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Firm Valuation and Financial Analysis
Prepared By: Ashley Mast [email protected]
Ashlynn Conder [email protected]
Danielle Albert [email protected]
Lorena Rios [email protected]
Rose DePinto [email protected]
Theresa Burcz [email protected]
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Table of Contents Executive Summary .............................................................................................................. 6
Industry Analysis .............................................................................................................. 8
Accounting Analysis ........................................................................................................ 10
Financial Analysis ............................................................................................................ 11
Valuation Analysis ........................................................................................................... 15
Company Overview ............................................................................................................ 16
Brief History ................................................................................................................... 16
Current Status ................................................................................................................ 16
Industry Overview .............................................................................................................. 17
Five Forces Model ........................................................................................................... 20
Rivalry Amongst Existing Firms ........................................................................................ 22
Industry Growth .......................................................................................................... 22
Concentration .............................................................................................................. 22
Switching Costs ........................................................................................................... 23
Cost Analysis ............................................................................................................... 23
Conclusion .................................................................................................................. 26
Threat of New Entrants ................................................................................................... 26
Patents and Licensing .................................................................................................. 27
Capital Requirements ................................................................................................... 27
Distribution Access and Relationships ........................................................................... 27
Conclusion .................................................................................................................. 28
Threat of Substitutes ....................................................................................................... 28
Relative Price and Performance .................................................................................... 28
Customers’ Willingness to Switch .................................................................................. 29
Conclusion .................................................................................................................. 29
Bargaining Power of Customers ....................................................................................... 29
Factors ....................................................................................................................... 30
Relationships and Competition ...................................................................................... 30
Conclusion .................................................................................................................. 30
Bargaining Power of Suppliers ......................................................................................... 31
Switching Costs ........................................................................................................... 31
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Relationships and Competition ...................................................................................... 31
Conclusion .................................................................................................................. 32
Conclusion to Porter’s Five Force Analysis ......................................................................... 32
Key Success Factors in Industry .......................................................................................... 33
Differentiation ................................................................................................................ 33
Research and Development ............................................................................................. 34
Product Quality and Product Variation .............................................................................. 37
Customer Relations and Loyalty ....................................................................................... 38
Conclusion ...................................................................................................................... 39
Competitive Advantage Analysis .......................................................................................... 39
Differentiation ................................................................................................................ 39
Product Quality and Product Variation .............................................................................. 40
Customer Relations and Loyalty ....................................................................................... 41
Conclusion ...................................................................................................................... 41
Introduction to Accounting Analysis ..................................................................................... 41
Identify Key Accounting Policies ....................................................................................... 42
Type 1 Accounting Policies ........................................................................................... 42
Type 2 Accounting Policies ........................................................................................... 46
Conclusion .................................................................................................................. 49
Assessing the Degree of Accounting Flexibility ..................................................................... 50
Goodwill ......................................................................................................................... 50
Operating Leases ............................................................................................................ 52
Pension Plans ................................................................................................................. 53
Conclusion ...................................................................................................................... 53
Evaluation of Actual Accounting Strategy ............................................................................. 53
Company Disclosure ........................................................................................................ 54
Accounting Policy Approach ............................................................................................. 54
Conclusion ...................................................................................................................... 55
Quality of Disclosure ........................................................................................................... 55
Potential Red Flags ............................................................................................................. 56
Accounting Distortions ........................................................................................................ 57
Defined Benefit Pension Plans .......................................................................................... 57
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Goodwill ......................................................................................................................... 58
Operating Leases ............................................................................................................ 60
Conclusion ...................................................................................................................... 62
Financial Analysis ............................................................................................................... 62
Liquidity Ratios ............................................................................................................... 63
Current Ratio .............................................................................................................. 63
Quick Asset Ratio ........................................................................................................ 64
Conclusion .................................................................................................................. 66
Operating Efficiency Ratios .............................................................................................. 66
Inventory Turnover ...................................................................................................... 66
Days Supply Inventory ................................................................................................. 68
Accounts Receivable Turnover ...................................................................................... 70
Days Sales Outstanding ............................................................................................... 71
Cash-to-Cash Cycle ...................................................................................................... 73
Working Capital Turnover ............................................................................................. 74
Conclusion .................................................................................................................. 76
Profitability Ratios ........................................................................................................... 76
Gross Profit Margin ...................................................................................................... 76
Operating Profit Margin ................................................................................................ 78
Net Profit Margin ......................................................................................................... 80
Return on Asset ........................................................................................................... 81
Return on Equity ......................................................................................................... 83
Asset Turnover ............................................................................................................ 84
DuPont Result ............................................................................................................. 86
Conclusion .................................................................................................................. 87
Capital Structure and Credit Risk ...................................................................................... 87
Debt to Equity Ratio .................................................................................................... 87
Times Interest Earned ................................................................................................. 89
Debt Service Margin .................................................................................................... 90
Altman’s Z-Score ......................................................................................................... 91
Internal Growth Rate ................................................................................................... 94
Sustainable Growth Rate .............................................................................................. 96
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Conclusion .................................................................................................................. 98
Forecasting Financial Statements ........................................................................................ 98
Income Statement .......................................................................................................... 99
Balance Sheet ................................................................................................................ 100
Statement of Cash Flows ................................................................................................ 104
Conclusion ..................................................................................................................... 106
Cost of Capital Estimation .................................................................................................. 106
Cost of Debt .................................................................................................................. 107
Cost of Equity ................................................................................................................ 108
Backdoor Cost of Equity ................................................................................................. 111
Weighted Average Cost of Capital ................................................................................... 112
Conclusion ..................................................................................................................... 114
Valuation Models ............................................................................................................... 115
Introduction .................................................................................................................. 115
Method of Comparables ................................................................................................. 115
Price to Earnings (P/E) Trailing and Forecast ................................................................ 115
Price to Book .............................................................................................................. 116
Dividend to Price ........................................................................................................ 117
Enterprise Value to EBITDA ......................................................................................... 118
Price to Earnings Growth (P.E.G.) ................................................................................ 118
Price to EBITDA .......................................................................................................... 119
Price to Free Cash Flow per share ................................................................................ 119
Conclusion ..................................................................................................................... 120
Intrinsic Valuation Models .................................................................................................. 121
Discounted Dividends Model ........................................................................................... 121
Discounted Free Cash Flow Model ................................................................................... 122
Residual Income Model .................................................................................................. 123
Long-Run Return on Equity Residual Income Model ......................................................... 123
Abnormal Earnings Growth ............................................................................................. 125
Conclusion ..................................................................................................................... 125
Analyst Recommendation .................................................................................................. 126
Works Cited ...................................................................................................................... 126
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Appendix .......................................................................................................................... 130
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Executive Summary
2010 2011 2012 2013 2014 2015Observed Price (11/1/2016) $71.03 3.70 4.43 3.77 3.39 3.40 3.28
52 Week Range $41.42 $82.30Revenue 1.76 BMarket Cap 1591.07 M ROE 14.15% IGR 1.40%Shares Outstanding 22.4 M ROA 6.54% SGR 11.11%Book Value per Share 28.50$
R^2 Beta 2 Factor Ke12 Month 61.17% 2.16 18.94%24 Month 35.97% 1.70 15.72%36 Month 26.56% 1.45 13.99%48 Month 15.00% 1.34 13.22%60 Month 16.63% 1.22 12.35%72 Month 15.68% 1.09 11.42%
Backdoor Ke 10.81%WACC-BT 13.76%WACC-AT 10.17%WACC-AT LB 14.46%WACC-AT UB 5.89%Published Beta (Yahoo Finance) 1.54 6.90$
41.14$ Lower BoundExpected VUpper Bound 32.02$
Cost of Equity (Ke) 6.90% 13.92% 20.95% 25.08$ Size-Adjusted Ke 8.70% 15.72% 22.75% 31.51$
Result
$98.61
Fairly Valued Fairly Valued Fairly Valued UndervaluedFairly Valued UndervaluedUndervaluedOvervalued
Intrinsic Valuation Models
$42.48$76.97$34.23$51.10
Dividend/PriceP.E.G
P/EBITDAP/FCF
EV/EBITDA
AEG
Discounted DividendsDiscounted Free Cash Flows
Residual IncomeLong-Run Residual Income
Valuation Model
Stepan - NYSE 11/1/2016Analyst Recommendation: Sell (Overvalued)
Cost of Capital20-Year Treasury Bond Regressions
Altman's Z-Score
Relevant Ratios
Method of Comparables Valuations
Comparable ResultP/B
P/E TrailingP/E Forward
$67.80$75.41$64.03
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Industry Analysis
Stepan Company operates in the specialty chemicals industry and its main
competitors are Olin, Innospec, and Minerals Technologies. These competitors were
chosen because they produce and sell similar products to Stepan and have similar market
caps. The specialty chemicals industry is a commodity-based industry that is affected by
economic cycles.
In order to better understand the specialty chemicals industry, we utilized Porter’s
Five Forces Model. This model allowed us to analyze the industry’s trends for each of the
five forces and the profitability of the overall industry. Due to Porter’s Five Forces Model,
we were able to value the specialty chemicals industry, this is shown in Figure 1.0.
Figure 1.0: Industry Profitability Diagram
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The five forces included in Porter’s model are rivalry among existing firms, threat
of new entrants, threat of substitutes, bargaining power of customers, and bargaining
power of suppliers. Rivalry among existing firms is mixed due to positive industry growth,
medium concentration, and high switching costs for customers. Even though the specialty
chemicals industry has been growing and is expected to keep growing, the number of
firms in the industry has remained low due to competition. High switching costs are due
to contracts that are costly to break.
Threat of new entrants is low due to high barriers to entry. These barriers are high
cost of capital, patents and licensing requirements, distribution access, and well-
established relationships with customers. The specialty chemicals industry is a mature
industry, making it difficult for new firms to enter. Threat of substitutes is also low
because substitutes or alternatives to the chemicals used in the specialty chemicals
industry do not exist.
In the specialty chemicals industry, the bargaining power of customers is mixed
due to high switching costs, integration, price sensitivity, and lack of available substitutes.
Since the industry is specialized, it is difficult for customers to begin producing products
that they receive from suppliers. This is why relationships are important to maintain within
this industry.
Bargaining power of suppliers is mixed due to high switching costs and mixed
relationships and competition of suppliers. Switching costs are high due to long-term
contracts that are costly to break. Relationships and competition of suppliers is mixed
because although contracts are in place, firms still have the option to do business with a
variety of suppliers.
After utilizing the Porter’s Five Forces model, we have concluded that the
profitability of the specialty chemicals industry is low. Firms in this industry focus on
product differentiation and use cost leadership in order to compete and succeed. Product
differentiation and cost leadership are two mutually exclusive events and when firms try
to utilize both, they are expected to earn a low profitability. In the specialty chemicals
industry, we found it was common for firms to use both methods, thus we concluded that
the specialty chemicals industry of low profitability.
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Accounting Analysis
After analyzing the specialty chemicals industry, we will now evaluate Stepan’s
accounting policies, accounting flexibility, and quality of accounting disclosure. Even
though GAAP has set standards that all companies must follow, it only requires a minimal
level of disclosure and firms sometimes take advantage of this. Not adhering to these
standards may cause companies to distort their financial reports and mislead their
stockholders. We will compare the accounting flexibility of the specialty chemicals
industry to Stepan in order to compare Stepan’s flexibility to that of the industry. We will
determine the quantitative and qualitative factors by evaluating the quality of disclosure.
Overall, the accounting analysis will help us evaluate Stepan and decide if it is
undervalued, overvalued, or fairly valued.
The key accounting policies consist of Type 1 and Type 2. Type 1 accounting
policies are linked to Stepan’s key success factors. The key success factors we have
determined for the specialty chemicals industry are research and development, product
quality and variety, and customer service/loyalty. We compared Stepan to the industry
norms and have concluded that Stepan has a normal level of disclosure.
Type 2 accounting policies are asset or liability accounts that can affect the
attractiveness of the firm to shareholders. A firm with high flexibility can alter these
accounting items and mislead investors by making the company look more favorable. We
concluded that the specialty chemicals industry has a high level of flexibility. The Type 2
accounting policies that most affect the specialty chemicals industry are goodwill, pension
plans, and operating leases. Similar to Type 1 accounting policies, we concluded that
Type 2 accounting policies adhere to the industry norms of the specialty chemicals
industry.
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We examined Stepan’s financial statements for any potential red flags, and
identified two common red flags. The first red flag found was Stepan’s tendency to use
financing mechanisms. These mechanisms can include research and development
partnerships, special-purpose entities, and the sale of receivables with recourse. The
financing mechanism Stepan uses is operating leases, which allows Stepan to understate
its liabilities.
The second common potential red flag was an increasing gap between Stepan’s
reported income and its stated cash flows. In 2015, Stepan’s operating activities were
$183.3 million but its net income was only $75.9 million. We concluded that this gap was
caused by Stepan’s administrative expenses increasing. We also realized that most of
Stepan’s operating income goes towards investing into new business projects.
We did not have to restate any financials because no accounts materially altered
our perception of Stepan. We did not have to restate because Stepan did not meet the
following thresholds: goodwill is more than 30% of net fixed assets, goodwill impairment
eliminates more than 30% of operating income, R&D expense reduces operating income
by more than 20%, capitalized operating leases increase non-current liabilities by more
than 20%.
Financial Analysis
After analyzing the accounting policies used by Stepan and the specialty chemicals
industry, we will now conduct a financial analysis for Stepan. We computed ratios in order
to compare Stepan to the specialty chemicals industry over the past five years. The ratios
used in our analysis were liquidity, operating efficiency, profitability, and capital structure.
In Figures 1.1-1.4, the “Performance” column measures Stepan and the “Trend” column
measures the specialty chemicals industry.
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Figure 1.1: Liquidity Ratios
Liquidity ratios measure whether a company has the ability to cover its debt
obligations with their currently held assets. They also measure the ability of the company
to convert its assets into cash. The liquidity ratios include current ratio and quick asset
ratio. We compared Stepan’s ratios to its competitors in the specialty chemicals industry
and found that Stepan is outperforming its competitors. Stepan’s liquidity ratios have
been increasing in the past six years, unlike the industry trend.
Figure 1.2: Operating Efficiency Ratios
Operating efficiency ratios are used to determine how fast a business can turn
assets into revenue. These ratios should be high, as it portrays that a company is efficient
when collecting its accounts receivables. It also shows that they are not hanging on to
inventory for long periods of time. Figure 1.2 shows the overall results of Stepan and the
specialty chemicals industry. For the inventory turnover, days supply inventory, and cash-
to-cash cycle Stepan is on trend with the industry, but differs from the industry norms
for the other ratios.
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Figure 1.3: Profitability Ratios
Profitability ratios show how efficiently a company is generating revenues in
comparison to its expenses. An industry is most profitable when these ratios are high.
High profitability ratios mean that companies have larger profit margins and greater
returns. Figure 1.3 displays the results of Stepan’s performance compared to the specialty
chemicals industry. Stepan is on trend with gross profit margin, asset turnover, return on
assets, and return on equity, but differs from the overall specialty chemicals industry for
operating profit margin and net profit margin.
Figure 1.4: Capital Structure Ratios
Capital Structure ratios show how a firm finances its operations and growth with
different sources of funding. Capital structure ratios vary depending on the company’s
debt preferences and maturity. Figure 1.4 shows Stepan’s ratio performances compared
to the specialty chemical industry’s trends. Stepan matches the trends of the specialty
chemicals industry for times interest earned, debt service margin, and sustainable growth
rate, and differs on debt to equity, Altman’s Z-score, and internal growth rate.
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After we found all of the necessary ratios, we were able to forecast the income
statement, balance sheet, and statement of cash flows out for 10 years. We looked at
past history and trends found in the ratio analysis to determine how to calculate the
forecasting ratios. The forecasting ratios were then used to forecast out each financial
statement. The most difficult statement to forecast is the statement of cash flows because
it has the most potential for error. The results from forecasting will later help us determine
the value for Stepan.
The final step in the financial analysis was calculating the cost of capital, also called
the weighted-average cost of capital (WACC). The cost of capital is the rate used to
discount the future cash flows of a firm. In order to find WACC, we had to calculate the
cost of equity and cost of debt first. Cost of debt is the rate being paid by the company
on its current debt, while cost of equity is the rate of return required by investors. The
cost of debt (Kd) can be derived by determining the weight of each of Stepan’s interest
bearing debt(s) and multiplying them by their respective interest rates. After our
calculations, Stepan’s cost of debt came out to be 4.46%. Cost of equity, Ke, can be
calculated using CAPM or backdoor cost of equity. We used CAPM in our valuation
analysis. The CAPM equation is as follow:
Ke = Rf + (Beta * MRP) + SP
The CAPM equation consists of the risk-free rate (Rf), Stepan’s beta, the market
risk premium (MRP), and the size premium (SP). To find the risk free rate, we used St.
Louis Federal Reserve website’s 20-year Treasury Bond yield. In order to find beta, we
computed a regression analysis using multiple yield curves including the 1-year Treasury
Bond, 2-year Treasury Bond, 7-year Treasury Bond, 10-year Treasury Bond, and 20-year
Treasury Bond. We used 7% for the market risk premium since that is the average
percent for MRP in the past couple of years. The size premium we used in our cost of
equity calculation was 1.8, which we found in the “Firm Size and Size Premium” table
using Stepan’s market cap. After we found the necessary variables, we used them in the
cost of equity equation to compute a Ke for Stepan of 15.72%, with a 95% confidence
rate. The last step was calculating the before and after-tax WACC for Stepan. The
calculated before-tax WACC was 13.76% and the after-tax WACC was 10.17%.
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Valuation Analysis
After completing the industry analysis, accounting analysis, and financial analysis,
we are now able to value Stepan Company as of November 1, 2016. The closing per
share price of Stepan on October 31, 2016 was $71.03. This was the number we used as
the comparable to the price per share each model gave us. The models we used are
method of comparables and intrinsic valuation models.
The method of comparables is not a reliable model as there are a lot of ratios
used. This creates a lot of potential for error and noise. After completing the ratios and
weighting them based on accuracy, this model concludes that Stepan is fairly valued.
The intrinsic valuation models consist of the dividend discount model, the
discounted free cash flow model, residual income model, long run ROE residual income
model, and abnormal earnings growth model. After completing the calculations for each
model, each outcome resulted in Stepan being overvalued. We chose to not include the
dividend discount model and discounted free cash flow model to make our final decision
because it is not accurate to base Stepan’s value on those models alone. We put more
weight on the remaining models in the intrinsic valuation as these models are more
reliable and accurate, therefore, Stepan is overvalued. Our analyst recommendation is to
take advantage of the overvalued stock and sell Stepan.
End of Executive Summary
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Company Overview
Brief History
Stepan Company, manufacturer of basic and intermediate chemicals, is
headquartered in Northfield, Illinois. Founded in 1932 by Alfred C. Stepan Jr. under the
name Chemical Distributors, Stepan launched the company to distribute chemical
products that would limit road dust on country roads. Stepan has been around for about
80 years and has acquired multiple businesses domestically and globally. They have
expanded to 17 facilities in 12 countries and have managed to do this while keeping the
business in the Stepan family.
In 1940, Chemical Distributors and General Oil Products Company merged to
become Stepan Chemical Company. Stepan Chemical Company went public in 1961 under
the ticker symbol “SCL”. Stepan experienced the most growth after going public, the
majority of it occurring in the 1980s and 1990s. During this period, Stepan acquired
businesses and formed joint ventures with other chemical plants. Most of Stepan’s global
business expansion occurred in the 21st century. This expansion lead Stepan Company to
become “the largest merchant manufacturer of anionic surfactants, with more than 2,000
employees and 17 manufacturing locations worldwide” (Stepan.com).
Current Status
Today, Stepan’s main products include surfactants, a crucial ingredient in cleaning
products, and three different variations of polymers. These include polyester polyols used
in rigid and flexible foams, powder coating resins which can enhance finishes on a wide
variety of surfaces, and phthalic anhydride a prominent raw material for plasticizers and
unsaturated polyester resins; an important part of Stepan’s polymer division
(Stepan.com).
Stepan continues to acquire new businesses with the most recent purchase of a
sulfonation production facility in Brazil previously owned by Proctor & Gamble. Since going
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public, the stock price has steadily increased, and currently appears to be at an all-time
high. Stepan’s market capitalization is at 1.62 billion dollars, and the total asset value for
the past five years is equal to about 5.27 million dollars. We believe that if Stepan
continues to acquire new businesses and expand domestically and globally, the
company’s stock should continue to rise and expand its overall asset value.
Industry Overview The specialty chemicals industry dates back to the mid-to-late 1800s. Specialty
chemicals are used by many other industries for various reasons. Some markets that
utilize these products are agricultural, construction, food, household, institutional and
industrial cleaning, oil field, personal care, pharmaceutical, and dietary supplements
(Value Line). In Figure 1.5 below, a pie chart found from Information Handling Services
(IHS), shows the world consumption of the specialty chemicals industry in 2014.
Figure 1.5: World consumption of Specialty Chemicals Industry in 2014
Even though the industry has been around for decades, it is constantly evolving
due to innovation and new findings. The demand for specialty chemicals essentially goes
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through cycles that are driven by economic activity. Profit potentials and sales
performances are often altered due to changes in economic shifts. Macroeconomic supply
and demand factors are strong determinants for the specialty chemicals industry. Industry
profits are also impacted by the price of raw materials (Stepan 10-K). This industry
produces a commodity product through the use of raw materials to make chemicals for
household products. Specialty chemicals is characterized as a mature industry because it
is well-established and has high barriers to entry. Figure 1.6 depicts historical market
entrants and acquisitions within the specialty chemicals industry.
Figure 1.6: Specialty Chemicals Market Participants
Stepan’s benchmark competitors in this industry include: Olin Corporation,
Minerals Technologies, and Innospec. These three competitors were chosen because they
are all in the same industry with similar market capitalization. Olin Corporation has been
involved in the production of chlor alkali products for over a hundred years, but like
Stepan they are also involved in the distribution of chemicals (olin.com). Minerals
Technologies “is a resource-and technology-based growth company that develops,
produces and markets worldwide a broad range of specialty mineral, mineral based and
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synthetic mineral products and related systems and services” (Minerals Technology
Website). Like Stepan, it specializes in polymers and other consumer products and offers
environmentally friendly options. Innospec, another global specialty chemicals company,
“serves a range of industries across the world” (Innospec Company Website). Innospec
supplies customers in various markets such as oilfields, fuels, refineries and power
stations and personal care products, similar to Stepan (Innospec Company Website).
The following tables and graphs display sales and growth throughout the specialty
chemicals industry. Figure 1.7 illustrates the amount of sales recorded from Stepan and
its competitors according to their 10-K’s. This table shows a constant increase in sales
from 2010 through 2015. Figure 1.8 shows the percentage of growth Stepan and its
competitors have experienced within the past five years. Figure 1.9 is a line graph
depicting the percentages of growth experienced by Stepan, their competitors and the
industry as a whole.
Figure 1.7: Sales Volume for Stepan and Competitors (in millions)
Figure 1.8: Sales Growth for Stepan and Competitors
Company 2010 2011 2012 2013 2014 2015
Stepan Company 1,431.1$ 1,843.0$ 1,803.7$ 1,880.7$ 1,927.2$ 1,776.2$
Olin Corporation 1,586.0$ 1,961.0$ 2,185.0$ 2,515.0$ 2,241.0$ 2,854.0$
Mineral Technologie 1,002.4$ 1,044.9$ 1,005.6$ 1,018.2$ 1,725.0$ 1,797.6$
Innospec 683.2$ 774.4$ 776.4$ 818.8$ 960.9$ 1,012.3$
Industry 4,702.7$ 5,623.3$ 5,770.7$ 6,232.7$ 6,854.1$ 7,440.1$
% Yearly Change 16.37% 2.55% 7.41% 9.07% 7.88%
Table of sales for Stepan and Competitors (millions)
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Table of Growth for Stepan and Competitors
Company 2011 2012 2013 2014 2015
Stepan Company 22.34% -2.18% 4.09% 4.74% -8.50%
Olin Corporation 19.12% 10.25% 13.12% -12.22% 21.48%
Minerals Technologies 4.07% -3.91% 12.60% 40.97% 4.04%
Innospec 11.78% 0.26% 5.18% 14.79% 5.08%
Industry 17.63% 7.72% 10.97% 4.14%
Figure 1.9: Sales Growth for Stepan and Competitors
Five Forces Model In order to understand the specialty chemicals industry, we will use Porter’s Five
Forces Model. This model is a “powerful tool for understanding where power lies in a
business situation” (Porter's Five Forces: Assessing the Balance of Power in a Business
Situation). It was created to evaluate an industry’s profitability by comparing different
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factors. We will utilize the model to analyze five important factors that determine how
firms or companies stack up against one another. The five forces include rivalry among
existing firms, threat of new entrants, threat of substitutes, bargaining power of
customers, and bargaining power of suppliers. The model not only assesses a company’s
current level of competitiveness, but it also can be used to determine how a company
would compete in a new industry or market. We will use Porter’s Five Forces Model to
evaluate the specialty chemicals industry’s profitability and level of competition. We will
conclude whether each force is high, low, or mixed in the industry in the analysis below.
A summary of our findings is shown in Figure 2.1.
Figure 2.1: Porter’s Five Forces Model for Specialty Chemicals Industry
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Rivalry Amongst Existing Firms The rivalry among existing firms refers to the “extent to which firms within an
industry put pressure on one another and limit each other’s profit potential” (Wilkinson).
The intensity of competition shapes potential earnings and affects the distribution of
market share. Along with the other forces, rivalry among existing firms determines the
degree of competitiveness in the specialty chemicals industry. If the level of rivalry is
high, competitors fight for market share and profits. Therefore, if new firms were to enter
the profit potentials of existing firms would reduce. Low rivalry allows firms to potentially
earn more and have higher profits. There are different factors that affect the rivalry
among existing firms. The factors that we will analyze include industry growth,
concentration, and switching costs.
Industry Growth The specialty chemicals industry has “experienced slower growth and lower overall
profitability within a more competitive environment than in the preceding period”
(Information Handling Services). Since firms in this industry sell their products to
companies in other industries, their profitability and growth closely correlate to the supply
and demand of other industries.
In 2012 the specialty chemicals industry growth rate increased by 17.63%, then
decreased to 7.72% in 2013. In 2014 it increased again to 10.97% and decreased to
4.14% in 2015 (Figure 1.4). In February 2016, the industry continued to increase in
growth. From this, we can conclude that the specialty chemicals industry has maintained
positive growth, and will continue to do so in the future.
Concentration Concentration is determined by “the number of firms in an industry and their
relative sizes” (Palepu). The level of concentration helps influence the extent to which
firms in an industry coordinate prices and other methods of competition. If there is one
dominant firm in an industry setting the prices they are the price setter, thus creating
high concentration. In the specialty chemicals industry, there is medium concentration.
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It is medium because there are few firms in this industry, but there is high competition
between them.
Switching Costs Switching costs are the costs customers would incur if they switched from one
company to another. Customers may switch for various reasons such as product
quality/quantity issues, or lack of differentiation. If switching costs are high, a customer
is less likely to switch from one company to another. This ensures that firms are less
likely to lose customers. In the specialty chemicals industry switching costs are high. The
companies in the industry have contracts with customers, which would be costly to break.
This creates higher switching costs for customers, but lessens the rivalry among the firms
in the specialty chemicals industry. High switching costs contribute to the mixed rivalry
among existing firms.
Cost Analysis We will now perform a cost analysis for Stepan and its competitors in order to determined the total fixed cost ratios of the major companies within the industry. Our results are displayed in Figure 2.2. Figure 2.2: Total Fixed Cost Ratio
24
25
Figure 2.2 shows the difference in revenues divided by the difference in costs in
order to find the variable costs per sales. We then used the equation: TC-TVC=TFC in
26
order to find total variable cost. We divided the TFC/ TVC to better understand Stepan’s,
and its competitors’, economic story. This was done for years 2013-2015 and 2011-2013,
to make sure our results were consistent.
From the 2013-2015 results, we found that the total fixed cost divided by total
variable costs equals .27 for Stepan. This low fixed cost ratio means that Stepan has
flexibility when it comes to adjusting its production. It can slow down its production if
needed. The ratios from 2011-2013 show similar results with a low fixed ratio cost .21.
This shows that Stepan has maintained a low fixed cost ratio throughout the past several
years.
In comparison with other companies in the industry, Stepan and Olin both have
the lowest fixed cost ratios. This tells us that Stepan and Olin both have the flexibility to
adjust production in different economic times. Companies like Minerals Technologies, with
a ratio ranging from .42-.55, still have flexibility to adjust production, just not to the same
extent if it had a fixed cost ratio lower like Olin. Innospec, however, has much less
flexibility to adjust production, with a fixed cost ratio ranging between .83 and 1.08 in
the past several years.
Conclusion In the specialty chemicals industry, competition is mixed between rival companies
due to mature growth rates, medium concentration, and high switching costs for
customers. The firms within the industry are continuing to have positive growth rates.
The specialty chemicals industry has medium concentration and high switching costs due
to contractual agreements with customers. All of these factors contribute to a mixed
rivalry among existing firms.
Threat of New Entrants
We will now analyze the potential threat of new entrants in the specialty chemicals
industry. The threat of new entrants can be harmful to the profitability of an industry due
to competition over customers, innovation, and suppliers. The threat of new entrants in
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the specialty chemicals industry is low due to high barriers to entry. Barriers to entry are
factors that keep potential competitors from entering into a specific market. The barriers
in the specialty chemicals industry include patents and licensing, high capital
requirements, and distribution access and relationships.
Patents and Licensing In order to succeed in this industry, patents and licenses are necessary to acquire.
Companies involved in the creation of specialty chemicals need a vast amount of
technologies and chemical products. These items must be licensed and permitted for the
company to have possession of, as well as patented so that competitors cannot create
similar versions. The leaders in the industry hold an array of licenses and patents, creating
a difficult barrier for new entrants. For example, the firms in the specialty chemicals
industry have over 50 patents (Stepan 10-K, Olin 10-K, Innospec 10-K, Minerals
Technologies 10-K). Licensing in itself would cost a great expense, however, with the key
products patented, success in the specialty chemicals industry would prove extremely
difficult for a new entrant.
Capital Requirements
Commonly, companies within this industry have a high cost of capital. The
percentage of the cost of capital for a firm in the specialty chemicals industry in the United
States is 8% on average, compared to 6.29% from the total U.S. market (Damodaran).
In order to stay competitive in the specialty chemicals industry, a company must maintain
its level of innovation and have the funds necessary for acquisitions and expansion. This
would be difficult for a startup company to achieve in order to compete with seasoned
companies in the specialty chemicals industry. The high cost of capital creates a
challenging barrier to entry for beginner companies.
Distribution Access and Relationships
In the specialty chemicals industry, previously-established relationships make it
difficult for a new company to enter and gain customers. In this industry, firms partner
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with customers to create and maintain sustainability (stepan.com, mineralstech.com,
olin.com, and innospecinc.com). This provides firms and customers with a common
objective, strengthening relationships.
Distribution access is another barrier to entry for newly established companies.
These distributors are highly unlikely to break away from an already successful company
for a new unknown company with fewer connections and more potential risks. These
factors contribute to the specialty chemicals industry having high barriers to entry, thus
having a low threat of new entrants.
Conclusion In conclusion, we believe that the industry profitability of specialty chemicals is not
endangered by the threat of new entrants. Patents and licenses, high capital
requirements, and distribution access and business relationships are all challenging
barriers to entry for a newcomer in the industry.
Threat of Substitutes
We will now analyze the threat of new substitutes that could potentially replace an
industry. Our analysis will be based on relative price and performance and customers’
willingness to switch.
Relative Price and Performance
The majority of the chemicals produced in the specialty chemicals industry are
commodities. These chemicals are used in everyday household products such as laundry
detergent and cleaning supplies. Although some chemicals are specially made for certain
markets, the companies within this industry are price takers. There are no known
substitutes to the chemicals used to make specialty chemicals. This creates a low threat
of substitution.
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Customers’ Willingness to Switch Customers’ willingness to switch is the degree to which customers are willing to
switch to another supplier or substitute product in order to receive a lower price. There
are no man-made substitutes for the chemicals used in the specialty chemicals industry.
The base ingredients used in these products are natural resources and organic
compounds. If man-made substitutes were to be created that were suitable
replacements, customers’ willingness to switch would increase, but for now it remains
low.
Conclusion
In the specialty chemicals industry, the threat of substitutes is low. There are no
substitutes to replace this industry. After analyzing relative price and performance and
customers’ willingness to switch, we have concluded that the probability of the threat of
substitution is very low for the specialty chemicals industry.
Bargaining Power of Customers
In Porter’s Five-Force Model, customer power contributes to the competitive
structure of an industry. The bargaining power of customers, or buyer power, “refers to
the pressure consumers can exert on businesses to get them to provide higher quality
products, better customer service, and lower prices” (Wilkinson). Buyer power is
important because it defines the ease at which customers can lower prices. Buyer power
is similar to supplier power but there are two key differences. The customers have the
potential to apply pressure to potential earnings of suppliers, and alter competition as it
relates to suppliers. Just like strong suppliers, strong buyers can impact an industry in a
way that would increase competitiveness. An increase in cost due to a change in quality
and quantity would become added costs for sellers to bear.
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Factors
Switching costs, integration, price sensitivity, and available substitutes are four
factors that affect customer power. We will analyze this force to evaluate how much
control customers have over pricing and quality in the specialty chemicals industry. Since
the industry is specialized, it would be difficult for customers to begin producing products
that they receive from sellers. Bargaining power of customers is also affected by economic
activity. In the specialty chemicals industry customers rely on firms for a specific quantity
of a product. Although customers are able to control the quantity and quality of products,
market disruptions can often limit the effect of bargaining power of buyers in the industry.
Relationships and Competition
Firms in the specialty chemicals industry manufacture products for many markets.
Due to the versatility and many uses of specialty chemicals it has become an important
input in many other industries. Specialty chemicals are used in several other industries
such as: oil and gas, industrial and household cleaning, food and beverage, agriculture,
personal care and nutrition. To retain customers, firms must maintain their service levels,
product quality and performance, and competitive pricing (Stepan’s 10K, Innospec 10k,
Minerals Tech 10K, Olin 10K). Customers form contractual agreements with companies
that they know will be able to supply the desired quantity and quality. This provides
beneficial relationships between customers and suppliers.
Conclusion
The bargaining power of customers in the specialty chemicals industry is mixed.
The four main factors that affect the bargaining power of customers are switching costs,
integration, price sensitivity, and available substitutes. These factors each play a different
economical role in the bargaining power of customers. Relationships and competition also
affect the bargaining power of customers. It is important that firms maintain a good
relationship with their customers. However, contracts are in place with customers so it is
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up to the customer whether or not they would like to go into business with that firm. Due
to these reasons, the bargaining power of customers is mixed.
Bargaining Power of Suppliers
We will analyze the bargaining power of suppliers in the specialty chemicals
industry. The bargaining power of suppliers, or supplier power, “refers to the pressure
suppliers can exert on businesses by raising prices, lowering quality, or reducing
availability of their products” (Wilkinson). In layman’s terms, supplier power defines the
ease at which suppliers can drive up prices due to a variety of factors. We will evaluate
the effects of switching costs and relationships and competition in order to determine the
level of supplier power in the specialty chemicals industry.
Switching Costs
Switching costs are a factor to consider when switching suppliers. If the cost to
switch to another supplier is high, then the bargaining power of suppliers is high and vice
versa if the cost is low. In the specialty chemicals industry, switching costs are high. The
majority of the companies within this industry have contracts with their primary suppliers.
For example, Olin Corporation has many long-term, cost-based contracts arranged with
The Dow Chemical Company (TDCC) in order to receive “reliable supply of key raw
materials and predictable and consistent demand for our end use products” (Olin 10-K).
These contracts are expensive to get out of, creating high switching costs. In the specialty
chemicals industry, switching costs for changing suppliers is high.
Relationships and Competition
We found that some companies in the specialty chemicals industry use a service
called SAP Ariba in order to easily conduct business. According to its website, Ariba
network is the “world’s largest business commerce network”. Ariba also claims that using
its services can help a company grow and strengthen and maintain customer
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relationships. We believe that this service will help strengthen the relationships in the
specialty chemicals industry.
The relationships with suppliers in the specialty chemicals industry depends on two
factors: the state of the economy, and the structure/form of the raw materials needed to
manufacture certain products. In this industry, firms typically compete in several
industries, and likewise use a variety of suppliers to provide raw materials. This allows
them to develop products specifically for the markets that they are selling to. The
economic activity determines the price sensitivity of specialty chemicals firms. If there is
a decline in economic activity, suppliers may not be able to oblige by contractual
agreements and will be at the mercy of buyer’s terms. Firms also use multiple suppliers
because certain suppliers are not well-equipped to produce certain amounts of raw
materials needed. In the specialty chemicals industry, relationships and competition of
suppliers is mixed.
Conclusion
Switching costs pertaining to the bargaining power of suppliers is high and
relationships and competition are mixed. Contracts in place make it expensive to switch
suppliers, but in the specialty chemicals industry, firms have the option to do business
with a variety of suppliers. Due to these factors, we have concluded that the bargaining
power of suppliers is mixed.
Conclusion to Porter’s Five Force Analysis
We have concluded that the rivalry amongst existing firms in the specialty
chemicals industry is mixed due to mature growth rates, medium concentrations, and
high switching costs for customers. The threat of new entrants is low because specialty
chemicals is a mature industry that has a significant number of barriers to entry. Threats
of substitutes is low because there are no substitutes for specialty chemicals. The
bargaining power of customers is mixed due to various economic factors and relationships
and competition. The bargaining power of suppliers is mixed because switching costs are
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high and relationships and competition between suppliers are mixed. We will use this
information to analyze the key success factors in the specialty chemicals industry.
Key Success Factors in Industry After analyzing the specialty chemicals industry, we determined that the key
success factors for this industry rely heavily on differentiation to gain and maintain a
competitive advantage over the competition. Since the specialty chemicals industry is a
mature industry, it has experienced slower growth within a more competitive environment
in the last decade (IHS). This slower growth means there are few new entrants, giving
firms within the industry a longer-lasting competitive advantage. Research shows that in
order to be successful in the specialty chemicals industry, firms must focus on
differentiation with a specific focus on investment in research and development in order
to capitalize on innovation and offer sufficient product quality and product variation. With
that being said, there is a 3-5 year competitive advantage for firms that successfully
innovate and differentiate their products from the competition. Firms must also create
and sustain a competitive advantage through product quality and customer reliability as
well as the previously stated differentiation.
Differentiation
Differentiation is a technique used by firms to stand out compared to its
competitors. This is done by making products unique to their specific company with the
goal of increasing demand for products, therefore increasing sales. Firms within the
specialty chemicals industry adopt differentiation through research and development and
innovation to increase demand for products. The specialty chemicals industry takes
research and development and innovation into high consideration because of the high
competition between firms. Due to the fact the industry is volatile to the macroeconomic
cycles, these cycles also create new demands for innovation and development.
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Research and Development
Research and Development is a crucial component when trying to accomplish
differentiation within the specialty chemicals industry. R&D is an investment used by firms
in the hopes of developing new and better products that will differentiate them from
competitors. Below is a table showing the increase of R&D growth of Stepan Company
and the benchmark competitors, Olin Corporation, Minerals Technologies, and Innospec.
In Figure 2.3, we first decided to compare the R&D expenses to the net sales of
all the firms over the past 5 years. We did this in order to see if the amount of research
and development expenses are correlated to the amount of net sales the companies
receive.
Figure 2.3: R&D Expenses as % of Net Sales for Industry
R&D Expenses per Net Sales
Company 2011 2012 2013 2014 2015
Stepan Company 1.3% 1.5% 1.5% 1.4% 1.7%Olin Corporation 1.3% 0.1% 0.1% 1.8% 1.7%Minerals Technologies 1.9% 2.0% 2.0% 1.4% 1.3%Innospec 2.3% 2.5% 2.5% 2.3% 2.5%
Industry Average 1.7% 1.5% 1.5% 1.7% 1.8%
We then wanted to look into each firm separately, and assess each firm's specific
R&D expenses. We wanted to see if the firms R&D expenses increased over time and
whether or not they are correlated to the net sales that are presented in the figure above.
Figure 2.4: Stepan Company Research and Development Expenses
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2011 2012 2013 2014 2015
R&D Expenses (millions) $25.10 $28.00 $28.80 $27.20 $30.30
% Yearly Change 10.36% 2.78% ‐5.88% 10.23%
Total Change from
2011‐2015
Stepan R&D Expenses
20.72%
In Figure 2.4 there was an overall increase of 20.72% from 2011 to 2016 in
research and development Costs. These expenses were incurred with the goal of new
technological discovery of products or bringing about the improvement to one of Stepan
Company’s existing products including Surfactants, Polymers, and Specialty Products.
Other research and development costs reflected for Stepan include routine product
testing, analytical methods of development and sales support services (Stepan 10-K).
Figure 2.5: Olin Corporation Research and Development Expenses
2011 2012 2013 2014 2015
R&D Expenses (millions) $2.70 $2.60 $2.50 $4.10 $4.90
% Yearly Change ‐3.85% ‐4.00% 39.02% 16.33%
Total Change from
2011‐2015
Olin R&D Expenses
81.48%
In Figure 2.5, there was an overall increase of 81.48% from 2011 to 2016 in
research and development costs for Olin Corporation. Research and development
activities are integrated through a product-group basis that takes place at many Olin
Corporation Facilities (Olin 10-K).
Figure 2.6: Innospec Inc. Research and Development Expenses
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2011 2012 2013 2014 2015
R&D Expenses (millions) $18.30 $19.60 $21.20 $22.20 $25.30
% Yearly Change 6.63% 7.55% 4.50% 12.25%
Total Change from
2011‐2015
Innospec R&D Expenses
38.25%
In Figure 2.6 there was an overall increase of 38.25% from 2011 to 2016 in
research and development costs for Innospec Incorporated. At Innospec, research and
development focuses on the growth of fuel specialties and performance chemicals
segments (Innospec 10-K).
Figure 2.7: Minerals Technologies Research and Development Expenses
2011 2012 2013 2014 2015
R&D Expenses (millions) $19.30 $20.00 $20.10 $24.40 $23.60
% Yearly Change 3.50% 0.50% 17.62% ‐3.39%
Total Change from
2011‐2015
Mineral Technologies R&D Expenses
22.28%
In Figure 2.7, there was an overall increase of 22.28% from 2011 to 2016 in
research and development costs for Minerals Technologies. Minerals technologies
research and development focuses on expanding their sales in existing satellite PCC plants
as well as possible new plants (Minerals Technologies 10-K).
Overall, from the information gathered from the tables above, all companies show
a significant growth in research and development indicating that R&D is a necessity in
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order to be successful in the specialty chemicals industry. It is directly linked to new
product development as well as innovation of existing products in order to increase and
sustain a firm's competitive advantage within the industry.
Product Quality and Product Variation Product quality and variety are crucial aspects in the specialty chemicals industry
because the industry produces products that many other market segments rely on. Some
of the markets that rely on the specialty chemicals industry include agricultural,
construction, food, household, institutional and industrial cleaning, oil field, personal care,
pharmaceutical and the dietary supplement markets. In the specialty chemicals industry,
product quality is achieved through the aforementioned research and development and
technological testing and innovation. That being said, because of the high competition
between firms in this industry, the quality of the product is a key aspect of a firm’s
success. Product quality is a necessity to retain existing customers and attract new ones
(Stepan, Innospec, Mineral technologies 10-K). If a firm in the specialty chemicals
industry lacks product quality they will lose customers and no longer be able to compete
with competitors.
Linked with product quality is product variation. Product variation is a key
component in the expansion and success of a firm within the specialty chemicals industry.
Successful firms in the specialty chemicals industry all offer an array of products that are
broken up into different segments. One way firms in the industry capitalize on product
variation is by acquiring other companies, therefore giving them more products, sales,
and cash flows. Figure 2.8 shows the different product segments Stepan, Olin, Minerals
Technologies, and Innospec offer (Stepan, Olin, Minerals Technologies, Innospec 10-K).
Figure 2.8 Product Segments offered by Stepan and its Competitors
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Stepan Olin Mineral Technologies Innospec
Surfactants Chlor Alkali Specialty Chemicals Fuel Specialties
Polymers Vinyls Refractories Performance Chemicals
Specialty Products Epoxy Performance Materials Octane Additives
Energy Services
Product Segments Stepan and Competitors
Winchester Construction
Technologies
Customer Relations and Loyalty
In the specialty chemicals industry, having strong customer relations and loyalty
from customers is of special importance. Aside from the inevitable macroeconomic cycle
that dictates supply and demand of the industry, the real foundation of the specialty
chemicals industry is a combination of innovation and customer relations/services. The
changing needs of customers is what motivates differentiation and innovation in the
specialty chemicals industry. For example, the relationships that firms have with their
customers is highly valued. Firms are willing to work with their customers to provide
cutting-edge chemical solutions to help their customers meet their sustainability goals.
One way of doing this in the industry currently, is by having “green,” or environmentally
friendly restrictions for products in order to match the current global concern for the
environment (ValueLine).
Many firms in the specialty chemicals industry have sustainability programs that
focus on four main areas: partnering with customers, commitment to their employees
and their communities, reducing carbon footprint and overall sustained growth. The fact
that firms list their customers first, shows the priority, dedication and loyalty firms have
towards their customers. In the specialty chemicals industry, the firm's overall goal is to
constantly add value and in order for them to do so, they must remain innovative and
offer new and improved products to customers.
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Conclusion
In conclusion, based on the information gathered above, the specialty chemicals
industry relies on differentiation through research and development, product variation
and quality, and customer loyalty/service as their key success factors to remain
successful. Although the specialty chemicals industry is a price taking industry due to the
supply and demand of the industry being based on the macroeconomic cycles, the key
success factors still prove to be differentiation because of the maturity of the industry,
the strong barriers to enter, and the high competition between the existing firms. Overall,
all firms in the specialty chemicals industry must innovate and differentiate their products
from the competition in order to establish and sustain a competitive advantage.
Competitive Advantage Analysis A company has a competitive advantage in an industry when it creates business
activities that add value for the shareholders and customers. In the specialty chemicals
industry, Stepan Company implements differentiation, product quality and variation, and
customer relations and loyalty to add value. Stepan primarily produces commodity
chemicals; however, due to the highly innovative nature of this industry, Stepan primarily
competes on differentiation, competing on cost about 30% of the time. In this section,
we will analyze Stepan’s value-adding business activities to the degree to which they
provide the firm with a competitive advantage within the specialty chemicals industry.
Differentiation According to Stepan’s website, 40% of their R&D resources are put in place to
support strategic innovation programs. Two well-established programs are the Novel
Feedstocks and Enhanced Oil Recovery (EOR). The Novel Feedstocks program specializes
in discovering raw materials in non-conventional sources, such as corn and cane. These
sources can be converted into useful consumer good ingredients. This program
differentiates Stepan from its competitors by utilizing biotechnology, and allowing Stepan
to keep up with customer needs and preferences on a competitive level. The Enhanced
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Oil Recovery or (EOR) program focuses on advancing Stepan’s surfactants and increasing
their knowledge of emulsification physical chemistry along with evolving different
methods to understand property relationships and data-driven models. This program
helps Stepan maintain its competitive advantage in this highly innovative industry through
differentiation.
Product Quality and Product Variation
Product quality and variation are two highly important factors within the specialty
chemicals industry. In order to maintain a competitive advantage, Stepan Company
focuses on providing a variety of quality products to its many different market segments.
These products are made to satisfy fluctuating needs and preferences between a variety
of different customers. Several of the markets that Stepan contributes to are the
agriculture, construction, food, household, institutional, industrial cleaning, oil field,
personal care, pharmaceutical, and dietary markets. Throughout these markets,
surfactants are widely used. Figure 2.9 below shows the percentage of net income of
each product. Based on the table, the majority of Stepan’s net income comes from the
sales of surfactants. Surfactants can be found in a wide variety of products including
detergents, household/industrial cleaners and emulsifiers. The rest of Stepan’s net
income is comprised of polymers and special products.
Figure 2.9: Percentage of the Net Income of Each Product
Product % of Net Income
Surfactants 68%
Polymers 28%
Special Products 0.04%
Each Product's % of Stepan's Net Income
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Customer Relations and Loyalty
Another one of Stepan’s competitive advantages is its strong relationships with
customers, as well as customer loyalty. This is displayed through the firm’s commitment
to its customers. According to Stepan’s website, “Stepan’s Customer Service Department
strives to create long-term customer relationships through trust, transparency and
exceptional service” (Stepan.com). They assist customers using different services: e-
business solutions, technical services, and analytical services. The e-business solutions
are used for efficiency and transparency for order placing between Stepan and its
customers. Technical services are used to help customers with product recommendations
and technical training. Lastly, analytical services help with manufacturing, plant, and
customer issues. Along with the different services offered by Stepan, the firm also
operates in multiple countries to provide tech support. These activities show the strong
commitment that Stepan has to its customers, both in the U.S. and worldwide.
Conclusion
In conclusion, competitive advantage distinguishes firms in the specialty chemicals
industry. Stepan Company has competitive advantages within this industry. Although a
producer of commodities, Stepan competes on cost only about 30% of the time. Due to
the competitive and innovative nature of the specialty chemicals industry, customer
demands force Stepan to compete through differentiation the other 70% of the time.
Stepan establishes a competitive advantage of differentiation through research and
development, product quality and variety, and customer relationships.
Introduction to Accounting Analysis In this section, we will be conducting a formal accounting analysis. This analysis
will include the identification of key accounting policies (KAP), an assessment of
accounting flexibility, an evaluation of disclosure quality, and the identification of potential
red flags. This analysis is important because it is an assessment of the profitability and
sustainability of a firm. We will utilize financial statements to assess past performance
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and will eventually use this information to estimate Stepan’s future performance and
overall company value.
Identify Key Accounting Policies
When identifying the key accounting policies for the specialty chemicals industry,
we focused on Type 1 and Type 2 policies. Type 1 policies allow us to determine the
performance and disclosure of an industry based on the key success factors. Type 2
policies pertain to the firm’s practices and how information can be altered to look more
favorable to investors. This includes accounts that companies can easily distort due to
accounting flexibility. Identifying these policies will allow us to determine the specialty
chemicals industry’s accounting flexibility and the quality of the information presented.
Type 1 Accounting Policies
In this section, we will specifically identify Type 1 policies. These policies are
linked to the following key success factors of the company: research and development,
product quality and variety, and customer service/loyalty. We will interpret how these
policies substantially impact the specialty chemicals industry. We will further analyze
these three factors in order to identify how Stepan is competing compared to the
benchmark competitors within the specialty chemicals industry.
Research and Development
The first Type 1 policy we will be discussing is research and development. In the
specialty chemicals industry, research and development is important because it creates
profit for firms as they create new ways to improve products. This allows firms to maintain
a competitive advantage of differentiation over competitors. We analyzed the companies’
10-K’s in the specialty chemicals industry to determine the level of importance research
and development plays in each company.
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First, we assessed Stepan’s 10-K. Stepan’s research and development costs are
incurred expenses. They are also directly linked to the information technology system to
compile and store data for further analysis in support of the R&D operations. Stepan
stresses how influential their IT system is in analyzing both financial and non-financial
metrics for R&D investments. Any data breach or data failure would distort R&D integrity
and continuity. This disclosure presented in Stepan’s 10-K, allows us to conclude that
R&D is an important part of Stepan’s everyday operations.
After concluding how Stepan presents its research and development, we looked at
Stepan’s competitors to see if research and development is handled in a similar manner.
We analyzed the 10-K’s of Olin, Innospec, and Minerals Technologies and found that all
companies stressed a high importance of research and development, and that it is vital
to their operations and competitive advantage. This allows us to conclude that Stepan is
operating similarly to the research and development norms of the specialty chemicals
industry.
Product Variety and Quality
Product quality and variety help differentiate one manufacturer from another in
the specialty chemicals industry. In this industry, product quality is a main success driver.
Companies take pride in offering their consumers high-quality products to retain their
current customers and attract new ones. Contracts are in place with suppliers to ensure
the inputs (raw materials) received by suppliers are up to par (Stepan.com, Olin.com,
Mineralstech.com, Innospecinc.com).
As for product variety, firms within the industry offer an array of products in order
to reach as many segments as possible. Figures 3.0-3.3 show the different product
segments offered by the different companies in the speciality chemicals industry. These
tables show the percentage of net sales each product segment contributes.
Figure 3.0: Stepan’s Product Segment Percentages
Stepan's Product Segment Percentages Per Net Sales
2011 2012 2013 2014 2015
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Surfactants 74% 72% 70% 67% 68%
Polymers 23% 24% 26% 29% 28%
Specialty Products 3% 4% 4% 4% 0.4%
Figure 3.1: Olin’s Product Segment Percentages
Figure 3.2: Innospec’s Product Segment Percentages
Innospec's Per Net Sales 2011 2012 2013 2014 2015 Fuel Specialties 67% 68% 69% 71% 75% Performance Chemicals 23% 23% 24% 23% 19% Octane Additives 10% 9% 7% 6% 6%
Figure 3.3: Minerals Technologies’ Product Segment Percentages
Minerals' Per Net Sales 2011 2012 2013 2014 2015 Specialty Minerals 65.0% 65.0% 66.0% 38.0% 36.0% Refractories 35.0% 35.0% 34.0% 21.0% 16.0% Performance Materials 0.0% 0.0% 0.0% 20.0% 29.0% Construction Technologies 0.0% 0.0% 0.0% 9.0% 10.0%
Energy Services 0.0% 0.0% 0.0% 12.0% 10.0%
Olin's Per Net Sales 2011 2012 2013 2014 2015 Chlor Alkali Products and Vinyls 71% 65% 69% 67% 60% Epoxy 0% 0% 0% 0% 15% Winchester 29% 35% 31% 33% 25%
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Figures 3.0-3.3 show that each firm offers at least three different product
segments, displaying product variety. These tables emphasize each company’s best-
selling products. Despite the large portion of net sales that these products make up, it is
important for each company to diversify with other product segments. An increase in
product variety decreases risk for the firms in the industry through diversification.
Product quality and variety is a key success factor of the specialty chemicals
industry because firms are able to differentiate from competitors. Overall, firms would
not be as successful in this industry if they were to only offer one product segment. This
reiterates the fact that product quality and variety is vital to this industry.
Customer Service and Loyalty
Customer service and loyalty is very important in the specialty chemicals industry
because companies do not sell directly to the retail markets, but sell to a wide range of
product manufacturers. In order to establish a loyal relationship with customers and gain
additional customers, firms within the industry must be aware of consumers’ needs. After
analyzing the specialty chemicals industry, we have found that companies take their
customers into consideration in two ways. The first way is by operating under
environmentally conscious methods that satisfy the interests of the environmentally
concerned customers. The second is by offering a variety of customer support options.
Firms in the specialty chemicals industry are regulated under federal, state, local
and foreign environmental, health and safety laws and regulations that govern the
discharge of hazardous materials in the air, soil and water. Compliance with these
environmental laws is crucial for the environment, but also to consumers who want an
environmentally friendly product. The biggest environmental concern that faces the
specialty chemicals industry is the disposal of toxic substances. Capital expenditures from
complying with the government-set regulations, resulted in an industry average of 2
million dollars per year. Recurring costs associated with this operation of waste treatment
and disposal are on-going. From this information we can conclude that failure to comply
with these regulations would be costly. Although it does not cost the industry a lot now,
that amount would significantly increase if firms failed to meet regulation requirements.
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We can also conclude that it is of industry norms to comply with government regulations
regarding the environment as these cost have remained about the same across the
industry.
The second way the specialty chemicals industry focuses on customer service and
loyalty is by offering a variety of customer support services. In the specialty chemicals
industry, we found that firms place a high importance on customer care. It is of industry
norm to provide around-the-clock customer support. Stepan in particular, offers a
program called eBusiness. eBusiness allows Stepan to offer its customers a variety of
solutions for a more “efficient handling of collaborative processes with our partners”
(Stepan.com).
Type 2 Accounting Policies
In this section, we will focus on Type 2 policies. These policies are asset or liability
accounts that can affect the attractiveness of the firm to shareholders. We will discuss
how Type 2 policies affect the specialty chemicals industry. We identified goodwill,
pension plans, and lease obligations as the Type 2 key accounting policies that most
affect the specialty chemicals industry. We will analyze how each of these items are
reported in the financial statements of the firms in the specialty chemicals industry.
Goodwill
Goodwill is an intangible, level three asset that is difficult to determine using fair
market values. It is the shortfall between the purchase price to the allocable future market
value of assets purchased in an acquisition. The unallocated portion of the purchase
price is goodwill. Goodwill is difficult to value due to inconsistencies in amortization
practices across the industry.
Historically, goodwill was amortized over a period of time. Today, goodwill is only
adjusted if a triggering event occurs that impairs the value of the goodwill. However, if
a negative triggering event occurs in the value of the company purchased, it supports a
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decrease in value, or impairment, of goodwill. Figure 3.4 displays the amounts of goodwill
for the competitors in the specialty chemicals industry.
Figure 3.4: Specialty Chemicals Industry Goodwill
Specialty Chemicals Industry Goodwill (in thousands)
2011 2012 2013 2014 2015
Stepan $ 7,000 $ 7,199 $ 11,726 $ 11,502 $ 11,265
Olin $627,400 $747,100 $747,100 $747,100 $2,174,100
Innospec $141,500 $149,000 $187,900 $276,100 $267,400
Minerals
Technologies $64,671 $65,829 $64,432 $770,900 $781,200
Pension Plans
Pension plans are level three assets that can be difficult to value. Firms in the
specialty chemicals industry typically have defined benefit or defined contribution plans.
A defined contribution plan is a pension plan in which the employer and employee both
make contributions regularly. Defined contribution plans are not an issue for firms
because there is not an outstanding liability for the firms. A defined benefit plan is a
retirement plan in which the employer contributes a promised benefit. In this section, we
will discuss how Stepan and its benchmark competitors differ in their recognition of
pension obligations.
Stepan “sponsors various funded qualified and unfunded non-qualified defined
benefit pension plans” (Stepan 10-K). However, these benefits are frozen and cannot be
accessed until retirement. Stepan has established a defined contribution plan to replace
the frozen defined benefit pension plans. Adjustments to Stepan’s pension plan can be
seen in their comprehensive income statement. Innospec recognizes a defined benefit
post retirement plan. They contribute to the defined plan and recognize cash
contributions and non-cash expenses on their financial statements (Innospec 10-K).
Minerals Technologies also recognizes a defined benefit plan. Their plan covers majority
of their employees and often includes post-retirement healthcare benefits. Minerals
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Technologies measures the cost of their obligations based on the best estimates (Minerals
Technologies 10-K). Similarly to Stepan, Olin Corporation recognizes a defined
contribution pension plan, which also includes qualified and nonqualified plans. Their
pension expenses are based on a variety of rules and regulations and beginning in
January 1, 2016 they began using spot prices and yield curves to estimate the plans cash
flows (service and interest costs).
After analyzing Stepan and its competitors, we concluded that Stepan’s pension
plans are in line with the industry norms. Although the firms may use different measures
and estimates they consistently mention in their 10-K’s pension plans and the liabilities
and expenses that occur as a result of them.
Lease Obligations
There are two main types of leases that are in the Type 2 accounting policies,
operating leases and capital leases. Operating leases are contracts that allow for the use
of an asset, but do not necessarily show ownership rights of the asset. On the other hand,
capital leases are a contract that transfers the rights of the asset to the purchaser,
creating both an asset and liability on the balance sheet. For the specialty chemicals
industry, we found it was of industry norms to have only operating leases.
The biggest issue with operating leases is that they are not on the company’s
financial statements. Therefore, no lease liability or asset is incurred. This becomes
problematic when analyzing and valuing a company. If operating lease obligations were
capitalized, they could potentially increase current liabilities by more than 20%. This could
have a significant effect on a company’s financial statements and overall value. Figure
3.5 displays the future obligations of operating leases for each company in the specialty
chemicals industry.
Figure 3.5: Operating Lease Schedule for Stepan & Competitors (in
millions)
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Operating Lease Schedule for Stepan and Competitors (in millions)
Stepan Olin Innospec Minerals
Technologies 2016 $ 5.84 $ 73.70 $ 3.80 $ 13.60 2017 $ 4.30 $ 60.90 $ 2.95 $ 9.80 2018 $ 3.56 $ 51.70 $ 2.95 $ 9.80 2019 $ 3.01 $ 39.50 $ 2.20 $ 7.00 2020 $ 2.71 $ 27.30 $ 2.20 $ 7.00
Thereafter $ 17.89 $ 80.20 $ 1.70 $ 35.40 Total $ 37.30 $ 333.30 $ 15.80 $ 82.60
In Figure 3.5, we found the amount of operating leases expense for the companies
in the specialty chemicals industry. This information helped us to determine how much
expense for the companies that operating leases make up for each company. For
example, Olin has a large amount of operating lease expenses compared to the other
companies. These large values could be distorted, linking back to Type 2 policies.
Conclusion
In this section we analyzed the factors that make up Type 1 and Type 2 accounting
policies in the specialty chemicals industry. The factors for Type 1 related to the value
drivers of the industry and included research and development, product quality and
variety, and customer service/loyalty. The Type 2 policies related to asset and liability
accounts that affect the attractiveness of the firm. These factors consisted of goodwill,
pension plans, and operating leases. These two policies allow us to assess the specialty
chemicals industry performance. For Type 1 policies we have concluded that Stepan is
adhering to industry norms. Similarly to Stepan’s competitors, Stepan is actively
increasing their R&D expenses and adjusting operating activities in order to meet
customer needs. As for policy 2, we have concluded that Stepan is also adhering to the
norms of the specialty chemicals industry in regards to goodwill impairment, pension
plans, and future lease obligations.
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Assessing the Degree of Accounting Flexibility Accounting flexibility is how easily “corporate managers can choose accounting
and disclosure policies that make it more or less difficult for external users of financial
reports to understand the true economic picture of their businesses” (Palepu). It is the
responsibility of a company’s manager to disclose information to its investors and
potential investors that portrays the correct financial data. Even though rules and
regulations exists, some managers manipulate financial statements and possibly mislead
investors.
When companies have a high degree of flexibility, they have the ability to choose
what information they want to disclose. Having a high degree of flexibility is not
particularly favorable for investors because they are not getting all the information
needed to accurately value the company. When companies have a low degree of
flexibility, they are not capable of manipulating data and all information needs to be
disclosed. Therefore, the company is more regulated, which is good for investors since
all the information is disclosed and accurate. We will analyze how flexible Stepan and the
firms in the specialty chemicals industry are at reporting their goodwill, operating and
capital leases, and pension plans.
Goodwill
Goodwill is an intangible asset that occurs when a company acquires another
company at a premium value. Since intangible assets are hard to value, it is possible that
a company can disclose goodwill for more than it is really worth. This means that the
degree of flexibility in the industry is high because companies are able to manipulate the
value of goodwill, and not admit to their investors that the company paid too much when
acquiring another company. It is the responsibility of the company to impair goodwill as
they see fit. This gives firms an opportunity to overstate their assets if they fail to impair
goodwill. Stepan, for example, stated in its 10-K that in the last five years no impairment
was needed after conducting a test. Figures 3.6-3.9 indicate how much goodwill was
impaired by Stepan in the last five years. The tables are divided into four sections:
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surfactants segment, polymer segment, specialty products segment, and total goodwill
for all sections.
Figure 3.6: Stepan Goodwill Impairment Expense - Surfactant Segment
Figure 3.7: Stepan Goodwill Impairment Expense - Polymer Segment
Stepan Goodwill Impairment Expense-Polymer Segment
(in thousands)
2011 2012 2013 2014 2015
Beginning Balance $ 978 $ 978 $ 978 $ 5,603 $ 5,461 New GW Acquired/Lost - - $ 4,642 - - Goodwill Impaired - - - - - Ending Goodwill $ 978 $ 978 $ 5620 $ 5,461 $ 5,380
Figure 3.8: Stepan Goodwill Impairment Expense - Specialty Products
Segment
Stepan Goodwill Impairment Expense-Specialty Products Segment (in thousands)
2011 2012 2013 2014 2015
Beginning Balance - $ 483 $ 483 $ 483 $ 483 New GW Acquired/Lost $ 483 - - - - Goodwill Impaired - - - - - Ending Goodwill $ 483 $ 483 $ 483 $ 483 $ 483
Stepan Goodwill Impairment Expense-Surfactant Segment (in thousands)
2011 2012 2013 2014 2015 Beginning Balance $ 5,739 $ 5,676 $ 5,779 $ 5,640 $ 5,558 New GW Acquired/Lost - - - - - Goodwill Impaired - - - - - Ending Goodwill $ 5,676 $ 5,779 $ 5,640 $ 5,558 $ 5,402
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Figure 3.9: Stepan Goodwill Impairment Expense - Total
Stepan Goodwill Impairment Expense-Total (in thousands)
2011 2012 2013 2014 2015
Beginning Balance $ 6,717 $ 7,000 $ 7,199
$11,726 $ 11,502 New GW Acquired/Lost $ 483 - $ 4,642 - - Goodwill Impaired - - - - - Ending Goodwill $ 7,000 $ 7,199 $11,726 $ 11,502 $ 11,502
As shown in the figures above, Stepan did not impair any goodwill in the last five
years because the test that was utilized indicated no impairment was needed. This is an
example of a company in the specialty chemicals industry having high flexibility by
choosing not to impair goodwill for so many years. This could result in understated
expenses and an overstated net income. This is important to note as we continue to
assess Stepan’s accounting flexibility.
Operating Leases
An operating lease is a contract that allows a company to use an asset, but does
not give them ownership rights of the asset. This type of lease does not affect the balance
sheet of a company, but it is listed as an operating expense
in the income statement. Unlike an operating lease, a capital lease is a contract that gives
the company temporary title of the asset. Companies would rather have operating leases
over capital leases because operating leases do not require debt obligation to be recorded
on the balance sheet, which is a huge advantage for companies.
Having the ability to choose between utilizing an operating or capital lease, leads
to a high degree of accounting flexibility. After looking at the 10-K’s of Stepan and its
competitors, we noticed that the specialty chemicals industry uses operating leases, but
not capital leases. This leads us to believe that the specialty chemicals industry has a
high degree of accounting flexibility when it comes to leases.
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Pension Plans
Pension plans are the post-retirement benefit plans that employees receive once
they retire from the company. We analyzed the degree of flexibility that firms in the
specialty chemicals industry have when recording pension plans.
Stepan originally utilized defined benefit plans, but switched to defined
contribution plans. This change was triggered by the frozen defined benefit plans that
were underfunded. These pension plans were $43.2 million underfunded so Stepan
decided stop adding new employees to this plan (Stepan 10-K). Employees can now
contribute to their own pension plans and Stepan is no longer the sole contributor to new
plans. The ability to change from one plan to another is what gives Stepan a high degree
of flexibility with its pension plans.
Conclusion
We have analyzed the effects that goodwill, operating leases, and pension plans
have on accounting flexibility. For example, if a firm fails to impair goodwill when it
should be impaired, this leads to a high degree of flexibility. Firms are able to choose
between operating leases and capital leases. Having the ability to choose between
operating leases instead of capital leases allows flexibility to be high. By implementing
defined benefit pension plans over defined contribution plans, companies are able to
have higher flexibility. Overall, this information will allow us to evaluate the actual
accounting strategy of Stepan.
Evaluation of Actual Accounting Strategy We will evaluate Stepan’s accounting strategy by comparing Stepan’s accounting
norms to the specialty chemicals industry accounting norms. The actual accounting
strategy is determined by the level of disclosure and how earnings are reported. After
assessing Stepan’s competitor’s 10-K’s, we determined that the industry is of low
disclosure, minimally satisfying the requirements of the generally accepted accounting
principles or GAAP. In this section we will evaluate Stepan’s accounting strategy and
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continue the discussion of accounting flexibility, and how it affects reported earnings on
the financial statements.
Company Disclosure
In order to evaluate Stepan’s accounting strategies, we utilized the guidelines
presented in Chapter 3 of Business Analysis and Valuation by Palepu and Healy. These
guidelines included comparing Stepan to specialty chemicals industry norms, assessing
the estimates and policies used over time, how realistic these estimates are, and
significant business transactions (Palepu & Healy). When we compared Stepan to its
competitors, Innospec, Olin, and Mineral Technologies, we found that it was of industry
norms to have low disclosure. In this industry the firms adhere to GAAP, but the majority
of the time, these companies do not go above and beyond to disclose additional
information that could affect the value of the company.
Stepan’s accounting policies have been consistent throughout the years. However,
Stepan’s estimates have varied over time when addressing raw materials, legal issues,
contracts, exchange risks, and market risks. We do not have a reason to believe that
they are utilizing certain business transactions to better their financial outcomes.
However, they are not disclosing important business activities such as operating lease
expenses, goodwill, or pension plans. Overall, Stepan provides a low disclosure of
accounting policies.
Accounting Policy Approach
We have analyzed how goodwill, operating leases, and pension plans are
reported. Stepan has not impaired its goodwill, thus its assets are overstated, leading to
an overstated net income. If a company has a higher reported net income, they are using
aggressive accounting policies. Stepan does not recognize any capital leases, therefore
its liabilities are understated. This also leads to higher reported earnings. Stepan’s
pension plans changed from defined benefit to defined contribution due to the defined
benefit plan being underfunded. This places the liability on the employees and allows
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Stepan to reduce its liabilities and expenses. Consequently this allows Stepan to report
higher earnings, thus taking an aggressive approach. Overall, we have determined that
Stepan’s accounting policies are aggressive because they lead to higher reported net
earnings.
Conclusion
After analyzing the actual accounting strategy, we concluded that Stepan
is a low disclosure company. Stepan’s financial reports minimally satisfy the
requirements set by GAAP. We also determined that Stepan is flexible when
disclosing information about its key accounting principles. This gives the
company the freedom to decide whether or not it wants to disclose certain
information. Stepan utilizes an aggressive approach when reporting its operating
leases, goodwill, and pension plans. Stepan’s failure to acknowledge the
transactions associated with these accounts leads to higher reported net
earnings.
Quality of Disclosure In order to evaluate the quality of Stepan’s disclosure, we must acknowledge the
fact that GAAP, although effective, only requires a minimal level of disclosure. This can
lead to companies taking advantage of the minimal requirements, and potentially
distorting their financial statements to appear better than they are.
The main factors we will use to assess the quality of Stepan Company’s disclosure
are the conciseness and accessibility of the information within its 10-K. Conciseness and
the ease at which readers can find information are important aspects for determining
quality because they enable the reader to find and understand information easily. This
shows high transparency and high disclosure. A lack of conciseness can create noise and
distort the meaning of the information.
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Stepan does not go into a lot of detail when explaining its accounting methods and
logic. For example, one of the sentences reported is, “goodwill is not amortized.” (SCL
10-K). Compared to other firms in the specialty chemicals industry, Stepan has low
disclosure. However, we believe that it is normal for this particular industry to be of low
disclosure.
There is also an inconsistency with Stepan’s reporting. At times Stepan could be
described as having too much information, forcing us to sift through all of the text in
order to find the important information. Its financial statements make it difficult for
readers to find important information. For example, information about goodwill was found
on different pages and in different sections in the 10-K’s. This indicated to us that the
firm is trying to hide information or confuse us. Overall, we believe that Stepan Company
has a low quality of disclosure. We will use this information to evaluate potential red flags
in Stepan’s financial statements.
Potential Red Flags We will begin our evaluation for potential red flags by referring to the list of
common red flags in the textbook, Business Analysis and Valuation, by Palepu and Healy.
In the text, there is a list of common scenarios that an analyst should look for when
examining a company’s financial reports. In this section we will examine Stepan’s financial
statements for any potential red flags.
A red flag we found was Stepan’s tendency to use financing mechanisms such as
research and development partnerships, special-purpose entities, and the sale of
receivables with recourse (3-13). According to Palepu and Healy, financing mechanisms
“provide management with an opportunity to understate the firm's liabilities, and/or
overstate its assets” (3-13). For Stepan, this financing mechanism is operating leases,
which gives them the opportunity to understate their liabilities.
Another common red flag found was an increasing gap between Stepan’s reported
income and its stated cash flows. In December 21, 2015, when the most recent 10-K was
filed, the operating activities totaled $183.3 million. However, Stepan’s net income for
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the year ended, was $75.9 million. According to Palepu and Healy, a reason for this could
be, “any change in the relationship between reported profits and operating cash flows
might indicate subtle changes in the firm’s accrual estimates” (3-12). A possible reason
for this is after reviewing Stepan’s 10-K, we found that its administrative expenses had
increased. Another reason for the large gap is Stepan is spending about $125 million in
investing activities. This large gap shows that a significant portion of operating income
goes towards investing in new business ventures.
Accounting Distortions After recognizing the red flags that we noticed in Stepan Company’s financial
statements, we will analyze the biggest issues of concern in this section. We concluded
that Stepan’s defined benefit plans, goodwill, and operating leases were the most
concerning and significant of the potential accounting distortions. These three items are
level three assets, which are obscure and often difficult to measure. Stepan Company
measures these level three assets based on estimates. Due to this, we have decided that
further analysis needed to be performed in order to make sure that the estimates of these
items were not taking advantage of the basic disclosure rules required and accepted by
GAAP. We will use this further examination to decide whether or not Stepan’s financial
statements will have to be restated.
Defined Benefit Pension Plans
In previous years, Stepan Company utilized defined benefit pension plans for the
majority of its employees’ retirement security. Stepan’s defined benefit plans have been
frozen for years, with defined contribution plans taking their place. No more liabilities are
being created, but Stepan is still responsible for satisfying current obligations from the
defined benefit plans.
Stepan’s estimated rates of return compared to the discount rates on the plans
differ quite significantly. Figure 4.0 shows the discount rate in 2015 for Stepan’s defined
benefit plans as 4.39%, compared to the estimated rate of return of 7.5%. By using a
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higher rate of return than the discount rate, Stepan could be creating distorted financials
by assuming away growth of the pension plans, but still accounting for a high rate of
return. This provides an illusion that Stepan has more than it actually does in plan assets.
After examining Stepan’s 10-K, we noticed that the total change in plan obligation
was $160,789. A return of $1,374 was recorded. This return was only 1.08% of the plan
assets, thus proving that the the stock market has not been returning 7.5%. Stepan did
properly record the actual return of $1,374 generated from the plan, therefore
restatement is not necessary.
Figure 4.0: Defined Benefit Rates
Goodwill
We have noted that Stepan has not impaired its accumulated goodwill. Stepan has
been using estimates for level three assets, such as goodwill, which managers did not
believe needed to be impaired. For 2015, Stepan Company’s 10-K listed the total goodwill
at $11,265,000. We will analyze Stepan’s goodwill and impairment of goodwill in order to
determine if the values were significant enough to restate the financials.
Stepan’s original ending balance of goodwill for 2015 is $11,265,000, which is only
1.82% of Stepan’s net fixed assets. We derived a new ending balance of goodwill for
2015 using the impairment schedule shown in Figure 4.1. The estimated new balance of
goodwill is $3,108,000. If Stepan Company impaired the goodwill, it would reduce the
balance of total net fixed assets by only 1.31%. Furthermore, this value is only 0.5% of
Stepan’s net fixed assets of $620,088,000, thus, not surpassing the threshold of greater
than 30% for restatement. The goodwill impairment that should be performed on Stepan
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for 2015 is an estimated amount of $2,364,800. This would account for 1.26% of Stepan’s
operating expenses of $188,313,000. The total accumulated goodwill that should be
impaired for year 2011 through year 2015 is $8,953,000.
These outcomes have led us to conclude that Stepan’s financials will not need to
be restated for goodwill impairment. Although, we would recommend that Stepan start
impairing its goodwill, and follow the suggested impairment schedule that we have
provided. The values, however, did not surpass the thresholds, nor did they significantly
affect operating expenses or total fixed assets. We have noted that Stepan most likely
has not impaired goodwill because it is such an insignificant amount of Stepan’s net fixed
assets. The restated values were not significant enough to justify a restatement of
Stepan’s financial statements.
Figure 4.1: Stepan Goodwill Impairment Expense
Figure 4.2: Stepan Company Goodwill Impairment Schedule
2011 2012 2013 2014 2015
Beg. Bal. Goodwill 6,717.00$ 5,856.60$ 4,416.60$ 7,600.60$ 5,235.80$
New Goodwill 483.00$ ‐$ 4,624.00$ ‐$ 237.00$
Less Should Impair (1,343.40)$ (1,440.00)$ (1,440.00)$ (2,364.80)$ (2,364.80)$
Plus Did Impair ‐$ ‐$ ‐$ ‐$ ‐$
Adj. Goodwill End. Bal. 5,856.60$ 4,416.60$ 7,600.60$ 5,235.80$ 3,108.00$
As Stated Goodwill 6,717.00$ 7,000.00$ 7,199.00$ 11,726.00$ 11,502.00$
Stepan Company Goodwill Impairment Expense (thousands)
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Operating Leases
Stepan Company, like many other companies, has operating leases, as well as
estimated amounts to be paid out for the first five years. Operating leases are an issue
because the leases are not recorded as liabilities or assets on Stepan’s balance sheet. We
will analyze Stepan’s operating leases in order to determine what potential debt
obligations would be on Stepan’s balance sheet if the operating leases were capitalized.
Figure 4.3 displays the current present value of Stepan’s operating leases. The
original five years of cash outflow estimated by Stepan were used, along with the
remaining estimated “thereafter” balance of an additional eight years. An estimated
interest rate of 5.31% was computed by taking a value-weighted average of interest rates
for current outstanding long-term debt. Stepan would have a present value of $28,022.51
in debt obligations if it chose to capitalize its operating leases. This number accounts for
approximately 6.4% of Stepan’s total noncurrent liabilities.
Additionally, Figure 4.4 shows the amortization of Stepan’s operating leases, had
they been capitalized. Although important to note, these amounts are not significant
enough in comparison to Stepan’s total liabilities to cause for restatement. Due to the
fact that none of the amounts calculated were above the threshold, we have determined
that we will not need to restate Stepan’s operating leases in the financial statements as
capital leases.
Figure 4.3 : Capitalization of Operating Leases (in thousands)
Capitalization of Operating Leases (in thousands)
Should Impair 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
Original Goodwill 1,343.40$ 1,343.40$ 1,343.40$ 1,343.40$ 1,343.40$
New Goodwill 2011 96.60$ 96.60$ 96.60$ 96.60$ 96.60$
New Goodwill 2012 -$ -$ -$ -$ -$
New Goodwill 2013 924.80$ 924.80$ 924.80$ 924.80$ 924.80$
New Goodwill 2014 -$ -$ -$ -$ -$ New Goodwill 2015 47.40$ 47.40$ 47.40$ 47.40$ 47.40$ Total Should Impair 1,343.40$ 1,440.00$ 1,440.00$ 2,364.80$ 2,364.80$ 1,068.80$ 972.20$ 972.20$ 47.40$ 47.40$ Did Impair -$ -$ -$ -$ -$ -$ -$ -$ -$ -$
Stepan Company Goodwill Impairment Schedule (in thousands)
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Payment Years PV Factor PV
2016 $ 5,836 1 0.95 $ 5,542 2017 $ 4,297 2 0.90 $ 3,875 2018 $ 3,560 3 0.86 $ 3,048 2019 $ 3,011 4 0.81 $ 2,448 2020 $ 2,708 5 0.77 $ 2,091 2021 $ 2,236 6 0.73 $ 1,639 2022 $ 2,236 7 0.70 $ 1,557 2023 $ 2,236 8 0.66 $ 1,478 2024 $ 2,236 9 0.63 $ 1,404 2025 $ 2,236 10 0.60 $ 1,333 2026 $ 2,236 11 0.57 $ 1,266 2027 $ 2,236 12 0.54 $ 1,202 2028 $ 2,236 13 0.51 $ 1,141
Goal PV OL $ 28,023
Figure 4.4: Amortization of Operating Leases
Amortization of Operating Leases (in thousands)
BB Int. Pmts EB 2016 $ 28,023 $ 1,488 $ 5,836 $ 23,675 2017 $ 23,675 $ 1,257 $ 4,297 $ 20,635 2018 $ 20,635 $ 1,096 $ 3,560 $ 18,170 2019 $ 18,170 $ 965 $ 3,011 $ 16,124 2020 $ 16,124 $ 856 $ 2,708 $ 14,272 2021 $ 14,272 $ 758 $ 2,236 $ 12,794
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2022 $ 12,794 $ 679 $ 2,236 $ 11,238 2023 $ 11,238 $ 597 $ 2,236 $ 9,598 2024 $ 9,598 $ 510 $ 2,236 $ 7,872 2025 $ 7,872 $ 418 $ 2,236 $ 6,054 2026 $ 6,054 $ 321 $ 2,236 $ 4,139 2027 $ 4,139 $ 220 $ 2,236 $ 2,123 2028 $ 2,123 $ 113 $ 2,236 $ 0
Totals: $ 174,717 $ 9,277 $ 37,300 $ 146,695
Conclusion
In conclusion, Stepan Company’s financial statements will not have to be restated
for any of the accounting distortions that we noted and analyzed. Pension plans, goodwill,
and operating leases did not meet the thresholds for restatement, and were insignificant
in comparison to the rest of Stepan’s financials. Although we would recommend that
Stepan managers change a few policies and accounting methods for valuing their level
three assets, the discrepancies found within Stepan Company’s financial statements are
not significant enough to call for restatement of any amounts.
Financial Analysis In this section, we will analyze Stepan’s financial statements to assess Stepan
Company’s value. We will do this using ratio analysis for Stepan and its competitors,
Innospec, Olin, and Minerals Technologies. Ratio analysis helps measure a company’s
liquidity, efficiency, profitability, capital structure, and credit risk. These ratios will help
us assess Stepan’s and its competitors’ financial performance. In this ratio analysis, we
will focus on liquidity ratios, operating efficiency ratios, profitability ratios, and capital
structure and credit risk metrics. This process will enable us forecast Stepan’s next 10
years of financial statements and determine Stepan’s value.
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Liquidity Ratios
A liquidity ratio measures whether a company has the ability to pay upcoming bills.
It also tells us how quickly a company is able to convert its assets into cash. The higher
the liquidity ratio, the more solvent a company is. In many cases, a bank will look at a
company’s liquidity ratio when deciding an interest rate on a loan. The better the
company’s liquidity, the lower the interest rate because a business with higher liquidity
has lower credit default risk. The liquidity ratios we will use to evaluate Stepan and its
competitors are the current ratio and the quick asset ratio.
Current Ratio
The current ratio is found by dividing current assets by current liabilities. This ratio
shows the ability a company has to cover its current liabilities with its current assets.
Ideally, the ratio should be above one and the bigger the ratio the better. Between the
years of 2010 and 2015, Stepan’s current ratio averages 2.23. This is a sufficient ratio
because it shows that they have at least two dollars of current assets to one dollar of
current liabilities. The data also reveals that Stepan’s current ratio is increasing year over
year, meaning their liquidity is also increasing. Figure 4.5
compares Stepan’s current ratio to its competitors current ratio.
Figure 4.5: Current Ratio
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Based on the information presented above, the industry average is above 2, which
is a substantial number. They are all considered to be liquid and show they all have
sufficient funds to cover their liabilities. Stepan is on par with the industry average.
Minerals Technologies has the largest market cap in the specialty chemicals industry, and
they have the largest current ratios on average.
Quick Asset Ratio
The quick asset ratio is found by dividing current financial assets by current
liabilities. Current financial assets consists of cash, marketable securities, and accounts
receivables. This ratio is different from the current ratio because it is a more conservative
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ratio, as it includes only certain highly-liquid asset accounts. The quick asset ratio should
be similar to the current ratio. If there is a large discrepancy between the two, it is
possible the company does not have the ability to pay off its current liabilities, nor is it as
liquid as it appears to be in the current ratio. Stepan’s average quick asset ratio is 1.5.
This number does not differ significantly from their current ratio average of 2.23. Figure
4.6 compares Stepan’s quick asset ratio to its competitors’.
Figure 4.6: Quick Asset Ratio
Based on the information in Figure 4.6, it can be seen that in the specialty
chemicals industry, all of the firms’ quick asset ratios are relatively close to their current
66
ratios. This shows that in this industry, companies are able to pay off their liabilities and
are solvent. Again, mineral technologies has the highest ratio which is attributed to their
larger market cap. Stepan had the second highest ratio, and this can be attributed to
their accounts receivables more than doubling from 2014-2015. This increase in accounts
receivables caused the current ratio to increase from 2.31 in 2014 to 2.55 in 2015, and
the quick asset ratio to increase from 1.43 in 2014 to 1.75 in 2015.
Conclusion
The liquidity ratio analysis helped us determine Stepan Company’s ability to pay
their obligations. In total, we have concluded that Stepan is solvent and has the ability
to pay its liabilities. Compared to its competitors, Stepan’s liquidity is on par with industry
norms, showing that the company is able to cover its debt. Overall, having substantial
liquidity ratios will help Stepan’s credibility when applying for loans, which is crucial in
order to obtain a lower interest rate. This will allow Stepan to continue to be a successful
company.
Operating Efficiency Ratios
Operating efficiency ratios are used to determine how fast a business can turn
assets into revenue. The operating efficiency ratios we will be utilizing are inventory
turnover, days supply inventory, accounts receivable turnover, days sales outstanding,
cash-to-cash cycle, and working capital turnover. Turnover ratios should be high, as it
could signal that a company is efficient when collecting on accounts receivable, and they
are not keeping their inventories for long periods of time. Below is a breakdown of each
operating efficiency ratio and how Stepan compares to other companies in the specialty
chemicals industry.
Inventory Turnover
The inventory turnover ratio is found by dividing the cost of goods sold by
inventory. A high inventory ratio could imply that a company has strong sales or heavy
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discounts. A low ratio could signal slow sales, resulting in excess inventory. The inventory
used for this ratio can be ending inventory or beginning inventory; it is important to
remain consistent. In order to calculate Stepan’s inventory turnover and that of their
competitors, we used the ending inventory found on the finalized annual balance sheets
within the company's 10-Ks. Figure 4.7 displays the inventory turnover ratio for Stepan,
Olin, Innospec, and Minerals Technologies.
Figure 4.7: Inventory Turnover
According to Figure 4.7, the range of the industry average for inventory turnover
is 5.61 to 7.07. Stepan is above its competitors and the industry average every year
except for 2013. This shows that Stepan is a top seller in the specialty chemicals industry
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and has stronger sales than its competitors, who have lower inventory turnovers.
Innospec consecutively has the lowest turnover compared to the industry. This could
signal that they have an excess in inventory and/or have slow sales.
Days Supply Inventory
Days’ Supply Inventory is calculated by dividing 365 days by the inventory turnover
ratio. The inventory turnover ratio is derived by dividing cost of goods sold by inventory,
as discussed in the previous subsection. The days’ supply inventory ratio allows us to
determine how many days worth of inventory Stepan has stored in its warehouses. This
measure also allows us to estimate how many days Stepan’s average level of inventory
will be sufficient. Figure 4.8 shows the days supply of inventory for Stepan and its
competitors within the specialty chemicals industry.
Figure 4.8: Days’ Supply of Inventory
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As shown in Figure 4.8, the number of days supply of inventory on hand for Stepan
has increased slightly every year since 2012. Stepan’s average days supply of inventory
is 35.96, while the industry average is 57.28. The industry average computed is offset by
Innospec’s high average of 95.35. With this information, it can be seen that Stepan is
doing relatively well because it does not keep inventory as long as its competitors. For
this ratio, a lower number is ideal because holding inventory is not cost efficient for a
firm.
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Accounts Receivable Turnover Accounts receivable turnover is derived by dividing total sales by accounts
receivable. This ratio tells us the number of times each year that a company collects its accounts receivables. Overall, the accounts receivables turnover ratio measures how efficient a firm is at providing credit to customers and collecting that credit. Figure 4.9 displays a comparison between Stepan’s and its competitors’ ability to efficiently issue and collect accounts receivable.
Figure 4.9: Accounts Receivable Turnover
Based on the figure above, Stepan collects its average outstanding receivables
7.12 times per year. From 2010 to 2015, Stepan has varied in its efficiency at collecting
its receivables only slightly. In 2015, Stepan was marginally less efficient than it was in
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2010, but the amount is not significant enough for a major impact. Stepan’s turnover
ratio is more stable and slightly above the industry average of 5.82 times as of 2015.
Overall, Olin has had the greatest efficiency up until 2015. One important thing to note
is the stability of Stepan’s accounts receivables turnover. While its competitors have
jumped quite a bit in the last six years, Stepan has remained relatively stable to previous
years. This shows longevity and stable dynamics. Creditors of Stepan Company prefer to
see high and steady values to ensure they will be repaid.
Days Sales Outstanding
The Days Sales Outstanding ratio allows us to measure the number of days it takes
Stepan to collect on its trade receivables after the sale. It is calculated by dividing 365 by
the accounts receivable turnover ratio that was discussed in the previous section. This
activity ratio allows us to understand how efficient Stepan Company is at collecting its
sales. Figure 5.0 portrays the days sales outstanding values for Stepan, its three major
competitors, and the specialty chemicals industry average.
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Figure 5.0: Days Sales Outstanding
According to Figure 5.0, Stepan’s days sales outstanding values are lower than the
overall industry average. In comparison to competitors, Stepan is relatively close to its
competitors in days sales outstanding. Minerals Technologies has remained higher over
the past five years than Stepan. However, Olin and Innospec have varied, sometimes
lower or sometimes higher than Stepan. A lower number for days sales outstanding is
best for companies because it means that they are more efficient at collecting their
account receivables. As of 2015, Stepan was collecting its accounts receivables about
every 51 days.
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Cash-to-Cash Cycle The cash-to-cash cycle is the sum of days supply and the days sales ratio. The
cash-to-cash cycle is the amount of time in between when a business pays for its
inventory and when it collects cash from its customers. Lower cash-to-cash cycles are
better. Lower values indicate that a company has a shorter time period between paying
for inventory and collecting cash. By analyzing the cash-to-cash cycle, we are able to
determine how much time Stepan Company has between purchasing its inventory and
receiving cash. Figure 5.1 displays the cash-to-cash cycles of Stepan, Olin, Innospec, and
Minerals Technology.
Figure 5.1: Cash-to-Cash Cycle
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As shown in Figure 5.1, Stepan currently has the lowest cash-to-cash cycle value.
The 2015 industry average of 140.53 is much larger than Stepan’s 2015 value of 93.67.
Over the past six years, Olin corporation has been the only competitor with values as low
as, or lower, than Stepan Company’s. Over the past six years, Stepan seems to be slowly
increasing the time between paying for inventory and receiving cash from customers.
This shows that Stepan is decreasing its efficiency at collecting cash, thus, lowering its
overall operating efficiency.
Working Capital Turnover
The working capital turnover ratio portrays a company’s effectiveness at using its
working capital. Working capital turnover is calculated by dividing net sales by working
capital, or current assets minus current liabilities. Figure 5.2 shows the working capital
turnover ratio of Stepan and its three major competitors: Olin, Minerals Technology, and
Innospec.
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Figure 5.2: Working Capital Turnover
As of 2015, Stepan is the most effective at using its working capital, compared to
its competitors. However, on average Olin has had greater effectiveness at using its
working capital over time. This shows that something may have occurred in Olin
Corporation internally to cause a drop in working capital effectiveness and efficiency.
However, it is apparent that Olin, Stepan, and Innospec have all experienced decreases
in their working capital turnover ratios. This leads us to believe that perhaps something
within the industry occurred that has made it more difficult to use working capital more
effectively.
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Conclusion In conclusion, by performing operating ratio analysis, we were able to determine
how efficient Stepan is at performing day-to-day operations in comparison to the overall
industry average and to its competitors. By analyzing each operating efficiency ratio, we
have concluded that Stepan is typically above the industry average for each ratio, and
has a high degree of operating efficiency in comparison to its competitors.
Profitability Ratios
Profitability ratios show how efficient a company is generating revenues in
comparison to its expenses and other costs. It is desirable to have a high profitability
ratio, especially when it comes to comparing a company to its industry. If a company
does not have similar profitability ratios to its competitors, that could be a sign of trouble.
The ratios we used to determine Stepan’s and its competitors’ profitability are gross profit
margin, operating profit margin, net profit margin, return on asset, and return on equity.
Gross Profit Margin
Gross profit margin is found by subtracting cost of goods sold from sales and
dividing that number by sales. This metric measures the amount of money left over from
sales after accounting for the cost of goods sold. The higher the percentage, the better
and more efficient that company is. Figure 5.3 displays the gross profit margin values
over the past six years for Stepan, Olin, Innospec, and Minerals Technologies.
Figure 5.3: Gross Profit Margin
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In comparison to its rivals, Stepan has a relatively low gross profit margin. This
tells us that Stepan does not have very high margins when comparing it to others within
the industry. This could mean that Stepan is either paying too much for its raw inputs, or
not selling its outputs at high enough margins. A solution to this could be to negotiate
lower prices with suppliers, or to increase sales margins. These low values are not a good
sign for the company, and decrease Stepan’s overall profitability. One positive thing about
Stepan’s low gross profit margin is that it increased from 2014 to 2015. This tells us that
Stepan is becoming slightly more profitable. We will have to keep an eye on this value
and analyze it in the next couple of years in order to determine just how efficient Stepan’s
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gross profit margin in. We would recommend that Stepan reevaluate input and output
strategies and make some changes in order to increase gross profit margins.
Operating Profit Margin
Operating profit margin is operating income divided by net sales. This margin
shows what proportion of a company’s revenue remains after variable costs have been
paid. In other words, operating profit margin tells us how much money Stepan Co. makes
in profits from each dollar of sales. In order to calculate the operating profit margin, you
take the operating income of that year and divide it by the net sales of that year.
Generally, the higher the operating profit margin, the better the company is doing. Figure
5.4 displays the operating profit margins for Stepan, Olin, Innospec, Minerals
Technologies, and the specialty chemicals industry average.
Figure 5.4: Operating Profit Margin
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Based on Figure 5.4, Stepan has primarily had the lowest operating profit margin
over the last six years in comparison to the industry average and its primary competitors.
A higher operating profit margin means that a company is making a larger profit for every
dollar of sales. Stepan’s operating profit margin is also not consistent and seems to be
fluctuating every year, which overall is not ideal for a company. Specifically in 2014,
Stepan dropped to its lowest operating margin of 4.70%, which can be attributed to the
lower operating income that year because of their high deferred compensation expense
which include retirement plans, stock-option plans and pension plans. In 2015, the
expense was cut in half, therefore boosting Stepan’s operating profit margin back up.
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Net Profit Margin
Net profit margin is a company’s net income divided by sales. The ratio is reflected
in a percentage and shows how much of each dollar collected by a company as revenue
translates into profit. A high net profit margin is ideal. Figure 5.5 displays the net profit
margins for Stepan, Olin, Innospec, Minerals Technologies, and the specialty chemicals
industry average.
Figure 5.5: Net Profit Margin
Based on Figure 5.5, Stepan has the lowest net profit margin out of all the
benchmark firms and the industry average. Stepan’s net profit margin is consistent
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throughout the years but continues to be lower than the industry norm. Although
Stepan’s net profit margin is not negative, Stepan might want to look into changing
current practices to decrease their cost to make and acquire their products (COGS) in
order to increase their net profit margin and get on par with industry norms.
Return on Asset
The return on asset percentage tells investors how profitable a company is relative
to the total assets of the company. It shows how efficient management is at using assets
to generate sales. In order to find the return on assets, net income is divided by the total
assets of the previous year. The higher a company’s ROA, the better because it means
the firm is using its assets efficiently to generate more sales.
Figure 5.6: Return on Asset
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Based on figure 5.6, Innospec shows the overall highest ROA in the specialty
chemicals industry. This shows that Innospec is an industry leader when it comes to
utilizing its assets in the most efficient way to generate more sales. In this particular ratio,
Stepan is below the industry average for every year. Compared to Stepan’s competitors,
Stepan is not as efficient. This low ROA could look unappealing to Stepan’s shareholders
and future lenders. Stepan should try and increase their ROA in order to compete better
across the industry.
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Return on Equity
The return on equity is the same as the return on assets, but instead of comparing
the assets to the profits of the company, it is comparing the firm's equity. The formula
for return on equity is: Net Income/ Total Equity from the year before. ROE measures
profitability by calculating the profits per dollar of stockholders’ equity. With that being
said, the higher the percentage the better. Since equity represents the investment in the
company, the higher the return means the better the investment.
Figure 5.7: Return on Equity
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According to figure 5.7, like ROA Innospec is the industry leader for ROE. Although
they are only higher than the industry average for the last three years. Stepan’s ROE is
much stronger than their ROA. They are above industry average for each year except for
in 2014 and 2015. This ratio will be more appealing to Stepan’s shareholders and creditors
as this shows that Stepan is a good company to invest in.
Asset Turnover
Asset Turnover is a lagged ratio that measures sales relative to the total assets of
the previous year. The higher the asset turnover, the better a company is at performing.
A high ratio implies a company is more efficient when it comes to generating more
revenue per assets. Lower asset turnover values are bad for a company’s profitability.
Figure 5.8 displays the asset turnover measurements for Stepan and its competitors.
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Figure 5.8: Asset Turnover
As shown in Figure 5.8, Stepan has the highest asset turnover ratio out of its top
competitors over a five-year time period. This informs us that Stepan is doing well at
generating more sales per dollar of assets. One primary trend that seems to be taking
place within the industry appears to be an average asset turnover between 0.90 to 1.40.
One red flag we noticed by analyzing Stepan’s asset turnover values is that the asset
turnover, while higher than competitors’, is still decreasing. Due to this, Stepan is actually
decreasing in operating efficiency as of the more recent years measured, but still appears
to have a high asset turnover for its industry.
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DuPont Result
The Dupont Result is found by multiplying net profit margin times asset turnover
times the equity multiplier. The Dupont result allows for calculating a higher return on
equity by valuing a company’s assets at gross book value instead of net book value
(Thorp). A higher Dupont result is better for a company.
Figure 5.9: DuPont Result
As shown in Figure 2.9, Stepan’s most recent value for the Dupont result is fairly
mid-range for the specialty chemicals industry. The ratio appears to be somewhat volatile
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for the major competitors within the industry, with values increasing and decreasing in a
quite irregular manner. Innospec paid off a great deal of debt in the last several years,
decreasing its liabilities and increasing its Dupont result. Paying off debt is one reason
why companies’ values will differ back and forth in a seemingly unstable manner. As
companies pay off and take on more debt, companies’ Dupont results will increase and
decrease. Overall, Stepan appears to have a fair average for the industry, with Innospec
remaining an outlier due to different strategies and debt levels. We believe that Stepan
has average profitability based on this ratio.
Conclusion
In conclusion, by analyzing the profitability ratios for Stepan Company, we were
able to determine Stepan’s ability to generate profits compared to costs. We have
concluded that Stepan is only marginally profitable. While generating profits fairly well, it
does not appear to be as profitable as its competitors are. We were able to determine
this conclusion by analyzing the gross profit margin, net profit margin, operating profit
margin, return on assets, return on equity, asset turnover, and the Dupont result for
Stepan and its competitors. Due to the competitive nature of this industry, this could be
a cause for concern in the long-run if Stepan is not able to increase its profitability.
Capital Structure and Credit Risk
Capital Structure ratios show how a firm finances its operations and growth with
various sources of funding. It is important because these ratios give analysts information
about the firm’s ability to pay off its debt and what its levels of equity. In the subsections
below, we will analyze each capital structure ratio for Stepan, its three main competitors,
and the industry average.
Debt to Equity Ratio
The debt to equity ratio is derived by dividing total liabilities by the book value of
equity. This is a leverage ratio that measures to what degree a company’s assets are
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financed by the debt and equity of a company’s business. In other words, we are able to
determine how much of the assets are financed by debt or actual equity within the
company. The figure below shows a graph and table of the debt to equity ratios for
Stepan, Olin, Innospec, Minerals Technologies, and the specialty chemicals industry
average.
Figure 6.0: Debt to Equity Ratio
As shown in Figure 6.0, Stepan’s debt to equity ratio has remained relatively stable
over the past five years. This indicates that Stepan has maintained about the same level
of debt compared to its equity, and has continued with the same capital structure
decisions. Competitors, such as Minerals Technologies and Olin have increased their debt
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to equity ratios quite a bit in recent years by making different capital structuring decisions
and taking on more debt. In comparison to its competitors, Stepan is about mid-range
with its debt to equity values.
Times Interest Earned
Time interest earned is calculated by taking the earnings before interest and tax
(EBIT) and dividing it by the interest expense. This ratio will tell us whether or not Stepan
is able to honor its debt and loan payments. This is an important ratio because it shows
the capability of firms to earn enough money to cover their interest expense.
Below is a table and graph benchmarking Stepan and its competitors.
Figure 6.1: Time Interest Earned
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Minerals Technologies is an outlier for 2013, this is because they increased their
EBIT and paid off the majority of their interest bearing debt. This can be seen in the table
below the graph. We were not able to include Mineral Technologies on the graph because
of the large outcome of 634.5 in 2013. This also affected the industry average. According
to Figure 6.1, the overall average of times interest earned in the industry is 13. Stepan’s
times interest earned is higher compared to Olin, but not compared to Innospec who has
been retiring debt over the last few year. Stepan’s value of 8.56 in 2015 tells us that the
company has a high enough EBIT to cover its interest expense. With this in mind, the
decrease in the times interest earned ratio for Stepan in recent years is minimal and not
of great concern. Stepan has increased its interest-bearing debt amounts slightly, causing
the times interest earned ratio to decline marginally. Regardless of this, Stepan does not
have potential for bankruptcy and is able to cover its interest expenses.
Debt Service Margin
The debt service margin is a lagged ratio. It calculates a firm’s ability to produce
enough cash flows from operations (CFFO) to pay the previous year’s debt payable. Figure
6.2 displays the debt service margins for each company in Stepan’s industry.
Figure 6.2: Debt Service Margin
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Innospec paid off almost all of its interest-bearing debt, leading to its values being
outliers compared to Olin, Minerals Technologies, and Stepan. We left out Innospec and
the industry average because the large values that did not match. In comparison to Olin
and Minerals Technologies, Stepan company has a very low debt service margin. The
company is still able to service its debts, just not as well as its competitors. One of the
reasons for this is that the other two companies initially had less debt than Stepan.
Altman’s Z-Score
The purpose of Altman’s Z-score is to “measure a company’s financial health and
predict the probability that the company will go into bankruptcy” (Strategiccfo.com). We
care about Altman’s z-score because it’s a “measure of how closely a firm resembles other
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firms that have filed for bankruptcy” (Business Insider). This value does not predict the
time/period in which firms may file for bankruptcy. It is computed using seven
performance values. The seven performance values consists of five ratios that are used
to compute the z-score. The Z-score is calculated as follows:
Altman’s Z-score= 1.2P1 + 1.4P2 + 3.3P3 + 0.6P4 +1P5
P1= Working Capital/Total Assets
P2= Retained Earnings/Total Assets
P3=Earnings Before Interest and Taxes/Total Assets
P4=Market Value of Equity/Book Value of Total Liabilities
P5=Sales/Total Assets
These components indicate several factors that would lead to bankruptcy. P1 is
used to assess liquidity, P2 measures profitability, P3 measures productivity, P4 is a quick
test (compares assets and liabilities), and P5 is a measure of asset turnover. For a given
firm, bankruptcy can be assessed by using these performance ratios. Companies typically
will head towards bankruptcy if they have decreasing liquidity, shrinking profitability,
aren’t productive (decreasing earnings), if their liabilities exceed their assets, and if they
cannot generate sales using their assets. When analyzing Altman’s Z-score, it is important
to know how to interpret the computed values. If the z-score is above 3.0 the chances of
bankruptcy are unlikely. If the z-score falls in between 1.8 and 3.0 then the chances of
bankruptcy cannot be forecasted because between these values is a gray area; firm's
performance can either improve or decline at this point. If the z-score for a given firm is
below 1.8 it is highly likely that they will go bankrupt (Strategiccfo.com).
Over the past six years, Stepan Company has had a z-score that is well above 3.0.
They have not been at risk for bankruptcy at any time during this time period. Compared
to its competitors, Innospec, Olin, and Minerals Technologies, Stepan has the best
financial health. Minerals Technologies has been at risk for bankruptcy in three out of the
six past years. They are currently in the gray-zone with a z-score of 1.90. Over the past
six years, Olin has remained in the safe zone for three years and has had a z-score below
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1.8 the other three years. Olin’s 2015 z-score of 0.73 is well below 1.8 (the measure
where bankruptcy is highly likely). Of all the benchmark competitors, Innospec most
resembles Stepan’s z-score trend. For the past six years, Innospec’s z-score has put it in
the “safe zone” or in the gray-area. It’s 2015 z-score is 3.01 which means they too aren’t
at risk for bankruptcy.
Figure 6.3 shows how the z-score has varied over the past six years for Stepan
and its competitors. The variance in these values can be explained by the change in value
of each performance factor (working capital, total assets, retained earnings, EBIT, MVE,
total liabilities, and sales). If each change in value is analyzed on a yearly basis it can be
determined what financial ratios have led to the decline in financial stability. Over the
years, Stepan and Innospec have seen relatively constant financial stability while Mineral
Technologies and Olin have seen a huge variance in stability.
Figure 6.3: Altman’s Z-Score
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Internal Growth Rate
The internal growth rate (IGR) is calculated by multiplying return on assets (ROA)
by one minus dividends divided by net income. The internal growth rate calculation
measures the maximum amount of growth that a firm can achieve by only using internal
financing instead of increasing debt. Figure 6.4 displays the IGR values for Stepan and
its three major competitors.
Figure 6.4: Internal Growth Rate
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In Figure 6.4, we did not include Olin Corporation or the industry average on the
line graph because it is a large outlier in 2015, affecting the industry average for that
year. Over the past five years, Stepan has shown little ability to continue growing by
internal financing only. Minerals Technologies has shown even less ability to support
growth internally up until 2015, when its IGR minimally increased. This is not necessarily
a bad thing for the companies. It simply means that the companies need outside financing
to support more growth. This is an issue for Stepan because it already has a good amount
of debt. Taking on more is not out of the question, but will not be as wise as it would be
if it had no debt and needed to support company growth. This calls into question the
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means of Stepan’s current debt amounts. If being used efficiently, the debt that Stepan
has already taken out should be financing more than about 1% growth.
Sustainable Growth Rate
The sustainable growth rate (SGR) is a complex calculation that will help us
determine the maximum amount of growth that Stepan Company can reach without
having to utilize outside financing and increasing leverage. Three important factors
analyzed in SGR are how much money Stepan is making, how much dividends it is paying
out, and how much leverage it has. The factors are analyzed using the net profit margin,
asset turnover, the plowback ratio, and the debt-to-equity ratio.
Figure 6.5: Sustainable Growth Rate
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In Figure 6.5, Olin was found to be an outlier due to its extremely high sustainable
growth ratios. Initially, these numbers were thought to be human error, however, after
checking and re-checking the numbers for Olin’s sustainable growth were found to be
correct. Stepan’s SGR is consistent with other competitors within the industry. Their SGR
tells us that Stepan has sufficient funds in order to possibly take on debt in order to
finance project or amounts for future growth. Based on Stepan’s SGR, Stepan can safely
grow at an average of 12.5% using their own revenue. However, if Stepan, on average,
wanted to grow at a rate higher than 12.5% they would have to seek outside funding.
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Conclusion
By performing an analysis of Stepan’s capital structure and credit risk against its
benchmark competitors and the industry average, we were able to gain an understanding
of Stepan’s capital structure and level of credit risk. After evaluating several measures,
we were able to assess Stepan’s and its benchmark competitors’ capital structure and
credit risk by comparing them to an industry average. Stepan’s debt-to-equity has been
relatively stable compared to a few of its competitors who have increased their debt-to-
equity ratio over the past few years. This means that Stepan’s competitors have more
leverage. When analyzing the times interest earned (TIE) ratios we found that Stepan is
able to cover their interest expenses. Stepan has been increasing their interest-bearing
debt while some of its benchmark competitors have been retiring debt and as a result
have decreased their TIE ratio. When analyzing debt service margins (DSM), we were
able to conclude that Stepan is below its competitors’ average DSM but is still able to
service its debt. Altman’s Z-score took into account several performance measures that
included several factors that let us assess bankruptcy for Stepan and its benchmark
competitors. Overall, Stepan and Innospec outrank the rest of the industry benchmarks,
which means they are not at risk for bankruptcy. Although Stepan has good credit,
manages its debt, and has less credit risk than its competitors, we recommend that they
reevaluates its capital structure.
Forecasting Financial Statements In order to determine Stepan Company’s actual worth, and how they will perform
in the future, we will forecast Stepan’s financial statements out 10 years. We will forecast
Stepan’s income statement, balance sheet and statement of cash flows to the year 2025.
In order to determine future values, we looked at Stepan’s past performance and
assumed that business will continue to operate in a similar manner. We looked for
patterns in our ratio analysis and continued these patterns throughout the next 10 years.
Ultimately, this forecast assumes that the economy will remain similar to today’s
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economy, as we cannot forecast the future of the economy. These numbers will not be
100% accurate, but they should help us hypothesize how Stepan will be performing in
the future.
Income Statement
The income statement is the first financial statement that has to be forecasted, as
values from the income statement are needed to complete the balance sheet and the
statement of cash flows. In order to begin our forecasting, we had to forecast specific
ratios to help us determine the future values for total number of sales, cost of goods sold,
gross profit, operating income, net income and dividends. We based our future ratios by
looking at Stepan’s past performance. We noticed patterns in the ratios found in the ratio
analysis and decided to continue these patterns for the next 10 years.
The first ratio that needed to be forecasted for in order to begin the income
statement is the year over year sales growth. This ratio is the most important one for the
income statement as it used to forecast sales. Sales plays an important factor in every
major account on the incomes statement. After sales is forecasted, every account that
needs to be forecasted is somehow from the sales account. In order to accurately forecast
the sales ratio to the best to our ability, we found a pattern in Stepan’s past sales. We
noticed that sales had an increasing, decreasing pattern. We decided that this would be
the best method to use when determining the sales ratio. Other ratios that needed to be
forecasted for the income statement are the gross profit margin, operating profit margin,
and net profit margin. Again, to forecast these ratios, we reviewed Stepan’s past
statements and replicated the patterns that we found. Figure 6.6 and 6.7 display Stepan’s
forecasted income statement and the common-sized income statement values. Once we
could forecast all the necessary values on the incomes statement, we were able to begin
forecasting the balance sheet.
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Figure 6.6: Forecasted Stepan Income Statements
Stepan Comapny
Consolidated Income Statement
Fiscal Year End of Dec. 31(Dollars in Thousands Except for Per Share Data)
2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025
Sales to Customers 1,431,122 1,843,092 1,803,737 1,880,786 1,927,213 1,776,167 1,967,105 2,107,753 2,302,720 2,442,265 2,566,820 2,765,749 2,919,248 3,113,670 3,365,877 3,694,050
Cost of Products Sold 1,195,144 1,587,539 1,512,184 1,599,101 1,677,650 1,467,926 1,677,350 1,749,013 1,937,969 2,104,988 2,099,402 2,334,569 2,397,287 2,593,687 2,872,103 2,989,595
Gross Profit 235,978 255,553 291,553 281,685 249,563 308,241 289,755 358,740 364,751 337,277 467,418 431,180 521,962 519,983 493,774 704,455
Less: Operating Expenses
Selling and administrative expenses 89,774 96,573 117,124 115,187 121,312 131,570
Research and development expense 38,307 40,524 45,713 46,809 45,451 50,243
Deferred Compensation expense 0 0 0 9,496 (11,903) 6,500
Total Expenses 128,081 137,097 162,837 171,492 154,860 188,313
Opearating Income 107,897 118,456 128,716 110,193 94,703 119,928 157,368 153,866 198,034 236,900 192,512 207,431 218,944 233,525 252,441 277,054
Interest Expense, net or portion capitalized (6,341) (9,095) (9,599) (10,358) (11,441) (14,533)
Other (income) expense net (77) (4,467) (3,395) (3,165) (3,718) (5,401)
Earnings before provision for taxes on income 101,479 104,894 115,722 95,630 75,535 102,856
Provision for taxes on income 35,888 32,292 36,035 23,293 18,454 26,819
Net earnings 65,591 72,602 79,687 72,337 57,081 76,037
Add: Net loss attributable to noncontrolling interest 491 20 (69)
Net earnings attributable to Stepan Company 65,591 72,602 79,687 72,828 57,101 75,968 71,012 86,629 82,437 65,208 102,159 110,077 116,186 123,924 133,962 147,023
Net earnings per share attributable to Stepan
Basic 3.18 3.44 3.71 3.34 2.51 3.22
Cash dividends per share 0.48 0.56 0.64 0.68 0.72 0.76 0.8 0.84 0.88 0.92 0.96 1.00 1.04 1.08 1.12 1.16
Average shares outstanding 10910.4 12728.8 14547.2 15456.4 16365.6 17274.8 18184 19093.2 20002.4 20911.6 21820.8 22730 23639.2 24548.4 25457.6 26366.8
Basic
22700 shares outstanding
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Figure 6.7: Common-Sized Stepan Income Statements
2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025
Sales 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%
Cost of Goods Sold 83.51% 86.13% 83.84% 85.02% 87.05% 82.65% 85.27% 82.98% 84.16% 86.19% 81.79% 84.41% 82.12% 83.30% 85.33% 80.93%
Gross Profit 16.49% 13.87% 16.16% 14.98% 12.95% 17.35% 14.73% 17.02% 15.84% 13.81% 18.21% 15.59% 17.88% 16.70% 14.67% 19.07%
Selling and Admin expenses 6.27% 5.24% 6.49% 6.12% 6.29% 7.41%
R&D Expenses 2.68% 2.20% 2.53% 2.49% 2.36% 2.83%
Deferred Compensation Expense 0.00% 0.00% 0.00% 0.50% -0.62% 0.37%
Operating Income 7.54% 6.43% 7.14% 5.86% 4.91% 6.75% 8.00% 7.30% 8.60% 9.70% 7.50% 7.50% 7.50% 7.50% 7.50% 7.50%
Internest Expense -0.44% -0.49% -0.53% -0.55% -0.59% -0.82%
Other Income or expenses -0.01% -0.24% -0.19% -0.17% -0.19% -0.30%
Earnings before provision for taxes 7.09% 5.69% 6.42% 5.08% 3.92% 5.79%
provision for taxes on income 2.51% 1.75% 2.00% 1.24% 0.96% 1.51%
Net earnings 4.58% 3.94% 4.42% 3.87% 2.96% 4.28% 3.61% 4.11% 3.58% 2.67% 3.98% 3.98% 3.98% 3.98% 3.98% 3.98%
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Balance Sheet
The balance sheet is the second financial statement that must be forecasted. The
statement of cash flows cannot be completely forecasted without the values from the
balance sheet. We first forecasted important ratios that were specific to the balance
sheet. This included asset turnover, current assets as a percentage of total assets, the
current ratio, days supply of inventory, and days sales outstanding. When analyzing the
patterns of these ratios over a six-year period, many of the values followed a specific
pattern. For example, if a value continued to increase every year, we took an average of
the increases and increased the ratio by that amount over the next ten years. When
forecasting days supply of inventory, 2011 had an outlier value that was abnormal from
the other years’ values. Due to this we calculated the average for the increase of the
other six years and increased the days supply of inventory ratio by 1.09 days each year.
For asset turnover and the current ratio we did not foresee any significant changes in
total assets. We also assumed that we would keep around the same proportion of current
and noncurrent assets. Due to these assumptions, we simply forecasted these ratios as
the same over the 10-year forecasted period. Stepan’s values for days sales outstanding
were also very close together and varied little over the previous six-year period. We took
an average of the values and got 51.29 days. The stability and lack of variation in this
ratio led us to leave the inventory at the same value of 51.29 days each year for the 10-
year forecasted period.
After we determined the forecasted income statement values as well as the
balance sheet ratios, we incorporated these values into the forecasted balance sheet. In
order to forecast inventory values, we originally found strange and abnormally low values
for the years 2016-2018. Then values then increased to a normal level in 2019 and
remained stable through the remainder of the 10-year forecasted period. In order to
smooth the forecasted values from 2016-2018, we calculated the difference from 2019
to 2015 and divided the value by the four years of difference and got $3,614.42. We
added this value to the years 2015, 2016, 2017, and 2018 in order to smooth the
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discrepant values and have a more realistic inventory forecast. For accounts receivables
we used the days sales outstanding ratio multiplied by sales and divided by 365 to obtain
forecasted values. We forecasted Stepan’s total assets by dividing the sales by the asset
turnover ratio for each year. Total current assets were then forecasted by multiplying the
forecasted values for total assets by the forecasted current ratio. We notice that property,
plant, and equipment had remained the same percentage of total noncurrent assets for
a five-year period. Due to this, we left property, plant, and equipment as the same 45%
of total noncurrent assets and grew it out each year by 45% for the 10-year forecasted
period.
In order to ensure that our balance sheets did indeed balance, we used the
forecasted values for total assets as the same values for our forecasts for the total
liabilities and stockholders’ equity section. Total current assets were forecasted by
dividing total current assets by the current ratio. The stockholder’s equity value was found
by adding the previous year’s equity value with net income and dividends. We assumed
that Stepan is going to continue to be a profitable company, so stockholders’ equity is
continually increasing each year.
Overall, we assumed that Stepan would continue to be a profitable company when
calculating forecasts for the balance sheet. The majority of the values increased
accordingly with the ratios and forecasting formulas. For the items that had conflicting
values, such as inventory that was explained above, we smoothed our values in a way
that would make more sense in the given financial years. For the noticeable trends, such
as property plant and equipment, we maintained the same trend over the next 10 years,
assuming that Stepan would continue with similar assets levels, property, plant, and
equipment levels, and inventory. Figures 6.8 and 6.9 contain the Stepan’s forecasted and
common-sized balance sheet values.
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Figure 6.8: Forecasted Stepan Balance Sheets
2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025
AssetsCurrent assets Cash and cash equivalents 111,198 84,099 76,875 133,347 85,215 176,143 Accounts receivable trade, less allowances for doubtful accounts 199,245 260784 255,858 265,721 270,436 249,602 276,419 296,183 323,579 343,188 360,691 388,645 410,214 437,535 472,975 519,090 Inventories 96,552 111,175 162,013 172,368 270,436 249,602 253,018 256,435 259,851 263,268 268,839 305,924 321,302 355,371 402,094 427,471 Deffered taxes on income 8,170 8,769 9876 12,637 183,233 170,424 Other current assets 12,661 14,915 18456 24,477 Total current assets 427,826 479,742 523,078 608550 575,556 619,573 642,578 688,522 752,210 797,794 838,482 903,464 953,606 1,017,117 1,099,503 1,206,704Non-Current assets Property, plant and equipment, net 353,585 383,983 422,022 494,042 524,195 555,463 578560 619927 677271 718313 754947 813456 858602 915785 989964 1086485 Goodwill 6,717 7,000 7,199 11,726 20,803 17,957 Other intangible assets, net 5,257 11,181 8,778 23,669 11,502 11,265 Long-term investments 11,904 12,464 14,093 18,305 15,364 0 Other non-current assets 6,142 6,748 10,308 10,910 9,741 14,493 Total non-current assets 383,605 421,376 462,400 558,652 586,458 620,087 643,112 689,094 752,836 798,457 839,179 904,215 954,399 1,017,962 1,100,417 1,207,708
Total assets 811,431 901,118 985,478 1,167,202 1,162,014 1,239,661 1,285,690 1,377,616 1,505,046 1,596,252 1,677,660 1,807,679 1,908,005 2,035,078 2,199,920 2,414,412
Liabilities and Shareholders' EquityCurrent Liabilities: Current Maturities of Long-term debt 31609 34487 32838 35377 27034 18806 Accounts Payable 115248 137764 157277 156983 128605 Accrued liabilities 58770 60975 76399 65496 95833Total Current liabilities 205627 233226 247167 268993 249,513 243,244 251,991 270,009 294,984 312,860 328,816 354,300 373,963 398,869 431,178 473,217Non-Current liabilities: Long-term debt 159963 164967 149564 235246 246,897 313,817 Deferred taxes on income 5154 8644 9200 20616 15,804 9,455 Other liabilities 87616 88816 98667 88606 112,856 114,761Total Non-current liabilities 252733 262427 257431 344468 375,557 438,033 389,554 354,652 356,499 348,798 279,330 250,277 190,761 143,791 115,826 113,315
Total Liabilities 458360 495653 504598 613461 536,944 558,384 641,546 624,660 651,483 661,659 608,146 604,576 564,725 542,660 547,003 586,532
Shareholders' Equity:
Common stock- $1 par value; authorized 60,000,000 shares 11512 11709 25142 25564 25640 25709
Additional paid-in capital 83852 94932 125003 135693 139573 144601 Accumulated other comprehensive income -25599 -41485 -38250 -29528 -83945 -125088 Retained earnings 305830 366293 420472 478826 520540 580208 635,073 699,518 763,786 813,173 882,571 969,136 1,061,330 1,160,041 1,267,466 1,386,549 Less: Common treasury stock, at cost -39106 -43195 -54930 -58269 -66262 -68446
Total Shareholders' equity 353071 405465 477437 552286 535,546 556,984 644,144 752,956 853,563 934,593 1,069,514 1,203,103 1,343,280 1,492,418 1,652,917 1,827,880
Total Stockholders' Equity and Liabilities 811431 901118 985478 1167202 1,162,014 1,239,661 1285690 1377616 1505046 1596252 1677660 1807679 1908005 2035078 2199920 2414412
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Figure 6.9: Common-Sized Stepan Balance Sheets
2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025
Assets
Current Assets
Cash and Cash equivalent 13.70% 9.33% 7.80% 11.42% 7.33% 14.21%
Accounts receivable 24.55% 28.94% 25.96% 22.77% 23.27% 20.13% 21.50% 21.50% 21.50% 21.50% 21.50% 21.50% 21.50% 21.50% 21.50% 21.50%
Inventory 11.90% 12.34% 16.44% 14.77% 23.27% 20.13% 19.68% 18.61% 17.27% 16.49% 16.02% 16.92% 16.84% 17.46% 18.28% 17.70%
Deferred taxes on income 1.01% 0.97% 1.00% 1.08% 15.77% 13.75%
Other current asset 1.56% 1.66% 1.87% 2.10% 0.00% 0.00%
Total current assets 52.72% 53.24% 53.08% 52.14% 49.53% 49.98% 49.98% 49.98% 49.98% 49.98% 49.98% 49.98% 49.98% 49.98% 49.98% 49.98%
Non-current assets
Property, plant and equipment 43.58% 42.61% 42.82% 42.33% 45.11% 44.81% 45.00% 45.00% 45.00% 45.00% 45.00% 45.00% 45.00% 45.00% 45.00% 45.00%
Goodwill 0.83% 0.78% 0.73% 1.00% 1.79% 1.45%
Other intangible assets, net 0.65% 1.24% 0.89% 2.03% 0.99% 0.91%
Long-term investments 1.47% 1.38% 1.43% 1.57% 1.32% 0.00%
Other non-current assets 0.76% 0.75% 1.05% 0.93% 0.84% 1.17%
Total Assets 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%
Liabilities and Shareholder's Equity
Current Liabilities
Current Maturities of Long-term Debt 3.90% 3.83% 3.33% 3.03% 2.33% 1.52%
Accounts Payable 14.20% 15.29% 0.00% 13.47% 13.51% 10.37%
Accrued Liabilities 7.24% 6.77% 0.00% 6.55% 5.64% 7.73%
Totoal Current Liabilities 25.34% 25.88% 25.08% 23.05% 21.47% 19.62% 19.60% 19.60% 19.60% 19.60% 19.60% 19.60% 19.60% 19.60% 19.60% 19.60%
Non-current liablities
Long-term debt 19.71% 18.31% 15.18% 20.15% 21.25% 25.31%
Deferred taxes on income 0.64% 0.96% 0.93% 1.77% 1.36% 0.76%
Other liabilities 10.80% 9.86% 10.01% 7.59% 9.71% 9.26%
Total non-current assets 31.15% 29.12% 26.12% 29.51% 32.32% 35.33% 30.30% 25.74% 23.69% 21.85% 16.65% 13.85% 10.00% 7.07% 5.26% 4.69%
Total liabilities 56.49% 55.00% 51.20% 52.56% 46.21% 45.04% 49.90% 45.34% 43.29% 41.45% 36.25% 33.44% 29.60% 26.67% 24.86% 24.29%
Shareholder's equity
Common stock 1.42% 1.30% 2.55% 2.19% 2.21% 2.07%
Additional paid-in-capital 10.33% 10.53% 12.68% 11.63% 12.01% 11.66%
Accumulated other comprhensive income -3.15% -4.60% -3.88% -2.53% -7.22% -10.09%
Retained Earnings 37.69% 40.65% 42.67% 41.02% 44.80% 46.80% 49.40% 50.78% 50.75% 50.94% 52.61% 53.61% 55.63% 57.00% 57.61% 57.43%
Less: Common treasury stock -4.82% -4.79% -5.57% -4.99% -5.70% -5.52%
Total Shareholder's equity 43.51% 45.00% 48.45% 47.32% 46.09% 44.93% 50.10% 54.66% 56.71% 58.55% 63.75% 66.56% 70.40% 73.33% 75.14% 75.71%
Total Shareholder's equity and Liabilities 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%
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Statement of Cash Flows
The statement of cash flows is the hardest financial statement to forecast because
you need the forecasted information from both the balance sheet and the income
statement. For the statement of cash flows we forecasted CAPEX, cash flows from
operating activities, and dividends to shareholders. In order to forecast the cash flows
from operating activities, we took the forecasted operating income from the income
statement and multiplied it by a 1.13 growth rate. We found the 1.13 by dividing CFFO
by the operating income from from 2010-2015 and found the average of those numbers.
We used the CFFO/operating income because it gave us the most realistic forecasted
numbers. To find CAPEX, we used the additions to PPE, proceeds from the disposal of
assets and acquisitions, net of cash required, and added those values together to find
the CAPEX. We also found change in non-current assets and the change in PPA. The
change in non-current assets is important because it tells us how much capital is being
used from day to day activities. In order to find the ratio for each of those changes, we
used the CAPEX. We then forecasted the dividends to shareholders by multiplying the
forecasted net earnings and the forecasted dividends payout ratio together to forecast to
the year 2025. Figure 7.0 displays the forecasted statements of cash flows for Stepan
from 2016-2025.
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Figure 7.0: Forecasted Stepan Statements of Cash Flows
2010 2011 2012 2013 2014 2015 AVG. STD. DEV. "Sharpe" 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025
Cash flows from operating activities
Net earnings 65591 72602 79687 72,337 57,081 76,037 71012 86629 82437 65208 102159 110077 116186 123924 133962 147023
Adj. to reconcile NI to cash flows from op. activities:
Depreciation and amortization of property and intangibles 40351 47099 51294 56,400 63,804 66,985
Deferred compensation 5020 1529 10252 9,496 -11,903 6,500
Realized and unrealized gain on long‐term investments -1367 156 -1460 -2,611 -214 -21
Stock based compensation 3789 3676 3122 2,783 -68 4,374
Other non‐cash items 1292 4967 2755 7253 8260 3830
Changes in assets and liabilities, excluding effects of acquisitions:
Receivables, net -34449 -60842 3906 -12749 -21229 4160
Inventories -16975 -12854 -50260 -3794 -18521 2851
Accounts payable and accrued liabilities 7409 25901 24055 26256 -4376 21219
Pension liabilities -2252 -2470 -4341 1997 -2709 932
Environmental and legal liabilities -2481 -772 -66 -353 6493 1398
Deferred revenues -1404 -1474 -662 2428 -732 -1345
Excess tax benefit from stock options and awards -3187 -2951 -7237 -3438 -640 -442
Net cash flows from operating activities 66,126 77,377 108,969 150,314 81,955 183,273 177826 173869 223778 267697 217538 234397 247406 263884 285258 313071
CFFO/Sales 0.0462 0.0420 0.0604 0.0799 0.0425 0.1032 0.075 0.0247 0.3292
CFFO/Operating Income 0.6129 0.4106 0.8466 1.3641 0.8654 1.5282 1.13 0.4307 0.3811
CFFO/Net Income 1.0082 1.0658 1.3675 2.0780 1.4358 2.4103 1.87 0.5283 0.2825
Cash flows from investing activities
Additions to property, plant and equipment -42631 -83166 -83,159 -92865 -101819 -119349
Proceeds from the disposal of assets 0 0 0 0 0 3262
Acquisitions, net of cash acquired -9835 -13562 0 -68212 0 -5133
Purchases of investments
Sales of investments
Other (primarily intangibles)
Net Cash Used by Investing Activities
Computed CAPEX -52466 -96728 -83,159 -161077 -101819 -121220 -123,293 34289.23 -0.28 -129458 -135931 -142727 -133,497 -125,672 -131956 -135,467 -133,675 -131,598 -135,667
Change in Non‐Current Assets -96252 -41024 -96252 -27806 -33629 -58993 30709.32 -0.52
computed CAPEX/Change in Non‐Current Assets 1.005 2.027 1.6735 3.662 3.605 2.39 1.064 0.45
Change in PPA -30,390 -38039 -72020 -30153 -31,268
CAPEX/Change in PPE 3.183 2.186 2.237 3.377 3.877
Cash flows from financing activities
Dividends to shareholders 10570 11513 12757 14474 15387 16300 16148 22183 18169 15822 32761 23512 23992 25214 26537 27940
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Conclusion
Overall, after analyzing the past financial statements and utilizing that information
to forecast the next 10 years, we concluded that Stepan will continue to grow. This is
assuming that business operations will not change much in the next 10 years and
economic conditions will not change drastically. The hardest part of forecasting was
determining the forecasting ratios and using those to forecast future values. The
statement of cash flows was the most difficult of the financial statements to forecast,
containing a great deal of uncertainties and errors. Of course, growing numbers in the
same way that they are growing now will present some errors due to potential changes
in business structure, but overall we ended up with numbers that make sense and provide
us with some insight as to how Stepan will be doing in the next 10 years.
Cost of Capital Estimation The cost of capital is the rate used to discount the future cash flows of a company.
It is also called the weighted average cost of capital, or WACC. Using WACC provides a
“discount rate for a financed project…[and] allows the firm to calculate the exact cost of
financing any project” (Wall Street Oasis). The WACC includes two main parts; the
company’s cost of equity and the cost of debt. The cost of equity (Ke) is the rate of return
required by investors, while the cost of debt (Kd) is the rate being paid by the company
on its current debt. We calculated Stepan’s cost of equity and cost of debt below, which
allowed us to later calculate Stepan’s WACC. The value of the firm and WACC have an
inverse relationship; as WACC increases, the firm value decreases and vice versa. The
cost of capital is a significant factor that can be used when making investment decisions.
The calculation considers the proportion of debt and equity, which are both sources of
financing for the company. After calculating WACC, we were able to assess whether or
not Stepan is undervalued or overvalued.
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Cost of Debt
The cost of debt is a component of capital structure. It refers to the “effective rate
paid by a company on its current debt” (Ready Ratios). It can either be calculated on a
before-tax or after-tax basis. The cost of debt is a useful measure because it lets investors
know the overall interest being paid on debt. This is important because it gives investors
some insight on the riskiness of firms. Usually companies with higher risk have a high
cost of debt. In Item 7A in Stepan’s 10-K, the company states that their debt is made up
of fixed-rate and variable-rate borrowings. In Note 6, Stepan provides a summary of debt
composition as of December 2014 and December 2015 but we will only use interest
bearing current and noncurrent liabilities. The majority of the company’s long-term debt
financing is composed of unsecured private placement notes issued to insurance
companies (Stepan 10-K). These notes have fixed rates ranging from 3.86% and 5.88%.
Another interest-bearing source of debt comes from a 5-year revolving credit agreement
with JPMorgan Chase. Stepan has committed $125,000,000 and as of December 2015
has $4,700,000 outstanding. The interest rate on this credit facility has several options
to determine interest rates and they all depend on leverage ratios. The interest rate
composition that we will use to find the weighted average cost of debt for this facility will
be the fixed rate plus LIBOR (0.975%-1.525%) plus the facility fee (0.150%-0.350%).
The last interest bearing cost of debt we will use is an issuance of $100,000,000 of
unsecured private placement debt that was issued July 10, 2015 with a fixed rate of
3.95%. Shown below in Figure 7.1 is the weighted average cost of debt calculations.
Figure 7.1: Weighted Average Cost of Debt
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After determining the weight of each interest-bearing rate we multiplied them by
their respective interest rates to come up with the weighted average cost of debt. The
revolving credit facilities variable interest rate doesn’t affect the weighted cost of Debt
significantly. Using the low end of each variable interest rate spread we see weighted
average cost of debt is 4.46% whereas the higher estimates yield an interest rate of
4.48%.
Cost of Equity
The cost of equity can be calculated by using the two-factor model called CAPM,
or Capital Asset Pricing Model. The equation for CAPM is as follows:
Ke = Rf + (Beta * MRP) + SP
Ke in the above equation is the cost of equity, Rf is the risk-free rate, MRP is the
market risk premium, and SP is the size premium. Using the St. Louis Federal Reserve
website, we were able to find the risk-free rate from the 20-year Treasury Bond yield.
The yield on the website was giving as an annual rate so we had to divide the yield by
12 so we could convert it into a monthly rate. The market risk premium and the size
premium we used in the equation was gathered by information found in the Business
Analysis and Valuation textbook. According to the textbook, analysts “assume that the
[historical] market risk premium is around 7 percent” (Palepu & Healy 8-9). There are
other analysts that have argue “that a variety of changes in the U.S economy make the
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historical risk premium an invalid basis for forecasting expected risk premium going
forward” (Palepu & Healy 8-9). We believe that 7% is an appropriate percentage for the
market risk premium since it has been the MRP for years; therefore, we do not see a
need to change it. The size premium can be determined by using the firm’s market cap.
Stepan happens to be in the 5th size decile, which means that it has a size premium of
1.8 and that is what we used in our cost of equity equation. We gathered this information
from Figure 7.2.
Figure 7.2: Firm Size and Size Premium
The last component of the cost of equity equation is beta. Beta is a “measure of
the volatility of a stock’s returns relative to the equity returns of the overall market”
(Macabacus). The market used for this valuation was the S&P 500. In order to find beta,
we ran multiple regression analysis so we could see the difference between the monthly
returns for Stepan and the monthly returns of the overall market. We did regressions for
multiple yield curves including the 1-year Treasury Bond, 2-year Treasury Bond, 7-year
Treasury Bond, 10-year Treasury Bond, and 20-year Treasury Bond. For each of these
yields, we ran regressions for 12, 24, 36, 48, 60, and 72 months. We collected all the
information from these regressions and made the table below.
Figure 7.3: Regression Analysis
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After running all the regressions and getting all this data, we had to decide on just
one beta to use for the cost of equity equation. The higher the r-squared, the accuracy
of the beta increases. Therefore, the beta we used in our CAPM calculation was 1.70
which was the regression with the highest r-squared of 61.20%. This beta was found in
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the 24 months, 10-year Treasury Bond yield. Having a r-squared, or systematic risk, that
high means that 35.95% of Stepan’s risk can be explained by the market risk. This also
means that 64.05% of Stepan’s risk is firm specific. Computing these regressions also
gave us lower and upper bounds for beta, which were 0.70 and 2.70. We can say that
we are 95% confident that the true value of beta is between 0.70 and 2.70. Just to make
sure our beta was reasonable, we compared the beta we computed with the beta posted
on Yahoo! and Google’s websites. Yahoo’s estimated beta for Stepan was 1.49 and
Google’s estimated beta was 1.13, which are both still within our lower and upper bounds.
The difference in our calculated betas could be due to the fact that we used different
data and therefore giving us different betas.
After gathering all the different components of the cost of equity equation, we
were able to compute Ke. Using the two-factor CAPM equation, the cost of equity came
out to be 15.72%. As stated before, the cost of equity is the rate of return required by
investors so an estimated 15.72% Ke means that investors are expecting a 15.72% return
from their investment in Stepan. We also computed the limits of cost of equity using the
Ke lower bound and Ke upper bound. With these limits, we are able to say that with 95%
confidence the true value of cost of equity is between 8.70% and 22.75%.
Backdoor Cost of Equity
The backdoor cost of equity is another way to determine a company’s cost of
equity. This formula combines the market view with our view of Stepan. The equation for
the backdoor cost of equity is:
(P/B) - 1 = (ROE - Ke)/(Ke - g)
The P/B in the above equation represents the current price-to-book ratio, the ROE
is the firm’s return on equity that we forecasted, the Ke is the backdoor cost of equity,
and the g
is the firm’s sales growth that we also forecasted. We gathered these numbers and
plugged them into the backdoor cost of equity equation as shown below:
2.45 - 1 = (.1415 - Ke)/(Ke - 0.085)
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Ke = 10.81%
After computing the calculations, the backdoor cost of equity came out to be
10.81%. The cost of equity using the CAPM equation was 15.72% so there’s a 4.91%
difference. We decided to use the Ke from the CAPM equation for the WACC calculations
because the backdoor cost of equity was also within the 95% confidence interval of
8.70% to 22.75%.
Weighted Average Cost of Capital
The weighted average cost of capital is “the overall cost of capital for all funding
sources in a company” (Strategiccfo). Companies raise money from three sources, equity,
debt, and preferred stock, and the total cost of capital is “defined as the weighted average
of each of these costs” (Strategiccfo). For purposes of this valuation, we will compute
WACC using the cost of debt and equity. We decided to use the CAPM cost of equity
versus backdoor cost of equity because The following formula is used when calculating
WACC:
WACCBT (Weighted Average Cost of Capital Before-Tax) = ((MVD/MVF) *Kd)
+ ((MVE/MVF) *Ke)
WACCAT (Weighted Average Cost of Capital After-Tax) =
((MVD/MVF)*Kd*(1-T)) + ((MVE/MVF) * Ke)
Where:
Kd= cost of debt
Ke= cost of equity
T= effective tax rate
MVD= market value of debt (liabilities)
MVE=market value of equity
MVF= market value of the firm
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To find market value of equity we used Yahoo Finance to find Stepan’s market
cap. The market value of debt was found when we calculated the cost of debt. The market
value of liabilities is $326.842 million and the market value of equity (according to Yahoo
Finance-market cap) is $1.55 Billion. Adding the market value of equity and debt you get
the market value of the firm which is about $1.88 Billion. We calculated WACC using the
weighted average cost of debt and equity found in the previous section. We calculated
WACC using the upper and lower bound measures found when we conducted several
regression analyses. We also used Stepan’s most recent 10-K to find the effective tax rate
so we could calculate the after-tax weighted average cost of capital.
Figure 7.4: After-Tax Weighted Average Cost of Capital
Figure 7.5: After-Tax Weighted Average Cost of Capital LB
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Figure 7.6: After-Tax Weighted Average Cost of Capital UB
Conclusion
In conclusion, we can assume that weighted average cost of capital falls in
between 7.97% and 19.57% on a before-tax basis. When taking taxes into account, the
WACC can be expected to fall in between 5.89% and 14.46%. The WACC is an important
value in allowing us to determine what types of investment decisions to make, as well as
what kind of borrowing, or capital structure, decisions that Stepan can make in order to
maximize the wealth of its shareholders.
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Valuation Models
Introduction
We will now use intrinsic valuation models and method of comparables model to
determine if Stepan Company is overvalued, undervalued, or fairly valued. The
observation date is November 1, 2016 and the closing price on October 31, 2016 were
$71.03 per share. The earnings per share were $3.87 and the shares outstanding were
22.4 million. These are the components we will use to drive the models and value Stepan.
Method of Comparables
The method of comparables is used to calculate the value of a firm using inputs
such as earnings per share, dividends, and free cash flows. In this valuation, we chose
to weight the multiple by the probability of its accuracy. This is due to some of the
multiples being outliers, thus it did not make sense to weight them the same as the
other multiples. We will now compute and analyze the ratios that make up the method
of comparables.
Price to Earnings (P/E) Trailing and Forecast
The P/E trailing valuation method measures a firm’s price and earnings to calculate
the value of a firm. In this method, we used the published P/E (Yahoo Finance), and
calculated the industry’s average P/E trailing . Olin was excluded from this calculation
because` it was negative. We multiplied this average by the earnings per share to get
Stepan’s price per share. Using this method of valuation, we found that the estimated
price per share is $75.41.
The P/E forecast uses the same calculations as the P/E trailing. These methods
differ in that Mineral Technologies was not included, but Olin was included. The ending
estimated price is $64.03. Our findings for both trailing and forecast are displayed in
Figures 7.7 and 7.8.
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Figure 7.7: P/E Trailing
P/E Valuation (Trailing)
Market Approach:
Stepan 20.01
Olin N/A
Innospec 16.13
Minerals 22.84
Industry Average of P/E 19.49
Industry Average multiplied by EPS 75.41
Figure 7.8: P/E Forward
P/E Valuation (forward)
Market Approach:
Stepan 18.03
Olin 18.63
Innospec 14.46
Minerals N/A
Industry Average of P/E 16.55
Industry Average multiplied by EPS 64.03
Price to Book
The price to book ratio is calculated by dividing price per share by book value per
share. This ratio allows us to see the correlation between the book value of equity and
the market value per share. Olin was an outlier with unusually low values for the specialty
chemicals industry and was not used in this method. The resulting price per share using
this method is $67.8. Figure 7.9 displays our findings for the price to book ratio. Based
on this method, Stepan is overvalued.
Figure 7.9: P/B Valuation
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P/B Valuation P/B ratio Shares outstanding/BVE Price per share
Stepan 2.72 24.93
Olin 1.73 14.64 25.32
Innospec 2.2 25.24 55.53
Minerals 2.54 26.85 68.19
Industry Average of P/B 2.37 26.04 61.72
Stepan price per share 67.80
Dividend to Price
The dividend to price ratio is the dividends per share divided by the price per share.
We used the dividend yield published by Yahoo Finance to derive the specialty chemicals
industry average dividend yield. We multiplied a time adjustment factor by the industry
average in order to get the value back to November 1, 2016. The industry average is
1.72%, meaning 1.72% of the price per share is comprised of dividends. After finding
the industry average dividend yield, we divided the dividends per share for Stepan by
the industry average dividend yield to find the price per share. Figure 8.0 shows the
price per share of $42 under this method.
Figure 8.0: D/P Valuation
D/P Valuation Time adjustment value
Stepan 1.04% 1.143 1.19%
Olin 3.15% 1.185 3.73%
Innospec 1.03% 1.104 1.14%
Minerals 0.25% 1.143 0.29%
Industry Average of D/P 1.48% 1.14 1.72%
Industry Average*by Stepan dividends paid per share 42.48
Using this method, Stepan would be overvalued because the calculated price per
share of $42 being less than the actual price per share of $71.03. The P/B ratio is above
2, thus we believe that Stepan is a growth company. Investors typically do not buy the
stock of growth companies for dividends. With this information we decided to give less
weight to the dividends to price valuation.
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Enterprise Value to EBITDA
Enterprise value to EBITDA is found by dividing the enterprise value by the
EBITDA. This ratio was given to us on Yahoo Finance and EBITDA is also given. We used
this information to calculate an industry average for the ratio, but excluded Olin from this
calculation. We then took the industry average and multiplied that by Stepan’s EBITDA/
shares outstanding, this resulted in the price per share totaling $98.61. Figure 8.1 displays
our results. According to this method, Stepan would be undervalued.
Figure 8.1: Enterprise Value/EBITDA
Enterprise Value/ EBITDA Ratio EBITDA
Stepan 8.9 210.07
Olin 9.27 818.20
Innospec 10.83 130.70
Minerals 10.20 343.40
Industry Average of EV/EBITDA 10.52 237.05
Stepan's EBITDA/ Shares outstanding 9.38Times Industry Average 98.61
Price to Earnings Growth (P.E.G.)
The P.E.G. ratio is given on Yahoo Finance. Although it is given, we must work
backwards to find the price of Stepan. While calculating the P.E.G. we came across an
inconsistency. We calculated that the P.E.G for Stepan to be 1.14, but Yahoo Finance
published it to be 0.96. The growth factor was found to be 18% using the forecasted
earnings, we multiplied 18% by 100 to adjust the growth rate.
Figure 8.2: Price to Earnings Growth
P.E.G (price/earnings)/growth P.E.G P.E.G* Growth Rate
Stepan 0.96 19.89
Olin 0.83
Innospec 1.38
Minerals N/A
Industry Average of P.E.G 1.11
Industry Average multiplied by EPS 76.97
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Minerals Technologies was excluded from the industry average because their P.E.G
was negative. The industry average P.E.G. was found to be 1.11. We used the industry
average and multiplied it by the adjusted growth rate of 18, which equaled 19.89. Then
we took 19.89 and multiplied it by 3.87, to find the price per share for Stepan. This
resulted in a price of $76.97 per share. Based on this method, Stepan is undervalued.
Price to EBITDA
The price to EBITDA is found by dividing the market cap by EBITDA. The EBITDA
published on Yahoo Finance and we took the company's market caps on our observation
day of October 31. We divided by the market by the EBITDA to find the ratio. Olin was
an outlier in this method because they had an abnormally high EBITDA for the specialty
chemicals industry. We calculated an industry average of 8.85 and multiplied that by our
earnings per share. This resulted in a price per share of $34.23 for Stepan. Based on this
method, Stepan is overvalued.
Figure 8.2: Price to EBITDA
P/EBITDA (un-levered measure) EBITDA Market Cap Market Cap/EBITDA
Stepan 210.07 1591.07 7.57
Olin 818.20 3626.02 4.43
Innospec 130.70 1426.81 10.92
Minerals 343.40 2326.34 6.77
Industry Average of P/EBITDA 430.77 1876.57 8.85
Industry Average multiplied by EPS 34.23
Price to Free Cash Flow per share
Price to free cash flow per share is found by dividing the market cap by the free
cash flows. That result is then multiplied by an industry average to price per share. When
calculating the industry average, we again did not include Olin because they have a
negative free cash flow. The resulting earnings per share for Stepan was $51.10,
therefore, based on this model Stepan is overvalued.
Figure 8.3: Price to Free Cash Flow
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P/(FCF per share) FCF (millions) Market Cap Market Cap / FCF
Stepan 177.42 1591.072 8.97
Olin N/A N/A N/A
Innospec 118.70 1426.81 12.02
Minerals 161.70 2326.338 14.39
Industr Average of P/(FCF per share) 140.20 1876.57 13.20
Industry Average multiplied by EPS 51.10
Conclusion
Figure 8.4: Methods of Comparables Overview
Comparable Price at 11/1/2016 Should Sell For Value WeightTrailing P/E $71.03 $75.41 fairvalued 16.50%Forward P/E $71.03 $64.03 fairvalued 11.00%Price/Book $71.03 $67.80 fairvalued 16.50%Dividend/Price $71.03 $42.48 undervalued 6.00%Enterprice Value/EBITDA $71.03 $98.61 overvalued 11.00%P.E.G $71.03 $76.97 fairvalued 16.50%Price/EBITDA $71.03 $34.23 undervalued 6.00%Price/Free Cash Flow $71.03 $51.10 undervalued 16.50%Overall $71.03 $67.25 fairvalued 100.00%
Methods of Comparables
Upper 10%: 78.13Fair Value: 71.03Lower 10%: 63.93
Figure 8.4 shows the price per share for each method in the method of
comparables. We weighted each method by what we believe would give us the most
accurate price per share. The most accurate ratios received a weight of 16.5%, middle
accuracy of 11% and the least accurate 6%. We chose to weight the dividend/price
method at 6% because we believe that Stepan is a growth firm, and stockholders do not
purchase Stepan for the dividends. Price/EBITDA was also weighted 6% because this
ratio calculates the price per share based on EBITDA, which does not include factors to
value a company.
We did this to get an overall price per share for the model utilizing a weighted
average of all of the methods. The price per share given from the model is $67.26, based
on our observation price, this is fairly valued. However, we believe that this model is not
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a reliable way to value Stepan because there is a lot of potential for error and noise built
into this model as it involves multiple methods.
Intrinsic Valuation Models In this section we will be using several intrinsic valuation models to determine the
value of Stepan. Under this method, “the value of an asset is estimated based upon its
estimated (forecasted) cash flows, growth potential and risk” (Intrinsic Value). We will
use the forecasted cash flows, growth and risk that we calculated in the financial analysis
section. For the following models we used a Ke of 15.72%.
Ke= Risk free rate+Size premium+(MRP * Beta)
Ke = 2.02% + 1.8% + (7 * 1.7)
Ke=15.72%
Discounted Dividends Model
The discounted dividends model values the price of a stock by discounting
forecasted dividends to obtain a present value. This valuation model has limitations. It is
sensitive to the perpetuity growth rate and cost of equity. This model will not work for
firms that have not paid dividends. We will use the dividends we forecasted for Stepan in
the forecasted statement of cash flows. The perpetuity will start in year 11 and will be
determined in today’s dollars. Using this model, the stock price is estimated to be $6.90.
Stepan’s observed stock price of 71.03 is overvalued under the discounted dividends
model. Figure 8.5 displays our calculations of the discounted dividends model.
Figure 8.5: Discounted Dividends Model
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Growth Rates0.25% 0.50% 0.75% 1% 1.25%
Lower 10.46% 10.46 10.59 10.72 10.85 1112.85% 8.47 8.54 8.61 8.68 8.76
Ke 15.72% 6.9 6.94 6.9 7.02 7.0617.59% 6.17 6.2 6.22 6.25 6.28
Upper 18.94% 5.74 5.75 5.78 5.8 5.82
Upper 10% 78.13Fair Value 71.03Lower 10% 63.93
Discounted Free Cash Flow Model
The discounted free cash flow model is a valuation method that utilizes forecasted
cash flows to determine the value of a company’s stock price. In order to determine value
using this model, we will forecast free cash flows back to the present. We used forecasts
over 10 years with a perpetuity starting in year 11. We discounted the forecasts to value
it in today’s dollars. Stepan’s stock price per share is $41.14 based on this model. This
tells us that Stepan’s observed stock price of $71.03 is overvalued. Figure 8.6 shows our
findings for the discounted free cash flow model.
Figure 8.6: Discounted Free Cash Flow Model
1% 2% 3% 4% 5%Lower bound 5.89% 99.09 123.77 165.53 251.49 530.62
8.03% 54.69 63.91 76.79 96.08 128.08WACC(AT) 10.17% 31.21 35.56 41.14 48.52 58.75
12.32% 16.65 18.99 21.84 25.37 29.86Upper bound 14.46% 6.83 8.20 9.81 11.73 14.06
Growth Rates
Upper 10% 78.13Fair Value 71.03Lower 10% 63.93
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Residual Income Model
The residual income model analyzes the differences between what the company
should earn in order to compensate shareholders for their risk and what the company’s
actual earnings in the period are. This model has the most explanatory power compared
to other intrinsic valuation models because it is less sensitive to forecast errors. This
model is more favorable because it takes into account the current status of a firm, and
net income is easier to forecast than dividends and free cash flow. The inputs needed for
this valuation are forecasted net income, forecasted dividends, and the cost of equity.
We will take 10 years of forecasting and start a perpetuity at year 11 and discount it all
back to today’s dollars. Figure 8.7 shows Stepan’s pricer per share is estimated to be
$32.02 under this model. Based on the residual income model, Stepan is overvalued.
Figure 8.7: Residual Income Model
-10% -20% -30% -40% -50%10.46% 44.07 42.29 41.39 40.85 40.4912.85% 37.85 37 36.55 36.27 36.08
Ke 15.72% 32.45 32.18 32.02 31.92 31.8617.59% 29.79 29.71 29.66 29.63 29.618.94% 28.22 28.21 28.2 28.2 28.2
Decaying Growht Rates
Upper 10% 78.13Fair Value 71.03Lower 10% 63.93
Long-Run Return on Equity Residual Income Model
The long-run ROE residual income model is similar to the residual income model.
The inputs needed to run this model are book value of equity, forecasted long-run ROE,
cost of equity, and decay rates. We will conduct three sensitivity analyses holding ROE,
growth, and cost of equity constant in separate scenarios. Isolating these factors will
allow us to see how each affects Stepan’s value. We calculated a long-run REO of 16%
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to use in the model. Figures 8.8A, 8.8B, and 8.8C provide our findings when each factor
is held constant.
Figure 8.8A: Constant Decay Rate
Ke10.46% 12.85% 15.72% 17.59% 18.94%
0.14 29.24 26.18 23.26 21.68 20.67 0.15 30.46 27.27 24.23 22.59 21.53
ROE 0.16 31.68 28.36 25.20 23.49 22.40 0.17 32.90 29.46 26.17 24.39 23.26 0.18 34.11 30.55 27.14 25.30 24.12
When holding the decay rate constant, Stepan’s price per share is $25.20.
Figure 8.8B: Constant ROE
Ke10.46% 12.85% 15.72% 17.59% 18.94%
-10% 31.68 28.36 25.20 23.49 22.40 -20% 29.46 27.32 25.12 23.87 23.05
g -30% 28.34 26.76 25.08 24.09 23.43 -40% 27.66 26.41 25.05 24.24 23.68 -50% 27.21 26.18 25.03 24.34 23.86
When holding ROE constant, the price per share for Stepan is $25.28.
Figure 8.8C: Constant Cost of Equity
ROE14% 15% 16% 17% 18%
-10% 23.26 24.23 25.20 26.17 27.14 -20% 23.73 24.43 25.12 25.82 26.52
g -30% 23.99 24.54 25.08 25.63 26.17 -40% 24.16 24.61 25.05 25.50 25.95 -50% 24.28 24.65 25.03 25.41 25.79
When holding cost of equity constant, the price per share is $25.08.
Upper 10% 78.13Fair Value 71.03Lower 10% 63.93
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Abnormal Earnings Growth
The Abnormal Earnings Growth (AEG) is a valuation model that measures the
current worth of a firm plus the present value of its growth opportunities. This model is
based on the residual income model and differs in that it includes the abnormal earnings
growth perpetuity. To make sure we derived the correct values, we used the values we
found in the residual income model for comparison. This model has less error than the
residual income model because it takes into account the growth factor and it can be
checked with the residual income model to make sure the values found are correct. After
computing this model and checking it with the residual income model check values, we
noticed that the last value did not match with the check values. We believe this could
most likely be due to a forecasting error. Figure 8.9 shows the AEG model with a price
per share estimated to be $31.51. According to this model, Stepan is overvalued.
Figure 8.9: Abnormal Earnings Growth Model
-10% -20% -30% -40% -50%10.46% 39.25 42.48 44.11 45.09 45.7512.85% 39.23 39.26 39.28 39.29 39.3
Ke 15.72% 31.17 31.39 31.51 31.58 31.6517.59% 27.61 27.86 28.01 28.11 28.1818.94% 25.59 25.85 26.01 26.11 26.18
Decaying Growth Rates
Upper 10% 78.13Fair Value 71.03Lower 10% 63.93
Conclusion
The discounted dividend, discounted free cash flow, residual income, long-run REO
residual income, and abnormal earnings growth models are the intrinsic valuation models
that we used to value Stepan. All of these intrinsic valuation models resulted in Stepan
being overvalued. We believe that these models are more accurate than the method of
comparables because they have less noise, and include the necessary information needed
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to value a company. The intrinsic valuation models are what we will use to base our
analyst recommendation on.
Analyst Recommendation In order to determine the overall value of Stepan, we took into consideration all
of our findings from the industry analysis, accounting analysis, financial analysis, and
valuation models. In our final recommendation, we did not include the method of
comparables to determine Stepan’s value. We looked at the intrinsic valuation models
and decided to put more weight on the residual income, the AEG and the long-run ROE
residual income models. We put less weight on the models that included dividends and
cash flows. Based on our calculations and analysis, we have concluded that Stepan is
overvalued. Our final recommendation is to sell Stepan Company because it is overvalued.
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Appendix
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1-year Treasury Bond
132
133
2-year Treasury Bond
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135
7-year Treasury Bond
136
137
10-year Treasury Bond
138
139
140
20-year Treasury Bond
141
142
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Discounted Dividends Model
Free Cash Flow
Year 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025DPS (Dividends Per Share) 0.73 0.77 0.81 0.85 0.89 0.93 0.97 1.01 1.05 1.09 1.13
PV Factor 0.841 0.707 0.594 0.500 0.420 0.353 0.297 0.250 0.210PV YBY Dividends in 12/31/2015 0.647 0.573 0.505 0.445 0.391 0.343 0.300 0.262 0.229
Total PV YBY Dividends (12/31/2015) 3.69 Growth RatesTerminal Value of Perpetuity 1.27 0.25% 0.50% 0.75% 1% 1.25% 6.046Model Price (12/31/2015) 4.96 Lower 10.46% 10.46 10.59 10.72 10.85 11Time Consistent Price FV factor 1.16 12.85% 8.47 8.54 8.61 8.68 8.76Time Consistent Model Price (11/1/2016) 5.74 Ke 15.72% 6.9 6.94 6.9 7.02 7.06
17.59% 6.17 6.2 6.22 6.25 6.28Observed Share Price (11/1/2016) $71.03 Upper 18.94% 5.74 5.75 5.78 5.8 5.82Initial Cost of Equity (You Derive) 18.94%Perpetuity Growth Rate (g) 0.25% Upper 10% 78.13
Fair Value 71.03Lower 10% 63.93
WACC BT 14.89% Kd 4.48% Ke 15.72%Free Cash Flow Valuation:
0 1 2 3 4 5 6 7 8 9 10 Perpetuity2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026
Cash Flow From Operations (Millions) 183.27 177.83 173.87 223.78 267.70 217.54 234.40 247.41 263.88 285.26 313.07-129.46 -135.93 -142.73 -133.50 -125.67 -131.96 -135.47 -133.68 -131.60 -135.67
FCF Firm's Assets 48.37 37.94 81.05 134.20 91.87 102.44 111.94 130.21 153.66 177.40PV Factor (WACC or Ke?) 0.874 0.763 0.667 0.583 0.509 0.445 0.389 0.339 0.297 0.259PV YBY Free Cash Flows 42.26 28.96 54.05 78.19 46.76 45.56 43.49 44.20 45.57 45.96Percent Growth -22% 114% 66% -32% 12% 9% 16% 18% 15%Total PV YBY FCF 475.00 58%FCF Perp 341.49 42% 1318.01Market Value of Assets (12/31/2015) 816.49 100%Book Value Debt & Preferred Stock (Millions) 680.01 1% 2% 3% 4% 5%Market Value of Equity 136.48 Lower bou 5.89% 99.09 123.77 165.53 251.49 530.62divide by Shares to Get PPS at 12/31 22.36 8.03% 54.69 63.91 76.79 96.08 128.08 Upper 10% 78.13Model Price per Share on 12/31/2015 6.10 WACC(AT) 10.17% 31.21 35.56 41.14 48.52 58.75 Fair Value 71.03Time consistent Price (11/1/2016) 6.83 12.32% 16.65 18.99 21.84 25.37 29.86 Lower 10% 63.93Observed Share Price (11/1/2016) $71.03 Upper bou 14.46% 6.83 8.20 9.81 11.73 14.06
WACC(AT) 14.46%Perp Growth Rate 1%
Cash Flow From Investing Activities (CAPEX)
Growth Rates
144
Residual Income Valuation Model
Percent Change in Residual Income -3672.73% -47.06% -31.90% 511.75% -1.71% -8.73% -7.85% -5.47% -5.47%PV Factor 0.886 0.785 0.696 0.617 0.546 0.484 0.429 0.380 0.337 0.299YBY PV RI (0.66) 20.81 9.76 5.89 31.94 27.82 22.50 18.37 15.39 12.89Annual Raw Changes in Residual Income 27.25 (12.47) (4.48) 48.90 (1.00) (5.01) (4.12) (2.64) (2.50)Book Value Equity (Millions) 558.38 72.84%Total PV of YBY RI 151.83 19.81%Terminal Value Perpetuity 56.42 7.36% 189.00MVE 11/1/2016 766.63 100.00% -10% -20% -30% -40% -50%divide by shares 22.4 10.46% 44.07 42.29 41.39 40.85 40.49Model Price on 34.22 12.85% 37.85 37 36.55 36.27 36.08Time consistent Price 37.85 Ke 15.72% 32.45 32.18 32.02 31.92 31.86
17.59% 29.79 29.71 29.66 29.63 29.6Observed Share Price (11/1/2016) $71.03 18.94% 28.22 28.21 28.2 28.2 28.2Initial Cost of Equity (You Derive) 12.85%Perpetuity Growth Rate (g) -10% Upper 10% 78.13
Fair Value 71.03Lower 10% 63.93
Decaying Growht Rates
145
Long-run ROE Residual Income Model
Book Value of Equity (in Millions) 558.38Long Run ROE 16%Ke 15.72% Upper 10% 78.13Decay Rates -10% -20% -30% -40% -50% Fair Value 71.03Ke 10.46% 12.85% 15.72% 17.59% 18.94% Lower 10% 63.93MVE=BVE+((BVE(ROElr-Ke))/(Ke-g))/shares outstanding
Ke10.46% 12.85% 15.72% 17.59% 18.94%
0.14 29.24 26.18 23.26 21.68 20.67 0.15 30.46 27.27 24.23 22.59 21.53
ROE 0.16 31.68 28.36 25.20 23.49 22.40 0.17 32.90 29.46 26.17 24.39 23.26 0.18 34.11 30.55 27.14 25.30 24.12
Ke10.46% 12.85% 15.72% 17.59% 18.94%
-10% 31.68 28.36 25.20 23.49 22.40 -20% 29.46 27.32 25.12 23.87 23.05
g -30% 28.34 26.76 25.08 24.09 23.43 -40% 27.66 26.41 25.05 24.24 23.68 -50% 27.21 26.18 25.03 24.34 23.86
ROE14% 15% 16% 17% 18%
-10% 23.26 24.23 25.20 26.17 27.14 -20% 23.73 24.43 25.12 25.82 26.52
g -30% 23.99 24.54 25.08 25.63 26.17 -40% 24.16 24.61 25.05 25.50 25.95 -50% 24.28 24.65 25.03 25.41 25.79
Growth is constant
ROE is constant
Ke is constant
146
AEG Model
WACC(AT) 0.1017 Kd 0.0448 Ke 0.1572
0 1 2 3 4 5 6 7 8 9 10 112015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026
Net Income (Millions) 75.97 71.01 86.63 82.44 65.21 102.16 110.08 116.19 123.92 133.96 147.02Total Dividends (Millions) 163 161.48 22.18 181.69 158.22 32.761 23.512 23.992 25.214 26.537 27.94Dividends Reinvested at Ke% (Drip) 20.75 2.85 23.35 20.33 4.21 3.02 3.08 3.24 3.41Cum-Dividend Earnings 107.38 85.29 88.56 122.49 114.29 119.21 127.00 137.20 150.43Normal Earnings 80.13 97.76 93.03 73.59 115.29 124.23 131.12 139.84 151.17Abnormal Earning Growth (AEG) 27.25 (12.47) (4.48) 48.90 (1.00) (5.01) (4.12) (2.64) (0.74) (0.21) Annual percent change in raw AEG -145.77% ##### -1192.44% -102.04% 402.52% -17.88% -35.79% -71.98%PV Factor 0.79 0.70 0.62 0.55 0.48 0.43 0.38 0.34 0.30PV of AEG 21.39 -8.68 -2.76 26.72 -0.48 -2.15 -1.57 -0.89 -0.22Residual Income Check Figure 27.25 (12.47) (4.48) 48.90 (1.00) (5.01) (4.12) (2.64) (2.50)
Core Net Income 71.01Total PV of AEG 31.36Continuing (Terminal) Value (0.91) PV of Terminal Value -0.27Total PV of AEG -10% -20% -30% -40% -50%Total Average Net Income Perp (t+1) 102.10 10.46% 39.25 42.48 44.11 45.09 45.75Divide by shares to Get Average EPS Perp 4.56 12.85% 39.23 39.26 39.28 39.29 39.3Capitalization Rate (perpetuity) 12.85% Ke 15.72% 31.17 31.39 31.51 31.58 31.65
17.59% 27.61 27.86 28.01 28.11 28.18Intrinsic Value Per Share (11/1/2016) 35.47 18.94% 25.59 25.85 26.01 26.11 26.18time consistent implied price 11/1/201 39.23November 1, 2016 observed price $71.03Ke 12.85% Upper 10% 78.13growth (-10 to -50) -10% Fair Value 71.03
Lower 10% 63.93
Decaying Growth Rates