Best Buy Equity Valuation and Analysis Valued at 1 November, 2006

Transcription

1 Best Buy Equity Valuation and Analysis Valued at 1 November, 2006 M.B.P. Analysts Richard Arce: [email protected] Chris Ashcraft: [email protected] Davies Crasta: [email protected] Kyle Lang: [email protected] Brandon Reyes: [email protected] Ryan Roskey: [email protected]

2 Table of Contents Executive Summary..2 Business & Industry Analysis..6 Accounting Analysis 17 Ratio Analysis & Forecast Financials 32 Valuation Analysis 60 Appendices Appendix 1.75 Appendix 2.76 Appendix 3.77 Appendix 4.82 Appendix 5.87 Appendix 6.95 Appendix 7.96 Appendix Appendix References

3 Executive Summary Investment Recommendation: Overvalued, Sell 11/1/06 BBY NYSE $ week range $ Revenue (2005) $30,848,000,000 Market Capitalization $25.5 Bil Shares Outstanding 492,000,000 Dividend Yield.9% 3-month Avg Daily Trading Volume 1,186,500 Percent Institutional Ownership 90.29% Book Value Per Share (mrq) $2.84 ROE 24.30% ROA 10.85% Est. 5 year EPS Growth Rate 11.30% Cost of Capital Est. R2 Beta Ke Ke Estimated 12.46% 5-year % 1-Year % 10-Year % 3-month % Published 1.04 Kd BBY: 5.16% Revised: 5.20% WACC BBY: 10.64% Revised: 10.80% Altman Z-Score BBY: 3.70 Revised: 2.99 EPS Forecast FYE 10/1 2005(A) 2006(E) 2007(E) 2008(E) EPS Ratio Comparison BBY CC RSH Trailing P/E Forward P/E M/B Valuation Estimates Actual Price (as of 11/1/06) $54.02 Ratio Based Valuations P/E Trailing $25.89 P/E Forward $18.07 Enterprise Value $18.95 M/B $4.87 Intrinsic Valuations Actual Revised Discounted Dividends $31.90 $17.98 Free Cash Flows $4.58 $2.41 Residual Income $22.41 $16.97 LR ROE ($3.66) ($5.30) Abnormal Earnings Growth $25.76 $

4 Recommendation Overvalued Firm Company, Industry Overview and Analysis Best Buy is the industry leader in sales, and online sales for the consumer electronics industry. Best Buy originally started as, Sound of Music inc. in 1966, however in 1983 they changed their name to Best Buy. As electronics sales have increased consistently over the years, the consumer electronics industry has benefited which also directly rewarded Best Buy. The other key players in the industry are Circuit City and RadioShack. Wal-Mart directly affects the consumer electronics industry because of their size, and their ability to undercut prices and have a steady supply of products on hand at all times of the year. We note that Wal Mart does have a strong influence over the number of sales for the three major competitors and the prices at which their products are sold. Creating a competitive advantage in this industry is clearly derived from the application of the cost leadership strategy which means tight cost control systems, and low costs exerted on research and development. Best Buy is currently utilizing a strategy in which they are trying to differentiate themselves from the rest of the industry using the customer end-to-end service and customer centricity. Accounting Analysis: A company s 10-k report that is released at the end of each fiscal year exhibits vital information about the company which can be used in the valuation process. The 10-K contains the balance sheet, the income statement, and the statement of cash flows; all these statements are analyzed through the use of screening ratios which test the consistency and transparency of the reporting. Besides the ratios, a thorough reading through the 10-K, should disclose clearly the operations of the company, upcoming projects, and any other binding contracts which could result in material gains or losses for the company. Upon completing computation of the screening ratios, we noticed many inconsistencies. Upon completing a thorough reading of the 10-K s for five years we all concluded that their quality of disclosure and transparency are terrible. Another section of the accounting analysis is looking for potential distortions in their 3

5 accounting methods. While studying the 10-K we found a $1.5 billion off-balance sheet transaction, which is created by Best Buy leasing a majority of their stores for periods ranging from years. However, they classify the leases as an operating lease instead of a capital lease. Including this $1.5 billion in our analysis creates two separate sets of forecast financials one with the $1.5 billion and one with what Best Buy discloses. When seeking information about specific aspects of the company, the structure within the 10-K creates a great amount of confusion unambiguously leading towards a poor quality of disclosure. Any individual lacking a background in finance would be unable to obtain necessary information in a timely manner, due to the lack of inconsistent structure. Financial Ratio Analysis: Financial ratio analysis consists of ratios subdivided into three categories: liquidity, profitability, and capital structure ratios. These ratios are helpful in determining the standing of the company in different areas when compared to their major competitors. There are seven liquidity ratios, which when evaluated as a group determines a company s financial standing and their ability to pay back current debts. These ratios are indicative of the health of the cash to cash cycle by way of inventory turnover, day s supply of inventory, receivables collection and day s sales outstanding. Profitability ratios take a look at another area of the company. When computed correctly, these ratios inform one about the historical profitability of a company, using the numbers derived directly from their balance sheets and income statements. Capital structure ratios take a look into the balance sheet, defining the financing used to acquire assets. We first look into the credit risk of the company with the debt to equity ratio determining their ability to repay interest and debt requirements. Forecasting financials for a consumer electronics retailer can prove to be challenging due to the nature of the industry s continuously changing nature of sales and cost structures. There are many assumptions made in trying to predict the various lines in financial statements; these assumptions were not held steady for the entire 10 years of forecasts. There are fluctuations based on the continuous changing nature of 4

6 the industry. When looking at our forecasts you will notice two sets of financials, created because of the inadequate accounting procedure applied for their leased buildings. Intrinsic valuations Fundamental to every intrinsic valuation model are the Weighted Average Cost of Capital (WACC), cost of equity, cost of debt, and a growth rate. Cost of equity and WACC have to be calculated by way of regressions and simple weighted averages for cost of debt. There are five different valuation models: discounted dividends, residual income, long run return on equity, free cash flow, and abnormal earnings growth. Each of the different intrinsic valuation methods has a varying degree of explanatory power when dealing with the stock price. Discounted dividends model has an explanatory power of up to ten percent; free cash flows 5-40 percent, AEG percent, RI percent. The valuation models were run twice, once with Best Buy s numbers and a revised set of numbers that included the $1.5 Billion accounting distortion. These two sets of valuations netted the following results: Discounted Dividends, Best Buy: $4.58, Revised: $2.41; Free Cash Flows, Best Buy: $31.90, Revised: $17.98; Residual Income, Best Buy: $22.41, Revised: $16.97; Long Run ROE, Best Buy: -$3.66, Revised: -$5.30; and Abnormal Earnings Growth, Best Buy: $25.76, Revised: $ The Altman Z- score is used to determine the credit worthiness of a company. A score of 1.8 or below makes you a high credit risk, while a score of 2.67 or above establishes you as a credit worthy company. Without accounting for the distortion, in 2005 Best Buy had a Z-score of 3.70, while with the revised accounting procedures the Z-score rose to

7 Business & Industry Analysis Company Overview Best Buy has been in business since 1966 when they began as Sound of Music Inc., and changed their name to Best Buy in They are a specialty retailer of consumer electronics, home-office products, entertainment software, appliances and related services. This industry is a large and rapidly growing industry which neared sales of $100 billion in Best Buy stores are located in forty nine states and five Canadian provinces. The company also operates approximately 941 retail stores internationally in Best Buy has opened at least 60 stores per year in the United States since 2001 while closing only one. This shows that the company has been growing consistently to meet the demands of its growing customer base. A major factor driving Best Buy s growth recently has been the sales of flat panel televisions. Due to the fact that retailers in this industry sell similar products it creates price wars forcing Best Buy to become a cost leader to further growth. An integral differentiator for Best Buy from its competitors is the firm s commitment to superior customer service. Best Buy s twenty largest suppliers provide over one half of the products sold in the store, so the loss of one of these suppliers would be a major setback to revenues. Consumer electronics products provide the largest percentage of the firm s revenue followed closely by home office products in the United States. Looking at Best Buy s international segment, a majority of their sales comes from consumer electronics products which provide over 95% of the firm s international revenue Assets Sales Stock Price *assets and sales in millions 6

8 Five Forces Model Rivalry Among Existing Firms In most industries, especially highly competitive ones, rivalry among existing firms is a key component in the firm s ability to create revenue. If rivalry is especially intense this will continually decrease profit margins. Industry Growth The growth of the industry shows how a firm can gain market share. With a strong growth industry firms are not forced to take others market share in order to grow. Best Buy is currently in a steady growth industry. Although the industry is becoming more competitive, the demand for such products like high end TVs is expected to grow as much as 36% from last year s sales, according to the Consumer Electronics Association. The industry which is cyclical can be heavily influenced by consumer spending but demand for consumer electronics continues to grow. Although Best Buy will be able to capture some growth from the increase in demand, most of the growth that Best Buy could experience will come from competing on customer service. This includes installation and support through Geek Squad, store placement and environment, product selection, financing, and low pricing models. The consumer electronics industry will continually grow at a fairly high rate. Concentration and Balance of Competitors Concentration and balance of competitors determines the amount of price competition in an industry. The industry is saturated with superstores such as Circuit City, Radio Shack, and even Wal-Mart. Best Buy has to compete on a value pricing model in order to continue its growth trend. Customers will look among competitors for the lowest priced product and buy from whoever has the best deal. In order to build store loyalty Best Buy is implementing a customer service model by offering services such as computer repair and home theater installation. Wal-Mart has become a competitor by selling HDTV sets at bargain prices but they do not offer the end-to-end services that Best Buy offers. Concentration of competitors is also growing because of 7

9 internet retailers. Although Best Buy has a brick and mortar website, competitors such as Amazon.com are able to offer the same products close to the same price. With all these competitors we conclude that the concentration on the market is moderately high. Best Buy is in a highly competitive market therefore driving firms into price competition. Degree of Differentiation and Switching Cost The level of product differentiation in an industry determines the consumer ability or willingness to switch between firms. In the Electronic Retail industry there is very little product differentiation among competitors. Most retailers sell the same brands and models which cause the companies to compete on pricing. This allows switching cost to be very low allowing consumers to shop on the basis of price. In order to differentiate between its competitors Best Buy tries to provide customer services, quality store locations and layout, and knowledgeable staff in order to create the effect of high switching cost. Also Best Buy is converting many of its stores to the customer centricity model. Best Buy classifies the individual stores major demographic and adjust products and services accordingly to cater to that store s major demographic. This industry consists of very little product differentiation which allows the customer to switch retailers solely on the basis of price. Ratio of Fixed to Variable Costs The ratio of fixed to variable cost has an effect on a firm s product pricing. Best Buy stores are financed though 20-year off-balance sheet operating leases. Domestically Best Buy has over 750 retail stores and over 6,000,000 square feet of warehouse space. In order to survive, players in the industry must turn over large amounts of products for fixed cost to cover variable cost. Best Buy is the leader in being able to utilize its fixed cost by turning over its inventory two times more a year than it closet competitor, Circuit City. 8

10 Exit Barriers and Excess Capacity There are large exit barriers related to the electronic retail industry. This allows companies such as Best Buy the ability to squeeze competition out of the market. There are few direct competitors in the industry; because of this many have large economies of scale. This puts small players at a disadvantage because they are not able to obtain prices larger firms receive from suppliers. There are so many retail stores between Best Buy and its competitors that it creates more supply than demand. This increases the exit barriers based upon the difficulty of being able to use resources in other enterprises. In order to overcome this Best Buy most follow a value pricing model and provide superior customer service. In the retail electronics industry exit barriers and excess capacity are high. Threat of New Entrants Economies of Scale Economies of scale are important in determining business strategy when entering a new industry. In an industry that has high economies of scale a new entrant must utilize a large amount of capital to try to compete with established firms. In order to compete in the electronic retail industry you must have the power to bargain with suppliers. In order to sell large quantities of product a company must posses large amounts of assets in their retail store space. This makes it difficult to enter in on the market and compete at the same price level as Best Buy and Circuit City. The majority of long term assets listed on Best Buy s balance sheet are accumulated in the Property, Plant, and Equipment section. Another restriction on new entrants is brand recognition. Customer services such as Geek Squad and Magnolia Home Theaters can be associated with the Best Buy brand. Even if a new entrant was able to compete on prices it might also be stretched to offer the services that Best Buy can. The only facet that makes it easy to enter into the market is the internet. This allows sellers to avoid investing in costly retail locations which in turn allows for competitive pricing. The only drawback is that customers cannot see the tangible product and compare them to other 9

11 working models. The combination of cost of assets and offering tangible services cause the economies of scale to be moderate. First Mover Advantage In an industry driven by low price competition it is extremely hard to generate a first mover advantage. Best Buy is currently trying to create a first mover advantage by converting many of their home theater departments into the Magnolia Home Theater Store. By doing this they are creating a way for customers to receive a complete home theater set up through Best Buy. This includes such services as high definition comparisons to actually installing your home theater. Other services they are the first to offer are computer repair services known as Geek Squad. Circuit City is still in the process of trying to create services that would compete with these two examples. Although customer service will increase customer switching cost most of the industry growth comes from low prices. Because of this the threat of first mover advantage is a low risk. Access to Channels of Distribution and Relationships It is absolutely necessary to keep your cost low by becoming efficient in your operations. In an industry that is driven by price there is a necessity of creating efficient distribution between suppliers, warehouse, stores, and ultimately customers. It is difficult to create a relationship where the manufacturer s of products that will effectively fulfill inventory orders and keep prices extremely low. You must have large economy of scale thus creating a difficult environment for new entrants to enter the market. Best Buy is able to gain channels by having a large contract with many of the manufacturer s to place products throughout all of Best Buy stores. Also in order to continue good relationships with manufacturers Best Buy will guarantee certain product shelf placement and product highlighting in Best Buy advertisement. 10

12 Legal Barriers In the retailing industry companies do not have many legal barriers that prohibit them from entering the market. The only barriers that exist when selling electronic products are insurance and liability cost of having consumers inside a retail location. Legal barriers such as patents or licensing regulations do not exist. Thus the lack of legal barriers creates a high risk of entrants into the market. Threat of Substitute Products The electronic retail industry is one that competes on basis of price. Best Buy and all of its competitors carry the same brands with vary little differentiation in product line. The consumer is willing to substitute their electronics based on price. Even if the consumer is loyal to a certain brand, more than likely, that consumer can shop between competitors to find the best price. In order for Best Buy to keep customers from substituting products they must offer superior services along with their products. Best Buy is able to do this by offering such services as Geek Squad and end-to-end home theater solutions from the Magnolia store brand. Jim Muehlbauer, Senior VP of Finance, commented about this in Best Buy s conference call on 9/12/06. Our differentiation strategy hinges on the successful interactions of employees with customers, and we are not cutting back on that relationship. The important part of the customer experience is our ability to offer end-to-end solutions, which is why we continue to invest in services. The threat of substitute products in the industry is relatively high. Without retailers offering superior services and knowledgeable staff customers are willing to substitute products. Bargaining Power of Buyers Electronic retailers compete heavily on price. Best Buy is the largest electronic retailer which allows a strong position in bargaining with its suppliers to keep its prices down. It must do this in order to compete with the high price sensitivity and moderate bargaining power of its buyers. Customers in this industry shop around for the best price possible. This also increases the bargaining power of the buyer because switching 11

13 cost is low and the availability of alternative products is high. One thing that keeps buyer bargaining power moderate is that there is no single buyer with a large percentage of sales. If Best Buy loses one customer it will not hurt the bottom line. In order to combat price sensitivity and product switching Best Buy offers a large array of price and quality within every category of product it sells. Also Best Buy continually strives to make its service and warranties an intangible benefit that will decrease the bargaining power of its buyers. The factors we considered keep the bargaining power of buyers a low threat. Bargaining Power of Suppliers In order to stay competitive in the electronic industry, companies must be able to receive low prices from there suppliers. The inability to do so will cause a loss in customers, based on their price sensitivity. Since Best Buy is the largest electronics retailer it has power over the suppliers to provide products at a competitive price. If the suppliers were not able to gain an order from Best Buy then the supplier s bottom line would be adversely affected. Even though this is true customers come to expect a certain product brand name, image, or quality. This gives suppliers an edge in bargaining power because consumers do recognize quality with a certain brand. In order for Best Buy to receive the benefits of both price and quality it must sustain a favorable relationship with its suppliers. We conclude that the threat of supplier s bargaining power is moderate. Competitive Advantage Analysis Classifying Industry The Consumer Electronics and Appliance Retail Industry have become increasingly competitive over the last few years. Best Buy leads the industry in sales over the last year followed by Wal-Mart, Circuit City, Dell, and Radio Shack. While Best Buy has been in a pricing war with its competitors, its stated goal is to differentiate itself from its competition by treating each customer as a unique individual, meeting their needs with end-to-end solutions, and engaging and energizing our employees to 12

14 serve them, while maximizing overall profitability. By looking at numerous competitors and evaluating the differences in approaches, we will be able to evaluate the firm more accurately. We will look into the way industries managers choose to approach the continuous changes in the market place and see if Best Buy stays ahead of the field or lag behind competitors in innovation. Key Success Factors Best Buy has historically adapted well to changes in technology and the market place. The store first began as an audio components retailer with the introduction of the videocassette recorder in the early 1980 s, and expanded into video products. This expansionary attitude has been apparent throughout its history. Today the company continues to expand into new territories. In 2003 they acquired Geek Squad, Inc. to provide residential and commercial computer support services, as well as give its customers technical support services. In 1989, we dramatically changed our method of retailing by introducing a self-service, noncommissioned, discount-style store concept designed to give the customer more control over the purchasing process. ( K pg.6) Best Buy started to differentiate itself from its competitors in 2005 by focusing on a five part plan that is based on Customer Centricity. The first part of this differentiation model is based on opening and converting stores to the customer centricity store model. These stores now account for 40% of all stores. Second, Best Buy has expanded its customer service by adding the Geek Squad and bringing its home theater installation back after being outsourced. The third piece is expanding individualized marketing through its Reward Zone program that has now reached seven million members. The Reward Zone program allows Best Buy to track the purchasing patterns of its most loyal customers. The fourth part of the plan involves reducing employee turnover which leads to an increase in customer service. The final piece of the five part plan is to improve their information technology systems and to supply chains over the next three years. Circuit City is a main competitor of Best Buy and has also gone through many changes over the years. Circuit City is an older company that has gone through similar 13

15 changes as Best Buy. They too do not have commissioned employees. One difference in the stores that can be seen from the financials is their main focus. Best Buy focuses on the in-store experiences with video-games you can play, and displays offering demonstrations of products. Circuit City has changed it strategy to the Internet to give its customers an easier way of buying products on-line but without waiting for it. Prior to the 2005 Christmas season they created the 24/24 pickup guarantee. This allows customers to shop for products at home and drive to the store and pick it up. On-line customers no longer have to wait for their products to be shipped. Best Buy into the Future Over the next year Best Buy will continue to try to differentiate itself from the competition through several means. They plan on opening up approximately 90 new stores which would bring their national total to 832 stores, considerably more than Circuit City s 626 locations. They also plan on expanding operations internationally. Best Buy currently operates both Future Shop and Best Buy stores in Canada and is looking to begin opening stores in China this year. They will also be looking to improve productivity and would like to enhance their ability to completely solve their customers problems. Growth Sustainability Sustaining a competitive advantage in a fast growing industry will become difficult. As a firm leader in the consumer electronics industry, Best Buy has over the past 15 years remained the innovative industry leader in customer service, inventory systems, and suppliers. To continue to capture growth Best Buy purchased Magnolia Hi-Fi retail stores in By offering primarily high end consumer electronics Best Buy has helped itself stay a leader in the consumer electronics industry. In 2002 when the industry was lagging, due to the economic recession in the United States, Best Buy s management focused on controlling debt and interest costs, by locking in interest rates on their loans. Continuing their growth as an international leader, Best Buy acquired part of Canadian consumer-electronic giant, Future-shop. Also with the addition of 14

16 Geek Squad it will allow Best Buy to continue their differentiation strategy by providing a full range of computer repair services. After careful inspection of a subsidiary, Musicland, management in 2002, decided to sell this branch of the company due to lagging sales and unmet objectives at time of acquisition. Musicland which is a retail store located in malls across the United States, sells music CD s, DVD s and other entertainment products. Growth with number of stores has been a significant aspect of Best Buy staying a leader in this particular industry. Solely in the past five years Best Buy has opened over 320 stores, all with the end-to-end management focus, which entails total customer satisfaction, and customer centricity. This growth in number of stores shows Best Buy its ability to grow and stay the leader in the industry with sales volumes, number of stores, and customer satisfaction. As mentioned earlier, being in an industry that primarily competes on cost, staying a leader needs innovation in various aspects of the business. For Best Buy, this innovation comes not only through international and national acquisitions, but from the floor of their stores. From 2002 onward, much of managements focus was to create an environment for the customers that will differentiate its self from other competitors. This model management aptly titled, Customer Centricity Strategy, revolves around complete customer satisfaction. Customer centricity has as much of a focus on the customers as it does on the employees that provide services for the customer. Part of customer centricity strategy was focused on restructuring and reengineering floor employees pay scales and training. Having emphasized the necessity and the significance of having satisfied customers, Best Buy focused on training even floor employees, and this paid off in the 2005 fiscal year, which saw a reduction of 15% in employee turnover. The acquisition of Geek Squad and an outsourcing company that installed home theater systems was also an application of the customer centricity strategy. Best Buy is opening a new corporate global sourcing office in Shanghai, China, which focuses on finding private-label suppliers and other manufacturers who produce goods cheaper than American manufacturers. Increasing efficiency through a growing number of distribution centers all around the country is another way Best Buy is 15

17 increasing efficiency and decreasing cost, helping maintain a competitive advantage, especially over Circuit City. There are no contracts that exist with Best Buy and their major suppliers. However Best Buy has disclosed in their financial statements consistently that they foresee no problems with supply disruptions from their major suppliers. Their major suppliers are companies such as: Gateway, Hewlett-Packard, Sony, Toshiba, and Panasonic, none of which are locked in with a contract. Part of their sustained advantage that has lasted for this period, and will continue is related to their bargaining power. Best Buy has invested an extraordinary amount in creating brand loyalty, and brand recognition. In doing so, large and small suppliers alike continue to want a presence in Best Buy stores. With a reengineering in line for upcoming years, that includes updating inventory systems, logistics and information technology systems within the company, Best Buy is locking their position as not only a national leader, but a global leader, in the consumer electronics industry. 16

18 Accounting Analysis Key Accounting Policies: A goal of accounting policy analysis is to see if the firm s accounting practices capture, current and prospective financial actions of the company. Best Buy is in the consumer electronic retail industry, which necessitates growth in number of stores, cost effectiveness, and enhanced Customer Centricity (end-to-end customer service). Success factors that are accounted for by Best Buy include; advertising/marketing expense, employee training (due to their emphasis on customer centricity), sustaining low costs through finding low cost suppliers and keeping the current low cost suppliers, and expanding their number of stores. Estimates are used by Best Buy s management team for; lease holdings (operating leases), buildings, fixtures/equipment, and inventory. Inventory is managed by ways of average cost or lower of cost, which is how another major competitor, Circuit City accounts for inventory. Their inventory account for the past five years has steadied in between $2.8 billion - $2.3 billion, inventory levels, have steadily increased in the past five years, especially due to the drastic increase in technological advancements in the consumer electronics sector. Radio Shack has remained the steadiest with its inventories; the inventories are valued at weighted average cost. Inventory for Five Years Millions $4, $3, $3, $2, $2, $1, $1, $ $ Years Best Buy Circuit City RadioShack 17

19 As the graph above demonstrates, Best Buy in general has the greatest amount of inventory and the amount of inventory continues to grow steadily in comparison to the rest of the industry. Radio Shack seems to have the lowest levels of inventory however they have little to no fluctuation in their carrying amounts. Circuit City s inventory levels have been on a generalized decline. This graph indicates Best Buy is a large company that continues to grow, while its competitors stay steady and continue in the same path. A majority of Best Buy retail stores are leased by way of capital lease. A capital lease is a lease that is considered to have the economic characteristics of an asset. Best Buy conducts majority of their retail and distribution operations from leases locations. (Footnotes 10-k 2005) Terms of the lease generally range from years; most of the leases contain renewal options and escalation leases (Footnotes 10- k 2006) In accounting for these stores as assets, Best Buy incurs the costs of having to pay for such taxes and expenses as: real estate taxes (which vary from state to state), insurance and common area maintenance, these expenses are in addition to rent. Expenses that are incurred due to leasehold improvements are capitalized. In the past 5 years, Best Buy has invested a material amount for lease-hold improvements for many stores, due to age and the new customer-centricity plan that was to be applied at all stores. The straight-line depreciation method is applied for depreciating assets. Inventory is primarily stored at distribution centers, and is delivered to stores when needed, which is recognized through the Best Buy information technology network. 10 Total distribution centers which are not considered satellite (for heavy traffic areas). Of these 10 distribution center six are leased, and four are owned by the Best Buy. In keeping track of inventory, for timely supply for stores, they employ a justin-time inventory system which delivers a sufficient amount of inventory based on sales history of various products. Accounting Flexibility From inventory valuation to characterization of leased assets, Best Buy s management team has a wide variety of choices when it comes to how they disclose 18

20 this information in their financial reports. Managers in most retail companies have a choice as to how they valuate their inventory. Best Buy chooses to use the average cost method instead of LIFO or FIFO. If circumstances arise where they need to lower their expenses, they could switch to a FIFO method to accomplish this, or vice-versa, increase economic expenses so to avoid taxes; they may have the desire to switch to LIFO. Best Buy has reported operating leases in an inadequate manner, due to the possibility that there is an un-necessary flexibility that is available to decrease liabilities. Self-Insured Liabilities, which cover Best Buy from certain losses related to health, workers compensation, and general liability claims is an area that Best Buy uses estimates in. This in turn gives Best Buy yet another area where managers have quite a wide-ranging spectrum when reporting numbers. In the K management had stated, a 10% change in our self-insured liabilities on February 26, 2004 would have affected net earnings by approximately $6,000,000 for fiscal year ended February 26, (10-K 2006) Again, managers have the ability to change their expenses and alter earnings. As visible a $6 million dollar decrease in net revenue, will affect the performance of Best Buy s stock, hence net profit is the bottom line that affects stock performance, and it is clamorous for managers to ensure that insured liability estimates stay low. Musicland was acquired by Best Buy in 2001 and sold in This allowed us to examine their use of goodwill impairments. On March 3, 2002 they adopted SFAS no.142, a new accounting principle allowing firms to determine their own impairments. Upon reevaluation at the end of each year, it is management s discretion and allows them to determine how much goodwill to write off on their own terms, instead of having them use straight line depreciation over a longer period of time, which in most cases would have been inaccurate. When Musicland was sold, they were able to determine the amount of goodwill they could write-off. Also during the time of the sale, managers had other estimating decisions to make. Costs Associated with exit activities include termination of a lease, employee termination benefits, and other moving costs. Musicland was sold for an operating loss $441 million dollars in

21 Operating leases which decrease liability and increase expense, are essential for corporations who have debt covenants to keep. However in the case of Best Buy operating leases which are between years should be capitalized, because those buildings are essentially assets for that period of time. If Best Buy were to capitalize these operating leases, it would create a total liability of $3.4 billion. Circuit City has operating lease obligations of $2.65 billion which is a difference of $750 million. Given the far ranging difference between capital leases and operating leases, Best Buy is exercising aggressive use of accounting standards. Capitalization of Circuit City s Operating Lease Obligations: Operating Leases Capital Leases year 6.03% PV PV 03 $1, $1, $ $ $1, $1, $ $ $1, $1, $ $ $1, $1, $ $ $1, $1, $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $54.30 $11, $2, Actual $11, Check $11, Diff -$0.91 The two charts, above and below, show the capitalization of Best Buy and Circuit City s operating leases. The discount rate, 6.03%, is about the industry standard for consumer electronics retail. Both companies are potentially hiding liabilities of $

22 Billion and $3.37 Billion dollars respectively this would have a great change on their ratio s and earnings statements if they used capital leases instead of operating leases. In the undoing accounting distortion section we will discuss further into detail Best Buy s aggressive discount rate (11%) and its understating of expenses related to operating leases ($1.5B). Capitalization of Best Buy s Operating Lease Obligations: Operating Leases Capital Leases year 6.03% PV PV 03 $3, $2, $ $ $3, $2, $ $ $3, $2, $ $ $1, $ $ $ $1, $ $ $ $1, $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $53.40 $14, $3, Best Buy has been given a good amount of accounting flexibility. All decisions mentioned are accepted and governed to some extent by the FASB and GAAP policies. Each company has the ability to choose how they disclose their information to best fit their company structure. Accounting Strategy Best Buy s two major competitors, Circuit City and Radio Shack, both show similar accounting numbers and practices to that of Best Buy. Circuit City for instance states 21

23 that it differentiates itself from competitors by offering a high level of customer service; offering competitive prices; providing complete product and service assortments; and providing consumers the option of multi-channel shopping. (Circuit City 10-K 2006). Radio Shack also states that Management believes we have three primary factors differentiating us from our competition. First is our extensive physical retail presence...second, our specially trained sales staff... Third is our ability to accelerate the adoption rate of new technologies. (Radio Shack 10-K 2006). The goals of the largest firms in the consumer electronics industry is to become differentiated from one another as the information above shows. This is important because we can now expect all three companies to report accounting items in a similar fashion. The financial statement ratio analysis has lead to an overwhelming conclusion that Best Buy uses aggressive accounting. The industry as a whole uses fairly aggressive accounting practices but Best Buy tends to stretch the bounds of GAAP. An item, which we have to pay special attention to, is pension expense, especially when individual contributions are matched by the company. Taking into consideration that human capital is of great necessity when in the consumer electronics retail industry, it is imperative for a company to keep its employees at all levels satisfied, especially those directly associated with store management and customers. Pension costs can become a significant cost to companies and hence is an area in accounting strategy that will be focused upon. Historically it has been acknowledged that companies do not contribute the necessary amounts of funds at the correct times, this is done in attempt to lower costs and hence increase net income. This leads to increasing expenses in forthcoming years, which necessitates higher pension payments to catch up on lost payments. Again, this creates much room for manipulation for the company on its financial statements, if a large writes down is expected a greater financial write down might be taken. Pension expense across the industry has been fairly standard with increasing amounts from the companies in the consumer electronics retail industry. For Best Buy the pension costs have been increasing steadily since 2001 with a little bit of a large jump from , this shows the company has been making 22

24 Pension Expense 25 Output Circuit City Radio Shack Best Buy Years timely payments in general so there will be no unexpected drastic decreases in revenue at random future time. The graph below displays the cost for Best Buy and its nearest competitors; in general cost has increased steadily for pension expenses. With Radio Shack the payments have been on the lower end, taking into consideration that Radio Shack does not have as many employees within their company in comparison to Best Buy. Quality of Disclosure: Disclosure quality, which entails footnotes and management discussion current activities and the economic future of the company are an important supplement to the 10-K financial statement package. Since management has control over disclosure it is significant to evaluate disclosure in comparison to other major players in the industry. Disclosure should assist with increased transparency and understandability of the financial reports. In an industry that permits itself to aggressive accounting practices one can safely state the Best Buy leads the pack in aggressive accounting. A majority of shareholders do not have a great working knowledge of accounting or accounting vocabulary and hence the management discussion and analysis is not obligated in anyway to disclose in depth accounting practices. A financially/accounting literate individual should consult the 10-k for proper information that is regulated by the SEC instead of the unregulated annual report, which is submitted by the company to 23

25 the stockholders. This report grossly omits the true financial standing of the company, and greatly misrepresents without appropriate information (balance sheet, income statement etc) the well being of the company, to increase investor confidence to continue holding shares in Best Buy. Aggressive accounting practices create a best case scenario which in turn leads to inadequate disclosure. Some practices which we found to be aggressive were; the discount rate used for future operating leases, stock options, consolidating reward zone points into accrued liabilities, improper aggregation of accrued liabilities, and hidden expenses within operating lease valuation. Regarding footnote disclosure, in a general sense the footnotes are acceptable in regards to the information they contain. The industry norm is to explain, in a mediocre manner, in the footnotes what is occurring within the financial statements and other off balance sheet transactions. While the industry norm does not go above and beyond the necessary information it is adequate in helping to identify potential inconsistencies, and hidden transactions. In respect to revealing potential bad news for all aspects of operations, the business norm seems to steer away from reporting or disclosing such damaging news. However Best Buy and the consumer electronics industry in the past five years has maneuvered their way out of any disclosure which may be damaging to the company or companies and their ability to attract a greater number of investors. A major problem we found with Best Buy s accounting was that the Balance Sheet does not balance for any of the past five fiscal years. This is not unusual but the deficits exceeded $500 million and at one point actually topped $1.2 Billion. This makes the valuation of the company exceedingly difficult because it seems as if Best Buy is trying to portray their company in the best possible light given Generally Accepted Accounting Practices. The disclosures of Best Buy are in general inadequate when performing a valuation. Each and every piece of information required for performing a satisfactory valuation is exceedingly difficult to find. It should be noted that as the entire project 24

26 came close to its end we became increasingly unhappy with Best Buy s accounting disclosure. As visible from the information provided above, it is evident that disclosure does help supplement a large sum of information coupled with the financials; this proves to create an environment by the management team to gloss the real financial and economic standing. We find that Best Buy s disclosure is at best marginal, because of this we feel it is only right to hold their poor disclosure against them when our final valuation is complete. Screening Ratio Analysis Radio Shack sales/cash from sales sales/net accounts receivable Sales/inventory Sales/assets cffo/oi cffo/noa Circuit City Sales/cash from sales Sales/net accounts rec Sales/inventory cffo/noa Best Buy Sales/cash from sales sales/net accounts receivable Sales/inventory Sales/assets cffo/oi cffo/noa The following is a discussion of Best Buy, Circuit City and Radio Shacks key financial screening ratios. The Net Sales/Unearned Revenue, Net Sales/Warranty 25

27 Liabilities, Total Accruals/Change in Sales, pension expense/sg&a, other employment expenses/sg&a ratios are left incomplete because of an inadequate amount of information, this information couldn t be found in the companies respective 10-K s Sales/Cash from Sales output year Radio Shack Circuit City Best Buy Sales/Cash from sales ratio may assist one in understanding the actual amount of cash that was collected from sales in comparison to sales. The smaller output number designates that the company collects majority of its sales cash and hence decreases the amount of allowance for doubtful accounts in accounts receivable. Here the industry is pretty tightly packed and shows that Best Buy does a descent job at collecting cash, and have stayed steady over time. Competitors fall short of best buy in this category for the most part. Circuit city has recently improved in the ratio and have even surpassed Best Buy in The ideal ratio would obviously be an even one, indicating you are collecting cash for all of your sales. This would eliminate the risk associated with accounts receivable. 26

28 Sales/Net Accounts Receivable Output Years RadioShack Circuit City Best Buy In case of this ratio, again one would like to have a higher ratio output. When providing goods or services collecting cash is the most secure manner for a business to ensure payment for the goods/services provided. With accounts receivable there is always the excess liability that comes with uncollectible accounts, hence in this case one would prefer a larger output for the ratio. In Best Buy s case in this ratio one can see that they lead the industry in their cash collections from their receivables keeping their receivables low, and decreasing uncollectible liabilities. Sales/Inventory Output Years RadioShack Circuit City Best Buy As visible from this chart again, Best Buy is leading the industry in their ability to move inventory out of their distribution stores. In a technological industry, such as the consumer electronics industry, it is essential that companies be able to move inventory with sales, and manage inventory stocks well. Best Buy seems to have found a median, in which they have sufficient inventory to be the industry leader, yet not carry an excess for it to be a liability or an insufficient amount which would impair sales. 27

29 Sales/Assets Output RadioShack Best Buy Circuit City Year Circuit City and Best Buy remain relatively close in this ratio output, with Radio Shack staying somewhat close. However in this industry the norm is to have operating leases as opposed to capital leases, where items appear as assets. This is a possible explanation for why the industry average is relatively high. Best Buy has a greater number of stores than the other two competitors. This in turn may justify why their sales are higher than the other two competitors. CFFO/NOA Output RadioShack Circuit City Best Buy Year CFFO/NOA is a way to measure the return a company is receiving from its operating assets, in terms of cash flow from operations. Best Buy is not investing a larger amount in operating assets to create a greater cash flow from operating activities. 28

30 CFFO/OI Output RadioShack Best Buy Year This ratio presents the amount of cash flow from operations which in turn are explained by operating income. The lower the output number, the better because it exhibits that more cash flows are coming from direct activities instead of investing for financing activities. The current trend in the industry is toward a decrease in this ratio which means that more of Best Buy s Cash Flows from Operations can be explained by its Operating Income. Potential Red Flags When working on financial valuation of a company, a certain amount of energy and time has to be spent on identifying information within the statements that could lead to a potential pitfall. When reading through and obtaining information from the financial statements, one statement which caught our attention was, Operating lease obligations do not include payments to landlords covering real estate taxes and common area maintenance. These charges, if included, would increase total operating lease obligations by $1.5 Billion, as of February 25, (10-K 2006, pg.43) $1.5 Billion being a material amount can and does affect many parts of the company s statements, including, income, and liabilities, expenses and owners equity. In 2006 Ernst & Young LLC was released by Best Buy from their duties of auditing and Deloitte & Touche were hired as the independent auditors. Discount rates play an enormous role, in providing accurate figures when a present value is given. When dealing with operating leases, Best Buy used a discount rate of about 11% which is almost double the industry standard which hovers around 29

31 6%. This in turn shows a large decrease in their liabilities. The discount rate is determined by historical experience, current trends and other factors, that management believe to be relevant at the time statements are prepared. While conducting our ratio analysis we did not find any outstanding or strange ratios. This has lead the us to believe that any major discrepancies that can be found for these companies come from shaving numbers, increasing their discount rates, and neglecting to place certain liabilities on their balance sheets. Undo Accounting Distortions As was discussed in the Accounting Flexibility Section and above in the Red Flag Section Best Buy used a Discount Rate of 11% for estimating operating leases as capital leases and they did not include $1.5 Billion worth of additional lease expenses. The table below shows Best Buy s capitalized leases after undoing these two accounting distortions. Corrected PV Original PV $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $95.90 $ $ $ $90.45 $ $ $ $85.30 $ $ $ $80.45 $ $ $ $75.88 $ $ $ $71.56 $ $ $ $67.49 $ $ $ $63.65 $ $ $ $60.03 $ $ $ $56.62 $ $ $ $53.40 $5, $3, As can be seen in these tables the adjusted capitalized lease for Best Buy shows a difference of almost $2.5 Billion. This shows that Best Buy s liabilities on the balance sheet are grossly understated. 30

32 After discounting the $1.5 billion and incorporating it into the operating lease obligation, with an appropriate discount rate the difference on a yearly basis, between the stated and the adjusted is substantial. This restatement shows that Best Buy defers a large amount of its lease obligations out into the future. BBY $5, $ $1, $1, $3, Operating Lease Obligation Total <1YR 1-3 YRS 3-5 YRS >5 YRS Adjusted $7, $ $1, $1, $3, Difference ($1,500.00) ($155.66) ($298.60) ($263.18) ($782.56) All Values In Millions Debt to capitalization ratio also did have a significant problem, because of the 11% discount rate used, which decreases debt significantly and also understated capital. Below is a chart which compares the reported and restated values with a discount rate which is 6%, or the industry average. BBY Revised Debt Capitalized Operating Lease Obligation Total Debt Debt Capitalized Operating Lease Obligation Total Stockholder Equity Adjusted Capitalization Adjusted Debt-to-Capitalization Ratio 49% 57% BBY was using an 11% discount rate for 20 years. We revalued the ratio using a 6% discount rate over 20 years. This table shows that there is about an 8% difference in the restated ratios. This restatement indicates just how much a company can play with numbers and remain within GAAP while reducing liabilities and puffing up ratios and assets. 31

33 Ratios Analysis and Forecast Financials Another aspect of a company valuation report entails computing a set of financial ratios and interpreting these ratios and their respective meaning for the standing of a company. Ratios also help create a relatively fair level for comparison between a company and its competitors since the numbers obtained give an industry benchmark. Coupled with ratio analysis, financial forecasting is an educated estimate based on historical information about the future performance of a company. Financial forecasting is primarily done through stating future balance sheets, income statements and statement of cash flows. There are three major categories into which these ratios are divided: liquidity analysis, profitability analysis, and capital structure analysis. These ratios will assist us in creating an industry comparison of Best Buy s strategy and its effectiveness or lack-there-of. Trend (Time Series) Analysis/Cross Sectional Analysis: The first category of ratios we are going to discuss will deal with liquidity. Having computed these ratios for five years, we are going to elaborate on trends and the possibilities that are triggering these trends. Liquidity ratios give a measure of a company s ability to pay back their short term financial obligations; they are also indicators of a firm s ability to generate cash flow. The first ratio that will be discussed is the current ratio. The current ratio is a value that is calculated by dividing current assets by current liabilities; both of these numbers are found on the balance sheet. Current Ratio= current assets/current liabilities Best Buy Circuit City RadioShack When interpreting this current ratio one must realize the output produced by the calculation may be stated as: for each dollar of liabilities, there exists a certain amount of current assets. Current assets are labeled as such because they are easily converted 32

34 to cash if necessary and are made up of accounts receivables, inventory, marketable securities, pre-paid expenses followed by cash and cash equivalents. The higher the current ratio the more liquid a company is, ensuring their ability to meet short term financial obligations when time comes due. A current ratio well above industry standard is a sign of inefficiency, indicating that the assets are not being utilized efficiently. Best Buy s current ratio output shows signs of efficient use of current assets throughout the five years for which they were calculated. This indicates that Best Buy appropriately uses their current assets and they do not have an excess of assets that are not being employed or being turned over. A flaw in calculation of the current ratio is its inclusion of inventory, which usually stays in current assets for a period of 6 weeks, which in turn causes the ratio to increase, showing profligacy which does not portray reality. Best Buy does not have an excess of any of the components which create current assets, which again is indicative of intelligent management core, employing all assets for the benefit of the company. Current Ratio Output Years BBY CC RSH Average Above is a cross sectional analysis graph which shows the industry average, and compares it to Best Buy, Circuit City, and RadioShack. As the chart designates Circuit City has the highest current ratio, which mathematically equates to their current liabilities being much lower than to those of Best Buy. Their current assets are almost as large as those of Best Buy which in-turn creates a high current ratio. This indicates the existence of an excess of current assets that could be utilized more efficiently elsewhere. RadioShack, like Circuit City, consistently stays above the industry average. This again proves that for each dollar of current liabilities they have an excess number 33

35 of current assets, which could be used to provide investment/financing income. Inventory turnover inefficiency is another possibility which could cause a drastic increase in the current assets number. Quick Ratio: cash + accounts receivables + securities/current liabilities Best Buy Circuit City RadioShack Best Buy s quick ratio has been increasing over the past five years which indicates an accumulation of quick assets and a minor decrease in current liabilities. A high quick ratio indicates inefficiency in use of current assets which could be used for other purposes in the business. The chart above shows Best Buy s quick ratio increased $.07 from and $.09 from , an explanation for this modest increase is greater investment in market securities for both years 2004 and 2005 which increases the numerator thus increasing the output. Although current liabilities grew the amount was not as large as the increase in quick assets, which contributed to the increase in the ratio output. Quick Ratio Output Years BBY CC RSH Average The graph above depicts the industry trend and creates a ground for comparison between the industry and Best Buy s performance. As visible from the chart, Circuit City has the highest ratios for each year after This indicates that their current liabilities are escalating faster than their quick assets. Circuit City has a range of $.52 from which increases and decreases. RadioShack, a company with a fair amount of fluctuation in their quick ratio comparison, creates inconsistency and 34

36 unpredictability in their future numbers. With a range of $.41 for their five year trend it is clear that there is a great amount of fluctuation in their levels of both quick assets and their current liabilities. Best Buy maintains a healthy level of quick assets in comparison to their current liabilities, demonstrating relatively healthy management of assets; again proving their ability to stay below the industry average for all five years. Inventory Turnover ratio: Cost of goods sold/inventory Best Buy Circuit City RadioShack Days Supply of inventory: 365/Inventory Turn Over Best Buy Circuit City RadioShack As stated above in the consumer electronics industry (retail sector) the lower the ratio the better. In both ratio outputs, Best Buy sets the industry model with a good turnover ratio which creates a strong day s supply of inventory. Best Buy s ability to use their inventory control systems effectively helps keep inventory costs low, and reduces stuffing especially for inventory. Best Buy s average inventory turnover for the five years is at 7.47; again this number states that the inventory was cleared out and reordered about 7.5 times a year in five years. This number also indicates that Best Buy has strong number of sales throughout the year; obviously the fourth quarter will have a greater number of sales, however there are a steady number of sales throughout the year. Along the same lines Best Buy s days supply of inventory is also is relatively low, except for the 2001 fiscal year, which again was expected because of the hit the U.S. economy took. From there the numbers stayed below that high of about 52 days, yet again indicating efficient inventory management on part of Best Buy. Best Buy also had a trend of increasing inventory level from taking inventory levels from $1.7 Billion to $ 2.8 Billion in five years, which is a substantial increase, however even with 35

37 that strong increase, Best Buy managed to keep their inventory turnover and their days supply of inventory at competitive levels for the retail industry in general. Inventory Turnover Output BBY CC RSH Average Years The graph above shows the number of inventory turnovers per year. Best Buy s numbers for all five years have placed them well above the industry average and their two main competitors for inventory turnover. Circuit City manages to stay above the industry average too, however is not nearly as competitive in their ability to turn inventory over. In comparison Circuit City inventory levels have also grown over the past five years, however they have not had as rapid a growth rate as that of Best Buy. RadioShack, because of their strategy, tends not to even come close to turning inventory as swiftly as the other two competitors. RadioShack tends to have many products that are part of the consumer electronics industry, which might not be available at Circuit City or Best Buy, such as input jacks and add cables. Due to its ability to turnover inventory, one can imply that Best Buy purchases/orders a significant amount of inventory when necessary, this intern creates a certain bargaining power that Best Buy has over it suppliers because of their brand recognition and their presence in the consumer electronics industry. Inventory turnover also has a direct impact on the working capital and the money merry-go-round of a company. The faster inventory is transferred out due to sales the shorter the cash to cash cycle, since money would not be tied up in inventory. 36

38 Days Supply of Inventory Output BBY CC RSH Average Years Best Buy sets the standard in the industry for inventory turnover ratio, which is a measure of how fast or how often they restock their inventory. The day s supply of inventory tells you the number of day s inventory that is ordered stays on hand, until a new batch of inventory is ordered and restocked. The industry average is extracted higher because of RadioShack s DSI which is the highest in the industry. Circuit City has a set of slightly competitive numbers when it comes to DSI in comparison to Best Buy. Again this can be equated to healthy sales on a quarterly basis for Best Buy, in comparison to RadioShack. As mentioned above Best Buy s inventory levels have increased by $1.1 billion over the past five years, and yet they have managed to move their inventory an average of days for the past five years. As stated above if inventory turnover is fast, the days supply of inventory is lower, which indicates their inventory is selling and not being stored inefficiently. A current ratio that is too high is a sign of inefficiency. With most companies you can compare the current ratio and quick ratio to inventory turnover, this comparison will tell you if inventory is the cause of a major variation. If a company is capable of expelling inventory quickly then a current ratio that is higher should not be an excessive concern because inventory is part of current assets, and tends to be a high percentage of current assets. However, if they have a high inventory turnover and a low day s supply of inventory one can be assured during normal economic conditions, those inventories will sell creating profits for the company. 37

39 Receivables Turnover: Sales/Accounts Receivables Best Buy Circuit City RadioShack Days sales outstanding: 365/receivables turnover Best Buy Circuit City RadioShack Much like the inventory turnover and DSI ratios the receivables ratios are a measure of the number of times receivables are collected on yearly basis for the turnover and the DSO (Days Sales Outstanding) is a specific day measure of the number of days receivables are collected. Receivables are a part of the current assets section in the balance sheet of a company which means that they are considered to be relatively liquid. The DSO ratio is more valuable the lower it is which means the company has limited worries for bad debt expense from uncollectible accounts. For inventory turnover Best Buy again is a distant leader, showing that they collect their receivables more often then either of the two competitors. The drastic drop from 2002 to 2003 for receivables turnover for Best Buy is due in large part to uncollected receivables from a subsidiary, Musicland, which was sold that year for a loss of $500 million. Preceding 2003 however Best Buy s receivables turnover has been on the rise, demonstrating their ability to collect receivables quickly. Since there is a direct inverse relationship between receivables turnover and DSO, one can instinctively come to the conclusion that Best Buy will also have the lowest DSO since they have the highest receivables turnover ratio. Again this ratio states that Best Buy collects their receivables on an average of every 4.93 days for the past five years. Since receivables is part of the money merry-go-round this indicates that there is a insignificant amount of time between when the sale is made and when the receivable is collected, which is great for the business because their cash from operations is on hand faster. 38

40 Receviables Turnover Output BBY CC RSH Average Years As an industry the general trend from , was an increase in the receivables turnover with 2005 having decreasing. RadioShack's position is the worst in the industry for receivables turnover. The five year working average for RadioShack when focusing on receivables turnover is a relatively pathetic turns per year. As visible Circuit City had a really weak receivables turnover ratio in 2001, however since the 2001 fiscal year, Circuit City's receivables turnover started climbing up into the 60 times per year, and they have kept it in the 60's for years 2004 and Circuit City caught onto a trend set by Best Buy; they sold their financing division to JP Morgan chase and started collecting their receivables with greater frequency after the sale. This again helps them shorten their cash to cash cycles and keeps the money merry go round stay proficient. This also reduces the liability of bad debt expense. Best Buy again clearly sets the industry benchmark in receivables collection because of the sale of their financing division, which helped them shorten their cash to cash cycles and almost eliminated their bad debt expense. A factor for success is the successful use of assets to create greater operating efficiency. 39

41 Days Sales Outstanding Output BBY CC RSH Average Years Days sales outstanding (DSO) is a measure related to the inventory turnover ratio. The days sales outstanding output lets one know how many times a year the receivables account is collected, it is imperative because cash is very significant to the operation of a business and the sooner you can collect cash and decrease the investment from outside the working capital. As visible from the graph the industry average is on the general in decline, with a little bit of a raise in DSO for RadioShack again, is the industry worst with their DSO, having a DSO that hovers around 21, again indicating that cash is collected approximately about once every 21 days. Circuit City started with a relatively high DSO but managed to decrease their DSO extensively, this was done through a sale of their finance division to Chase bank, which manages their credit card accounts. Hence all sales made on account are collected within 1 week, in comparison to the 2001 fiscal year at which it was about 20 days. Since RadioShack manages its own credit line, it is evident that they are not as efficient as Circuit City or Best Buy in their DSO. As mentioned earlier this entails that their cashto-cash cycle is a significantly larger than those of Best Buy and Circuit City. Best Buy set the example for Circuit City to follow in selling their credit division hence helping their ability to collect receivables sooner. Again the faster a company is capable of collecting receivables the more liquid they are because they have cash coming is sooner. 40

42 Working capital turnover: Sales/ (Current assets current liabilities) Best Buy Circuit City RadioShack As visible from the table above, Best Buy has had a significant decrease since 2001 in working capital turnover. Working capital turnover is a measure of the ability of a dollar of working capital to create sales. A high working capital turnover number is desirable because it is indicative of high sales revenue for every dollar of working capital. Best Buy has the highest ratio in the industry by far, however the number has been decreasing in general since For the year 2005, Best Buy had increased short term liabilities which lead to a decrease in their working capital turnover for that particular year. Even though the ratio from 2001 is low we still found an average for the years from of 18.9 which is a decent standard for Best Buy. The 18.9 ratio illustrates that for each dollar in the working capital there are $18.90 of sales that are created because of it. Working Capital Turnover Output Years BBY CC RSH Average In the graph above there is an obvious outlier, which is Best Buy s Working Capital Turnover for the year The Working Capital Turnover of 71 was a great ratio, but it wasn t duplicated and is considered an outlier. A higher working capital turnover indicates that for a certain amount of working capital there are a certain number of sales that are generated. The industry average throughout the five years is relatively low with a sudden jump of about 2 from , due to an increase in sales for the industry as a whole. Best Buy is by far the most efficient in their use of 41

43 working capital for the generation of sales in the industry. In order for the working capital ratio to increase, the working capital number should decrease (decrease current assets, or increase current liabilities), or the sales number should increase. The industry as a whole has experienced a general increase in sales, as a result of this working capital turnover across the industry has increased. With a new focus and a customer centricity approach to the industry Best Buy has had to increase their investment in current assets which decreased the ratio. Liquidity Analysis Opinion Current Ratio Positive Quick Ratio Positive Inventory Turnover Days Supply of Inventory Steady Neutral Receivable Turnover Slightly Negative Days Supply of Inventory Steady Working Capital Turnover Positive 42

44 PROFITABILITY RATIOS: Gross Profit Margin: Gross Profit/Sales Best Buy 20% 21% 24% 24% 24% Circuit City 24% 25% 24% 23% 25% RadioShack 48% 49% 50% 48% 47% Gross profit margin is a measure of income after taking out the cost of goods sold. The higher the margin, the better because it shows that the company is working at decreasing their cost of goods sold. Best Buy has been staying fairly constant between 20%-24% for the past five years, which indicates that even with increasing price levels they are able to hold their costs of purchasing inventory relatively steady. Since the consumer electronics industry is an industry with high costs associated with inventory and quick depreciation rates for inventory, this number can fluctuate widely because of how quickly inventories may become obsolete. Since about 25%-30% of Best Buy's sales are generated from the home office/small business sales, a majority of these materials are items such as printers, computers and such which do become obsolete relatively quickly. This decreases the sales price which decreases profit percentages and decreases the gross profit margin. Gross Profit Margin Output Years BBY CC RSH Average RadioShack has the highest gross profit margin of the major players in the industry. The five year gross profit margin average for RadioShack is about 48.4% which says that for each dollar of sales 48% of it goes towards the gross profit. Lagging 43

45 behind in a distant second is Circuit City, who averages about 25% gross profit margin for the five year average, which is almost half of RadioShack profit margin. A high gross profit margin exists either due to high number of sales dollar or a relatively low number for cost of goods sold, which is what is subtracted from sales to get gross profit. In case of RadioShack this high profit margin exists because of a lower cost of goods sold account, because of the type of products within the consumer electronics industry that RadioShack sells. Circuit City and Best Buy have a close gross profit margin percentage which is likely because they sell a similar product line of goods, in which there is a high cost of goods sold. Operating expense Margin: operating expense/sales Best Buy 16% 16% 20% 20% 16% Circuit City 23% 23% 23% 23% 24% RadioShack 93% 90% 89% 88% 93% Operating expense margin is a measure of the amount of expense endured when there is a dollar of sale. This number should be a lower number because it shows the company's management is working on controlling costs to increase profits. Typically operating expenses are expenses that can not be associated with running a business but are not applicable directly to the product line of goods and services being offered. Best Buy's operating expense margin held steady for the years at 16% indicating healthy control of costs. However in 2003, 2004 the number increased to 20% indicating a rise in the cost of operations, but in 2005 the number decreased back to This decrease occurred because of a decrease in administrative costs which directly reduces operating expense. Also there have been drastic increases in sales, which is also what occurred from which when the denominator is large the output will be lower. Since sales did increase by around 15% from it is understandable that there was such a strong decrease in the operating expense margin. 44

46 Operating Expense Output BBY CC RSH Average Years The industry as a whole has a relatively high operating expense margin, because of RadioShack, who has the highest margin level. As stated above, the operating expense margin measures the percentage amount of each sales dollar that goes toward operating expenses. RadioShack s five year average is about 91% which is high. This typically proves that their selling, general and administrative costs are too high which directly causes the net income level to be drastically lower. Circuit City and Best Buy have levels which are much lower that that of RadioShack and the industry average. Circuit City s output is a bit higher in comparison to Best Buy s but nonetheless a competitive number indicating, that the management team at Circuit City does a commendable job of controlling costs for the company. Best Buy again leads the industry in the operating expense margin section, the average for the past five years for Best Buy is about 17.7%. Since only 17.7% of each sales dollar for Best Buy is used for covering operating expenses this leaves a larger percentage of revenue to flow down to the net income. The net income is directly affected by a company s operating expense margin, and the lower the margin ratio the higher the net income. Net Profit Margin: Net Income/Sales Best Buy 3% 3%.5% 3% 4% Circuit City 1.6% 2.3%.8% -.9%.6% RadioShack 3% 6% 6% 7% 5% In a competitive consumer electronics industry, Best Buy manages to have a steady percentage for the net profit margin. The consumer electronic industry is very 45

47 competitive and profit margins are low. Best Buy manages to hover at about 3%, a number which states that only $.03 on every sales dollar makes it to Net Income. In 2003 Net Profit Margin was drastically affected by the sale of Musicland; however they did manage to rebound quite well. Net Profit Margin 0.08 Output BBY CC RSH Average Years RadioShack manages to have the highest net profit margin in the industry, however when one looks at their operating margin, which hovers around 91%, it seems to imply that they have no other costs and the other 7%-9% manage to flow through directly to their net income. Circuit City has struggled with keeping a healthy net profit margin, which has been decreasing since 2002 with a slight increase from the years of The negative margin in 2004 was a result of slow sales year for Circuit City, which affected their net income drastically. The whole industry was slower that year however, RadioShack managed to increase their margin. Best Buy manages to remain steady at 3.5% for all three years, with 2003 being an outlier because of the loss incurred from the sale of Musicland. Asset Turnover: Sales/total assets Best Buy Circuit City RadioShack The asset turnover ratio is a measure of the efficiency of asset use in generating sales. Since this is an industry with relatively lower margins the asset turnover number will be lower, the asset base will tend to be a little larger, primarily because of inventory 46

48 and property plant and equipment. For the consumer electronics industry, Best Buy has a sound asset turnover with an average of A number which states that for each dollar of assets the company holds, it generates a return of $2.67 in sales. The cause of the higher number in 2001 was a lower level of assets that Best Buy had kept on hand because of the economic recession of However, after 2002 the number leveled off at about 2.5, indicating a healthy return. The increase in the 2005 number is directly associated with an increase in the current assets section of total assets, Best Buy had transferred from cash to investments in short term marketable securities and also increased inventory levels. The increase in the short term investments account, does not generate sales, however does have returns, which can be seen in the statement of cash flows under the cash flows from investing activities section. Asset Turnover 3.50 Output BBY CC RSH Average Years The industry asset turnover ratio stays relatively close over the five years we compared. Best Buy and Circuit City are the industry leaders, staying very close in their asset turnover, which indicates both of the firms efficiently use their assets to create sales. RadioShack still has a competitive turnover output which falls below the industry standard. This ratio can be changed depending on the level of sales and assets; if the assets are too high and sales are not competitive the turnover output number will be relatively low. If there is a higher sales number with a lower asset number, the turnover number will be high. In the case of this industry the sales are strong and continue to grow from year to year with the asset base also increasing. The increase in assets is not as drastic as sales which hurt the turnover ratio by lowering. The consumer electronics industry is an industry in which balance between assets, sales and 47

49 net income are highly related and so there should be a steady/healthy balance between sales and assets. Return on Assets: Net Income/Total Assets Best Buy 8.18% 7.74% 1.21% Circuit City 4.2% 4.8% 2.1% -2.4% 1.6% RadioShack 7% 12% 13% 13% 12% The return on assets ratios places net income over total assets. Return on assets for Best Buy increased from as a result of an increase in sales and cost controls. This is a respectable output since this is a highly competitive industry with low cost being a part of the strategy. The gross profit margin and operating expense margin outputs are directly associated with the return on assets ratio. If gross profit ratio and operating expense ratios are too high for each dollar of sales there is an excessive amount of costs which in turn decreases net income, and decreases return on assets. Return on Assets 15.00% Year 10.00% 5.00% 0.00% -5.00% Output (%) BBY CC RSH Average RadioShack leads the industry for all five years in their return on assets. Circuit City has been struggling with their return on assets. In 2004 they had a negative return. In 2003 Best Buy absorbed a substantial loss from the sale of Musicland which resulted in their poor performance. The industry average stayed around 5% for all five years. Best Buy outperformed the industry three out of the five years. In this span of time Circuit City never beat nor approached the industry average. RadioShack has a lower asset base in comparison to Best Buy and Circuit City but does 48

50 have strong income numbers, which gives them the strength to lead the industry in asset return. Return on Equity: Net Income/Owner s Equity Best Buy 21.73% 22.61% 3.63% 20.60% 22.12% Circuit City 6.83% 7.97% 3.45% -4.00% 2.97% RadioShack 21.42% 36.18% 36.57% 36.57% 45.35% A measure of a company s ability to provide returns on equity funding, is the return on equity ratio. This particular ratio indicates that for a dollar of owners equity there is about 22% return on that dollar. Best Buy s ROE has fluctuated over the past five years. In 2003 ROE dropped drastically (see Musicland) but they returned to their previous ROE in 2004 and Holding equity relatively steady and increasing net income was the primary source of the increase in the ROE for the past two successive years. Return on Equity 50.00% Output (percentage) 40.00% 30.00% 20.00% 10.00% 0.00% % BBY CC RSH Average Years In the cross sectional analysis graph above, RadioShack is outperforming the rest of the industry in ROE. Again their equity base is smaller in comparison to those of Best Buy and Circuit City but their management of income is strong, which increased their ROE in comparison to the industry. Circuit City remained below the industry average for all five years because of their inability to generate superior sales. Best Buy, with the exception of 2003, is holding strong with their ROE averaging about $.20 per dollar of equity. Best Buy has managed to stay competitive with the industry for four of the five years. 49

51 SGR Best Buy 57.72% 66.07% 10.86% 44.60% 45.76% The table above shows the Sustainable Growth Rate for Best Buy over the last five years. We ve found that the Sustainable Growth Rate for Best is unattainable and is inflated because of Best Buy s high Debt to Equity ratio. We project Best Buy s growth to be 15% over the next four years followed by 11% growth in the three years following that. The reason for such a nice growth rate is that the consumer electronics industry is experiencing a bit of boom with its flat panel television sales, and this boom should continue for the next four to six years. Profitability Analysis Opinion Gross Profit Margin Operating Expense Margin 20% 21% 24% 24% 24% Positive 16% 16% 20% 20% 16% Positive Net Profit Margin 3% 3%.47% 3% 4% Neutral Asset Turnover Negative Return On Assets 8.18% 7.74% 1.21% 7.73% 9.16% Slightly Positive Return On Equity 21.73% 22.61% 3.63% 20.60% 22.12% Slightly Positive Capital Structure Ratios: There are primarily two ways for a company to obtain resources to grow, internal or external financing. Internal financing entails using retained earnings to help expand their operations, typically these funds come from income generated from operations by the company. With external financing there are two additional forms of cash flow, equity financing and debt financing. A company may obtain financing through debt, 50

52 which could involve issuing bonds or through obtaining loans. These transaction amounts appear on the balance sheet under the liabilities section, typically classified as long term liabilities specifically bonds payable, and notes payables. The first ratio we will discuss will be the debt to equity ratio. It is a measure of how much equity exists within the company for each dollar of debt the company has incurred. Debt to equity ratio: total liabilities/ total owners equity Best Buy Circuit City RadioShack Best Buy averages about a 1.75 debt to equity ratio. This ratio indicates that for every dollar of equity they have $1.75 of liability financing. Best Buy reduces their overall debt to equity ratio by not capitalizing their operating leases which leads to a lower ratio. A decreasing trend in the Debt to Equity ratio indicates that Best Buy is trying to reduce liabilities in comparison to Owners Equity. Because of Best Buy s size they have the ability to borrow greater amounts of cash and finance more of their activities through loans. Best Buy has shown strong growth and to sustain that growth some debt financing is necessary but creditors don t seem to believe there is a threat for default. Debt to Equity 3.00 Output Years BBY CC RSH Average 51

53 Circuit City has the lowest average Debt to Equity ratio which indicates that they are financing their growth mostly through the issuance of stocks and bonds. Circuit City should be able to borrow money at a pretty low rate due mostly to their low ratio which indicates a low credit risk. Radio Shack is clearly the most leveraged of Best Buy s competitors and should be working toward lowering their Debt to Equity ration through more internal growth because any financing they might attain could have a very large interest rate attached. Times Interest Earned: Operating Income/ interest expense Best Buy Circuit City RadioShack Times Interest Earned is obtained by dividing Operating Income by Interest Expense. This ratio is used when determining a companies ability to repay its interest on borrowed money. Best Buy s ability to repay its interest has decreased from This is due mostly to its increased leverage. Times interest earned Output BBY CC RSH Average Years Circuit City s ability to repay interest has fluctuated greatly over the span of our analysis. Their ability to repay debt has shown great fluctuations because of their Operating Expense increases and decreases. RadioShack confirms the fact that they are overleveraged with a Times Interest Earned ratio of 7.23 which is the lowest in the industry. RadioShack has created most of its growth over the last few years by 52

54 borrowing large sums of money and increasing their leverage. It should be noted that RadioShack is the only company in the industry that shows what their liabilities would look like if they capitalized their operating leases. Debt Service margin: year1 Cash flow from operations/current portion of long term debt year Best Buy Circuit City RadioShack The Debt Service Margin measures the cash flow generating abilities of a company versus its current portion of notes payable. This ratio indicates whether a company can pay for the current portion of its long term debt with the cash flow generated by operations. We found that industry wide there is no trend and for each company we see a wide variation between the high and low ratios. Debt serivce margin Output Years BBY CC RSH Average Best Buy showed a difference of 1364 points between its highest and lowest ratio over the last five years. Circuit City showed a difference of 498 points between it s high and low ratios. RadioShack remained fairly steady with no major fluctuations. As indicated previously there is no way of obtaining a trend for either Best Buy or the industry. 53

55 Capital Structure Opinion Debt To Equity Neutral Times Interest Earned Debt Service Margin Positive No Trend Ratio Analysis with inclusion of $1.5 Billion as Capital Lease: With the inclusion of the $1.5 billion as a capital lease there would be differences amongst some of the ratios, not all ratios will be affected. The main ratios that will be affected are the current ratio; the quick ratio, the Debt to Equity ratio, and the Debt to Service Margin are the only ratios that will change. Current Ratio with $1.5B 3.50 Output BBY CC RSH Average Years As understandable the current ratio does decrease for the 2004 and 2005 fiscal years, in which the capital lease is entered into the balance sheet and does directly affect the current assets because it decreases the cash account and increases the current liability account because of the current portion of long term debt. It also affects the long term liabilities by way of the long term capital lease liability. However this does not affect any ratios, and was inserted for knowledge sake. 54

56 Quick Ratio with $1.5B Output Years BBY CC RSH Average The quick ratio does see a small drop as well in the 2004 and 2005 years. This ratio drops because the cash account which does have a somewhat strong influence on that quick assets as a total decreases because of payments for the capital lease which occur in 2004 and The debt to equity ratio increases by a small amount in the 2005 year from 1.41 to 1.47 because the amount of total debt does increase whereas the amount of equity did hold steady for that year. Another ratio that is affected by the accounting is the debt to service margin ratio. Debt To Equity Output Year BBY CC RSH Average The Debt to Equity Ratio increases with the addition of the $1.5 Billion by 4.5% from 1.41 to This increase points to Best Buy s reduction of debt to equity ratio by not capitalizing their operating leases which leads to a lower ratio. A decreasing trend in the Debt to Equity ratio indicates that Best Buy is trying to reduce liabilities in 55

57 comparison to Owners Equity. Because of Best Buy s size they have the ability to borrow greater amounts of cash and finance more of their activities through loans. Debt serivce margin Output Years BBY CC RSH Average The ratio made up by dividing the current portion of long term debt divided into the cash flow from operations. With the addition of the capital lease the CFFO increases because depreciation increases and is added back in to create the CFFO number. However the current portion of the long-term debt does not change because the payments for each subsequent year are included into the notes payable section which does not affect this ratio. Financial Statement Forecast Methodology Income Statement with Best Buy Information In preparing an accurate forecast, we first searched for trends over the past five years of Best Buy s financials. We projected that net sales will increase 15% from , then 11% from , and then 7% growth from We could not use Internal Growth Rates to support our growth because we do not believe the company will grow at twenty percent per year. We instead based our progression of decreasing growth for Best Buy based on the comparison of patterns noticed in both the past PC market boom to the current flat panel television market. Recent growth for the company has been driven by flat panel sales and we believe the market for these goods will gradually become saturated over the next ten years, much the same way the PC industry behaved. For the remainder of the income statement forecasts we used a 56

58 five year average (excluding outliers) to complete our forecast and used those percentages to obtain our bottom line. Balance Sheet with Best Buy Information The balance sheet forecast was done in the same method as the majority of our income statement. We took a five year average and used those rates over the entire ten year forecast. We computed our total assets forecast by taking an average of the previous five years net sales divided by total assets which came to 36.9%. We multiplied each year s net sales by this percentage and established our ten year forecast. Once we were able to forecast out total assets we then based all current and non-current assets (excluding cash and equivalents) as percentages of total assets. Liabilities and Debt were again handled in much the same manner. We took five year averages compared to total assets to arrive at our ten year forecasts. Total current liabilities were averaged to be 50.25% of total assets over the last 5 years and were used to obtain our forecast. Our total debt was calculated to be 8.5% of total assets, and total liabilities were found to be 60.64% of total assets. Statement of Cash Flows Statement of Cash Flows with Best Buy Information In order to forecast the items on the statement of cash flows we started with their average over the past five years. From there we grew that number at the same rate as net sales which were grown at 15% from , 11% from , and 7% from For example we took the average of depreciation over the past five years which was We grew that number at 15% for three years which came out to From there we grew it at 11% for the next three years which was That number was grown by 7% for the remaining three years which gave us We looked at and tried to forecast only the major items which were depreciation, deferred taxes, changes in working capital, and capital expenditures. We weren t able to forecast many of the items on the statement of cash flows because there was no apparent trend. 57

59 Income Statement Revised After the accounting distortion was corrected, it directly affected the interest expense. We estimated a reasonable interest rate of 5.4% on this capital lease, for the buildings covered under the lease. This increased the interest expense line item on the income statement which directly decreases net income amounts. This increase in interest expense will affect the subsequent year s forecasts directly affecting the net income lines for each year. When compared to the original forecasts with given Best Buy information, the net income lines from 2005 on are lower. However with the capitalized lease, we did decrease the operating expenses, since the building is now an asset as opposed to an operating lease item. Balance Sheet Revised With the restatement of the $1.5 billion as a capital lease, there are quite a few accounts within the balance sheet that are affected, which directly affect the total assets, and total liabilities and owners equity. When paying for the lease, we deducted the cash account from the current assets which does deduct the total on the total asset account. It also increased the capital lease assets which are part of the long term assets, again increasing the total assets accounts. All accounts that hamper the assets also have an equal weight on some liability or owners equity account. The liability accounts that were affected were both in the short term and long term liability accounts. The short term liability account that was affected was the notes payable/short term debt account which was increased in 2005 and each year after that. The long term liability account that was increased was the capital lease obligations account, which was increased by $ billion in 2005 and was reduced (depreciated) each year after that. Overall the total assets and liabilities increased in equal amounts and the appropriate accounts were increased. Statement of Cash Flows Revised Only two line items changed on the Statement of Cash Flows from the restating of the $1.5 Billion accounting distortion. The first line item to change was the Net 58

60 Income which came from the Income Statement and was discussed above. The other change is an increase each year in the depreciation of assets. The decrease in Net Income each year is partially offset each year by the increase in the depreciation rate. The Cash Flow from Operations start off higher in 2006 than in Best Buy s version but the Cash Flow s from Operations grow slower for the revised version so by the end of the forecast Best Buy s numbers are higher than the revised. This is due to the offsetting changes that the $1.5 Billion caused. Analysis and Forecasting Conclusion Now that we have forecasted the financials of Best Buy, we believe that they will continue to grow at a fast rate for a few more years then sales will flatten out. In an industry that is dominated by trends it is hard to predict when a boom will start or end. We believe that Best Buy has positioned itself to grow rapidly over the next few years and is in an industry that is suitable for rapid expansion. A large portion of the sales growth will be driven by the flat panel television market but it won t be the sole driver of sales in Best Buy s expansion since they will be opening many new locations and have recently signed a deal to sell Apple Computers. A major weakness in our analysis is that we do not know when the current cycle of growth will end and how much of a slowdown will be caused. The consumer electronic retail industry is very cyclical and fickle. Any industry that is driven by technology will always find a new star to carry on the mantle of success and drive revenues higher. 59

61 Valuations Analysis Cost of Capital There are several models that have been developed in the area of finance that derive prices that compare to the current market price of the share. In order to calculate outputs for these models, consistent inputs are necessary such as the cost of equity, the cost of debt and the Weighted Average Cost of Capital (WACC). Computations are necessary for the cost of equity and the cost of debt. Regressions using historical stock prices for 12, 24, 36, 48 and 60 months, were run with the monthly market return of the S&P 500 for those respective months with a risk free rate. In this case the risk free rate used was the 5 year Treasury bond, which we thought was appropriate because it had the highest explanatory power (adjusted r squared) in comparison to the other alternatives. When the regressions were complete, a beta was obtained based on the highest r squared output. The beta we selected had a value of 2.28 and an adjusted r squared of 21.50%, which was the highest of all the explanatory models. After having a definitive beta, it was carried over into the CAPM model, to obtain a clear value for the cost of equity. The cost of equity is an integral number for the firm, because it is considered to be the rate of return that keeps investors require for their investments. When a potential project is under consideration, the cost of equity is used as the discount rate. Even a zero net present value project will be accepted because it meets investors return standards. Ke = (.0357) The calculation of cost of debt was relatively simple and less involved in comparison to finding beta. All information needed was found on the balance sheet or in the management discussion and notes. Steps used for calculating the cost of debt were getting a total of current and long term liabilities, followed by getting a weighted average, and multiplying each item by its respective interest rate. 60

62 Total Kd Total Liabilities (Before Correction) % Total Liabilities (After Correction) % Weighted Average Cost of Capital (WACC) has two possible outcomes, one before tax and the other after tax. The after tax version is the number that was used in all our calculations because, it is a more accurate representation of the cost of capital because it takes into account the net tax effect since Best Buy pays taxes on their revenues. In the case of this particular project there are two WACC values because of, an accounting distortion, one valuation with the inappropriate accounting standards, and one that was calculated as it appears on Best Buy s financials. WACC = Ve/Vf (Ke) + Vd/Vf (Kd)(1-Tax rate) Before Correction=23202/29808 (.1246) /29808 (.0516)(1-.35)=10.64% After Correction=23202/31309(.1246) /31309(.05195)(1-.35)=10.8% Above is the formula for calculating WACC as evident when the accounting distortion is capitalized it will change the value of debt, hence changing the WACC. The value of WACC without the correction is 10.64% whereas with the correction the WACC is 10.8% which occurs because there is increased debt for Best Buy. Comparables Valuations In order to obtain a share price using the method of comparables you get an industry average excluding zeros and negatives. The method of comparables does not give you an accurate price per share because it takes the industry average using companies that may not be equivalent with the company to be valued. This will skew your price per share because the factors affecting other companies averages may not be affecting the company being evaluated. The method of comparables does not give you an accurate valuation but it is useful because it is quick and easy. In calculating the industry average we did not include Best Buy in the average calculation. 61

63 Method of Comparables PPS EPS BPS DPS BBY CC RSH n/a.25 Trailing Price/Earnings: BBY Industry CC BBY EPS 2.33 RSH 9.48 EST Share Price $ The Trailing P/E estimates the price to be $ This makes Best Buy undervalued at a current share price of $ We found these results by taking the price per share for that period and dividing by the Earnings per Share from the last period. Next you take the industry average and multiply it by Best Buy s Earnings per Share (EPS) to derive the estimated price per share. Forward Price/Earnings: BBY Industry CC BBY EPS 2.88 RSH EST Share Price $76.75 The Forward P/E estimates the price to be $ This makes Best Buy undervalued at a current share price of $ We found these results by taking the price per share for that period and dividing by the projected Earnings per Share for the next period. Next you take the industry average and multiply it by Best Buy s Earnings per Share to derive the estimated price per share. 62

64 Market/Book: BBY 4.87 Industry 2.19 CC 2.19 BBY BPS RSH n/a EST Share Price $23.43 The Market/Book ratio estimates the price to be $ This makes Best Buy current share price overvalued at $ Radio Shack has not come out with their K so we are unable to estimate Radio Shack s book value of equity. To derive these values we divided the price per share by the book value of equity per share. Next we took Best Buy s book value of equity per share and multiplied it by the industry average to find the estimated share price. Dividend/Price: BBY.005 Industry.009 CC.003 BBY DPS.26 RSH.015 EST Share Price $29.72 The Dividend/Price ratio estimates the price to be $ This makes Best Buy current share price overvalued at $ To find the share price we divided dividends per share by price per share to find the industry average. To get the price per share we divided Best Buy s dividends per share by the industry average to find the estimated share price. P.E.G Ratio: BBY Industry 9.95 CC BBY EPS 2.33 RSH 9.95 Growth Rate 15.92% EST Share Price $

65 The P.E.G ratio estimates the price to be $ This makes Best Buy current share price overvalued at $ We found the share price by taking the P/E ratio and dividing it by 1 minus the EPS growth rate. Then to get the estimated share price we multiply the industry average by 1 minus the EPS growth time Best Buy s EPS. Intrinsic Valuation Methods: Discounted Dividends Model The first model that will be discussed is the Discounted Dividends Model. The cost of equity is the discount rate that is used and the growth rate of the dividends is subtracted from the discount rate in the denominator. The dividend stream that is forecasted in our financials is what is used for the next ten years, and each of these values was discounted back with the appropriate present value factor for each year. For the tenth year we created a perpetuity value, because within this model we assume that dividends will continue indefinitely and this perpetuity is also discounted back to present value. Overvalued (>90%) $48.62 Undervalued (<110%)$59.42 Above is the sensitivity analysis which shows what type of price would be created when either the cost of equity or the growth rate are manipulated. Incase the cost of equity or the growth rate are wrong, it provides a way to show variation within our estimations by having a wide variance between our calculated cost of equity and other values around it. As visible from the above sensitivity analysis it is obvious that the Dividend Discount Model does not have that much of explanatory power for the market price that is derived from the forecasting of dividends. 64

66 Discounted Dividends Model Revised With the correction to the accounting error, there is a direct implication towards the dividend pay out from the firm. Since the real meaning of the valuation is based on the dividend payout on a yearly basis, it is clear that the effect will be felt throughout the entire discounted dividend model. The dividend payout ratio decreased in comparison to the original unrevised number, which directly decreased the value derived for this valuation. Overvalued (>90%) $48.62 Undervalued (<110%)$59.42 The only difference with this sensitivity analysis in comparison to the sensitivity analysis above is that these numbers are computed using the revised accounting standards that were applied by this group. Even with these new accounting standards it is clearly evident that Best Buy is over valued. However before any conclusions are drawn, it is imperative to recall as stated above that the explanatory power for the discounted dividends is the weakest of all the intrinsic valuation models. Discounted Free Cash Flows The discount rate that is used in this model, unlike the previous Discounted Dividends Model, is the WACC. The WACC, as mentioned above, before the correction is 10.64%. As the name implies the free cash flows are calculated by subtracting the cash flow from investment from the cash flow from operations (CFFO-CFFI). This subtraction is carried for nine of the forecasted years and discounted by 1/(1+WACC) t, where t is the year number in the forecast. The next calculation is the perpetuity which is also discounted back to the present date. Upon the completion of these listed computations, the sum of all the present values is taken and added to the present value of the firm which will enable us to find the value of the firm. The value of the debt is 65

67 extracted directly from the 10-K of the company. Next subtract the value of debt from the value of the firm to get the value of equity. The value of equity is then divided by the number of shares outstanding to get it to a per share basis. Overvalued (>90%) $48.62 Undervalued (<110%)$59.42 The sensitivity analysis for the discounted free cash flows with the normal set of numbers shows that the discounted free cash flows is better at explaining the current market prices that Best Buy s stock is trading at. With the FCF model there is an explanatory power that ranges from 5%-40%. As visible with a higher WACC there is a decreasing market price that is computed as the output. With an increasing growth rate and the WACC held constant it is evident again that the computed price increases. The closest price to the observed price of Best Buy on November 1, 2006 $54.02 occurs through the sensitivity analysis when the WACC is at a value of 8% and the growth rate is at between 0% and 1%. Discounted Free Cash Flows Revised With the differences in the WACC created by the accounting revisions the WACC changes to 10.8%. With the difference in the WACC there will a visible amount of variation because of the discount factor. However with the new CFFO numbers there will be another deviation between the previous discounted free cash flows model and the current one. With this variance there will be a somewhat drastic difference in the final outcomes for the price. 66

68 There appears to be no clear trend between the difference in the sensitivity analysis computed with the revised set of numbers and those with their original set of numbers. The computed numbers are not necessarily smaller than the previous analysis valuation. The only clear trend that we can be sure of is that with an increasing cost of capital (WACC) and a constant growth rate, the prices keep decreasing when going left (following the path of the trend described). Abnormal Earnings Growth This intrinsic valuation method is also heavily based on the dividends paid out and the expected earning per share. The core dividend per share is multiplied by the Ke, and added to the earning per share for the next year. The core earning per share is then multiplied by (1+ Ke), at which time a determination is made as to whether the company has created, maintained or destroyed value. In order the maintain value the difference between cumulative dividends earning and normal earnings should be zero. If value is destroyed then the value attained after subtraction is negative. If value is created by the firm the difference between these numbers is positive. Overvalued (>90%) $48.62 Undervalued (<110%)$59.42 Unlike the FCF model for the AEG, the cost of equity is again used in the discount factor instead of the WACC. With this sensitivity analysis one can see the closest price obtained with the cost of equity of 12.46% was at the growth rate of.05. The price at that point was $25.97 with that cost of equity. However with a lower cost of equity the denominator decreases which increased the price derived from the model. When you look at the prices for lower costs of equity you will notice the higher numbers. 67

69 Abnormal Earnings Growth Revised With the correction of the accounting distortion, there was a direct effect to the dividends per share and the company s earning per share; effectively decreasing both values because of increased expenses on the income statement and increased liabilities and depreciation on the balance sheet. The values with the proper accounting procedures in place will decrease the EPS and the DPS which overall will decrease the value of the outputs given. Overvalued (>90%) $48.62 Undervalued (<110%)$59.42 There is a difference between the revised model for the AEG and the normal model. Even though there are similar numbers used for the cost of capital and the growth rate the dividends per share and the earnings per share create a difference. Both of the DPS and the EPS are lower in the revised model than in the original model. When calculated this gives us numbers that are less than the sensitivity analysis above. If we had a cost of equity around 8% then we would state that the stock price for the Best Buy was overpriced. However, with a greater cost of equity at around 12.5% it is evident that Best Buy is severely overvalued. The growth rate changes do not drastically affect the model with the cost of equity being held constant. Residual Income Like the discounted dividends model and the abnormal earnings growth model, the Residual Income model uses the cost of capital as it is discount rate when present values are needed. In the residual income valuation the formula expressed in words reads: the book value of equity is added to the net income, followed by a subtracting out of the dividends paid which is provides an ending value of equity for that year. The ending value of equity for the previous year carries over and becomes the beginning book value of equity for the next year. Next comes the calculation of the Normal income 68

70 which is done by multiplying the beginning book value of equity by the discount rate. The residual income is calculated from using having the net income above and subtracting it from the normal income. From there we derive a value for the perpetuity created from the 10 th year s residual income, which is then carried out forever and discounted back to the current year s price with the present value factor. Overvalued (>90%) $48.62 Undervalued (<110%)$59.42 With the cost of equity we calculated the closest price to the stock price on November 1 st, is with a growth rate of 0. Especially with decreases in the cost of equity, we see the price calculated increases dramatically; however with the increase in the growth rate with a smaller cost of equity; the numbers turn out to be negative because there is a negative value in the denominator of the model. Hence when the positive numerator is divided by a negative denominator, a negative result is obtained. Residual Income Revised When computing the respective values for the residual income model with a correction for an accounting distortion the valuation changes drastically. When calculating residual income with the revised numbers the residual income is actually positive because when the normal earnings are subtracted from the earnings per share the number generated is smaller. The EPS with the revised numbers are smaller than the numbers taken directly from Best Buy s financials. With a small residual income number the discounted value for the current year is obviously smaller, which directly leads to a smaller estimated price per share. This again points to the fact that Best Buy s stock is overvalued. 69

71 Overvalued (>90%) $48.62 Undervalued (<110%)$59.42 This output is significantly smaller than the model above with the original numbers, with the accounting correction we see that the CFFO decreases. With this decrease the numbers that are obtained from this sensitivity analysis are going to be smaller. However the overall pattern still sustains, with a cost of equity of 12.46% at any growth rate, it is obvious that Best Buy is extremely overvalued. However with a smaller cost of equity the values indicate that the company is heavily undervalued. This is because these smaller numbers are used in the discount factors, which create much smaller discount values so when multiplied they create a larger value for a present value. Long Run ROE Perpetuity The long run ROE perpetuity is yet another method that can be used to intrinsically value a company. The formula for the long run ROE perpetuity is: = BVE 0 + BVE 0 ( ROE Ke) / (Ke - G)) As visible from the formula above variations in value derived from the model can be directly related to the book value of equity or differences in the ROE or cost of equity and or the growth rate. With the numbers directly forecasted from Best Buy financials with the accounting error the book value of equity and the EPS change which is calculated through the use of the ROE. The value derived for growth is derived directly from the changes in book value of equity for a year to year basis. In our case while doing the forecast financials our growth rate for the book value of equity was relatively large, hence creating a larger growth rate than cost of equity and giving us some negative results. 70

72 Overvalued (>90%) $48.62 Undervalued (<110%)$59.42 The long run return on equity perpetuity can be manipulated with three variables, those being the cost of equity, the growth rate, and the average return on equity. Due to the many ways there are to value the company we performed three sensitivity analyses. In each of them there is a variation between the cost of equity, the growth rate or the average return on equity. The first two are primarily negative because if the growth rate is lower than the cost of equity this again creates a negative denominator which will return a value that is negative. Or the numerator is negative with the cost of equity being greater than the return on assets which again will create a negative output, unless the denominator is negative as well. Long Run ROE Perpetuity Revised As with all the revised intrinsic valuations above, all numbers derived from our set of forecast financials with the revised numbers creates a lower number for book value of equity for each passing year. With these lower numbers for the book value of equity, even the growth rate changes making it smaller. Due to the decrease in the book value of equity and the direct decrease in the growth rate, the return on equity to 71

73 decreases. With this decrease in the return on equity it is possible to attain a higher value for the intrinsic value of the stock. Overvalued (>90%) $48.62 Undervalued (<110%)$59.42 As listed above the any of the three variables can be manipulated when conducting sensitivity analysis. Depending on the changes in either of the variables whether it be the return on equity, the cost of equity or the growth rate, all have a distinct impact on the output of the number. This model will have large fluctuations whenever one of the three factors is manipulated to give an accurate calculation for the appropriate numbers. Altman Z- Score Credit analysis The Altman Z-score is an original method that has been extensively used by major financial institutions and investment houses to evaluate the credit worthiness of companies. The formula consists of weights given to items that are directly extracted from the either the balance sheet or the income statement. The formula for the Z-Score is listed below: 72

74 Z-Score = 1.2(Working Capital/Total Assets) + 1.4(Retained Earnings/Total Assets) + 3.3(Earnings before Interest and Taxes/Total Assets) +.6(Market Value of Equity/Book Value of Debt) + 1.0(Sales/Total Assets) As the formula above indicates, there are weights assigned to the various ratios that will be calculated with the respective numbers. The highest weight of, 3.3 is given to the ratio of EBIT/Total Assets, which is a measure of how much operating income is being generated by the total assets. This is an example of where the numbers come from; the EBIT comes from the income statement where as the total assets from the balance sheet. The Z-scores for Best Buy without the revision made to the accounting error is 3.7. This high number is indicative of very healthy credit ability for Best Buy. Companies are thought of as being credit worthy as long as the score is above 2.6. As understood the cost of debt is directly related to the z-score calculated by financial institutions, because a score lower than 1.6 indicates unhealthy credit standing. A score ranging from indicates a company with some credit problems; hence any loans granted will be given at a higher interest premium. After the accounting revision the z-score decreased substantially to 2.99, which is still a healthy number. Overall the credit rating of Best Buy even when looking at the revised number is a relatively strong number, enabling them to attain debt/loans at a relatively cheap rate. Valuation Conclusion: After using numerous models to calculate the value for Best Buy we can confidently say the company is overvalued. All of our models showed different degrees of Best Buy being overvalued. We found misleading accounting methods which altered our valuations. To deal with this we ran two separate valuation models, one with the given information, and one with the revised financials. The model which gave the lowest value for the company was the Dividends Discount Model, which found the value for the company to be $4.58. The model showing the highest value for the company was the Free Cash Flows Model. It gave a value of $ After revising our 73

75 statements to account for the deceptive disclosure the new valuation numbers were $2.41 in the Discounting Dividend model and $31.21 for the Free Cash Flows. This shows that the failure to disclose their capital leases did in fact lower their share value. Because the value given by the Discounted Dividends model is entirely too low we have rejected it as a true representation of the value. The other models we used were the Abnormal Earnings Growth which found the value to be $25.76, and $19.21 with the revisions. The Residual Income model gave a similar value of $22.41, and $ The final valuation method we used was the Long Run Return on Equity model which gave us numbers that were once again too low to consider as truth. It derived the value of the company at $7.72, and $8.12 with the revisions. We can confidently say that the true value of Best Buy Stock is definitely under $ This is even more apparent when we take into consideration the misleading accounting procedures performed by Best Buy. It takes the value of the company even lower. We found that the unrevised average stock value for Best Buy is $27.69 after disregarding the Long ROE and Discounted Dividends. With the revised numbers the Best Buy average value for stock was $18.99 which is clearly indicative of the additional $1.5 Billion of capitalized leases. We can therefore positively assess the firm as over valued. 74

76 Appendix 1 Screening Ratios Sales/Cash from Sales BBY CC RSH Sales/Net Accounts Receivable BBY CC RSH sales/inventory BBY CC RSH sales/assets BBY CC RSH NA NA NA NA NA 2.31 cffo/oi BBY CC RSH NA NA NA NA NA 1.04 cffo/noa BBY CC RSH NA NA

77 Appendix 2 Core Financial Ratios 76

78 Appendix 3 Pro Forma Financial Statements 77

79 78

80 79

81 80

82 81

83 Appendix 4 Pro Forma Financial Statements (Revised) 82

84 83

85 84

86 85

87 Revised 86

88 Appendix 5 Cost of Capital 87

89 3 Month Regression 88

90 1 Year Regression 89

91 5 Year Regression 90

92 10 Year Regression 91

93 92

94 Weighted Average Cost of Debt (Unrevised) Weighted Average Cost of Debt (Revised) 93

95 Weighted Average Cost of Capital (Unrevised) Weighted Average Cost of Capital (Revised) 94

96 Appendix 6 Method of Comparables 95

97 Appendix 7 Valuation Models (Unrevised) Discounted Dividends (Unrevised) 96

98 Free Cash Flows (Unrevised) 97

99 Residual Income (Unrevised) 98

100 Long Run Return on Equity (Unrevised) 99

101 Abnormal Earnings Growth (Unrevised) 100

102 Appendix 8 Valuation Models (Revised) Discounted Dividends (Revised) 101

103 Free Cash Flows (Revised) 102

104 Residual Income (Revised) 103

105 Long Run Return on Equity Perpetuity (Revised) 104

106 Abnormal Earnings Growth (Revised) 105

107 Appendix 9 Altman Z-Score Unrevised Revised Z-Score = 1.2(Working Capital/Total Assets)+1.4(Retained Earnings/Total Assets)+ 3.3 (Earnings Before Interest and Taxes/Total Assets) + 0.6(Market Value of Equity/Book Value of Liabilities) + 1(Sales/Total Assets) 106

108 References 1.) Best Buy Website: 2.) Circuit City Website: 3.) Radio Shack Website: 4.) Wal Mart Website: 5.) Yahoo Finance: 6.) Google Finance: 7.) Palepu, Healy and Bernard, Business Analysis and Valuation (Ohio: Thomson- Southwestern, 3 rd Edition, 2004) 8.) Best Buy 2 nd Quarter Fiscal Year 2007 (Qtr End 08/26/06) Earnings Call Transcript (BBY): 9.) Edgar Scan, PWC: 10.) St. Louis Federal Reserve Interest Rate Data: Excelsior! 107