Business Valuation Of Colgate-Palmolive Company: Residual Earnings And Discounted Cash Flow Methods

Part A: Ex-post Valuation

Colgate- Palmolive company was established in the year 1806 by William Colgate. It operates its business in consumer goods industry. The headquarter of the company is situated on Park Avenue in the Midtown Manhattan, New York City (Colgate- Palmolive Company., 2022). The company specializes in the production and distribution of household, personal care, health care and the veterinary products. The company has been in competition with Procter & Gamble, which is the largest soap and detergent maker all over the world. It operates its business in more than 200 countries with more than 50,000 employees all over the world. It is a multinational American company that manufactures diversified products including personal and dental care products, household and commercial cleaning products and pet foods in the United States. The products offered by the company are trusted by the customers for their families and homes all around the globe.

The company operates in two different segments, namely, Oral, Personal and Home Care and Pet Nutrition. Under the Oral, Personal and Home Care, the company engages in offering toothbrushes, toothpaste, bar and liquid hand soaps, mouthwash, conditioners, shampoos, shower gels, antiperspirants and deodorants, dishwashing detergents, skin health products, household cleaners, fabric conditioners and other similar items. It also includes pharmaceutical products for health professionals and dentists (Amani, Vorobei and Razumova 2018). The Pet Nutrition segment of the company engages in offering everyday products for nutritional needs under the Hill’s Science Diet Brand and the range of products to manage the disease condition in cats and dogs. The company sell its product under this segment through pet veterinarians, supply retailers and eCommerce retailers.

The business valuation of an entity provides the management with the numerous facts and figures pertaining to the actual value or worth of the company.            

The main advantage of ex-post intrinsic value of equity is that it is not contaminated by the stock markets fixation on the reported earnings. The ex-post valuation implies the usage of past performance for determining the value of the company. It is ascertained by considering the beginning and the ending value of the asset, the growth and the decline of the asset. and any earned income. It is in contrast with the ex-ante method of valuation, which uses the forecast for determining the future value of the company. It is the standard practice that relies on the proven results instead of forecast for arriving at the figures. The two business valuation techniques that are used for evaluating are Residual Earnings valuation and the Discounted Cash Flow method.

Business Valuation refers to the process of determining the economic value of the firm. There are several methods that can be used to determine the value of the firm. However, there is no single method of valuation that is accepted in generally (Fazzini 2018). Different types of business valuation techniques include the dividend discount model, residual earnings valuation, discounted cash flow model and so on (Coulon 2021). The intrinsic value derived from these methods are used to make investment decisions by the investors.

Business Valuation

The residual earnings method also known as the residual income method, is widely used by the financial analysts to determine the value of the company’s stock (Fernandez 2019). The residual income of the company is derived after accounting for the firm’s cost of capital. This method of valuation is similar to that of the dividend discount method, substituting the future dividend payments with the residual earnings (Budagaga 2020). One of the major advantages of using this method of valuation is that the data required for the valuation is readily available on the firm’s financial statements. the residual income refers to the income generated by the firm after accounting for the equity cost of capital of the firm. It is to be noted that the company only accounts for the cost of debt in the interest expense and the cost of equity is ignored (Pinto 2020). Therefore, while determining the residual income, the cost of equity is multiplied with the book value of equity to obtain the equity charge for the company. In order to determine the residual income of the firm, it is important to calculated the cost of equity (Kaszas and Janda 2018). It may be calculated using the CAPM model. The equity charge is then subtracted to determine the value of residual income. Under residual earning valuation method, the intrinsic value of the firm is calculated by adding the present book value and the present value of future residual earnings (Petkov and Patev 2020). The cost of equity is the most important driver in the residual income valuation.

The cost of equity of the Colgate – Palmolive Company is calculated using the Capital Asset Pricing Model. The risk-free rate for the company is assumed to be 2.473%, which represents the 10-year US treasury bonds. The beta of the company is assumed to be 0.61 for Colgate-Palmolive (Yahoo Finance, 2022). The average market annual returns is taken as 10% representing the S&P 500 Index average. The cost of equity for the firm using CAPM is calculated as 7.06%, which is used to determine the equity charge for the firm.

Figure 1 US Treasury Yield Source: CNBC 2022

The intrinsic value of the firm using the residual earning model is calculated as $71,841,821,006. The equity value per share is calculated as $57.66, whereas the historical share performance shows that the market price of company’s share was $59.52 at the end of the year 2018. This indicates that the company’s stock was overvalued to a larger extent.

The discounted cash flow method of business valuation accounts for the time value of money concept which states that the value of the company decreases with the increase in time (Espinoza et al. 2018).  The current value of money is more than the same amount of money in future. The DCF valuation is based on the forecast of unlevered free cash flow which is discounted back to obtain the present value of the firm. The cash flow represents the cash generated by the business to distribute it to the investors or reinvested into the business. The Unlevered free cash flow represents the cash that is available to both equity and debt investors (Pinto, Robinson and Stowe 2019). Cash reflects the economic value; it means that the firm may have a positive net income but a negative cash flow. It is the cash which is valued most by the investors, instead of accounting profit. The cash flow obtained from the accounting profit are discounted to obtain the present value of the future cash flows. The WACC is often used as a discounting factor or hurdle rate for arriving at the present value of FCF.

Residual Earnings Valuation Model

For determining the economic value of Colgate-Palmolive using the Discounting Cash Flow Model of valuation. The actual figures of 2019 and 2020 are taken as the forecasted figures. This is done to understand the validation of two different valuation techniques. The unlevered FCF are discounted at the rate of 6.53% (WACC) to obtain the present value of the future cash flows. The terminal value of the cash flows is determined using the EBITDA Multiple Approach. The sensitivity analysis is also presented to show the impact on the changes in inputs within the model such as EBITDA multiple and the cost of capital (Burgess 2021).

Using the EBITDA Multiple approach in DCF valuation method, the enterprise value of the firm is calculated as $83,056 million, with the equity value of $83,782. The equity value per share of the company was $57.16, according to the DCF valuation model. Using the Perpetual Growth approach, the equity value per share is calculated as $52.06.

The two methods used for determining the value of the company’s equity are residual earnings model and the discounted cash flow model. The equity market value per share using the residual earnings model shows the equity per share value to be $57.66 whereas the actual market price of company’s share at the end of the year 2018 was $59.29. The enterprise value of the firm using the residual earnings is closure to the actual market value of the share. The enterprise value using the residual earnings model is calculated using the following formula:

Enterprise Value = Book value of equity + PV of future Residual Income

The valuation using the discounted future cash flow method gives the more accurate value than the residual earnings method. The actual free cash flows of the firm for 2019 and 2020 is used to determine the enterprise value of the firm. For the period of less than 5 years, the terminal value of the company comprises the 50% of the total net present value. Due to this reason, the EBITDA multiple approach is used to determine the terminal value. Through the use of EBITDA Multiple of 20 times, the market share price of the company at the end of the year 2018 is calculated as $57.16, which is also nearer to the actual market price of $59.29 as on Dec 31, 2018 (Yahoo Finance, 2022).

Under the discounted cash flow method, the perpetuity growth may also be used to determine the terminal value of the firm. It is assumed that the perpetuity growth rate for the company will be 3% for the calculation of equity value. Using the perpetuity growth rate, the equity value per share is calculated as $52.06. Overall, the discounted cash flow method gives more accurate figures for the ex-post valuation of business.

The residual earning model is best suited for those entities who do not pay dividend or generate positive free cash flow. The DCF model is the best method for the stocks that don’t generate dividends but still generate the free cash flow. The DCF valuation method has an advantage over the residual income valuation as it returns the closest to the stock market value. The DCF valuation method is most theoretically correct than any other form of valuation techniques because of its preciseness. One of the greatest disadvantages of the DCF valuation method is that it is very sensitive to the changes in the assumptions. However, in case of ex-post validation, the forecast of cash flows is taken from existing figures of the financial statements. It is for this reason that the DCF gives the most accurate valuation of the company.

Discounted Cash Flow Method

Among the two techniques utilized for determining the ex-post value of the firm as of 2018 was Residual Earnings model as it provide most accurate value per share of the company. However, this assertion is limited to the extent as the valuation under DCF model is based on assumptions with respect to the growth rate of perpetuity to determine the terminal values of the firm. The approach adopted for determining which method of valuation is limited to certain extent due to the following reasons. Firstly, the valuation of terminal value is based on assumptions with respective to the perpetuity growth rate and EBITDA Multiple. Secondly, the valuation of company’s equity using DCF is highly sensitive to the changes in the value of growth rate and EBITDA multiple. Thus, the Residual Earnings is considered to be more powerful over cash flows while determining the ex-post intrinsic value of the firm. This assertion is supported by FASB that the accrual-based earnings are superior than the cash flows for investors in ex-post intrinsic values.

The credit risk analysis refers to the analysis of the ability of potential buyers to pay their debt using the financial ratios. The credit analysis is usually performed to understand the credit worthiness of the company. It refers to the failure of the issuers to meet the debt obligations in the form of interest and exposing the investors with the potential loss arising from the investment (Cui et al. 2018). The chosen company for analyzing the creditworthiness of the corporate borrowers is Colgate-Palmolive Company.

There are several ratios used by the analysts for determining the profitability, solvency, efficiency and liquidity ratios to determine the financial performance of the company. The four ratios that are chosen for evaluating the short-term solvency, long-term solvency, and the profitability ratios include: 1) Current ratio; 2) Operating Profit Ratio; 3) Debt-to-asset ratio; and 4) interest coverage ratio. Each of these ratios will help in understanding the creditworthiness of the Colgate – Palmolive Company. The financial ratios are calculated for the period starting from 2018 to 2020. The discussion and interpretation with respect to each of the ratio is as follows:

Current ratio is one of the most important liquidity ratios, which shows the short-term solvency position of the company. It is calculated by dividing the total current assets of the firm by the total current liabilities. The current ratio of the firm indicates its ability to repay the short-term obligations using the most current assets owned by the firm (Shama and Gurunathan 2022). The current ratio of 1 indicates that the current asset equals to total short-term liabilities of the company. The current ratio of more than 1 is considered to be good as the company would be in a position to repay its current liabilities using the current assets of the firm (Nuryani and Sunarsi 2020). The current ratio of the company is calculated as 1.14 for the year 2018, which is reduced to 1.03 during 2019 and further reduced to 0.99 in the year 2020. This shows that the company’s current asset was not enough to repay the current liabilities of the company. The current ratio of the firm keeps on deteriorating during the period of evaluation. The Colgate-Palmolive company should focus on improving its liquidity position by delaying any capital purchase and/or selling any capital assets that do not generate profits for the firm.

Comparison of both the valuation techniques for ex-post validation

In addition, the company should also focus on increasing the sales revenue, which might lead to inflow of cash and helps the business to bring stability in its liquidity position. From The perspective of the lender, the short-term solvency position of the company is poor as the business would not be able to repay its short-term liabilities using the current assets of the firm. The creditworthiness of the company for short-term loans is less as the current ratio is declining from the last three years of operation.

The operating profit margin is one of the profitability ratios which is used to understand the profitability position of the company. The operating profit is also known as earning before interest and taxes. This ratio is calculated by dividing the operating profit by the net sales revenue of the firm. This ratio indicates how much profit a company makes after accounting for the variable costs and other administrative costs (Capasso, Gianfrate and Spinelli 2020). The operating profit refers to the profit before any interest or tax expenses are recorded. It shows the efficiency of the company in increasing the sales revenue and reducing the operational expenses of the firm. it is expressed in the percentage of the sales revenue generated by the firm during the period. The Operating profit of the firm is calculated as 23.76%, 22.65% and 23.59% for the year 2018, 2019 and 2020 respectively. The company’s operating profit ratio remains stable around 23% throughout the evaluation period. However, it was reduced by a slight margin in 2019 and then increased by almost 15 in the next year. Overall, the operating profit margin of the firm remains stable during the period from 2018 to 2020.

It is one type of leverage ratios that is used to evaluate the long-term solvency position of the firm. It is calculated by dividing the total debt by the total assets owned by the firm. The total debt of the firm includes the short-term debt as well as the long-term debt. This ratio is often used by the credit analysts to check whether the company’s total assets is sufficient to pay the debt obligations of the firm (Husna and Satria 2019). In worst scenario, if the company are forced to shut down, this ratio is to determine whether the company would be in a position to clear its debt by selling its assets. If this ratio is greater than 1, it means that the company’s total debt is higher than the total assets, which means it is too risky to grant credit to the firm. In contrast, when this ratio is less than 1, it shows that the company would be able to repay its debt by selling the assets, if the company fails. The total debt of Colgate – Palmolive company is calculated by adding the Notes and loan payable, current portion of long-term debt and long-term debt.

The debt to asset ratio of the company is calculated as 52.35%, 52.20% and 47.74% for the year 2018, 2019 and 2020 respectively. This means that the company’s long-term solvency position is improving as the company’s debt is reducing in comparison with the total assets owned by the firm. The debt to asset ratio of 47.74% in 2020 shows that 47.74% of the company’s asset is financed through debt. The debt-to-asset ratio of Colgate – Palmolive company is favorable for the investor to grant loans to the firm. Interest Coverage Ratio

The interest coverage ratio shows the ability of the company to pay the interest on the amount of capital borrowed. It is one of the most important ratios for the lenders as it indicates that whether the company will be able to pay the interest expense through the profits in the coming years. It is calculated by dividing the EBITDA by the interest expense of the firm. This ratio is also known as Time-Interest-Earned ratio.

The interest coverage ratio for Colgate- Palmolive company is calculated as 29.41, 28.09, and 26.98 for the year 2018, 2019 and 2020 respectively. The higher interest coverage ratio shows better financial health of the company as the company would be capable to meet the interest obligations of the firm. The interest coverage ratio of the company is deteriorating from 2018 to 2020. However, the ratio of 26.98 is considered to be very good and the company would be able to pay its interest obligations very easily.

Conclusion

From the above discussion and analysis, it has been observed that the DCF model is superior over any form of valuation techniques, while determining the firm’s value at certain period of time when the forecasted proforma’s are used in valuation. However, in ex-post valuation, the residual earnings valuation has superiority over the cash flow model of valuation. This outcome is in accordance with the assertion of FASB that the abnormal earnings are superior over cash flows for determining the ex-post intrinsic value of the firm. The analysis carried out in Part A of the report suggest that the residual earnings valuation is better as it gives the more accurate value of the company’s stock. From the analysis conducted in Part B of the report, it can be deduced that the liquidity position of the company is deteriorating; profitability position is stable; long-term solvency position is improving while the interest coverage ratio is deteriorating. However, the company is in a position to pay its interest obligations easily. Overall, the credit risk analysis reveals that the company would be in position to clear its debt and pay the interest obligations in future.

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