causes the multiplier to

decrease making the internal growth rate decrease.

Sustainable Growth Rate

The sustainable growth rate measures the highest growth that a company can perform

with the leverage it is already using. Once this growth rate increases above this level,

more borrowing will need to ensue. This measurement is calculated by multiplying the

internal growth rate by one plus the debt to equity ratio of the previous year.

According to the above graph, Wyeth’s stated sustainable growth rate is able to sustain

a higher level of growth compared to its competitors for every year except 2004. After

using restated figures, the growth rate deceases for the same reasons as the internal

growth rate decrease. Total assets have increased by a greater amount than net

income. As with the internal growth rate, a convergence to about three percent seems

to be taking place. A convergence seems to be focused around 30% in this growth

rate.

110

2003 2004 2005 2006 2007

Internal Growth Rate 0.126 0.083 0.146 0.155 0.166

Industry IGR 0.145 0.123 0.128 0.152 0.148

Sustainable Growth Rate 0.401 0.279 0.499 0.463 0.403

Industry SGR 0.370 0.274 0.306 0.336 0.300

Conclusion

After reviewing Wyeth’s liquidity, profitability, and capital structure analyses, it is

evident that they mostly perform at about the same level as their closest competitors.

Wyeth’s area of strength is the ability to cover liabilities with current assets as well as

receiving payment for sales. In terms of profitability, Wyeth performs about the same

as the industry. Over the past six years Wyeth has decreased their debt to equity ratio

showing that that they are now financing more of their activities with equity rather than

debt. The internal growth rate for Wyeth shows that the company has been growing

steadily over the past three years. The sustainable growth rate indicates that the

growth rate is slowly declining after a large increase in 2004. Wyeth continues to be a

leader in the pharmaceutical industry by consistently changing their debt structuring to

finance more endeavors through equity and producing earnings.

111

Financial Statement Forecasting

Income Statement

The income statement is the first financial statement that is used when forecasting a

company. This financial statement reflects revenues and expenses and therefore is the

simplest statement to forecast. Past income statements have been spliced onto one

spreadsheet and analyzed for red-flags that would have an effect on forecasting. Then

a common sized income statement is made using these figures. Forecasted figures

were placed in this common sized statement in the form of percentages. The first three

years after 2007 were forecasted as a running average while a constant change was

used for the following years until 2018. This was done because of the obvious

fluctuations that take place from year to year.

Net revenue is the first item to be forecasted because it is easily the most significant.

This item was forecasted using sales growth forecasts. The future sales growth

percentages were calculated by averaging the past five years of financials and using

this percentage growth extended until 2018. Sales growth was relatively steady for the

past five years and this is the reason why the average of sales growth was used.

Ultimately, net sales were increased by a constant percentage of 8.96%. The highest

growth rate was 10.07% and the lowest was 8.05 so the rate we decided upon is

relatively conservative. This figure is used to help forecast the rest of the income

statement and therefore, the rest of the financial statements so it was decided that this

figure should be of a conservative number.

The next item on the income statement that was forecasted is the cost of goods sold.

This line item is very important for any company that is producing products to sell. The

cost of goods sold for past couple of years never changed by more than one percentage

point. The forecasted cost of goods sold is the average of the past six years. The

lowest year was in 2002 with 26.87% of total revenue while the highest cost of goods

sold was in year 2005 with 28.96%.

112

After calculating the gross profit by subtracting cost of goods sold from net revenue,

the selling, general and administrative expenses were forecasted. Over the past couple

of years there was a steady decreasing trend regarding this line item. The forecasted

figures were calculated by taking the percentage change of the previous year and using

that figure for the following year. This change became constant after the third year of

forecasting.

Research and development is one of the most important elements within Wyeth, let

alone any pharmaceutical company. The item was forecasted by taking the average of

the past three years of the year being forecasted. This is due to the fact that the trend

over the past six years did not seem like a reasonable figure to use. Because of this,

research and development was observed from a more recent perspective.

After calculating the operating income by subtracting the forecasted selling, general and

administrative expenses and research and development from gross profit, net income

was the final line item to be forecasted. The percentage of net income to net revenue

was extremely erratic from 2002 to 2004; however the years 2005 to 2007 represented

very stable percentages. In fact, there was only a .01% change from 2006 to 2007.

This information is the reason why net income was forecasted by taking the average of

the past three years of the year being forecasted. As with the rest of the line items on

the income statement, forecasted net income became constant after the third year.

113

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4,94

0,39

3

5,44

9,46

2

5,

925,

209

6,45

6,34

3

7,03

5,08

8

7,

665,

712

8,35

2,86

4

9,10

1,61

2

9,

917,

478

10

,806

,478

11,7

75,1

68

Wy

eth

In

com

e S

tate

men

t

in m

illio

ns20

0220

0320

0420

0520

0620

0720

0820

0920

1020

1120

1220

1320

1420

1520

1620

1720

18

Ann

ual S

ales

Gro

wth

N/A

8.68

%9.

51%

8.05

%8.

50%

10.0

7%8.

96%

8.96

%8.

96%

8.96

%8.

96%

8.96

%8.

96%

8.96

%8.

96%

8.96

%8.

96%

Net

Rev

enue

100.

00%

100.

00%

100.

00%

100.

00%

100.

00%

100.

00%

100.

00%

100.

00%

100.

00%

100.

00%

100.

00%

100.

00%

100.

00%

100.

00%

100.

00%

100.

00%

100.

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C

ost o

f goo

ds s

old

26.8

7%27

.61%

28.5

0%28

.96%

27.4

6%28

.19%

28.2

8%28

.22%

28.0

3%28

.03%

28.0

3%28

.03%

28.0

3%28

.03%

28.0

3%28

.03%

28.0

3%

Gro

ss P

rofit

73

.13%

72.3

9%71

.50%

71.0

4%72

.54%

71.8

1%71

.72%

71.7

8%71

.97%

71.9

7%71

.97%

71.9

7%71

.97%

71.9

7%71

.97%

71.9

7%71

.97%

S

ellin

g, g

ener

al a

nd a

dmin

istr

ativ

e ex

pens

es34

.36%

34.5

0%33

.41%

32.6

2%31

.95%

30.1

5%28

.45%

26.8

5%25

.34%

25.3

4%25

.34%

25.3

4%25

.34%

25.3

4%25

.34%

25.3

4%25

.34%

R

esea

rch

and

deve

lopm

ent e

xpen

ses

14.2

6%13

.21%

14.1

8%14

.66%

15.2

8%14

.54%

14.8

3%14

.88%

14.7

5%14

.75%

14.7

5%14

.75%

14.7

5%14

.75%

14.7

5%14

.75%

14.7

5%

Ope

ratin

g In

com

e24

.51%

24.6

8%23

.91%

23.7

7%25

.31%

27.1

2%28

.45%

30.0

5%31

.88%

31.8

8%31

.88%

31.8

8%31

.88%

31.8

8%31

.88%

31.8

8%31

.88%

In

tere

st e

xpen

se, n

et1.

39%

0.65

%0.

64%

0.40

%-0

.03%

-0.4

0%

O

ther

inc

ome,

net

-2.6

3%-2

.10%

-1.9

0%-2

.12%

-1.3

3%-1

.30%

G

ains

rel

ated

Im

mun

ex/A

mge

n C

.S. t

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actio

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7.99

%-5

.43%

0.00

%0.

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0.00

%0.

00%

D

iet

drug

litig

atio

n ch

arge

s9.

60%

12.6

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.92%

0.00

%0.

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%

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peci

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harg

es2.

34%

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%0.

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0.00

%0.

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%

In

com

e be

fore

fede

ral a

nd fo

reig

n ta

xes

41.8

1%14

.90%

-0.7

5%25

.49%

26.6

8%28

.82%

P

rovi

sion

for

fede

ral a

nd f

orei

gn ta

xes

11.3

1%1.

96%

-7.8

6%5.

99%

6.06

%8.

22%

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Inc

ome

30.4

9%12

.94%

7.86

%19

.49%

20.6

2%20

.61%

20.2

4%20

.49%

20.4

5%20

.45%

20.4

5%20

.45%

20.4

5%20

.45%

20.4

5%20

.45%

20.4

5%

Act

ual

Fin

anci

al S

tate

men

tsF

orec

aste

d F

ina

ncia

l St

atem

ents

Act

ual

Fin

anci

al S

tate

men

tsF

orec

aste

d F

ina

ncia

l St

atem

ents

114

Wy

eth

Res

tate

d I

nco

me

Sta

tem

ent

in m

illio

ns20

0220

0320

0420

0520

0620

0720

0820

0920

1020

1120

1220

1320

1420

1520

16

N

et R

even

ue14

,584

,035

15,8

50,6

32

17

,358

,028

18,7

55,7

90

20

,350

,655

22,3

99,7

98

24

,407

,710

26,5

95,6

10

28

,979

,633

31,5

77,3

59

34,4

07,9

44

37

,492

,263

40,8

53,0

59

44

,515

,115

48,5

05,4

38

C

ost o

f goo

ds s

old

3,91

8,38

7

4,37

7,08

6

4,94

7,26

9

5,43

1,20

0

5,58

7,85

1

6,31

3,68

7

6,90

1,46

2

7,50

5,10

9

8,12

4,38

9

8,85

2,65

7

9,64

6,20

7

10,5

10,8

90

11

,453

,083

12,4

79,7

35

13

,598

,414

Gro

ss P

rofit

10,6

65,6

48

11

,473

,546

12,4

10,7

59

13

,324

,590

14,7

62,8

04

16

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20,8

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24

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26,9

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73

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32,0

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81

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5,

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6,

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7,

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11,2

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12

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8,

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10

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10

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11

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and

deve

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expe

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416,

038

418,

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492,

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549,

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621,

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651,

357

759,

427

885,

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1,03

2,33

2

1,12

4,15

4

1,22

4,92

3

1,33

4,72

5

1,45

4,36

9

1,58

4,73

8

1,72

6,79

4

G

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expe

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749,

150

763,

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771,

282

767,

279

785,

148

827,

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O

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net

(382

,931

)

(3

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(330

,100

)

(397

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(271

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)

(2

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G

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rel

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Im

mun

ex/A

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.S. t

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-

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-

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0,80

0

63

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-

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6,09

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5

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1,61

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(129

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)

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9

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4

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2

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for

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1,65

0,04

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1,12

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1

1,23

3,19

8

1,84

0,72

2

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ome

5,36

2,20

8

2,96

2,42

0

2,43

1,20

3

5,08

8,53

1

5,89

8,80

6

6,39

4,38

8

6,88

8,09

3

7,60

2,21

6

8,24

4,90

7

2,00

8,57

8

2,18

8,62

6

2,38

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4

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8

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1,52

4

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1

Wy

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Res

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Sta

tem

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in m

illio

ns20

0220

0320

0420

0520

0620

0720

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0920

1020

1120

1220

1320

1420

1520

16

Ann

ual S

ales

Gro

wth

N/A

8.68

%9.

51%

8.05

%8.

50%

10.0

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8.96

%8.

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8.96

%8.

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8.96

%8.

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%8.

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N

et R

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%

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ost o

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old

26.8

7%27

.61%

28.5

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.96%

27.4

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.19%

28.2

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.22%

28.0

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.03%

28.0

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.03%

28.0

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.03%

28.0

3%

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ss P

rofit

73.1

3%72

.39%

71.5

0%71

.04%

72.5

4%71

.81%

71.7

2%71

.78%

71.9

7%71

.97%

71.9

7%71

.97%

71.9

7%71

.97%

71.9

7%

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g, g

ener

al a

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dmin

istr

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e ex

pens

es34

.36%

34.5

0%33

.41%

32.6

2%31

.95%

30.1

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.45%

26.8

5%25

.34%

25.3

4%25

.34%

25.3

4%25

.34%

25.3

4%25

.34%

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.78%

37.8

9%38

.09%

38.4

2%40

.59%

41.6

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.27%

44.9

3%46

.63%

46.6

3%46

.63%

46.6

3%46

.63%

46.6

3%46

.63%

In

tere

st e

xpen

se, n

et1.

39%

0.65

%0.

64%

0.40

%-0

.03%

-0.4

0%

R

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rch

and

deve

lopm

ent d

epre

ciat

ion

expe

nse

2.85

%2.

64%

2.84

%2.

93%

3.06

%2.

91%

3.11

%3.

33%

3.56

%3.

56%

3.56

%3.

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3.56

%3.

56%

3.56

%

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oodw

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mor

tizat

ion

expe

nse

5.14

%4.

82%

4.44

%4.

09%

3.86

%3.

69%

O

ther

inc

ome,

net

-2.6

3%-2

.10%

-1.9

0%-2

.12%

-1.3

3%-1

.30%

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ains

rel

ated

Im

mun

ex/A

mge

n C

.S. t

rans

actio

ns-2

7.99

%-5

.43%

0.00

%0.

00%

0.00

%0.

00%

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iet

drug

litig

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n ch

arge

s9.

60%

12.6

2%25

.92%

0.00

%0.

00%

0.00

%

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peci

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harg

es2.

34%

4.04

%0.

00%

0.00

%0.

00%

0.00

%

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me

befo

re f

eder

al a

nd f

orei

gn ta

xes

41.8

1%14

.90%

-0.7

5%25

.49%

26.6

8%28

.82%

P

rovi

sion

for

fede

ral a

nd f

orei

gn ta

xes

11.3

1%1.

96%

-7.8

6%5.

99%

6.06

%8.

22%

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Inc

ome

36.7

7%18

.69%

14.0

1%27

.13%

28.9

9%28

.55%

28.2

2%28

.58%

28.4

5%6.

36%

6.36

%6.

36%

6.36

%6.

36%

6.36

%

Act

ual

Fin

anci

al S

tate

men

tsFo

reca

sted

Fin

anci

al S

tate

men

ts

Act

ua

l F

ina

nci

al

Sta

tem

ents

Fo

reca

sted

Fin

anci

al

Sta

tem

ents

115

Balance Sheet

The balance sheet was the second financial statement to be forecasted. Although it was

more difficult to forecast than the income statement, it is not as difficult as the

statement of cash flows. We used ratios that link the balance sheet with the income

statement to forecast with the most accuracy possible. Also, we created a common-size

balance sheet to observe and critically analyze trends that would support our forecasts.

Assets are the first item on the balance sheet and linked to sales by the asset turnover

ratio. Total asset turnover is the strongest ratio that links the income statement with

the balance sheet. We forecasted the asset turnover as an average of the past six

years’ turnovers because of the variability in the trend. We estimated a constant asset

turnover of .58 from 2008 to 2018. In order to calculate forecasted total assets each

year, we simply took the asset turnover divided by the forecasted sales for the next

year. Once we had total assets, we could forecast the common-size balance sheet to

calculate forecasted values of current and non-current assets. We calculated running

averages for accounts receivable, inventories, and non-current liabilities on the

common-size balance sheets. Then we simply multiplied these common-size amounts

by the value of total assets we forecasted, as each item is in percentage of total assets

in common-size form.

Next, we forecasted the current ratio to calculate the current assets and current

liabilities for Wyeth from 2008 to 2018. We used a running average of the past six

years, as our forecasted current ratio due to the variability in the trend, of 2.16. To

forecast values of current liabilities, we multiplied the current asset values we

forecasted by the forecasted current ratio.

116

Wye

th B

alan

ce S

heet

s20

0220

0320

0420

0520

0620

0720

0820

0920

1020

1120

1220

1320

1420

1520

1620

1720

18As

sets

:C

ash

and

cash

equ

ival

ents

2,94

3,60

46,

069,

794

4,74

3,57

07,

615,

891

6,77

8,31

110

,453

,879

Mar

keta

ble

secu

ritie

s1,

003,

275

1,11

0,29

71,

745,

558

618,

619

1,94

8,93

12,

993,

839

Acco

unts

Rec

eiva

ble

2,37

9,81

92,

529,

613

2,79

8,56

53,

030,

580

3,38

3,34

13,

528,

009

3,81

2,10

74,

110,

512

4,51

0,45

34,

938,

528

5,39

7,47

65,

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007

6,36

3,43

16,

930,

726

7,56

1,19

38,

241,

101

0In

vent

orie

s1,

992,

724

2,41

2,18

42,

478,

009

2,33

3,54

32,

480,

459

3,03

5,35

83,

192,

195

3,44

2,10

53,

693,

935

3,99

1,63

64,

396,

284

4,81

7,12

15,

245,

106

5,69

7,49

46,

196,

626

6,75

4,59

60

Oth

er c

urre

nt a

sset

s in

clud

ing

defe

rred

taxe

s1,

776,

330

2,84

0,35

42,

672,

327

4,44

6,20

82,

923,

199

2,97

2,51

3

Pro

perty

, pla

nt a

nd e

quip

men

t:La

nd17

3,74

318

2,84

918

7,73

217

7,50

717

7,18

818

2,25

0Bu

ildin

gs3,

401,

490

4,13

0,83

84,

630,

910

6,49

2,60

57,

154,

928

7,92

1,06

8M

achi

nery

and

equ

ipm

ent

3,78

2,53

34,

184,

292

4,65

7,71

64,

860,

953

5,49

1,98

76,

170,

239

Con

stru

ctio

n in

pro

gres

s2,

477,

219

3,18

8,27

33,

600,

993

1,51

6,03

31,

659,

391

1,94

7,62

4To

tal P

P&

E7,

235,

692

8,66

1,05

19,

524,

350

9,35

3,35

310

,146

,259

11,0

72,1

5812

,104

,398

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,270

,131

15,4

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7516

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,538

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,098

,068

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580

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dwill

3,74

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93,

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Oth

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s, n

et o

f acc

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am

ort.

145,

915

133,

134

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360

279,

720

356,

692

383,

558

Oth

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s in

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defe

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s3,

309,

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3,45

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25,

598,

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84,

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4,14

2,96

6To

tal N

on-C

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sset

s14

,436

,893

16,0

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,675

17,7

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,474

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8026

,206

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28,5

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Wye

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Bal

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She

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2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

2018

Asse

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Cas

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TAT

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429

7,79

2,31

19,

231,

479

9,09

6,74

311

,492

,881

Accr

ued

post

retir

emen

t be

nefit

obl

igat

ions

965,

081

1,00

7,54

01,

024,

239

1,10

4,25

61,

600,

751

1,67

6,12

6O

ther

non

curr

ent

liabi

litie

s3,

890,

052

4,22

4,06

26,

429,

709

3,56

3,06

13,

100,

205

3,51

1,62

1To

tal L

iabi

litie

s17

,886

,682

21,7

37,5

4323

,781

,803

23,8

46,7

5921

,019

,549

24,0

04,9

1016,624,286

16,303,253

15,028,406

17,625,277

20,512,882

23,726,794

27,305,770

31,292,045

35,731,639

40,674,696

46,175,856

Sto

ckho

lder

s Eq

uity

Com

mon

sto

ck44

2,01

944

4,15

144

5,03

144

7,78

344

8,41

744

5,92

9Ad

ditio

nal p

aid-

in c

apita

l4,

582,

773

4,76

4,39

04,

817,

024

5,09

7,22

86,

142,

277

7,12

5,54

4Re

tain

ed e

arni

ngs

14,0

36,6

7816

,709

,804

18,3

93,2

5320

,993

,414

25,7

26,7

3428

,919

,078

35,115,505

41,789,729

48,970,568

52,809,102

56,933,767

61,360,706

66,107,503

71,193,321

76,639,041

82,467,413

88,703,231

Accu

mul

ated

oth

er c

ompr

ehen

sive

inco

me

-155

,571

-26,

487

467,

152

-64,

725

-672

,666

221,

433

Tota

l Sto

ckh

olde

rs E

quit

y18

,905

,899

21,8

91,8

5824

,122

,460

26,4

73,7

0031

,644

,762

36,7

11,9

8442,908,411

49,582,635

56,763,474

60,602,008

64,726,673

69,153,612

73,900,409

78,986,227

84,431,947

90,260,319

96,496,137

119

Wye

th R

esta

ted

Com

mon

Siz

e B

alan

ce S

hee

ts2

002

200

320

04

200

520

06

200

720

08

200

92

01

02

011

20

122

013

20

142

015

20

162

017

201

8As

sets

:Ca

sh a

nd c

ash

equi

vale

nts

8.00%

13.91%

9.90%

15.13%

12.87%

17.22%

Mar

keta

ble

secu

ritie

s2.73%

2.54%

3.64%

1.23%

3.70%

4.93%

Acco

unts

Rec

eiva

ble

6.47%

5.80%

5.84%

6.02%

6.42%

5.81%

6.06%

5.99%

6.03%

6.06%

6.06%

6.00%

6.03%

6.03%

6.03%

6.04%

6.03%

Inve

ntor

ies

5.42%

5.53%

5.17%

4.64%

4.71%

5.00%

5.08%

5.02%

4.94%

4.90%

4.94%

4.98%

4.97%

4.96%

4.95%

4.95%

4.96%

Oth

er c

urre

nt a

sset

s in

clud

ing

defe

rred

tax

es4.83%

6.51%

5.58%

8.84%

5.55%

4.90%

Tota

l Cu

rren

t A

sset

s31.54%

34.29%

30.14%

35.86%

33.26%

37.85%

33.82%

33.07%

33.07%

33.07%

33.07%

33.07%

33.07%

33.07%

33.07%

33.07%

33.07%

Prop

erty

, pla

nt a

nd e

quip

men

t:La

nd0.47%

0.42%

0.39%

0.35%

0.34%

0.30%

Build

ings

9.25%

9.47%

9.67%

12.90%

13.59%

13.05%

Mac

hine

ry a

nd e

quip

men

t10.28%

9.59%

9.72%

9.66%

10.43%

10.16%

Cons

truc

tion

in p

rogr

ess

6.73%

7.31%

7.52%

3.01%

3.15%

3.21%

Tota

l PP&

E19.67%

19.85%

19.88%

18.59%

19.27%

18.24%

19.16%

19.03%

18.86%

17.97%

17.97%

17.97%

17.97%

17.97%

17.97%

17.97%

17.97%

Goo

dwill

aft

er a

mor

tizat

ion

8.14%

7.00%

6.44%

6.10%

5.96%

5.45%

Oth

er in

tang

ible

s, n

et o

f ac

cum

ulat

ed a

mor

t.0.40%

0.31%

0.44%

0.56%

0.68%

0.63%

Oth

er a

sset

s in

clud

ing

defe

rred

tax

es9.00%

7.92%

11.69%

8.60%

8.61%

6.82%

Res

earc

h an

d D

evel

opm

ent

4.52%

3.84%

4.11%

4.37%

4.72%

4.29%

Tota

l Non

-Cur

rent

Ass

ets

68.46%

65.71%

69.86%

64.14%

66.74%

62.15%

66.18%

66.93%

66.93%

66.93%

66.93%

66.93%

66.93%

66.93%

66.93%

66.93%

66.93%

Tota

l Ass

ets

100.00%

100.00%

100.00%

100.00%

100.00%

100.00%

100.00%

100.00%

100.00%

100.00%

100.00%

100.00%

100.00%

100.00%

100.00%

100.00%

100.00%

Liab

ilitie

s:Lo

ans

paya

ble

4.50%

6.96%

1.39%

0.06%

0.59%

1.30%

Trad

e ac

coun

ts p

ayab

le3.76%

4.65%

3.99%

3.75%

5.31%

5.28%

Accr

ued

expe

nses

21.24%

25.13%

29.65%

36.73%

27.02%

22.22%

Accr

ued

taxe

s1.17%

2.04%

0.86%

1.18%

1.44%

1.71%

Tota

l Cu

rren

t Li

abili

ties

30.67%

38.78%

35.89%

41.72%

34.36%

30.51%

49.26%

49.98%

57.30%

53.24%

49.84%

46.95%

44.46%

42.27%

40.34%

38.61%

37.06%

Long

-ter

m d

ebt

42.19%

37.15%

32.77%

38.71%

43.28%

47.88%

Accr

ued

post

retir

emen

t be

nefit

obl

igat

ions

5.40%

4.64%

4.31%

4.63%

7.62%

6.98%

Oth

er n

oncu

rren

t lia

bilit

ies

21.75%

19.43%

27.04%

14.94%

14.75%

14.63%

Tota

l Lia

bili

ties

100.00%

100.00%

100.00%

100.00%

100.00%

100.00%

100.00%

100.00%

100.00%

100.00%

100.00%

100.00%

100.00%

100.00%

100.00%

100.00%

100.00%

Stoc

khol

ders

Equ

ity

Com

mon

sto

ck2.34%

2.03%

1.84%

1.69%

1.42%

1.21%

Addi

tiona

l pai

d-in

cap

ital

24.24%

21.76%

19.97%

19.25%

19.41%

19.41%

Ret

aine

d ea

rnin

gs74.24%

76.33%

76.25%

79.30%

81.30%

78.77%

81.84%

84.28%

86.27%

87.14%

87.96%

88.73%

89.45%

90.13%

90.77%

91.37%

91.92%

Accu

mul

ated

oth

er c

ompr

ehen

sive

inco

me

‐0.82%

‐0.12%

1.94%

‐0.24%

‐2.13%

0.60%

Tota

l Sto

ckh

olde

rs E

quit

y100.00%

100.00%

100.00%

100.00%

100.00%

100.00%

100.00%

100.00%

100.00%

100.00%

100.00%

100.00%

100.00%

100.00%

100.00%

100.00%

100.00%

Net

In

com

e6,111,358

2,482,981

1,540,741

3,701,944

3,980,210

4,095,832

4,684,724

5,056,437

5,456,967

2,008,578

2,188,626

2,384,814

2,598,588

2,831,524

3,085,341

3,361,911

3,663,271

Div

iden

ds p

aid

(1,2

19,1

73)

(1,2

23,1

58)

(1,2

27,0

34)

(1,2

59,3

98)

(1,3

58,7

69)

(1,4

23,4

94)

(1,511,703)

(1,617,787)

(1,723,872)

(1,829,956)

(1,936,040)

(2,042,125)

(2,148,209)

(2,254,294)

(2,360,378)

(2,466,462)

(2,572,547)

120

Statement of Cash Flows

The statement of cash flows is always forecasted last because it is the most difficult of

the financial statements. There are only a few categories that can actually be

forecasted. We looked at the three major sections separately and managed to forecast

an important element for each one.

First, we looked at the operating income section. We compared three ratios that

involved the cash flows provided from operations: CFFO/sales, CFFO/operating income,

and CFFO/Net Income. We chose CFFO/Sales because it had the most noticeable trend.

We then forecasted the ratio by taking the 6-year average and found it to be 0.18. That

allowed us to take our forecasted sales and multiply it by 0.18 to find that year’s cash

flows from operations. Next, we forecasted the cash flows from investing by finding the

change in the property, plant, and equipment and adding it to the previous year’s cash

flows from investing. Finally, the only aspect of the financing section we can forecast

was the dividends paid which was calculated while forecasting the balance sheet. We

found a noticeable trend with Wyeth’s historical dividend payments. They have four

yearly payments; the last is in November which is increased consistently by two cents.

We forecasted out our dividends per share by the previous mentioned trend. This

enabled us to find the forecasted dividends paid by multiplying Wyeth’s dividends per

share by their 2007 shares outstanding. On the common size statement of cash flows

we forecasted CFFO, CFFI, and CFFF to all be 100% because any element in the

individual sections would be expressed as a percentage of that relative cash flow.

121

Wye

th S

tate

men

t of C

ash

Flow

s20

0220

0320

0420

0520

0620

0720

0820

0920

1020

1120

1220

1320

1420

1520

1620

1720

18Op

erat

ing A

ctivit

iesNe

t Inc

ome

4,44

7,20

5

2,05

1,19

2

1,23

3,99

7

3,65

6,29

8

4,19

6,70

6

4,61

5,96

0

4,94

0,39

3

5,44

9,46

2

5,92

5,20

9

6,45

6,34

3

7,03

5,08

8

7,66

5,71

2

8,35

2,86

4

9,10

1,61

2

9,91

7,47

8

10,8

06,4

78

11,7

75,1

68

Adjus

tmen

ts to

reco

ncile

net

inco

me

tone

t cas

h pr

ovide

d by

ope

ratin

g ac

tivitie

s:Di

et d

rug

litiga

tion

paym

ents

(1,3

07,0

13)

(4

34,1

67)

(8

50,2

00)

(1,4

53,7

33)

(2

,972

,700

)

(481

,581

)

Seve

nth

Amen

dmen

t sec

urity

fund

(dep

osit)

/refu

ndN/

AN/

AN/

A(1

,250

,000

)

400,

000

N/A

Diet

Dru

g Lit

igatio

n ch

arge

s1,

400,

000

2,

000,

000

4,

500,

000

N/

AN/

AN/

A

Gains

relat

ed to

Imm

unex

/Am

gen

com

mon

stoc

k tra

nsac

tions

(4,0

82,2

16)

(8

60,5

54)

N/

AN/

AN/

AN/

ATa

x on

repa

triat

ionN/

AN/

AN/

A17

0,00

0

N/

AN/

ASp

ecial

Cha

rges

340,

800

639,

905

N/A

N/A

N/A

N/A

Net g

ains o

n sa

les a

nd d

ispos

itions

of a

sset

s(3

29,3

64)

(343

,064

)

(156

,175

)

(1

27,2

28)

(28,

545)

(59,

851)

Depr

eciat

ion46

1,55

4

50

5,70

2

58

1,56

7

74

9,16

3

76

1,69

0

84

2,72

5

Am

ortiz

ation

23,1

46

32,1

81

40

,832

37

,710

41

,350

75

,954

Stoc

k-ba

sed

com

pens

ation

N/A

20,6

09

24

,634

10

8,53

4

39

3,33

0

36

7,52

9

Ch

ange

in d

efer

red

incom

e ta

xes

1,10

9,53

5

(433

,994

)

(1,4

70,5

32)

54

2,92

0

63

0,13

1

75

6,68

7

Pe

nsion

pro

vision

(405

,000

)

30

2,38

3

29

4,83

8

31

7,04

7

35

4,53

1

33

8,77

9

Pe

nsion

cont

ribut

ions

(909

,602

)

(2

30,7

87)

(4

07,6

00)

(328

,895

)

(2

71,9

09)

(330

,749

)

Chan

ges i

n wo

rking

capit

al, n

et:

Acco

unts

rece

ivable

271,

988

69,6

28

(1

30,3

25)

(357

,582

)

(2

38,7

64)

(1,6

24)

In

vent

ories

(185

,611

)

(2

45,4

53)

4,

295

7,

410

(7

,910

)

(337

,173

)

Othe

r cur

rent

ass

ets

(124

,738

)

48

,870

38,4

03

16,9

58

(39,

037)

(181

,456

)

Trad

e ac

coun

ts pa

yable

and

acc

rued

exp

ense

s(2

50,8

87)

469,

661

(144

,161

)

18

5,32

6

70

,868

16

9,51

4

Ac

crue

d ta

xes

(33,

214)

115,

990

(145

,322

)

15

,719

(7

,536

)

60,3

79

Ot

her i

tem

s, ne

t(2

40,8

53)

(188

,395

)

(172

,086

)

61

,994

(2

7,82

8)

40

,586

Net C

ash

Prov

ided

by O

pera

ting

Activ

ities

185,

730

2,91

1,10

3

2,87

8,74

3

2,35

1,64

1

3,25

4,37

7

5,87

5,67

9

4,37

9,28

1

4,77

1,83

9

5,19

9,58

5

5,66

5,67

4

6,17

3,54

4

6,72

6,93

8

7,32

9,93

9

7,98

6,99

3

8,70

2,94

5

9,48

3,07

4

10,3

33,1

34

CFFO

/Sale

s0.

010.

180.

170.

130.

160.

260.

180.

180.

180.

180.

180.

180.

180.

180.

180.

180.

18

Inve

sting

Acti

vities

Purc

hase

s of i

ntan

gibles

and

pro

perty

,pla

nt a

nd e

quipm

ent

(1,9

31,8

79)

(1

,908

,661

)

(1

,255

,275

)

(1,0

81,2

91)

(1

,289

,784

)

(1,3

90,6

68)

1,03

2,24

0

1,04

6,68

4

1,11

9,04

9

1,16

3,84

4

1,46

8,56

3

1,42

8,37

7

1,76

7,15

2

1,77

2,16

6

1,93

4,70

0

2,11

9,32

4

N/A

Proc

eeds

from

sales

of a

sset

s79

8,27

4

40

2,69

2

35

1,87

3

36

5,18

4

69

,235

12

1,71

6

Pu

rcha

se o

f add

itiona

l equ

ity in

tere

stin

affili

ate

(92,

725)

(102

,187

)

(2

21,6

55)

Pu

rcha

ses o

f mar

keta

ble se

curit

ies(2

,235

,872

)

(1,2

72,9

95)

(2,3

45,3

54)

(6

51,0

97)

(2,2

39,0

22)

(2

,534

,216

)

Pr

ocee

ds fr

om sa

les a

nd m

atur

ities o

f mar

keta

blese

curit

ies2,

532,

538

1,

217,

114

1,

697,

864

1,

777,

005

91

5,33

9

1,

422,

488

Ne

t Cas

h Pr

ovide

d by

/(Use

d fo

r) In

vesti

ngAc

tivitie

s3,

419,

015

18

,067

(1,5

50,8

92)

31

7,07

6

(2

,646

,419

)

(2,6

02,3

35)

(3,6

34,5

75)

(4

,681

,259

)

(5,8

00,3

08)

(6

,964

,152

)

(8,4

32,7

15)

(9

,861

,093

)

(11,

628,

245)

(13,

400,

411)

(15,

335,

111)

(17,

454,

435)

N/A

Fina

ncing

Acti

vities

Proc

eeds

from

issu

ance

of l

ong-

term

deb

t5,

820,

000

1,

500,

000

2,

500,

000

Re

paym

ents

of lo

ng-te

rm d

ebt

(250

,000

)

(6

91,0

87)

(1

,500

,000

)

(328

,187

)

(1

2,10

0)

(1

20,8

06)

Ot

her b

orro

wing

tran

sacti

ons,

net

(13,

797)

(76,

522)

(6,5

87)

82

,125

47

,334

(5

,717

)

Divid

ends

paid

(1,2

19,1

73)

(1

,223

,158

)

(1

,227

,034

)

(1,2

59,3

98)

(1

,358

,769

)

(1,4

23,4

94)

(1,511,703)

(1,617,787)

(1,723,872)

(1,829,956)

(1,936,040)

(2,042,125)

(2,148,209)

(2,254,294)

(2,360,378)

(2,466,462)

(2,572,547)

Purc

hase

s of c

omm

on st

ock f

or T

reas

ury

(113

,927

)

(6

64,5

79)

(1,3

16,7

34)

Exer

cises

of s

tock

opt

ions

215,

370

126,

895

57,4

73

234,

992

515,

853

716,

896

Net C

ash

Prov

ided

by/(U

sed

for)

Fina

ncing

Activ

ities

(2,4

11,5

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123

Cost of Capital Estimation

Cost of Equity

The final step of analyzing a company is to perform certain economical valuations to

determine if the company is fair valued, undervalued, or overvalued. A key variable to

the cost of capital estimations is their cost of equity, thus we calculated this factor first.

The cost of equity can be described, as the required rate of return a company should

make in order to please potential investors.

The cost of equity is most commonly calculated by a formula known as the Capital

Asset Pricing Model; we will refer to this as CAPM. CAPM has three individual elements:

a risk free rate, beta, and the market risk premium. In order to find the risk free rate

we used the June 1 10-year Treasury bill rate (June 1 is the date we are valuing the

company), which was 3.98%. Next, beta is found my running regression analyses

through excel using stock returns and market risk premiums. As for the market risk

premium we found the difference between the market return and the risk free rate that

is the minimum return an investor desires. The final formula for CAPM is: Rft + Bj(Rmt-

Rft).

Running the regression analysis for Beta is the most intricate part of calculating CAPM.

We ran the same analysis for 72, 68, 48, 36, and 24 months so we could find five

points on the yield curve. We also did the same regression for 3 month, 6 month, 2

year, 5 year, and 10-year treasury bills. The different market risk premiums were used

as our x-variable and the y-variables were Wyeth’s historical monthly returns. We used

a 95% confidence interval; meaning we are 95% confident that our beta lies within the

lower and upper bounds. When selecting the Beta to use we selected the Beta with the

highest adjusted R^2 per regression. The adjusted R^2 is the explanatory power the

Beta possesses. The bolded line in each regression represents the Beta chosen for that

particular Treasury bill rate. Our analysis yielded the following statistics:

124

3-Month Regression:

Months Beta Adj R^2 Raw CAPM Size Adj Adj Ke Lower Upper

72 1.200 0.307 0.1238 0.007 0.131 0.781 1.620

60 0.575 0.045 0.0800 0.007 0.087 -0.016 1.166

48 0.760 0.089 0.0930 0.007 0.100 0.114 1.406

36 0.841 0.093 0.0987 0.007 0.106 0.042 1.640

24 1.024 0.140 0.1115 0.007 0.118 0.050 1.997

6-Month Regression:


72 1.201 0.308 0.1239 0.007 0.131 0.781 1.620

60 0.575 0.045 0.0800 0.007 0.087 -0.016 1.166

48 0.760 0.089 0.0930 0.007 0.100 0.114 1.407

36 0.842 0.093 0.0988 0.007 0.106 0.043 1.642

24 1.026 0.141 0.1116 0.007 0.119 0.052 2.000

2-Year Regression:


72 1.202 0.309 0.124 0.007 0.131 0.783 1.621

60 0.578 0.046 0.080 0.007 0.087 -0.014 1.170

48 0.758 0.088 0.093 0.007 0.100 0.111 1.405

36 0.842 0.093 0.099 0.007 0.106 0.042 1.642

125

24 1.027 0.141 0.112 0.007 0.119 0.052 2.002

5-Year Regression:


72 1.200 0.310 0.124 0.007 0.131 0.784 1.622

60 0.584 0.047 0.081 0.007 0.088 -0.008 1.176

48 0.754 0.088 0.093 0.007 0.100 0.108 1.401

36 0.839 0.092 0.099 0.007 0.106 0.041 1.638

24 1.022 0.140 0.111 0.007 0.118 0.049 1.994

10-Year Regression:


72 1.204 0.310 0.124 0.007 0.131 0.785 1.622

60 0.587 0.047 0.081 0.007 0.088 -0.006 1.179

48 0.751 0.087 0.092 0.007 0.099 0.106 1.397

36 0.836 0.092 0.098 0.007 0.105 0.040 1.633

24 1.016 0.139 0.111 0.007 0.118 0.046 1.987

After selecting the proper Beta for each regression we were able to calculate the cost of

equity by using the previous discussed CAPM formula. Although are results were very

close we ultimately chose the 10-year Treasury bill with a 72 month regression. The

Beta was 1.016 with an adjusted R^2 of .139 after adjusting our cost of equity for

Wyeth’s market cap we concluded their Ke (cost of equity) to be 13.1%.

126

Finally, after calculating Wyeth’s cost of equity using the CAPM formula we chose to try

an alternative method to be completely confident in our results. This formula also has

three individual elements; the price to book ratio, return on equity, and the growth rate

of net income. The price to book ratio was taken from Wyeth’s key statistics of

yahoo.com. The return on equity was calculated by taking the forecasted Net income

divided by the previous years total equity. After calculating ten years worth of

forecasted ROE we used the average for this particular equation. Finally the growth rate

was found by finding the average growth change for the same forecasted Net Income

we used to find ROE. Once we had all of the information we plugged the particular

elements into the following equation: Ke= (ROE + ((P/B)-1) * g) / (P/B)). Wyeth’s

alternative cost of equity was 10.9%, which we were pleased to discover was very close

to there original CAPM cost of equity. Now that we are confident with Wyeth’s cost of

equity it will enable us to perform specific valuation models such as, AEG, Discount

Dividends Approach, Residual Income, and Long Run Residual Income Approach.

Cost of Debt

Firms borrow money in order to finance their assets and sustain their capital structure.

Debt holders are the first to be compensated in the event of total liquidation of a firm.

We know that different levels of risk should expect relative levels of return. The rate of

return at which these debt holders earn money on the funds they lend out, are different

for each type of liability account. In order to accurately estimate the cost of debt for

Wyeth, we first had to find the most appropriate rates for each item of total liabilities.

Since Wyeth has current and long-term notes payable, we found the stated rates for

these notes in their 10K, published 2008.

The rates for all current liabilities, except current portion of long-term debt, were the

most reasonable interest rates applicable to the risk and type of current liability. Trade

accounts payable and accrued expenses use the 90-day non-financial commercial paper

monthly interest rate. We took the rate of 3.25% at January 1, 2008 from the Federal

127

Reserve Bank of St. Louis’ website for Economic Research

(http://research.stlouisfed.org/fred2/data/CPN3M.txt). For accrued taxes, we found the

10-year Treasury Bond Rate, which is also the risk-free rate we used to calculate our

cost of equity, to be the most relevant rate. Wyeth states the rate used for each portion

of long-term debt in their 10K. To find the total rate of long-term debt, we found the

weighted rate for each note and calculated the total rate of long-term debt. Included in

long-term debt is a liability amount attributable to interest rate swaps. Wyeth uses the

LIBOR rate +/- varying percentages based on the loss or gain on the swap. We took a

weighted average of the losses and gains in order to find the rate for the liability

attributable to rate swaps as a portion of long-term debt. Pensions and other

postretirement benefits had explicit rates stated in the 10K. The table below shows the

calculation of weighted rates we used to find a cost of debt to be 5.19%.

Liabilities: Rate Weight Weighted Rate 2007Current Portion of LTD 4.13% 0.013 0.05% 311,586Trade accounts payable 3.25% 0.053 0.17% 1,268,600Accrued expenses 3.25% 0.222 0.72% 5,333,528Accrued taxes 3.98% 0.017 0.07% 410,565Total Current Liabilities 7,324,279

Long-term debt 5.81% 0.479 2.78% 11,492,881Accrued postretirement benefit obligations 6.45% 0.070 0.45% 1,676,126Other noncurrent liabilities 6.45% 0.146 0.94% 3,511,621Total Liabilities 5.19% 24,004,907

Weighted Average Cost of Capital

Weighted average cost of capital is the total of both the cost of debt and the cost of

equity. The weights are derived from the value of debt or equity over the value of the

firm (D+E) multiplied by its respective cost we previously calculated. There are two

types of WACC, before and after tax, where the tax implications are on the weighted

cost of debt only. Using our cost of debt we found, 5.19%, and the cost of equity,

13.08%, we derived from our regression analysis and CAPM, we found WACC before

128

tax to be 11% and after tax, 10%. The following charts show the original or current

WACC for Wyeth in comparison to the restated WACC.

Cost of Debt Weight of Debt Tax Rate Cost of Equity Weight of Equity WACCBefore Tax 5.19% 0.28 0% 13.08% 0.72 0.11After Tax 5.19% 0.28 34% 13.08% 0.72 0.10

Cost of Debt Weight of Debt Tax Rate Cost of Equity Weight of Equity WACCBefore Tax 5.19% 0.40 0% 13.08% 0.60 0.10After Tax 5.19% 0.40 34% 13.08% 0.60 0.09

Weighted Average Cost of Capital

Restated Weighted Average Cost of Capital

Valuation Analysis

Method of Comparables

The method of comparables is a simplistic manner by which to value a company. The

underlying process that all of these methods use is finding the industry average of the

specific ratio being used, leaving Wyeth’s ratio out of the average, and comparing it to

the denominator to find the price of Wyeth. These comparables can be performed

quickly because all of the information used is listed in financials found in periodicals and

websites and few calculations are used. The downside to these methods is that they

are too simple to provide a reliable approximation of a firm’s value. The share price

used in these measurements is the listed price of $44.13 as of June 2nd 2008. The

margin of safety observed is 15%.

129

Price-to-Earnings Trailing

Trailing P/E

Firm PPS EPS P/E Trailing

Comparables Price

Wyeth 44.13 3.48 12.68 54.94

Wyeth Restated 44.13 4.82 9.15 76.10

Industry Avg 15.78

Abbott 53.75 3.23 16.64

Pfizer 17.69 1.10 16.08

Eli Lilly 46.94 3.21 14.62

Trailing price to earnings ratio is a comparable method that uses current price per share

and current earnings per share. The figures used in this evaluation were found in

finance.yahoo.com. The trailing price to earnings ratio is calculated by dividing the

earnings per share by the price per share. This is done for everyone except Wyeth in

order to obtain an industry average. Afterwards, Wyeth’s earnings per share is found

and multiplied by the industry average price to earnings ratio. This ultimately gives one

an approximation of the price per share of Wyeth as compared to its industry.

After using past data for this method, Wyeth’s price per share was $54.94. This is

above the listed price of $44.13, making the share price undervalued. After restating

Wyeth’s statements the share price rose to $76.10, making the listed price appear

undervalued as well. There is a fundamental flaw with using this method in that one

is observing past data rather than future figures. The final price found using this

method should not be seriously considered because of this problem.

130

Price-to-Earnings Forward

Forward P/E

Firm PPS EPS P/E Forward

Comparables Price

Wyeth 44.13 3.73 11.84 47.04

Wyeth Restated 44.13 5.19 8.50 65.58

Industry Avg 12.63

Abbott 53.75 3.69 14.57

Pfizer 17.69 outlier outlier

Eli Lilly 46.94 4.40 10.68

The forward price to earnings ratio is a step in the right direction regarding accuracy in

comparable methods. Instead of using past figures one uses the earnings of one year

ahead. The forecasted earnings found in the forecasted income statement were used

in this equation. Similar to the trailing price to earnings ratio, the industry average

price to earnings ratio is measured, leaving Wyeth out of the equation. The new

forecasted earnings is multiplied by this figure to calculate the price per share. The

forward price to earnings method is a little more reliable compared to the trailing price

to earnings method but it is still a very crude calculation.

When using Wyeth’s stated figures in this measurement, the comparables price is

$47.04. This is higher than the listed price of $44.13 but not higher than the margin of

safety making the listed price fairly valued. The restated amounts give a comparables

price of $65.58, which is above the margin of safety. The restated amount makes the

listed price appear undervalued.

131

Price-to-Book

Price/Book

Firm PPS BPS P/B Comparables Price

Wyeth 44.13 13.73 3.21 56.26

Wyeth Restated 44.13 27.69 1.59 113.41

Industry Avg 4.10

Abbott 53.75 11.65 4.61

Pfizer 17.69 outlier outlier

Eli Lilly 46.94 13.11 3.58

Price-to-book ratio is a comparable valuation ratio where market price is driven by book

value of equity per share. We found the price per share for each of Wyeth’s identified

competitors and their respective book value of equity divided by shares outstanding.

Then we computed the price-to-book ratio by dividing price per share by book value per

share, then took an average to calculate the industry price-to-book. We did not include

Pfizer in the industry average as we decided that its values were an outlier of the

industry and would adversely affect the average. To find Wyeth’s comparable price, we

multiplied the industry price-to-book by Wyeth’s book value per share. Our analysis

based on the price-to-book ratio shows that the market price for Wyeth is

undervalued.

132

Price Earnings Growth

Firm P/E Trailing EGR PEG Comparables PriceWyeth 13.54 12.65 1.07 15.88Wyeth Restated 9.77 9.07 1.08 11.39Industry Avg 1.26Abbott 16.64 14.57 1.14Pfizer 16.08 outlier outlierEli Lilly 14.62 10.68 1.37

PEG

The price earnings growth model or PEG ratio is based on a price-to-earnings ratio and

our forecasted analysis. First we used the trailing price-to-earnings ratio, as previously

calculated, and divide it by the forecasted earnings growth per share. This earnings

growth is calculated based on the one year projected growth of our forecasted earnings

divided by the number of shares outstanding. Once again, we found Pfizer to be an

outlier that would inaccurately affect the industry average so we threw it out. By

multiplying the industry average by the earnings growth rate of Wyeth and Wyeth

Restated, we found the market price to be very undervalued. The results of the PEG

ratio are so far overvalued that although, the numbers are calculated correctly, we do

not find it to be a fair comparable ratio for valuation. We do not consider the PEG ratio

to be a reliable valuation tool to be used without any other comparable analysis to back

up these results.

133

Price-to-EBITDA

Firm Market Cap(billons) EBITDA P/EBITDA Comparables PriceWyeth 61.36 4.58 13.39 47.42Wyeth Restated 61.36 7.04 8.72 72.84Industry Avg - - 10.35Abbott 81.71 6.78 12.05Pfizer 117.44 outlier outlierEli Lilly 52.15 6.03 8.65

Price/EBITDA

The price over EBITDA model is a little more refined than the previous comparable

models in that it focuses on specific items that help value a firm in a more reliable

manner. The price factor for this measurement is the market cap. This number is

calculated by multiplying the price of shares by the number of shares. EBITDA stands

for earnings before interest, taxes, depreciation and amortization. This figure gives one

a clearer picture of cash flow into the firm without other variables affecting the amount.

Pfizer is not included in the industry average because the ratio would skew the figure

too much. The industry average price over EBITDA is calculated and multiplied by the

EBITDA of Wyeth to measure the market cap of Wyeth. The comparables price listed

above is a market cap measurement. Dividing this figure by the total amount of shares

will provide one with the price per share comparable. The market cap found using this

method is $47.42. This ratio demonstrates that Wyeth’s Market cap is fairly valued

considering the listed market cap of $61.36. When using restated figures, the market

cap is undervalued.

134

Price-to-Free Cash Flows

Price/Free Cash Flows

Firm Market Cap(billons) FCF(billons) P/FCF

Comparables Price

Wyeth 61.36 3.27 18.75 49.48

Industry Avg - - 20.11

Abbott 81.71 4.05 20.19

Pfizer 117.44 Outlier outlier

Eli Lilly 52.15 Outlier outlier

The price to free cash flows comparable is calculated by dividing the free cash flows of

the company from the market cap. The market cap takes the place of price in this

ratio. As stated before, the market cap is calculated by multiplying the share price by

the total amount of shares. Free cash flow is measured by subtracting cash flow from

investing from cash flow from operations. This comparable ratio takes into effect how

cash flows maintain the value of equity. Pfizer and Eli Lilly are not used in the industry

average due to the fact that their ratios will skew the industry average too much to be

able to calculate a reasonable average. The industry average is calculated and

multiplied by the free cash flow figure that is measured from Wyeth’s statements. The

listed comparables price is the market cap. Dividing this figure by the number of shares

will provide one with the price of shares compared to other companies in the industry

through the price to free cash flows ratio. The listed market cap is higher tan the

comparables price, making the listed price overvalued.

135

Enterprise Value-to-EBITDA

Enterprise Value/EBITDA

Firm EV EBITDA EV/EBITDA Comparables Price

Wyeth 74.91 4.58 16.36 42.33

Industry Avg - - 9.24

Abbott 91.92 6.78 13.56

Pfizer 105.75 19.44 5.44

Eli Lilly 52.65 6.03 8.73

The enterprise value is the amount of money it would take to completely buy a firm.

This figure includes the market cap plus the book value of liabilities, because when

obtaining a company one will also inherit the liabilities associated with the company.

Finally, cash and cash equivalents are subtracted from this amount because this money

is sitting in the bank and can be pocketed immediately. The EBITDA is divided from the

enterprise value to obtain the ratio. This ratio is performed for all of Wyeth’s

competitors excluding Wyeth and an average is found. This average, multiplied by the

EBITDA of Wyeth, gives one the enterprise value of Wyeth compared to its competitors.

This price is much lower than the listed enterprise value, making the price overvalued.

136

Conclusion

All of these methods can be used to help derive a value for the firm being analyzed.

Unfortunately they are extremely fickle and should not be completely relied upon to

provide an accurate portrayal of the company. As can be seen by the above methods

of comparables, some show Wyeth’s share price as being overvalued, others show an

undervalued amount while other provide fairly valued prices. It is proof that the

method of comparables should not be used by themselves as a means to value a

company. They are fast and easy to calculate and might provide an extremely general

description of the value of the firm but should be used along with more in depth

valuation procedures that take into effect more than the industry averages.

137

Discount Dividends Approach

The discount dividends approach attempts to measure the value of a firm by calculating

an estimated share price mainly based on dividends per share and the company’s cost

of equity. This approach believes that an investor would continuously hold onto a

companies stock based on the amount of dividends received. This is highly unrealistic

because an investor does not plan on holding onto stock forever and considers more

then just dividends when purchasing shares of a company. Since this approach does not

have a high explanatory power it has very low reliability when valuing a company. We

are choosing to include it in our analysis anyways Wyeth does pay dividends and the

analysis is possible to run.

In order to value the current share price based on dividends approach we must first

forecast dividends per share. When looking at Wyeth’s historical dividend payments we

noticed a trend. Wyeth pays four dividends per year, the last payment in November is

steadily increase by two cents. Therefore we forecasted our dividends using the same

approach and increased the last payment. This did not give us a consistent rate of

growth. For the growth rate that is required for the discount dividends approach we

found the average dividend growth rate for the ten forecasted years, which was 5.65%.

After finding Wyeth’s forecasted dividends we assumed the time of the perpetuity to be

2018 and the dividend per share was found the same was as mentioned earlier. We

found the present value factor for each year by using the formula: 1/((1+ke)^t). After

having each years PV factor we multiplied that by the corresponding years dividends

per share. The sum of the present value year-by-year dividends per share was $8.179.

Next, we had to calculate the present value of the perpetuity we took the time 11

dividend per share and divided it by the cost of equity minus the growth rate. This

process gave us the terminal value of the perpetuity we then discounted it back by

using year 10’s present value factor giving us $7.604. Adding this with the year-by-year

sum we found the 12/31/2007 price to be $15.78. Since we are valuing the company at

138

June 1, 2007 we had to find the future value (by five months) of the share price.

Wyeth’s final observed price using the discount dividends approach was $16.61.

The next step was to perform the sensitivity analysis. Based on what we know about

the discount dividends approach the sensitivity analysis is expected to show Wyeth as

being extremely overvalued. We used a 15% interval based on the confidence in our

forecasting. With the June 1, 2008 observed price being $44.13 we concluded our price

judgments to be as followed:

50.76 or >= undervalued

37.51-50.75= fair valued

50.76 or < = overvalued

*legend for sensitivity analysis

For our cost of equity we started with our 13.1% and then using our higher and lower

beta intervals we found two more cost of equity points to examine. Our original growth

rate is the 5.65% and we used other reasonable growth rates for the range.

Sensitivity Analysis

0 0.02 0.04 0.0565 0.06 0.08 0.1(GR)0.102 17.31 19.14 22.15 26.62 28.02 44.57 392.220.110 15.94 17.38 19.65 22.79 23.73 33.24 80.810.119 14.63 15.75 17.44 19.64 20.27 26.01 43.840.131 13.16 13.98 15.16 16.61 17.01 20.3 27.840.139 12.33 13.00 13.95 15.08 15.37 17.77 22.610.148 11.50 12.05 12.80 13.66 13.89 15.61 18.780.160 10.55 10.97 11.53 12.15 12.31 13.48 15.43(Ke)

139

Like we expected the dividend discount approach shows Wyeth to be overvalued.

However, when concluding the overall value of Wyeth the dividend discount approach

will have the least effect.

140

Discounted Free Cash Flows Model

The discounted free cash flows model is a valuation method used to determine the

value of a firm through the present value of future cash flows. The main components

of this model include cash flow from operations and investing activities, book value of

debt and preferred stock, before tax weighted average cost of capital, and a perpetuity

growth rate. The CFFOs and CFFIs in this model are both stated in after tax terms, so

we used a before tax WACC of 11% in our calculations.

To determine the value of a firm based on the discounted free cash flows model, you

must begin by subtracting CFFI from CFFO for each period which gives the free cash

flows of the firm. The next step is to adjust the time value of these cash flows by

multiplying each by their respective present value factor using the WACC as the

discount rate. The sum of these periods gives you the present value year by year free

cash flows. From there, the market value of assets is derived by adding the year by

year cash flows to the terminal value perpetuity. The terminal value of perpetuity is

found by taking the forecasted estimate in year 11 and discounting it back 10 years to

get the present value. At that point, you subtract the market value of assets from the

book value of debt and preferred stock which gives you the book value of equity. Using

this amount, you divide by the number of shares outstanding to get a model price and

then adjust it to the time consistent price for the date of interest.

There are a few disadvantages in drawing conclusions from this model. This model

uses information and inputs that are not only difficult to estimate, but also can be

manipulated to portray a false picture of the firm’s value. This method is one of the

least predictive among the valuation models due to its high sensitivity to the terminal

value growth rates.

141

A sensitivity analysis of the discounted free cash flows models was used to estimate the

intrinsic value of Wyeth at various WACC and growth rates. The following chart shows

the results of this analysis.

Discounted Free Cash Flows Sensitivity Analysis Growth Rates

WACC

0.0 1.0 2.0 3.0 4.0 5.0

9.00% 22.75 19.70 19.84 19.88 19.91 19.92

9.60% 22.63 19.74 19.88 19.93 19.95 19.97

10.14% 22.54 19.77 19.92 19.97 19.99 20.00

11.00% 22.42 19.84 19.99 20.04 20.06 20.07

11.28% 22.38 19.86 20.01 20.06 20.08 20.09

11.85% 22.32 19.90 20.06 20.10 20.12 20.14

13.00% 22.23 19.98 20.14 20.18 20.21 20.22

Overvalued < $37.51 $37.51 < Fairly Valued > $50.75 Undervalued >

$50.76

The observed share price on June 1, 2008 was $44.13. The time consistent price

estimated through this model was $22.42. The results of the discounted free cash

flows model show that Wyeth is highly overvalued. Due to the low predictability and

high sensitivity of this model, it is necessary to use additional valuation methods in

determining the value of this firm.

142

Residual Income Model

The residual income model is a predictive valuation model used in estimating the

intrinsic value of a firm. The primary components of this model include forecasted net

income, forecasted total dividends, book value of equity, cost of equity, and a

perpetuity growth rate. This model provides a more accurate valuation of the firm as

compared to the free cash flow and discount dividends model because it is not as

sensitive to terminal value growth rates.

In computing this model we used the major components listed above based on Wyeth’s

10-K and our forecasted financials, which includes the restated financials to account for

the impairment of goodwill and the classification of R&D as an asset. The cost of equity

used in this valuation is 13.1%.

In order to determine the value of a firm based on this model, you must begin by

calculating the book value of equity. This amount is found by taking the previous year’s

book value of equity, adding the current year’s net income, and subtracting the current

year’s total dividends. From there you compute the residual income by taking the

current year’s net income less the normal benchmark income. The benchmark income

is found by taking the previous year’s book value of equity and multiplying it by the cost

of equity. The next step is to take the present value residual income of each year and

add it to the terminal value perpetuity. Using this amount, you divide by the number of

shares outstanding to get a model price and then adjust it to the time consistent price

for the date of interest.

A sensitivity analysis of this model was used to determine the intrinsic value of Wyeth

at various costs of equity and growth rates. The results of this analysis can be seen on

the following two charts.

143

Residual Income Sensitivity Analysis Growth Rates

Cost of E

quity

0% ‐0.1% ‐0.2% ‐0.3% ‐0.4% ‐0.5%10.2% 42.50 36.86 34.95 34.00 33.42 33.0411.0% 37.92 33.83 32.38 31.64 31.18 30.8811.9% 33.62 30.82 29.77 29.22 28.89 28.6613.1% 28.94 27.33 26.70 26.36 26.15 26.0013.9% 26.35 25.31 24.88 24.65 24.50 24.4014.8% 23.83 23.27 23.02 22.89 22.80 22.7516.0% 21.01 20.88 20.83 20.79 20.77 20.76

Overvalued < $37.50 $37.51 < Fairly Valued > $50.75 Undervalued >

$50.76

Restated Residual Income Sensitivity Analysis Growth Rates

Cost of E

quity

0% ‐0.1% ‐0.2% ‐0.3% ‐0.4% ‐0.5%

10.2% 19.15 18.89 18.80 18.76 18.73 18.71

11.0% 17.54 17.61 17.63 17.64 17.65 17.66

11.9% 16.01 16.32 16.44 16.50 16.54 16.56

13.1% 14.30 14.82 15.02 15.13 15.20 15.25

13.9% 13.34 13.93 14.18 14.31 14.39 14.45

14.8% 12.39 13.03 13.31 13.46 13.56 13.62

16.0% 11.30 11.97 12.27 12.44 12.54 12.62

Overvalued < $37.50 $37.51 < Fairly Valued > $50.75 Undervalued > $50.76

The observed share price for Wyeth on June 2, 2008 was $44.13. The initial time

consistent price found using this model was $28.94, and $14.30 using the restated

financial statements. Based on the results of the residual income model, we conclude

that Wyeth is extremely overvalued. Because this model provides a more accurate

valuation than other methods, we feel that this is a valid estimation of the firm’s

intrinsic value.

144

Abnormal Earnings Growth Model

The abnormal earnings growth model is another valuation model used in estimating the

value of a firm. According to Palepu and Healy, this approach “expresses the value of a

firm’s equity as book value plus discounted expectations of future abnormal earnings”.

Abnormal earnings are simply the total earnings minus normal earnings. For this model

we used our original and restated forecasted financial statements with a cost of equity

of 13.1%.

The estimation of a firm’s value using this model starts with the calculation of drip

income. Drip income is found by taking the previous year’s dividends and multiplying

them by the cost of equity. The drip income is then added to the current year’s

earnings to arrive at the cumulative dividend earnings. The annual AEG is then

calculated by subtracting the normal (benchmark) income from the cumulative dividend

earnings. The benchmark income is derived by taking the previous year’s net income

multiplied by 1 plus the cost of equity.

As with previous models, each annual value must then be multiplied by its present

value factor in order to adjust all values to the same time period. The sum of these

adjustments is added to the net income of the period and the terminal value perpetuity

to arrive at the total adjusted earnings perpetuity. The market value of equity is then

found by taking this adjusted perpetuity and dividing it by the cost of equity. Using this

amount, you divide by the number of shares outstanding to get a model price and then

adjust it to the time consistent price for the date of interest.

Similar to the residual income method, we conduct a sensitivity analysis of the AEG

model using costs of equity and growth rates in estimated the intrinsic value of this

firm. The following two charts show the results of this analysis based on the original

and restated financial statements.

145

Abnormal Earnings Growth Sensitivity Analysis Growth Rates

Cost of E

quity

0% ‐0.1% ‐0.2% ‐0.3% ‐0.4% ‐0.5%

10.2% 35.90 34.54 34.08 33.85 33.71 33.61

11.0% 33.30 32.71 32.50 32.39 32.32 32.28

11.9% 30.60 30.70 30.73 30.75 30.76 30.77

13.1% 27.29 28.09 28.40 28.57 28.68 28.75

13.9% 25.22 26.39 26.87 27.13 27.29 27.41

14.8% 22.99 24.51 25.15 25.50 25.73 25.89

16.0% 20.17 22.04 22.87 23.34 23.64 23.85


Restated Abnormal Earnings Growth Sensitivity Analysis Growth Rates

Cost of E

quity

0% ‐0.1% ‐0.2% ‐0.3% ‐0.4% ‐0.5%

10.2% 21.92 19.59 18.80 18.40 18.16 18.01

11.0% 21.08 19.05 18.33 17.96 17.74 17.59

11.9% 20.20 18.46 17.81 17.47 17.26 17.11

13.1% 19.12 17.68 17.11 16.80 16.61 16.48

13.9% 18.44 17.16 16.64 16.36 16.18 16.05

14.8% 17.70 16.59 16.12 15.85 15.69 15.57

16.0% 16.77 15.83 15.42 15.18 15.03 14.93


The observed share price on June 1, 2008 was $44.13. The initial time consistent price

estimated through this model was $27.29, and $19.12 using the restated financial

statements. The results of the abnormal earnings growth model are in agreement with

the previous method findings that Wyeth is overvalued.

146

Long Run Residual Income Model

The long run residual income perpetuity model is used by analysts to calculate the

equity value of a firm. The difference between this model and the residual income

model is that return on equity is used instead of net income multiplied by the cost of

equity. The first step in calculating this model is determining the long run estimate of

return on equity. After subtracting the cost of equity, this figure will portray the long

run rate that will outperform investor’s required rate of returns. The present day effect

on this outperformance in the future is found by dividing by the cost of equity minus

the growth rate of equity. Finally, multiplying this figure by the present day book value

of equity will establish the surplus book value of equity. Dividing this last number by

the total shares outstanding will give the book value of equity in a per share basis and

the approximate value of the shares according to one’s research.

The return on equity used in this equation was found by calculating the average of the

forecasted return on equity figures based off of forecasted statements. The 12% equity

growth rate that was used in the long run residual income model was determined by

observing the forecasted equity growth rate and taking into effect the trend that was

taking place.

Sensitivity was analyzed three different times with changing variables. The different

variables used include return on equity, equity growth rates and cost of equity. The

share price was fairly valued when the growth rate decreased and the return on equity

increased. The majority of the prices were overvalued. When using restated net

income and stockholders equity there was a substantial increase in fairly valued prices.

The long run residual model states that Wyeth is undervalued.

147

Long Run Residual Income Sensitivity

ROEKe 0.10 0.12 0.14 0.16 0.18 0.20 0.22

0.102 15.26 ‐ (15.26) (29.77) (45.78) (61.03) (76.29) 0.11 27.47 ‐ (27.47) (53.59) (82.40) (109.86) (137.33) 0.119 274.66 ‐ (274.66) (535.88) (823.97) (1,098.63) (1,373.29) 0.131 (24.97) ‐ 24.97 48.72 74.91 99.88 124.84 0.139 (14.46) ‐ 14.46 28.20 43.37 57.82 72.28 0.148 (9.81) ‐ 9.81 19.14 29.43 39.24 49.05 0.16 (6.87) ‐ 6.87 13.40 20.60 27.47 34.33

GrowthKe 0.09 0.1 0.11 0.12 0.13 0.14 0.15

0.102 78.99 405.27 (84.15) (29.77) (14.23) (6.87) (2.58) 0.11 47.39 81.05 ‐ (53.59) (19.93) (8.71) (3.10) 0.119 32.69 42.66 74.80 (535.88) (36.23) (12.44) (4.00) 0.131 23.12 26.15 32.06 48.72 398.56 (29.03) (6.52) 0.139 19.34 20.78 23.21 28.20 44.28 (261.23) (11.26) 0.148 16.34 16.89 17.72 19.14 22.14 32.65 (61.95) 0.16 13.54 13.51 13.46 13.40 13.29 13.06 12.39

GrowthROE 0.09 0.1 0.11 0.12 0.13 0.14 0.15

0.1 3.35 ‐ (6.54) (24.97) (411.99) 61.03 36.14 0.12 10.05 8.86 6.54 ‐ (137.33) 30.52 21.68 0.14 16.75 17.72 19.62 24.97 137.33 ‐ 7.23 0.16 23.45 26.58 32.70 49.94 411.99 (30.52) (7.23) 0.18 30.15 35.44 45.78 74.91 686.64 (61.03) (21.68) 0.2 36.84 44.30 58.86 99.88 961.30 (91.55) (36.14) 0.22 43.54 53.16 71.93 124.84 1,235.96 (122.07) (50.59)

undervalued > $50.75fairly valued $37.50 ‐ $50.74overvalued < $48.739

148

Restated Long Run Residual Income Sensitivity

ROEKe 0.10 0.12 0.14 0.16 0.18 0.20 0.22

0.102 30.76 ‐ (30.76) (60.02) (92.28) (123.04) (153.81) 0.11 55.37 ‐ (55.37) (108.03) (166.11) (221.48) (276.85) 0.119 553.70 ‐ (553.70) (1,080.33) (1,661.11) (2,214.81) (2,768.51) 0.131 (50.34) ‐ 50.34 98.21 151.01 201.35 251.68 0.139 (29.14) ‐ 29.14 56.86 87.43 116.57 145.71 0.148 (19.78) ‐ 19.78 38.58 59.33 79.10 98.88 0.16 (13.84) ‐ 13.84 27.01 41.53 55.37 69.21

GrowthKe 0.09 0.1 0.11 0.12 0.13 0.14 0.15

0.102 159.24 817.02 (169.65) (60.02) (28.70) (13.86) (5.20) 0.11 95.54 163.40 ‐ (108.03) (40.17) (17.55) (6.24) 0.119 65.89 86.00 150.80 (1,080.33) (73.04) (25.08) (8.06) 0.131 46.61 52.71 64.63 98.21 803.48 (58.51) (13.15) 0.139 39.00 41.90 46.80 56.86 89.28 (526.63) (22.71) 0.148 32.95 34.04 35.72 38.58 44.64 65.83 (124.89) 0.16 27.30 27.23 27.14 27.01 26.78 26.33 24.98

GrowthROE 0.09 0.1 0.11 0.12 0.13 0.14 0.15

0.1 6.75 ‐ (13.18) (50.34) (830.55) 123.04 72.86 0.12 20.26 17.86 13.18 ‐ (276.85) 61.52 43.71 0.14 33.76 35.72 39.55 50.34 276.85 ‐ 14.57 0.16 47.27 53.58 65.92 100.67 830.55 (61.52) (14.57) 0.18 60.77 71.45 92.28 151.01 1,384.26 (123.04) (43.71) 0.2 74.28 89.31 118.65 201.35 1,937.96 (184.57) (72.86) 0.22 87.78 107.17 145.02 251.68 2,491.66 (246.09) (102.00)

undervalued > $50.75fairly valued within $6.62overvalued < $37.51

equity analysis and valuation - texas tech...

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